Premises and Promises of Theory Formation in Economics

Premises and Promisesof Theory Formation in Economics ao.Univ.Prof. Dr. Franz Hörmann University of Economics and Business Administration, Vienna http://www.franzhoermann.com http://www.antibilanz.info

Introduction Franz Hörmann franz.hoermann@wu-wien.ac.at Department for Accounting and Tax Management University of Economics and Business Administration, Vienna Fellow at University Linz Main Field of Research: Accounting Information Systems & Knowledge Management

Contents • Why (Macro- & Micro-)Economics? • Use and Abuse of Science (Scientific Whistle-Blowing) • From the Hidden Premises to the Economical Nonseum • What Can (Must) Scientists Do? • Some Visions, Not Too Far

Why (Macro- & Micro-)Economics? Why (Macro- & Micro-) Economics?

Why (Macro- & Micro-)Economics?

Why (Macro- & Micro-)Economics? • The utmost Goal of Economics: • The Optimal Use of Scarce Resources • „Optimal Use“  Mathematical Methods (Optimization) • „Scarce Resources“  Tangible Assets, Raw Materials etc.

Why (Macro- & Micro-)Economics? • Optimal Use • The „Optimal Use“ is already known beforehand, it can only be ONE use (the „optimal“), all future production methods, future demands, future possible uses etc. must already be known (otherwise: what would a „temporary optimality criterion“ be good for?).

Why (Macro- & Micro-)Economics? • Optimal Use • Using mathematical models (Equations)  up pops the „market equilibrium“ (what else can we find, if we describe everything using equations?!) • Measurement of optimality: Numbers (monetary values, money = measure … what‘s the value of money itself??)  Numeromania (temperature, stock rates, news reports, sports news…?)

Why (Macro- & Micro-)Economics? • Scarce Resources • They are „scarce by definition“ (finite quantities at hand but potential infinite demands for in the future): Natural Resources, Production Plants, Money, … •  Scarcity = Measure of Value (Manipulation!)

Why (Macro- & Micro-)Economics? • Scarce Resources • But: Limited Resources (Supply) & possibly unlimited Demand gives us a „Scientific Rationale for War“ (Warfare by „the Laws of Nature“) • Economics  Bunch of Zero-Sum Games (only by the magical power of words, some thoughtless definitions) • The „Limits of Growth“ apply!

Why (Macro- & Micro-)Economics? • Alternative View • The Goal of Economics: • To Promote Human Evolution (mental, social, …) by supporting individual development • EVOLUTIONARY ECONOMICS • Growth: in knowledge, skills, understanding, empathy, … in mental and spiritual areas unlimited growth is possible  no „scarcity of resources“, no „reasons“ for war!

Why (Macro- & Micro-)Economics? • Alternative View • How do we Measure Success (do we need some numbers)? • For meaningful measurement the final goal must already be known in advance (length, weight, temperature… we know, why we measure them, because some causality is implied). • But: what‘s the final goal of Human Evolution? •  only if we can answer this question, mathematical measurement makes sense!

Why (Macro- & Micro-)Economics? • Alternative View • We (Humans) are the Products of our own Evolution (we can only mistrust and restrain or trust and further, but never „measure“ it). • Evolution has given us all the necessary decision tools we need to succeed on our way: (pleasant and unpleasant) Feelings • Behavioral Finance, Behavioral Economics, … why so late?

Use and Abuse of Science Use and Abuse of Science

Use and Abuse of Science • The Use of Science • Innovation, Solution of Problems for Society, Discovery of new Knowledge, … • „Definition“ of Science • … what scientists do (= the biography of a scientist)

Use and Abuse of Science • The Abuse of Science • Personal Wealth, Fame, Support of Lobbies and Political Parties to gain or sustain Power • To keep the Business Models of powerful Professions going (Stock Exchanges, Investment Banks, CPAs, …). • (ever wondered, why tax laws are so overly complicated and why the new members of the EU – the former communist countries – are the first ones to implement a Flat Tax system…?)

