Why would an auditor miss a bank run?

I have decided to write on this topic because I currently work as an auditor. I have been up to this date in many firms where i conducted audits of the firm's financial statements and through various ways have "tested" the company's balance sheet's to determine any wrongdoing.

The thing that caught my eye was the fact when an auditor approaches a bank, the audit procedures in my opinion somehow breakdown. This is due to the fact that manufacturing firms have to sell a product and pay off suppliers to remain in business. A bank creates money from loaning out demand deposits and captures a spread.

The main difference when going about on audit of a mancufacturing company and a bank, is the perception of the person conducting the audit. The primary focus on a manufacturing firm is the ability to generate cash flow and the unbiaseness of the accrual process. When auditng a bank, most of the itme is focused on bank product of the bank - its' loans (for traditional markets this is the case).

If the loan receiver has a hard time paying of the loan, the auditor will quesiton the vaildity of the asset and request an impairment of th asset. The auditor however never questions the origins of the loan. By this I mean the systemic imbalance of borrowing short and lending ex nihilo long. The auditor is never concerned of any bank run due to the modern nature of the banking system.

I found this particularly odd. The only logical conclusion that I come by is the perception of the participant doing the audit, and the repetitiveness of the process. The participant views the fractional nature sound because a supranational (central bank) is stranding behind the Entity making sure that the diminishing reserves to cover the deposits is in line with "historical practices", or in line with industry and economic wide conditions.

This can be clearly seen at the examples in Cyprus a month ago, when the banks run ensued. I am sure that each bank that went under in Cyprus had an auditor. The auditor went through their books and determined no material misstatements of the banks' balance sheets. The other problem that would arise is the going concern basis: If the bank was unable to honor it's depositors for withdrawl on demand, then the bank would have been prepared for a banckruptcy filing. This hasn't occured as well. It is if the auditors were fooled or something; unable to see that the bank is always insolvent and can be brought to it's knees with a run.

The bottom line is this: An auditor can't see a bank run, because he is not interested in one, nor do most of them have any knowledge of economic theory underpinning their analysis. If they did have knowledge of economic cycles they would have made an adverse opinion of the statements during the boom faze, when the percentage of NPL's (non performing loans) is at a low in the cycle.

Unfortunatley, the common practice is to follow the mainstream approach and give a green light. Anyone that stands out will be attacked as reactionary and insance. Just as the rating agency Egan-Jones was called to b mad when they downgraded US debt and other debt for that matter.

There should be first of all an overhaul of the banking practices, and then an auditor will be able to make decent calls just as they do for manufacturing firms.

Why capital accumulation is important and how it effects the price structure

 

The title of this blog post is directly related to a key tenant in Austrian economics, which says that the joy of consuming wealth is derived from the self evident supply of given good or rendered service X,Y,Z.  We shall skip the semantics regarding resource transformation to fulfill this desire.

The primary goal of creating any supply of capital is to sustain the individual for a lengthy period of time in order for him to complete other tasks he deems satisfactory or necessary to bring him in a state that he strives to. Capital accumulation in a free market is a wonderful process because it is based on voluntary compliance of a mass of individuals, each seeking its own end.

This process is disturbed when a self appointed entity with a monopoly on the judiciary system can appoint how and what resource may be effectively employed in a certain endeavor. This entity compounds the problem when it, through the banking system, legalizes the counterfeiting of the currency through fractional reserve banking, creating an artificial boom in the capital goods industry and subsequent inflation.

According to business.hr, the inventory of the manufacturing industries fell 12,3% YOY. While this may be a bullish sentiment for commodity broker dealers, who may just take a long position in a certain commodity and with the same demand dynamics that prevail YOY expect to profit from a spike in inventory products, this is bad for the average consumer, because it will eat away a part of his income when purchasing the final product.

Unfortunately, this is what happens when the economy is shaking of the addiction of cheap credit from the banking system. When the boom faze is over, the manufacturers are forced to dump their inventory onto the market at deep discounts in an attempt to salvage themselves from insolvency. Sometimes, they go under. The subsequent step in this process, is the curtailing of expansion, brought by lower inventory levels.

Some of this inventory had to be sold at a deep discount, as some inventory, due to the artificial boom, have been used in an accelerated manner as the boom faze continued, as more often in industries where day were wasted in suboptimal projects. So, now, it will take time for these stocks to be replenished.

If the government stays out of this process, the recovery will happen sooner than later. If the government interferes in this process through subsidizes of purchases or outright price controls, there will be even less inventory numbers YOY.

The market has to clear. The malinvestments must be liquidated and capital must be freed in optimal projects. If the government inflates it will only lead to more resource consumption and with that lesser inventory numbers.

To reiterate what was said at the beginning, capital formation makes economies tick. A greater unused level of inventory that is known to satisfy future demand in certain industries boosts the economy. Artificial credit gives a artificial boost and excess inventory consumption.

The government better let the market clear and make it easier for producers to sell their products in lines of production which are most profitable for them. Until that happens, expect more inventory volatility…

Cracking Krugman on Croatia

 

Princeton Professor of Economics Dr. Krugman was interviewed by Jutarnji list newspaper a couple days ago regarding the way Croatia should get itself out of an economics rut it has been it for the past couple of years.

The headline reads: “Spend, spend, spend!”

