Saturday, January 06, 2007

When In Doubt, Raise the Reserves

China has decided to try to curb inflation (or shall we say more inflation) by requiring that banks hold a higher amount of reserves. (Source)

prison_high_jump
[Thanks to reefsanctuary.com and Witfull for this photo.]

You see, they have so many dollars and dollar instruments already in their collective accounts that there would be excessive credit expansion without someone intervening.

Mind you, there wouldn't be need of this intervention if they hadn't intervened in the dollar/yuan exchange rate already. (See this post for an explanation of Chinese pegging.)

The Chinese have been accumulating dollars and dollar instruments at a rate that is inconsistent with international trading and monetary practices; but they have been doing it anyway, and in spite of much international mock-frowning. They must park the stuff somewhere, so they park it in their bank reserves. Then, because banks' whole purpose in life is to create credit, and because they do this on what is called a reserve banking system, this means that for every $100 or 100 yuan they hold as deposits, they can create 900 more, making a total of $1,000 or 1,000 yuan worth of liabilities (assuming that they, like us, have a 10% reserve requirement. In fact, they're at 9.5% now.)

They have already lifted the reserve requirement three times last year to help alleviate the problem of excess credit (or, more appropriately, excess excess credit), and now they have to do it again.

Why can't they just stop intervening in the dollar/yuan exchange rate and let things work themselves out? Well, this is a long story that I have delved into at the above-mentioned link, and here.

1 Comments:

Blogger Nicolaas Smith said...

Non-monetary inflation can be stopped.

"People today use the term `inflation' to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise." Ludwig von Mises - "Inflation: An Unworkable Fiscal Policy".

All prices do not rise. Only the prices of variable real value non-monetary items while many constant real value non-monetary items are not fully updated and many are not updated at all.

The second inevitable consequence of inflation is the tendency of many constant real value non-monetary items NOT to rise at all - during the Historical Cost era while some constant real value non-monetary items are not fully updated.

Inflation today has and always had a second consequence during the 700 year old Historical Cost era.

Inflation has a monetary consequence, called cash inflation refered to above by Ludwig von Mises and defined as the economic process that results in the destruction of real economic value in depreciating money and depreciating monetary values over time as indicated by the change in the Consumer Price Index.

Inflation´s second consequence is a non-monetary consequence defined as Historical Cost Accounting inflation which is always and everywhere the destruction of real economic value in constant real value non-monetary items not fully or never updated (increased) over time due to the use of the Historical Cost Accounting model or any other accounting model which does not allow the continuous updating (increasing) in constant real value non-monetary items in an economy subject to cash inflation.

Inflation´s second consequence is solely caused by the global stable measuring unit assumption.

The stable measuring unit assumption means that we regard the annual destruction of a portion of the real value of our monetary unit by cash inflation in low inflation economies as of not sufficient importance to update the real values of constant real value non-monetary items in our financial statements.

This results in the destruction of at least $31bn in the real value of Dow companies´ Retained Income balances each and every year. Globally this value probably reaches in excess of $200bn per annum for the real value thus destroyed in all companies´ Retained Income balances.

The International Accounting Standards Board recognizes two economic items:

1) Monetary items: money held and "items to be received or paid in money" – in terms of the IASB definition.

2) Non-monetary items: All items that are not monetary items.

Non-monetary items include variable real value non-monetary items valued, for example, at fair value, market value, present value, net realizable value or recoverable value.

Historical Cost items valued at cost in terms of the stable measuring unit assumption are also included in non-monetary items. This makes these HC items, unfortunately, equal to monetary items in the case of companies´ Retained Income balances and the issued share capital values of companies without well located and well maintained land and/or buildings or without other variable real value non-monetary items able to be revalued at least equal to the original real value of each contribution of issued share capital.

The stable measuring unit assumption thus allows the IASB and the Financial Accounting Standards Board to conveniently side-step the split between variable and constant real value non-monetary items. This is a very costly mistake in low cash inflation economies - or 99.9% of the world economy.

Retained Income is a constant real value non-monetary item, but, it has been in the past and is, for now, valued at Historical Cost which makes it, very logically, subject to the destruction of its real value by cash inflation in low inflation economies - just like in cash.

It is an undeniable fact that the functional currency's internal real value is constantly being destroyed by cash inflation in the case of low inflation economies, but this is considered as of not sufficient importance to adjust the real values of constant real value non-monetary items in the financial statements – the universal stable measuring unit assumption which is the cornerstone of the Historical Cost Accounting model.

The combination of the implementation of the stable measuring unit assumption and low inflation is thus indirectly responsible for the destruction of the real value of Retained Income equal to the annual average value of Retained Income times the average annual rate of inflation. This value is easy to calculate in the case of each and very company in the world with Retained Income for any given period.

