Shaping the Way We Play: an Economist’s View

The 11th Annual Public Sector Finance Forum. 11 September, 2007  


Keywords: Governance; Regulation & Taxation; Statistics; 


In my paper yesterday, I argued that we too frequently misuse data for rhetorical and political purposes. Today’s paper is an extension of that theme, but it focuses on a less conscious process, while providing an economist’s perspective of some accounting practices. Let me make it clear I am not arguing that accountants are wrong. Rather I am going to argue that accounting is right, but in a limited way and that a lack of appreciation of that limitation means that we distort the behaviour of the agencies to which the accounting is applied. 


To do this I am going to have to talk about some of the relations between accounting and economics. I want to begin with a law taught to me by a former professor of accountancy, Dr Don Gilling, who has just given a paper to this conference. Because the law is such a useful one, it deserves a name. I shall call it Gilling’s Law, although I know Don would be happy to defer to someone else who has priority, if there be one. Don is a scholar. 


Gilling’s law states The way the game is scored, shapes the way the game is played. It is a simple idea, nicely illustrated by rugby. When I was a boy, a big match between two evenly balanced sides typically ended with a score line of something like 9 to 6 – three penalties to two. Then the scoring system was changed. Tries became worth five points instead of three, so you scored much more for a try than a penalty. Moreover, bonus points were introduced into tournaments. Score four tries and the team got an extra point on top of the four for a win, while a losing team that got within ten points of the winning team also earned a bonus point. The result of this incentive to risk scoring is that today’s great matches are thrilling affairs involving many tries often with forty or more points scored between the teams. Changing the scoring system changed the way rugby is played. 


That change was intended. Today I am more concerned with unintended consequences of changing the scoring system. For instance consider GDP, or Gross Domestic Product. Its conceptual framework was originally designed to enable economists to track unemployment, and later inflation and, even later, changes in the volume of material production. Nowadays, however, it is also used as a measure of national welfare and as objective which we should aim to increase and judge policy by. 


I dont know how many here have read the Narnian stories by CS Lewis. Those that do will recall The Voyage of the Dawn Treader in which Prince Caspian visits a number of islands in a picaresque adventure, in which Lewis explores some economic questions using an event in each island to do so. The first landfall is the Lone Islands on which there is slavery. Caspian orders the slaves to be freed. but the unpleasant island Governor Gumpas explains that it is ‘an essential part of the economic development of the islands .. Our present burst of prosperity depends on it.’ When the Prince insists, Gumpas goes on to say that Caspian does ‘not understand the economic problems involved. I have statistics, I have graphs …’. ending slavery ‘would put the clock back. Have you no idea of progress, of development’. 


Lewis is writing in the 1950s before the cult of GDP. No doubt today Gumpas would commission a consultant who would say ending slavery would reduce the island GDP by some large amount, and then Wilberforcians would come along with their consultants who would conclude that ending slavery would increase GDP by an equally large amount. Now, I have no problem at looking at the economic consequences of ending slavery, and accept one measure would be the change in GDP. But that is hardly relevant to the decision. Slavery is wrong. Whatever the economic consequences, it is wrong, and as Prince Caspian says, it should be abolished. At best GDP is a measure of material market product, and can be used as an intermediate indicator of human welfare. But it is not an ultimate objective. 


The Relevance of GDP 


Actually economists have known this from the beginnings. Look at J.K. Galbraith’s Affluent Society written in 1958. I know the worldly-wise and ill-read trot around as if they have just discovered the truth that GDP is not a good measure of welfare. But I was taught that in the early 1960s as a routine part of my economic training. 


As it happens, there is a theorem which connects GDP to human welfare. From it one learns how tenuous the connection is. Moreover, in recent years the key assumptions that more material product means greater happiness has been challenged empirically. That story belongs to another venue, but briefly it turns out that in rich countries incomes and happiness do not correlate very well at all. Your age and your matrimonial status are more important. One example from the research is that Americans are only as happy as they were 50 years ago, despite their material consumption more than doubling. 


We are not sure what this means but for today’s purposes I want to remind you how GDP connects to accounting practices. I simplify the economic theory, but there exist persuasive theorems that under certain circumstances, if each owner deploys her or his factors of production – such as capital, intellectual property, labour or land – to give the highest market reward, then material output or GDP is maximized. There are various caveats, but we dont need to pursue them today. What is relevant here is that for the principle to become operational we need a measure of the return on the factors of production particularly on the capital. 


That is where accounting comes in. Measuring the return on any activity is problematic enough, but in the case of the return on capital – on the owner’s savings in the enterprise which are taking the market risk – the measurement challenge is exceptional. 


