I'm an accountant....and I'm sorry (Update #2)

As I've said before, I feel I must apologize. Yes, I am an accountant. Been one for decades. Seen a lot of financial crap and crises in that time. For the first time I feel I'm part of the problem.

My profession has much to apologize for something called 'mark to market' for certain financial transactions. Here is my first updated post on that subject.

Well, a couple of days ago I read a very good article entitled "Mark to Market Means Mayhem" with which I agree.

What is most amazing about this crisis is that the government is unwilling to address one of the root causes of investor fears -- mark-to-market accounting. For some reason, normally stalwart free market thinkers are willing to support trillions of dollars of government intervention, but are unwilling to support a suspension of mark-to-market accounting. They trust government solutions more than private sector solutions.

This has happened before. In the 1970s, when inflationary pressures were rising because of excessively easy monetary policy, the government tried everything but tightening money to fix the problem. A partial list includes: wage and price controls, windfall profits taxes, tax hikes, credit controls, WIN buttons, and price caps on energy products.

None of this worked because inflation was a monetary phenomenon. But every convoluted attempt at fighting inflation that did not address the real problem created even more problems elsewhere. The end result of all of this was stagflation as government interference in free markets undermined growth.

Milton Friedman, who understood the problem, and proposed the solution that was eventually put in place by Paul Volcker, was considered too narrow-minded. Many thought that inflation was intractable and something we would have to live with.

Sadly, it seems that the U.S. government is repeating a similar error all over again. Conventional wisdom argues that the problems we face are fundamental in nature. That this is a classic case of an economy gone awry, and that the only way out is for government to bail us out.

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To understand this process, imagine that a forest fire one mile to the east of your home in Montecito, California, was being blown your way by the Santa Ana winds. How much would your home be worth at that moment? How about the loan on the books of your lender? Then imagine that the wind shifts to come from the ocean, your house is saved, and its value is unimpaired once again. Which set of books is right?

The only difference between this example and today's economic crisis is that no matter what price we place on the house, it will not affect the direction of the wind or power of the fire. But because marking-to-market impairs capital and therefore the financial system as a whole, it is causing the fire to burn hotter and the wind to blow harder. Marking to what might happen forces the system to accommodate losses that may not occur in reality.

Subprime loan problems, which started out as a $300 billion problem, have morphed into a $1.5 trillion dollar problem affecting many different markets and types of institutions. Even if the wind shifted, and the fire moved the other way, the damage would have already been done. In other words, it would not matter if the house had actually survived because the bankruptcy would have already occurred.

Suspending mark-to-market accounting will not keep institutions that took excessive risk from failing. Bad loans are still bad loans and there is no way to avoid the pain that they cause. It will, however, end the negative feedback loop, which drags everyone down. It allows time to see if the wind shifts and keeps the flames from spreading.

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The government has tried multiple strategies. The only thing they all have in common is that they are designed to offset or stop the damage caused by mark-to-market accounting.

I don't hold any real hope that this simple solution will ever be implemented. Too many people will have to admit that they were wrong in the first place and that this error in judgment contributed so much to this financial meltdown.

Again, as an accountant, I apologize. I repeat a point I made before: Accounting is for clarity and transparency...or it should be. It should not be the instrument of wholesale destruction at the hands of regulators.