Use and Abuse of Science • The Abuse of Science • „Publish or Perish“: Quantity instead of Quality in all-important Journals (quantitative measurement of science!) • Science = Earn your living as a scientist = write (many) articles in prominent journals  get famous  get rich (by publishing sensational discoveries… using some statistical tricks, e.g., again faked numbers!) • Management BY the Numbers  Management OF the Numbers

Use and Abuse of Science • The Abuse of Science • Management Consultants sell Methods (Formulas) for Controlling Corporations (Financial Management  Formulas containing monetary numbers, Shareholder Value, e.g. = symbolic services) • The rising importance of Shareholder Value („Value Orientation“) leads to dominance of pseudo-scientific formulas in our economies

From the Hidden Premises to the Economical Nonseum From the Hidden Premises to the Economical Nonseum

From the Hidden Premises to the Economical Nonseum • Hidden Premises • Implicit assumptions (mental models, e.g.) that shape structure and/or meaning of the models • Nonseum • Kind of museum of nonsensical artefacts • If fundamental premises of models remain implicit, those models are endangered of degeneration to nonsensical artefacts

From the Hidden Premises to the Economical Nonseum • Some Hidden Premises • Homo Oeconomicus: the decision maker is simplified to become an algorithm • If this would be possible, our mathematical methods would apply (kind of wishful thinking) • Financial Statements • a) Financial Statements don‘t report (any kind of) reality but they are the result of application of reporting standards (US-GAAP, IFRS, national laws etc.) • What kind of economical reality can we describe, if we follow normative rules (regarding structure as well as valuation of financial statement items) – „True and Fair View“?

From the Hidden Premises to the Economical Nonseum – Financial Statements • b) Financial Statements (FS) are always outdated (closing the books, preparation, auditing, publishing) • c) FS show the liquidation value of the corporation (and not the value of the „going concern“!) „… corporations are not normally run to be liquidated!“ (Peter Drucker) – The valuation of single items and the premise of „going concern“ are a contradiction! But: what‘s the value of the „going concern“? Is business valuation (shareholder value) an answer?

From the Hidden Premises to the Economical Nonseum – Financial Statements • d) Valuation of single balance sheet items isn‘t any „measurement method“: • measurement: always the same rule is applied (length, temperature etc.) • balance sheet items: many different valuation rules (comparable??) • e) Fair Values (market values) for long lived assets are meaningless! Market values have only some (very limited) meaning for retail goods or finished products – never for buildings, plants, etc.

From the Hidden Premises to the Economical Nonseum – Financial Statements • f) Who wants to „compare“ companies using financial statements? • American Institute of Certified Public Accountants (AICPA): nobody! • „Research shows investors, creditors and company executives in fact don’t use financial statements as their primary decision-making tool.“ (http://www.aicpa.org/pubs/jofa/jun2005/anderson.htm) • Outsiders („external investors“) without knowledge of the company and it‘s business model = speculators • They are the only ones who could benefit from a „comparable international reporting standard“.

From the Hidden Premises to the Economical Nonseum – Financial Statements • The AICPA already knows, that the FS-model isn‘t useful for their clients any more: • 1991: Jenkins Report (A Customer Focus - http://accounting.rutgers.edu/raw/aicpa/business/main.htm) • 1997: CPAVision Project (2011 and beyond – financial statement preparation and auditing as business model already missing – consulting as new primary business focus for CPAs - http://www.cpavision.org/) • 2005: Enhanced Business Reporting Consortium („… will improve information quality, integrity and transparency… subject to reasonable limits for commercially sensitive information.“ - http://www.aicpa.org/pubs/jofa/jun2005/anderson.htmhttp://www.ebr360.org/) The founding members: AICPA, Grant Thornton LLP, Microsoft, PricewaterhouseCoopers LLP

