By Richard Murphy
February 9, 2010 Forbes.com
Governments around the world are using Keynesian ideas to fix the damage done by the global financial meltdown. But one problem John Maynard Keynes never had to deal with when designing his solution to the economic crisis was the way financial rewards are calculated today, with bank chiefs rewarding themselves on the basis not of past performance, but of a discounted future.
That is because he didn't have to deal with the perception, now completely dominant in economics and finance, that value is determined by an arithmetic formula where the future cash flows of an asset are discounted at an agreed interest rate. Financiers then compute a current worth with all future flows added together, as if they occurred in the present moment.
This approach may have a computational neatness but its impact has been pernicious. First, it's open to abuse in finance because if the value of a security is not what you first thought, simply change one of your assumptions about the future and it soon will be whatever you desire it to be – and who's to prove you wrong?
Secondly, and more importantly, the idea of discounting the future is fundamentally subversive. Once you assume that you can discount the future consequences of current decisions into a current cash value, what's to stop you paying yourself the whole of that supposed value to yourself as a bonus, to reflect the value your own math?
This has been happening on an enormous scale and the consequence is obvious. Those who arrange financial deals pay themselves the full value today of the benefit they claim their mergers, acquisitions, pension fund investment allocation decisions and other programs will create in the future.
If you discount the future by deeming it to have a cash value today, which you alone can determine using models you create, the value you can pay yourself knows almost no bounds. Since finance is most susceptible to this kind of analysis, unsurprisingly the bonus culture in banks has been huge. Wherever there's been mark-to-market or fair value accounting, executives in the financial world have used this technique to book profit and pay the bonuses made for themselves.
The return on investment thus leaves little for the future. That's why your pension scheme has made little or nothing for a decade or more: a banker claimed the growth in your pension scheme as the basis for their bonus years before.
That is also why state finances have been distorted by an inevitable boom and bust cycle. In boom years the state is paid taxes on profits that are completely illusory - this is tax paid on the current benefit of future investment returns.
Governments have a conundrum: how do they create wealth without depending on taxes, jobs and growth from the finance sector? An attitude in the financial community of living in the present and recognizing it is quite separate from the future would represent a major step forward.
That, though, would require a fundamental reform of economics. Is the financial sector up for that? It's doubtful when they've been so well rewarded for telling a few they can live today off the jam that should be someone else's tomorrow.
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