I shall skip over the troubles of measuring capital and, consequently, of measuring income since its formal definition includes the change in capital, although I cannot resist pouring scorn on those who have misappropriated the notion into such concepts as community capital, cultural capital or social capital, without any understanding of the rigorous intellectual underpinning of the concept nor the foggiest idea of how their notion might be measured. . 


Accountants practically resolve the measurement problems of accounting capital in a similar manner that economists have when calculating GDP. There is a huge manual setting out the conceptual framework of the System of National Accounts together with the recommended practices to measure the concepts. Generally the approach seems to work without causing too many paradoxes, although we know they are lurking there, as the experience of Enron and its auditors remind us. Nor should we ignore the practical complications of measurement error and the need to make assessments of prospects. 


It is easiest to value capital assets traded in a competitive market. Mark-to-market seems sensible. But Enron had assets for which there was a no competitive market benchmark so they – as in the infamous praise of a former prime minister – ‘made it up’. That is sort of inevitable for big businesses which in part exist because they are a monopoly and hence are unique. 


Gilling’s law applies trivially. In business profits are the way the game is scored, and they largely determine the way the game is played. We are so familiar with this that we overlook an extraordinary implication. The function of the business is to seek profits. What it does as a business is for that purpose. To take an extreme case, suppose the business is a forestry company but it discovers it it is good at doing something quite different such as mobile phones. It does not say, ‘we are a forestry company so we dont make phones’. Rather it says we can make a bigger profit making mobiles, so we give up being a forestry company. 


The Nokia story is a little more complicated than that, and sometimes a business does not change direction because it thinks its key assets and skills belong where they are. Nevertheless what determines the success of a business is not what it does, but the profits it makes. Economic theory says: that if it does that, in certain circumstances it will contribute most to material production and – under certain psychological assumptions – to social welfare. 


Sometimes those circumstances and assumptions do not apply. What are we to make of the profit return then? Very often such activities end up in the public sector. There are numerous reasons but two important ones are businesses which a serious monopolies, or it may be that the economic institution has a purpose other than profit maximisation. 


Monopolies and Profits  


The first case is for businesses which are monopolies or experience strong economies of scale or some other such non-standard characteristic; network effects are another example. We can illustrate the difficulty with Telecom, a natural monopoly because of the almost unique link from exchange to home. It pursued maximum profitability, using its monopoly power to do so. 


It is hard to argue that the result was in the national interest or contributed to the maximisation of GDP. Today New Zealand is behind most of the OECD in its telecommunications performance – especially its broadband penetration. In recent years the government has been trying to impose a regulatory framework on the telecommunication sector to restrain Telecom’s use of its monopoly power. Hopefully that will improve the industry performance, with flow-on benefits to the rest of the economy. 


There is an argument that even with the same regulatory framework a publicly owned monopoly is likely to be less abusive of its monopoly power than a privately owned one. That IS sometimes the economics justification for the maintaining of some state-owned-enterprises in public ownership. 


The accounting profession argues that their principles and practices which apply to general firms should also apply to monopolistic ones. I have no problems with this approach. Every business is at least to a small degree a temporary monopoly. There is no discontinuity between the extremes of pure competition and monopoly. We need a comprehensive accounting standard to cover them all. 


However consider Gilling’s law. In the case of the pure competitor, the profit in the bottom line is a good indicator of what we as a society require from the business (subject of course to general laws, such as those which prohibit slavery) and so the interests of society are aligned with the interests of the owner. In the case of a pure monopoly the interests of the owner and of society as a whole are not aligned. Yet the bottom line still shapes the way the monopoly behaves. 


This simple lesson was overlooked when Telecom was privatised. The owners of the publicly owned entity – the government – gave directions to the company which had the effect of limiting its ability to exploit monopolistically. They almost certainly also reduced its profits. Those directions were abandoned by the private owners of Telecom in their pursuit of profit. As a result we ended upi with an inferior telecommunications system. The effect of changing the scoring system was that the game was played for the worse – unless you were a Telecom shareholder. 

So once there is a strong monopolistic element in a firm the profit measure becomes a weaker measure of how much the firm contributes to the economy. It is still important, but it is not nearly as decisive as for the purely competitive firm and so some more rules have to be added to ensure the game is played the way we want it to in the public interest. Creating the right regulatory framework is not easy but that is not my main theme today. My concern is that a set of proper accounting conventions leads to measures which can distort the economic game if it is used naively. 


Entities with Non Market Purposes 


A second case is where accounting can lead to the wrong behaviour is where the purpose of the institution is not a market led one, where – in effect – the aim is not to maximise GDP but to change its composition, and where the objective is about the quality of life rather than the quantity of production. 