Everybody agrees that the destruction of the internal real value of the monetary unit of account is a very important matter and that cash inflation thus destroys the real value of all variable real value non-monetary items when they are not valued at fair value, market value, present value, net realizable value or recoverable value.

But, everybody suddenly agrees, in the same breath, that for the purpose of valuing Retained Income – a constant real value non-monetary item – the change in the real value of money is regarded as of not sufficient importance to update the real value of Retained Income in the financial statements. Everybody suddenly then agrees to destroy hundreds of billions of Dollars in real value in all companies´ Retained Income balances all around the world.

Yes, inflation is very important! All central banks and thousands of economists and commentators spend huge amounts of time on the matter. Thousands of books are available on the matter. Financial newspapers and economics journals devote thousands of columns to the discussion of the fight against inflation.

But, when it comes to constant real value non-monetary items:

No sir, inflation is not important! We happily destroy hundreds of billions of Dollars in Retained Income real value year after year after year.

However, when you are operating in an economy with hyperinflation, then we all agree that, yes sir, you have to update everything in terms of International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies: Variable and constant real value non-monetary items.

But ONLY as long as your annual inflation rate has been 26% for three years in a row adding up to 100% - the rate required for the implementation of IAS 29. Once you are not in hyperinflation anymore (for example, Turkey from 2005 onwards), then, with an annual inflation rate anywhere from 2% to 20% for as many years as you want, you are prohibited from updating constant real value non-monetary items. Then you are forced by the FASB´s US GAAP and the IASB´s International Accounting Standards and International Financial Reporting Standards to destroy their value again – at 2% to 20% per annum - as applicable!

For example:

Shareholder value permanently destroyed by the implementation of the Historical Cost Accounting model in Exxon Mobil’s accounting of their Retained Income during 2005 exceeded $4.7bn for the first time. This compares to the $4.5bn shareholder real value permanently destroyed in 2004 in this manner. (Dec 2005 values).

The application by BP, the global energy and petrochemical company, of the stable measuring unit assumption in the accounting of their Retained Income resulted in the destruction of at least $1.3bn of shareholder value during 2005. (Dec 2005 values).

Royal Dutch Shell Plc, a global group of energy and petrochemical companies, permanently destroyed $2.974 billion of shareholder value during 2005 as a result of their implementation of the stable measuring unit assumption in the valuation of their Retained Income. (Dec 2005 values).

Revoking the stable measuring unit assumption is actually allowed this very moment by IAS 29 but ONLY for companies in hyperinflationary economies. At 26% per annum for three years in a row, yes! At any lower rate, no!

It is prohibited by US GAAP and IASB International Standards for companies that are operating in a low inflation economy.

That means the following at this very moment in time: Today all companies in, most probably, only Zimbabwe (1000% inflation) are allowed to update all their variable real value non-monetary items as well as all their constant real value non-monetary items.

But not the rest of the world.

The rest of the world is forced by current US GAAP and IASB International Standards to destroy their/our Retained Income balances each and every year at the rate of inflation because of the implementation of the stable measuring unit assumption whereby we are all forced to regard the change in the value of the unit of account - our low inflation currencies - as of not sufficient importance to update the real values of constant real value non-monetary items in our financial statements.

We are forced to destroy them year after year at the rate of inflation till they will reach zero real value as in the case of Retained Income and the issued share capital values of all companies with no well located and well maintained land and/or buildings at least equal to the original real value of each contribution of issued share capital.

The 30 Dow companies destroy at least $31bn annually in the real value of their Retained Income balances as a result of the implementation of the stable measuring unit assumption. Every single year.

Retained Income can be paid out to shareholders as dividens. Poor Dow company shareholders. They will never see that $31bn of dividens destroyed each and every year.

We have all been doing this for the last 700 years: from around the year 1300 when the double entry accounting model was perfected in Venice.

When we do this at the rate of 2% inflation ("price stability" as per the European Central Bank and as per Mr Trichet, the president of the ECB) we are forced to destroy 51% of the real value of the Retained Income balances in all companies operating in the European Monetary Union over the next 35 years - when that Retained Income remains in the companies for the 35 years - all else except cash inflation being equal.

Each and every one of those 35 years will be classified as a year of "price stability" by the ECB and Mr Trichet. Mr Trichet will not be the president of the ECB in 35 years time.

I think we will do ourselves a great favour by revoking the stable measuring unit assumption as soon as possible.

FREE DOWNLOAD : You can download the book "RealValueAccounting.Com - The next step in our fundamental model of accounting." on the Social Science Research Network (SSRN) at http://ssrn.com/abstract=946775




--------------------

Nicolaas J Smith
http://www.realvalueaccounting.com/

9:48 AM  

Post a Comment

Links to this post:

Create a Link

<< Home