Now, I am sure that Krugman doesn’t spend all of his salary on consumer goods and therefore surely “deepening” the depression in The US, lets just briefly skim across the interview and make some short assessments of what he said.

The following unbiased short excerpts are:

“In a recent manifesto, which tries to primarily to summon economic reason in TheUS - hence the title "Manifesto for Economic Sense" - Krugman and his collaborator on the project is Richard Layard of the London School of economics,  put forward the thesis that the assertion of the majority of today's politicians and economic policymakers that the main cause of the present crisis is irresponsible borrowing countries is completely wrong. Krugman and Layard exception is Greece, which broke all reasonable limits long before the catastrophe that has happened to her.”

So according to Krugman, it is the “level” of “excess” spending that is to blame for Greece’s mess, but not for Spain’s nor Italy’s mess. Too bad he couldn’t specify what “level” of spending this is.

Next, no mention of a credit expansion in these countries, that manifested itself in the capital goods market that brought on a subsequent boom. But, before we dive into that, the following line is also intriguing:

- If you save your income so you do not buy from me, you destroy my income and my sinking jointly deepen the crisis.

Again, what magical level of personal consumption is sufficient to satisfy Krugman? Which level won’t worsen the crisis? 20%? 60? 130?

I ask the question, why do I have to save then? Lets look at the 100% option. I spend all my resources on consumer goods. I cannot purchase durable consumer goods, which qualify as capital goods, because an automobile (a durable consumer good) is purchased with a lot of resources. So, with my salary, I am priced out of this market. To buy a car I will have to lever up. I will have to go into debt. OK. Cool. So, someone will have to give me funds, WHICH ARE SAVED SO I CAN PURCHASE THIS VECHILE. Nope, can’t do that, everyone else is also spending all of their funds on consumer goods as well.

Hmm, I really hope that factories that produce consumer goods will able to keep up with all this demand. I wonder, how will factories that produce machinery which, sell them to other consumer producing factories be able to obtain funds, if all the funds that directly hit the consumer goods industries bid for factors of productions for their immediate disposal (selling clerks, janitors, new corporate automobiles, computers etc.)? They have a choice (the consumer producing industries), to bid for resources (even outbid) to satisfy the demand for their products, or save the funds and investment them in PP&E. THEY CAN’T HAVE BOTH AT THE SAME TIME.

We haven’t even discussed the effects that new money entering the economy has on the capital structure. Again, lets postpone this question for a little later. Lets assume that there is no new money in the economy. The money supply is highly inelastic.

Nobody can consume above the level he earns, unless there are individuals that refrain from immediate consumption. So, how does a factory get built? Can people chill on the beach and drink a pina colada from the pina colada factory if there is no factory? Well, I don’t think so. So, what do they have to do?

They will have to sacrifice a confortable time at the beach and drinking the colada for working on the factory. But since that they haven’t got a product (colada) to drink, their consumption level is zero. (Their consumption level is also zero if they stay on the beach, the colada doesn’t magically appear out of nowhere. I am sure that there is a demand for the colada, but without supply, good luck drinking one!). So these people will have to SAVE (refrain from consumption that doesn’t exist due to a lack of supply) whatever resource they can to sustain themselves while building the factory! This may be, for simplicity’s sake, dirt that grows on trees. They will have to use their own labor and time to accumulate dirt that grows on trees, to be able to sustain themselves while building the pina colada factory. What if they eat all their accumulated dirt that grows on trees before they finish the factory? They will have to USE THEIR TIME TO COLLECT MORE, WHICH COULD HAVE BEEN USED TO COMPLETE THE FACTORY! Again, they cannot make the cake and eat it too.

Enter credit expansion. According to ABCT, credit expansion creates the Cantillon effect and the subsequent reverse Ricardo effect that impoverishes the capital structure which is A MUST to maintain a certain level of consumption. If new money enters the economy in the capital goods industries, a boom will occur, if it enters the consumer goods industry, it will impoverish the capital structure, setting inflation, high nominal wages, and no capital structure to produce these goods.

Krugman gives no mention of what these effects have on the economy. He of course doesn’t even consider what occurs when you run out of loanable funds (present supply of resources that sustains you through the investment process). He acknowledges a need for a minimum level of inflation, of around 3%. Why not 5%? It is only marginally higher. Why not 30%? Things would really take off then.

Professor Krugman is confused of how economies function. He adheres to John Law and other monetary cranks and fiscal charlatans, such as John Maynard Keynes.

The art of spending money must not be confused with the art of creating wealth. Because, according to Krugman, people who are stupid enough to save  during the boom years, are at fault at causing the present crisis. Which means, under consumption is to blame for a depression, and not consuming more what you don’t have. That is, consuming capital to create false GDP growth.

The logical argument of Krugman’s assertions fall on the first pillar of growth. How does he get around the notion that if you wake up on a desert island, or if you are dropped of in the jungle, HOW ON EARTH, CAN YOU CONSUME SOMETHING IF THE RESOURCES HAVEN’T BEEN ACCUMULATED (SAVED)  TO SUSTAIN YOURSELVE THOUGH THE PRODUCTION PROCESS?

Professor, I encourage you to go to a location where there isn’t a trace of modern civilization (you can bring your co-author as well) and try to build up the skyscrapers as in New York, by spending your way to prosperity. 

Until then, go brake a window, since you will be helping the economy by creating demand for a window manufacturer…