Editor’s Note: Have you balanced your check book this month? It’s mundane, and with online banking, it’s become less of a habit. But that most basic form of accounting is also easy. Maybe that’s why it’s too often overlooked, perhaps not to our personal peril, but when ignored on a larger scale, putting at risk our government and corporate institutions. Louis XIV, for example, stopped carrying golden notebooks of his expenditures and revenues, and his nation plunged into the red under the weight of multiple wars and opulent palaces. For a modern example of the importance of accounting, look no further than the collapse of Lehman Brothers. Simply put, accounting has made the difference between when societies and institutions rise and fall. University of Southern California professor Jacob Soll makes that point in his recently published book, “The Reckoning: Financial Accountability and the Rise and Fall of Nations.”
But it’s not that simple. We were interested in Soll’s argument because it’s a nuanced, and, in true Making Sen$e spirit, interdisciplinary one. (Soll, a MacArthur “Genius Grant” recipient, is a professor of history and accounting, with advanced degrees from Cambridge and Paris’ École des Hautes Études en Sciences Sociales.) Soll shows that financial accounting is intrinsically linked to political accountability. The very culture of accounting, he writes, brought about capitalism and representative government. And yet, he cautions, that’s not an ascendant path. In other words, the culture of accounting still breaks down. Financial accountability is still elusive for both corporations and governments, even democracies like the United States, which hasn’t undertaken a significant accounting of what the big banks have done with government money they received during the financial crisis.
If Americans can’t even balance their checkbooks, let alone perform the double-entry bookkeeping that Romans considered essential knowledge, how can we keep our political leaders accountable? That humans, over hundreds of centuries, continue not to recognize how fragile this basic, but very important accounting can be, suggests that Soll will have a lot more to write about in the future.
— Simone Pathe, Making Sen$e Editor
In September 2008, just as I was finishing a book about the French King Louis XIV’s famed finance minister Jean-Baptiste Colbert, I found something remarkable: Colbert commissioned miniature golden calligraphy account books for the Sun King to carry in his coat pockets.
Twice a year, starting in 1661, Louis XIV would receive these new accounts of his expenditures, his revenues and his assets. It was the first time a monarch of his stature had taken such an interest in accounting. Here, then, it seemed, was a starting point of modern politics and accountability: a king who carried his accounts so that, at all moments, he might have some reckoning of his kingdom.
I was at least as startled to learn next just how short-lived this experiment was. For as soon as Colbert died, in 1683, Louis — consistently in the red due to his predilection for costly wars and palaces like Versailles — discontinued the account books.
Rather than tools of administrative success, Louis came to see his account books as illustrations of his failings as a king. He had created a system of accounting and accountability, and now he began breaking up the central administration of his kingdom. This made it impossible to unify the accounts of each ministry into one clear, central register, as Colbert had done, and for any minister to effectively critique, let alone understand, the king’s financial management. If good accounting meant facing the truth when the news was bad, Louis, it seemed, now preferred ignorance. Speaking those famous words, “l’État c’est moi,” he apparently really meant it. No longer would a functioning state interfere with his personal will. On his deathbed in 1715, Louis admitted that he had in effect bankrupted France with his spending.
The mirage of Lehman Brothers
Rather than some relic of a bygone age, the story of Louis’s rise and decline seemed to me all too familiar as I digested the parable of the Sun King’s golden notebooks. That very week in September, a startling parallel was unfolding in the collapse of Lehman Brothers Bank. A monument of American and world capitalism, Lehman was suddenly exposed now as little more than a mirage. Just as Louis had held onto his power through snuffing out good accounting in his government, so U.S. investment banks had made untold riches, even as they destroyed their own institutions by cooking their books through trading overvalued bundles of worthless subprime mortgages and credit default swaps. A financial system, which had been deemed healthy by accountants and regulators alike, now revealed itself as dysfunctional by design.
If Louis preferred not to know, so, too, it seemed, Wall Street and its regulators had chosen to overlook the rot threatening the entire financial system. The chairman of the New York Federal Reserve, Timothy Geithner, was supposed to have at least an expert knowledge of the financial markets, and yet he appeared not to know, or know fully, what was going on just blocks from his office. The Securities and Exchange Commission (SEC), which is responsible for enforcing good corporate accounting, was caught similarly unaware, as were the Big Four accounting firms — Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers. No one, it seemed, had effectively audited the bank’s books. They missed the barely hidden fact that Lehman Brothers used accounting fraud to manipulate its accounts and appear solvent.