From the Hidden Premises to the Economical Nonseum – Financial Statements • When part of the CPA profession deserted to managment consulting and 30% less students took accounting as a major at US-Universities: up popped the so-called „financial reporting scandals“ (ENRON, WorldCom, …) • "Lynn Turner, who was the chief accountant at the SEC in the late 1990s, has described very plainly what goes on behind the scenes. Turner abhors the games that accountants play, but he nevertheless knows the world where they go on: for years he was a partner at one of the major auditing firms, and he has also served as chief financial officer of an international manufacturer of computer products. In spring 2002 Turner was interviewed on a nationally televised program about the accounting scandals being uncovered. ... The interviewer asked him (in italics below with his response following):

From the Hidden Premises to the Economical Nonseum – Financial Statements • What kind of things were being done when you were working on Wall Street for an accounting firm?"All of the Big Five accounting firms have a group of accountants kind of like a financial services group, and that group of accountants works with Wall Street. In my prior life, we acutally had a retainer arrangement with each of the major Wall Street investment banking firms under which we would help them financially engineer or structure hypothetical transactions for finding financing, keeping it off balance sheet, making companies look better than, quite frankly, they really were."

From the Hidden Premises to the Economical Nonseum – Financial Statements • You mean doing the kinds of things that Enron and Andersen did?"Yes. Exactly."So there's a whole system that does this?"A system that turns around and does it. Without a doubt."And all of the big accounting firms have that?"Yes. Every one of the big accounting firms has such a group...."So, in Enron, we haven't just stumbled into something that may have happened. We've run into something that is a fairly common practice?"This is day-to-day business operations in accounting firms and on Wall Street. There is nothing extraordinary, nothing unusual in that respect with respect to Enron." • D. Quinn Mills ("Wheel, Deal, and Steal - Deceptive Accounting, Deceitful CEOs, and Ineffective Reforms", 2003, pp. 84)

From the Hidden Premises to the Economical Nonseum – Financial Statements • g) Private Standard Setting doesn‘t work: „As harsh as it might seem, we think that essentially the only message today's auditors send to users is that they should consider the financial statements to be essentially useless because they comply with politically derived accounting principles." • Miller/Bahnson ("Quality Financial Reporting", 2002, p. 50)

From the Hidden Premises to the Economical Nonseum – Financial Statements • h) Private Standard Setting = Market Inefficiency (overregulating the Market of Company Information) • Alternative View • Investors and Corporations should be enabled to negotiate freely the kinds and methods of information flows between them (including communication technology) = Contract Based Capital Market Communication. • Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) hinder the evolution of communication methods (like in the Soviet aera of total economical planning!)

From the Hidden Premises to the Economical Nonseum – Investment Theory • Net Present Value • Discounting future cash flows to make them „comparable“ with the cash flows in t0 (the moment of decision). • But: future cash flows (in t1, t2, … tn) are no cash flows at all! They are planned, promised, negotiated, contracted, … but no REAL cash flows (categorization error!). • And: the formulas of financial mathematics are plain mathematics – nothing economical can ever be found in them (equations of a higher degree)! • Using the same formula (NPV, SHV e.g.) for different corporations  the result tells us only something about the mathematical relations and NOTHING about economic causes (customers, competitors, employees, … don‘t exist!).

From the Hidden Premises to the Economical Nonseum – Investment Theory

From the Hidden Premises to the Economical Nonseum – Investment Theory • Internal Rate of Return • It‘s a simple mathematical formula with no possibility of any meaningful economical interpretation! • Net Present Value • To calculate NPV the knowledge of all future cash flows AND the expected life of the investment object MUST BE KNOWN IN ADVANCE. Otherwise: only rough estimations but no exakt „calculations“ are possible!

From the Hidden Premises to the Economical Nonseum – Investment Theory • Why calculate (demand, negotiate) compound interest at all? • Compound interest: a mathematical (pseudo-scientific) method to make even more money out of some money. It‘s a matter of culture (religion) and NOT OF SCIENCE (islamic countries: no compound interests are used, Martin Luther: puts usurers on a level with robbers and murderers – usury: to demand any kind of interest, not only exorbitantly high rates!).

