IFRS – controlling the invisible hand?

Notes on a recent speech in Edinburgh by IASB Chair Hans Hoogervorst

He starts as follows:

  • “Edinburgh was the home town of Adam Smith, often referred to as the father of modern economics. Adam Smith is best known for The Wealth of Nations and its concept of the ‘invisible hand’. In his view, rational self-interest guides market participants to trade in a mutually beneficial manner. However, he also wrote The Theory of Moral Sentiments, in which he describes how the act of observing others makes people aware of the morality of their own behaviour.
  • These concepts are as relevant today as they were in the 18th century. I would like to think Adam Smith would have been a big fan of IFRS, because it allows the ‘invisible hand’ to work at an international level. IFRS helps investors to identify opportunities and risks across the world. Capital can be allocated on the most efficient basis, while the friction of national accounting regimes is removed. Adam Smith would probably also have approved of IFRS because it helps investors to observe how others, namely company management, are looking after their resources.”

It would be interesting to know how an expert in Smith’s work would assess this appropriation. From my extremely inexpert perspective, it seems as plausible that Smith would have focused on the limits of IFRS as on its strengths. If nothing else, I’m not sure that the kind of “observation of others” facilitated by IFRS is sufficiently direct and clear to promote the kind of sympathy and behaviour modification that Smith talked about. Among other things, he believed in natural principles that could be identified and reinforced – “founded upon experience of what, in particular instances, our moral faculties, our natural sense of merit and propriety, approve, or disapprove of.” But it’s hard to conclude that anything about IFRS (except, perhaps, the underlying equilibrium of double-entry bookkeeping itself) is based in any such natural sense of harmony.

Hoogervorst probably isn’t being that specific – he’s likely just proposing that Smith would have approved of the idea of IFRS, even if he disliked some of the details (it’s possible, for instance, that Smith’s warnings about the “overtrading” that results when “profits of trade happen to be greater than ordinary” would have indicated a greater propensity toward conservatism than exists in the current conceptual framework, but who knows). Here too though, the fact that something is widely established doesn’t in itself mean that it’s virtuous. Smith wrote that “custom interferes with social judgment on both the collective and the individual level’ and observed that “”our views are apt to be most partial when it is of most importance that they should be otherwise.” That is to say, it seems possible he might have seen IFRS only as a customized screen of interference that supports the perpetuation of bad judgment rather than facilitating the good or, at best, falls short of its potential due to the self-interest of those who implement it.

Regarding the invisible hand cited by Hoogervorst, here’s Smith’s famous use of that term:

  • “The rich only select from the heap what is most precious and agreeable. They consume little more than the poor, and in spite of their natural selfishness and rapacity, though they mean only their own conveniency, though the sole end which they propose from the labours of all the thousands whom they employ, be the gratification of their own vain and insatiable desires, they divide with the poor the produce of all their improvements. They are led by an invisible hand to make nearly the same distribution of the necessaries of life, which would have been made, had the earth been divided into equal portions among all its inhabitants, and thus without intending it, without knowing it, advance the interest of the society, and afford means to the multiplication of the species.”

Jack Weinstein aptly comments that “As an economic argument, this might have been more convincing in Smith’s time, before refrigeration, the industrial revolution, modern banking practices, and mass accumulation of capital…” He goes on though: “its relevance to the history of economics is based upon his recognition of the role of unintended consequences, the presumption that economic growth helps all members of the society, and the recognition of the independence of the free market as a natural force.” But if, for the sake of the exercise, we focus on how this relates to IFRS, it’s hard to get past Weinstein’s obvious caveat. Smith’s proposition that the invisible hand leads to “nearly” an equal distribution of the spoils often seems justifiable now only with a highly distorted sense of the near versus the far. Decades of financial reporting, let alone the fairly recent ascendancy of IFRS, haven’t done much to limit this – indeed, you could easily argue that inequality has only worsened since IFRS hit its stride. No doubt that’s more a correlation than a causation, but still…

This is, of course, more reflection than Hoogervorst ever intended to spark – after those opening thoughts, he rapidly moves on, spending most of the time on pension accounting. Even so, since I’ve criticized his speeches in the past for being shallow, I appreciated him opening up greater depths here. But, truly, I suspect that to happily rope in Adam Smith as a “big fan” of IFRS only indicates an absence of the rigorous ongoing self-interrogation that Smith might have counseled…

The opinions expressed are solely those of the author

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