This can be illustrated by The Treasury itself. Its purpose is not to make a profit. It would be astonishing were The Treasury to announce it was abandoning its present activities and going into, say, selling mobile phones. Even so we use broadly the same accounting principles and practices to record the funding flows in the Treasury as we do a commercial business including measuring its surplus, or profit. The logic for such an approach might be summarised in four useful outcomes: 


1. Using the same accounting conventions, albeit adapted for the particularities of the government sector, means that there is a commonality of understandings across the accounting profession rather than a muddle of special applications. 


2. The management accounting practices that are used in the private sector to reduce resource waste can, hopefully, also be applied in the public sector. The objective of efficient utilisation of resources applies even where the purpose of the entity is not profit generation. 


3. Comprehensive sets of financial reports enable the politicians and the public to assess what is happening to the funds provided to each government agency, enabling them to monitor its resource use. 


4. The accounting processes provide a reporting framework which minimises the element of surprise, as when an entity requires more funds than the central funder planned. 


But such considerations do not make the Treasury a profit centre, nor make it focus on its operating balance as an indicator of its success. This is so obvious in the case of the Treasury that we hardly need make the point. But there are government entities for which the same principles apply, but for which the points are overlooked and which the notion of a profit centre dominates when it should not. 


Entities in Market Environments with Other Purposes 


I illustrate this with one such entity: Television New Zealand. To do so, I need to say something about free-to-air television as a market activity. It exists as a strange hybrid in which the funder is not, or not simply, the apparent audience and as a result the purpose of the commercial activity is not clear. 


Consider a newspaper. You probably think of it as an item you purchase for its news and features content. However a considerable proportion of its revenue – typically more than half – comes from the advertising. In effect the advertising subsidises the content for the reader, who acquires a product at a price below the cost of production. 


However, the advertisers do not provide their revenue as a public benefit. They have a commercial objective, paying the newspaper for access to its readers. This means the newspaper needs to attract an audience of interest to its advertisers. I leave here a discussion about whether the two tasks – providing news to attract an audience and providing an audience to attract advertisers – are aligned. That there are multiple audiences leads to a very complicated analysis. It is sufficient to draw attention to the existence of the tension. 


A more extreme version of this tension is illustrated by give-away newspapers, whose funding is entirely from the advertisers seeking an audience. The reader cannot grumble about the coverage or quality of the paper, since it is free. 


So what about free-to-air television? What claim has the viewer got for television content, since like the give-way newspaper he or she is contributing nothing to its financing? Why should you grumble about TV3, say, when the rules of the game are that you can switch it off, or switch to a pay channel. Why is TVNZ any different? 


Media buffs will forgive me if I do not answer this question in any detail but merely observe that there is a view that TVNZ should just be like TV3, and it has been prepared for privatisation. Why do we keep it in public ownership? 


Reasons for public policy decisions are always complex, but a simple answer is that we believe that were TVNZ left to the market disciplines that private ownership would result in, as for Telecom, an inferior outcome. However in this case the performance measure is not the maximisation of GDP which private ownership of television failed to attain. In the case of TVNZ we want a different outcome – which might be summarised as a different composition of GDP. The public regulation of TVNZ is about using the entity for a different purpose, other than GDP maximisation. 


Now many people believe that despite these public interventions with their alternative objectives to GDP maximisation, the outcome has not been very successful. I have not the space here to evaluate such claims. We are concerned with the mechanisms which lead TVNZ to behave the way it does. 


The funding of TVNZ remains advertising – about 90 percent of its revenue comes from that source. Moreover we ask it to make a profit, according to standard accounting conventions. Admittedly there is a statement of intent with all sorts of noble sentiments about public broadcasting, and there is a little public money, the purpose of which is to enable the pursuit of those sentiments. But the TVNZ revenue stream primarily depends upon advertising, and is therefore driven by the necessity of finding an audience for its advertising clientele. If there exists a program whose audience is not of interest to the advertisers – say they are too poor, or too small, or too impervious to advertising – then the program is not given priority, no matter how worthy it is in terms of the public broadcasting sentiments. 


It is Gilling’s Law again. The score card is the profit line, the means of obtaining a profit is to seek audiences which attract advertising revenue, and so the game is shaped by seeking the audiences the advertisers want, rather than pursuing the worthy sentiments in the statement of intent. 


TVNZ is perhaps an extreme example of this phenomenon. But no matter what our noble objectives the game can be shaped by the bottom line of the accounts. If you look at the annual reports of Crown entities, especially by those that have to interface with the market, you will be struck by noble sentiments which are not scored, and pages and pages of financial statements which are. Not surprisingly the entity’s performance is shaped more by the quantitative score card than the qualitative statements of intent might imply. 