Soon after Lehman Brothers collapsed in September 2008, other American investment banks began failing, and the world financial system was threatened with collapse. In October, the Bush administration stepped in to bail out the banks and buoy the financial system. Thus came to pass the Troubled Asset Relief Program (TARP), which gave massive funds to troubled banks and put the American capitalist economy on a government life support system. By 2009, Barack Obama was president, promoting Geithner to secretary of the Treasury. And yet, in spite of Obama’s claims of a new age of accountability, a sense of impunity pervaded Wall Street. The $350 billion recapitalization of American banks managed to stave off the financial chaos that risked consuming the world economy. Yet, no strings were attached to the money. No audits were ever made to see how the banks spent it. America’s economy stumbled, but the bankers, at least, had avoided a reckoning.
Six years later, it is not just banks that are threatened by financial crisis brought on by bad bookkeeping. Leading nations — the United States, European countries, and China — find themselves facing their own larger potential crises of accounting and accountability. From opaque banks and the sovereign debts of Greece, Portugal, Spain and Italy, to the financing of municipalities worldwide, there seems little certainty in balance sheets and reports on debt levels and pension obligations. Confidence in private auditors and public regulators also lags. At the very moment we most need careful audits to assess balance sheets, the SEC remains woefully underfunded, and government regulation has limited the capacity of the Big Four accounting firms to aggressively audit corporations.
There has been little to no outcry over dangerously feeble financial accountability, private and public alike. One hears complaints about the impunity of banks, on one hand, or some version of indignation over perceived government interference with the freedom of Wall Street, on the other. Yet there has been no serious discussion about what exactly financial accountability is, how it works, where it comes from, and why modern societies find themselves mired in crises of not only financial but also political accountability, as governments and citizens seem either unable or unwilling to hold corporations and themselves accountable.
This is the reason I believe the history of accounting is essential to understanding why accountability is so hard to achieve. Often overlooked as boring or marginal, accounting, in fact, is at the basis of building businesses, states and empires. It has helped leaders craft their policies and measure their power. And yet, when practiced poorly or neglected, accounting has contributed to cycles of destruction, as we saw all too clearly in the 2008 financial crisis.
An accounting of accounting
From the decline of Renaissance Italy, the Spanish Empire and Louis XIV’s France to the Dutch Republic, the British Empire, and the early United States, effective accounting and political accountability have made the difference between a society’s rise and fall. Over and over again, good accounting practices have produced the levels of trust necessary to found stable governments and vital capitalist societies, and poor accounting and its attendant lack of accountability have led to financial chaos, economic crimes, civil unrest and worse.
All this is every bit as true in our own day of multitrillion-dollar debts and massive financial scandals as it was in the Florence of the Medici, Holland’s Golden Age, the heyday of the British Empire, and, of course, 1929 on Wall Street. Capitalism and government, it seems, have flourished without massive crises only during distinct and even limited periods of time when financial accountability functioned. People have known how to do good accounting for nearly a millennium, but many financial institutions and regimes have just chosen not to do it. Those societies that have succeeded in building complex capitalist economies are not only those rich in accounting and commercial culture but also the ones that have worked to build a sound moral and cultural framework to manage the fact that humans have a regular habit of ignoring, falsifying and failing at accounting. My book examines why a lesson so simple has so rarely been learned.
The first successful capitalist societies developed systems of accounting and corresponding financial and political accountability. In 1340, the Republic of Genoa kept a large register in the central government office. It recorded the city-state’s finances through double-entry bookkeeping. Accounting brought with it a fundamentally different way of thinking about political legitimacy: Balanced books equaled not just good business but also good government. At any moment, the maritime republic knew the state of its finances and could even make plans for future difficulties. The Genoese, Venetians, Florentines, and other merchant republics, or at least their ruling classes, could expect a certain level of accountability. This was the beginning of modern government as we ideally imagine it: semi-rational, well ordered and generally accountable.
And yet, as successful as they were, accountable societies and governments proved to be difficult to maintain. In the 16th century, with the decline of the Italian republics and the rise of the great monarchies, the interest in accounting faded. Even as merchants became ever more familiar with the practice of double-entry accounting, it all but disappeared as a political administrative tool outside Switzerland and Holland, bastions of republicanism in a world of monarchies. At the height of the Renaissance and the scientific revolution that emerged from it, between 1480 and 1700, kings did take an interest in accounting. King Edward VII of England, King Philip II of Spain, Elizabeth I of England, the powerful Austrian emperors, Louis XIV, and the German, Swedish, and Portuguese kings examined accounts and kept treasurers and account books. Yet none managed or ultimately desired to create the kind of stable, centralized, double-entry state accounting system so carefully controlled by the 14th-century Genoese and other northern Italian republics. Indeed, keeping good state ledgers implied that the king answered to the logic of balanced books. Much as they tried to reform their administrations, monarchs, in the end, saw themselves as accountable to God, not to bookkeepers. This inherent conflict between monarchy and financial accountability helped cause centuries of European financial crisis.