From the Hidden Premises to the Economical Nonseum – Investment Theory • Why is interest earned? • The creditor foregoes the use of his money (consumption or an alternative investment: opportunity costs) • But: the alternative investment is never really carried out! • The so called „opportunity cost“ is in fact arbitrary (justified by pseudo-scientific formulas with no economic meaning)!

From the Hidden Premises to the Economical Nonseum – Mainstream Finance • Mainstream Finance • Dogma: The capital markets are „efficient“ (all market participants have the same expectations and no one can use any information for his own advantage, because „the market“ knows everything already in advance). •  If it would be so financial reporting would be a very costly, but totally useless endeavor (as well as investment newsletters, technical chart analysis etc.)!

From the Hidden Premises to the Economical Nonseum – Mainstream Finance • Mainstream Finance • Efficient capital markets and financial reporting standards are a logical contradiction • Departments for „Finance and Accounting“ at Universities… a practical joke? • „Diversification“: Buy non-correlated assets to „reduce risk“. • But: it cannot work, if everyone has a diversified portfolio and in times of falling market rates all investors sell all their assets  then asset correlation = +1.

From the Hidden Premises to the Economical Nonseum – Mainstream Finance • Mainstream Finance • The myth (q.e.d.) of diversification: • In times of rising market rates  diversified portfolio generates less profit. • In times of falling market rates  all investors sell all their assets, correlation = +1, risk cannot be reduced! • Diversification can be defeated without a single line of mathematical formulas (plain logical thinking!). • But: even nobel laureates had to learn it „the hard way“ by losing billions of dollars (http://www.amazon.com/gp/product/0375758259/)

From the Hidden Premises to the Economical Nonseum – Business Valuation • Business Valuation (using Discounted Cash Flow Models, DCF) • The future cash flows of the next 5-7 years are discounted and for the rest of the „lifetime“ of the corporation an perpetual annuity (continuing value) is calculated (CF/p). For this the CF of the last year (5th or 7th) are used – the most uncertain CF have the most influence on the calculation result! • In many cases, the sum of the residual value makes for 75% of the total business value (or even more than 100% in the case of start ups with negative CFs in the first years).

From the Hidden Premises to the Economical Nonseum – Business Valuation

From the Hidden Premises to the Economical Nonseum – Conclusio • Financial Planning is a Myth • The future cash flows are never known in advance • The decision criteria are unlogical and are derived from oversimplified, plain mathematical formulas with no economical meaning (no goods, services, customers, creditors, employees, … are represented in those models) • Financial numbers are only the result of economic activities and can never provide any causal explanations of events in the real economy

From the Hidden Premises to the Economical Nonseum – Conclusio • Economic Education aims at Behavior • The real goal of economic education today is a kind of behavioral conditioning of students to fit the existing power structures in private and public industries • Those structures are frozen and cannot be changed simply by publishing scientific theories (they are part of our western culture and a way how we differentiate from people of other parts of the world, therefore they resist change and evolution  a kind of religion?)

From the Hidden Premises to the Economical Nonseum – Conclusio • Economic Education in the current form endangeres human evolution • It makes students thoughtlessly obey rules • It destroys creativity • It kills the believe that evolution and change (to the better) are possible • Those frustrations in the subconscious minds of the masses will certainly rise violence (France) • Economical arguments (cost cutting, short term planning of quarterly revenues) hinder scientific progress: a recursive problem structure!

What Can (Must) Scientists Do? What Can (Must) Scientists Do?

What Can (Must) Scientists Do? • Question all models that are widely used • The older and more prominent models are – the more illogical and the better hidden are their premises! • Those very old models have mostly become part of our thought structures and part of our (business) culture. • Develop alternatives (even if they seem quite „alien“ – don‘t use interest, e.g.).

What Can (Must) Scientists Do? • Change the way of teaching • Personal development of students is (far!) more important than scientific skills and methods. We need every piece of creativity that we can find! • Show students, that THEY are responsible for improving our societies and NOT the lecturers, deans, university administration, politicians, scientists, … • Give room (physical and in the curriculum) for experimentation and „learning by doing“.

Premises and Promises of Theory Formation in Economics