I am not criticising those financial reports. As in the case of the Treasury’s they have an important role in the management of the entity and of the ability of the politician and the public to evaluate the entity’s performance. Moreover, those who devised the conceptual framework for crown accounting were aware of the problem, at least in part. But their enthusiasm to develop high class accounting standards, and their competence, has left each entity lopsided, overdeveloped on its accounting scorecard and underdeveloped on the scorecard about its real purposes. 


The situation not unlike the standard criticism of GDP. It is a useful indicator, but it does not tell the whole story. Because it is quantitatively sophisticated compared with other things we care about the story economists tell is often distorted. 


Can we get a better balance between the accounting and the non-accounting score cards? There has been some effort to do so, but in many cases the situation remains that the overt purpose is one scorecard, but the covert accounting scorecard dominates the way the game is played. 


I would argue that in such circumstances we need an integrated scorecard with the important caveat that given the accounting part will be quantitative, the non-accounting part has to be too. That can be very difficult. 


Suppose one really wanted to change the nature of TVNZ. The integrated score card would need to define in quantitative terms the objectives of the station and then connect the objectives to the bottom accounting line. For instance, suppose the objectives said that a station should provide children’s programs with an audience coverage defined differently from that for which advertisers pay. Given that we are likely to keep the existing accounting conventions – for the reasons I have already outlined – then there would need to be some payment to the profit account as the children’s audience was attained. In effect the public would be buying the audience rather than the advertiser. 


I have chosen here what seems to be a straight forward integration, and yet it would be a very complicated exercise. Dealing with the more complicated objectives may be nigh on impossible. And yet if we dont do that we cannot get an integration and the accounting score card will dominate the game. 


The Public Sector Story 


The same struggle applies to the funding of health care. We have moved from a pure bottom line objective in the early 1990s, to the current situation which seems to me to be a muddle. (In another venue I could talk about the resulting managerial-professional tensions.) 


Another area which is thoroughly muddled is tertiary education where we have rightly shifted from the disastrous bums-on-seats – never mind the quality, pay by the number of students – approach. But the objectives of the new system are not well integrated with funding incentives – particularly the student contribution. Experience may prove that it is not integrated at all. 


The difficulty arises because once we move to more complex objectives the natural advantages of market mechanism are lost. It is easier to pretend a university or hospital or a television station can attain its social objectives by pursuing profits in a market environment. We nobly load the statement of intent with worthy objectives. But the bottom line shapes the entity’s game. 


And so we come back to the dreaded reality of GDP. We want a different sort of society than that which simply maximises GDP – although we do want a high material standard of living – but to do that we have to provide resources to pursue these other objectives. Because we are reluctant to do so – it involves taxation – we end up with muddle we are currently in. 


Increased efficiency is not the solution. Of course every public entity should seek to use its resources as efficiently as possible. Recall the claim in the early 1990s that switching our hospitals to a private sector management regime would give efficiency gains of 20 percent and more. They never appeared. There is no evidence that they are less successful at doing so that privately owned businesses. 


Yes there is inefficiency in the public sector, but the fat is not that of rump steak, thick and easily cut out. Rather it is stippled through prime porterhouse, with the danger that if you try to remove it, you will damage the meat. 


As a past Secretary of the Treasury, Graham Scott remarked, outsiders talk ‘as though it will be easy to cut enough fat from the state to pay for tax cuts – it won’t be. Believe me,’ Scott says, ‘I’ve been there and I have done that. The combination of the State Enterprises Act, the Public Finance Act and the State Sector Act, which I helped to design and implement, brought remarkable improvements in the effectiveness of public organisations and lower costs. … We can get better value for money but it has to be done with a scalpel not an axe.’ 


(I am even more pessimistic that Scott. The gains from the scalpel are small and take time. Big quick gains can only come from cutting programs and entitlements, the living red meat.) 


So the accounting reforms seem to have succeeded insofar as they have eliminated most of the inefficiency in the public sector. But sometimes they have done so at a cost of distorting the practical of the purpose of the entity, especially towards the maximisation of material output, of GDP. Yet we need to avoid the view that GDP is the ultimate arbiter of the economic game we want to play. Its is a useful indicator of economic performance, but it is not the only one, and certainly not the highest one. You are probably aware of the claim that if economics is the father of the System of National Accounts, then accounting is the mother – but they have never married. 


The implication for public sector accountants is they need to be careful that their framework does not unconsciously adopt GDP as an ultimate goal when that is inappropriate. And yet the success of the implementation of a system of financial reports for Crown entities and their resulting practical usefulness, creates a score card, which as Gilling’s law warns, shapes the way the game is played. 


<>A revised scorecard which shapes the game differently is a challenge which we ignore at the cost of nation’s welfare. It is a challenge for all of us, including public sector accountants. We need to improve the existing score card not abandon it.



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