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Premises and Promises
of 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
Page 2 11-02-07
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
Page 3 11-02-07
Why (Macro- & Micro-)Economics?
Why (Macro- & Micro-) Economics?
Page 4 11-02-07
Why (Macro- & Micro-)Economics?
Page 5 11-02-07
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.
Page 6 11-02-07
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?).
Page 7 11-02-07
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…?)
Page 8 11-02-07
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!)
Page 9 11-02-07
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!
Page 10 11-02-07
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!
Page 11 11-02-07
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!
Page 12 11-02-07
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?
Page 13 11-02-07
Use and Abuse of Science
Use and Abuse of Science
Page 14 11-02-07
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)
Page 15 11-02-07
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…?)
Page 16 11-02-07
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
Page 17 11-02-07
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
Page 18 11-02-07
From the Hidden Premises to the Economical Nonseum
From the Hidden Premises
to the Economical Nonseum
Page 19 11-02-07
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
Page 20 11-02-07
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“?
Page 21 11-02-07
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?
Page 22 11-02-07
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.
Page 23 11-02-07
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“.
Page 24 11-02-07
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.htm
http://www.ebr360.org/) The founding members: AICPA, Grant
Thornton LLP, Microsoft, PricewaterhouseCoopers LLP
Page 25 11-02-07
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):
Page 26 11-02-07
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."
Page 27 11-02-07
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)
Page 28 11-02-07
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)
Page 29 11-02-07
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!)
Page 30 11-02-07
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!).
Page 31 11-02-07
From the Hidden Premises to the Economical Nonseum –
Investment Theory
Page 32 11-02-07
From the Hidden Premises to the Economical Nonseum –
Investment Theory
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From the Hidden Premises to the Economical Nonseum –
Investment Theory
Page 34 11-02-07
From the Hidden Premises to the Economical Nonseum –
Investment Theory
Page 35 11-02-07
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!
Page 36 11-02-07
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!).
Page 37 11-02-07
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)!
Page 38 11-02-07
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.)!
Page 39 11-02-07
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.
Page 40 11-02-07
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/)
Page 41 11-02-07
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).
Page 42 11-02-07
From the Hidden Premises to the Economical Nonseum –
Business Valuation
Page 43 11-02-07
From the Hidden Premises to the Economical Nonseum –
Business Valuation
Page 44 11-02-07
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
Page 45 11-02-07
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?)
Page 46 11-02-07
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!
Page 47 11-02-07
What Can (Must) Scientists Do?
What Can (Must) Scientists Do?
Page 48 11-02-07
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.).
Page 49 11-02-07
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“.
Page 50 11-02-07
What Can (Must) Scientists Do?
– Change the way we think of „errors“
– Errors are necessary for learning and our evolution.
– And: only after the facts we know, what really was an
„error“ (and even this conviction might change once again!).
– Errors should be documented, published, celebrated,
rewarded… they are necessary and valuable!
– It‘s a matter of culture: don‘t „avoid“ errors, but never
commit an error twice.
Page 51 11-02-07
What Can (Must) Scientists Do?
– Change the academic Institutions
– Universities have not been invented to earn profits!
– They should be places to experiment, and dream (without
calculating the opportunity costs of those dreams!)
– We must relieve the burden of all day life (earning a living)
from students as well as scientists – only then there will be
enough leisure for dreaming and creativity!
Page 52 11-02-07
What Can (Must) Scientists Do?
– The VINDOBONA University Project
(in accreditation):
• Reinventing Economics and Social Sciences around Philosophy
and Psychology (model of humans in the center of
communication networks)
• Business and political leaders with mainstream education in
management science and economics cannot cope with
paradigm shifts (crash of the economy, break thru innovations,
radical change of social values etc.), because they know only
one (western) model of an economic system
• We need the capability to communicate with members of
different economies and cultures on an even level (without
falling prey to our prejudices, that are part of our education!)
Page 53 11-02-07
Some Visions, Not Too Far -
Economics
Some Visions, Not Too Far
Page 54 11-02-07
Some Visions, Not Too Far -
Economics
– What is money?
– Using current technology: whatever we want it to be!
– Not only a certain data type (float, currency), i.e. one
number, but arbitrarily complex data structures (the end of
anonymous money).
– Money with it‘s own memory (linked to electronic
contracts, everyone can see why this amount of money has
been exchanged by whom and for what kind of product or
service).
Page 55 11-02-07
Some Visions, Not Too Far -
Economics
– What is money?
– Money with an (electronic) endorsement (whenever a
customer complains about the quality of a product the
money he once used to pay loses it‘s purchasing power and
can‘t be used any more – the former seller of the critized
product must provide other electronic „coins“ and can‘t use
the „protested money“ until the complaint of his customer is
settled).
– Virtual money is the great chance to make those things
valuable in society, that we all think are valuable!
Page 56 11-02-07
Some Visions, Not Too Far -
Economics
– How do we earn (and spend) money?
– Virtual communities will provide their own money (money-
servers, economy-servers, LET-Systems: http://www.gmlets.u-
net.com/, http://www.openmoney.org/,
http://www.complementarycurrency.org/, e.g.)
– Virtual realities will spread and transform into „parallel
economies“, where soon children will earn more money than
their parents (http://www.entropiauniverse.com/,
http://www.secondlife.com/, e.g.)
Page 57 11-02-07
Some Visions, Not Too Far -
Economics
– How do we earn (and spend) money?
– If the (M.I.T.-developed) Fabricator comes into every house
(within the next 20 years), our economy might completely
transform into online-games.
– Question: is an economic system as „gambler‘s paradise“
(the way mainstream finance describes it) as an online-game
less harmfull than our „real economic system“ of today?
Page 58 11-02-07
Literature
Alex Berenson: The Number - How the Drive for Quarterly Earnings
Corrupted Wall Street and Corporate America
ISBN 0375508805
Roger Lowenstein: When Genius Failed, 2001, ISBN 0375758259
Miller/Bahnson: Quality Financial Reporting
ISBN 0071387420
Mills: Buy, Lie, and Sell High - How Investors Lost Out on Enron and the
Internet Bubble ISBN 0130091138
Mills: Wheel, Deal, and Steal - Deceptive Accounting, Deceitful CEOs, and
Ineffective Reforms ISBN 0131408046
Mulford, Charles W./Comiskey, Eugene E.: The Financial Numbers Game:
Detecting Creative Accounting Practices, 2002, ISBN 0471370088
Page 59 11-02-07
Literature
Howard M. Schilit, Financial Shenanigans - How to Detect Accounting
Gimmicks & Fraud in Financial Reports, 1993, ISBN 0070561311
Robert J. Shiller: Irrational Exuberance (2nd Edition), Feb. 2005, ISBN
0691123357
Nassim Nicholas Taleb: Fooled by Randomness, 2005, ISBN 0812975219
Page 60 11-02-07
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