Monarchs considered transparent accounting practices dangerous, and, indeed, they could be. In 1781, eight years before the French Revolution, Louis XVI’s finance minister, the comte de Vergennes, found his country crippled by debt from the American War of Independence. These debts, he warned, could never be revealed, however, for publicly exposing royal accounts would surely undermine that most critical religion of monarchy: secrecy. In the end, Vergennes knew little about finance — France was, in fact, nearly bankrupt by this point — but he was right about monarchy. Opening up the books opened the floodgates of accountability. When royal accounts and the depth of the crown’s financial difficulties were discussed publicly for the first time during political debates in the 1780s, Louis XVI lost part of his regal mystery. For this, and a host of related reasons, he would later lose his head.
Yet even with the emergence of nominally open, elected governments in the 19th century, accountability was still often unattainable. During the 19th century, as England ruled its empire and was the center of world finance, corruption and unaccountability plagued its financial administration. As 19th-century America carefully designed mechanisms of financial accountability, it, too, was mired in the massive financial accounting frauds, scandals and crises of the robber barons of the Gilded Age. There has never been a perfect model of a constantly accountable state. Financial accountability — both corporate and governmental — still remains elusive even in democratic societies.
The study of accounting and accountability allows us to understand how institutions and societies succeed and fail at their most basic levels. We recognize that the Medici Bank, the Dutch dominance of commerce, and the British Empire were successes, and yet, of course, they no longer exist. So if each one of these institutions knew massive success, it also knew great decline and fall, and accounting was central to each of these stories. Seen through the lens of the history of financial accountability, then, the history of capitalism is neither simply a history of ascent nor a cycle of booms and busts. Rather, capitalism and modern government have an inherent weakness: At crucial moments, accounting and the mechanics of accountability break down, adding to financial and political crises, if not creating them. The success of a society, at least financially, is, in great part, the mastery of accounting, accountability, and the ensuing struggle to successfully manage them.
The magic of double-entry accounting
Without double-entry accounting, neither modern capitalism nor the modern state could exist, for it is the essential tool in calculating profit and loss, the basis of financial management. Double entry emerged in Tuscany and northern Italy sometime around 1300. Until then, the great ancient and medieval societies persisted without it. Indeed, the advent of double-entry accounting marks the beginning of the history of capitalism and modern politics.
So what exactly is double-entry accounting? Single-entry accounting, like balancing a checkbook, tallies only what goes in and out of a single account. Double-entry accounting, by contrast, is a method of exacting control and accurately calculating profit, loss, and the value of assets. It consists of two separate columns. Every transaction of expenditure could be checked against the corresponding income: if one sold a pig for three florins, one gained three florins and, in the other column, lost a pig. Then a tally of profit or loss is calculated, or balanced on the spot. Once the balance has been tallied, the transaction is over, and both sides have a line drawn through them. Profit and loss are known at all times.
Double-entry bookkeeping for capitalism can also be understood with what accountants call the fundamental accounting equation: The assets controlled by an organization are always exactly equal to the claims on those assets held by its creditors and owners. This allows businesses and governments to track their assets and obligations, while preventing and deterring theft. These measures of performance — wealth and income and, above all, profit — make double-entry accounting a tool for financial planning, management and accountability.
The founders of modern economic thought — from Adam Smith to Karl Marx — saw double-entry accounting as essential to the development of successful economies and modern capitalism. In 1923, the pioneering German sociologist and theorist of capitalism Max Weber wrote that the modern firm is bound with accounting, “which determines its income yielding power by calculation according to the methods of modern bookkeeping and striking a balance.” Weber saw accounting as one of many cultural elements necessary to the growth of complex capitalism, placing it squarely among the fundamental traits of the Protestant work ethic that he believed allowed early Americans to master capitalist culture.
Even blunter was the influential German economist Werner Sombart: “One cannot imagine what capitalism would be without double-entry bookkeeping: the two phenomena are connected as intimately as form and contents.” The Austrian American economist, political scientist, and coiner of the term “creative destruction,” Joseph Schumpeter, not only saw accounting as central to capitalism but also lamented that economists had not devoted more attention to it; it was only through a historical understanding of accounting practices, he wrote, that effective economic theory could be formulated.
A judgment as good as God’s
These thinkers saw accounting as an ingredient to economic success and a key to understanding economic history. What they did not see, however, is how political stability is grounded in cultures of accountability, which rely on double-entry accounting systems. Double entry mattered not only for calculating profit but also because it brought with it a central concept of the balanced book, which could be used to judge and hold accountable a political administration. In medieval Italy, not only did balanced books mirror the divine aspect of God’s judgment and a tally of sins, but they also came to represent sound business and good government. Of course, it is one thing to have a set of values; the challenge is to uphold them, and maintaining financial accountability was and is a constant struggle.
What this book shows is that financial accountability functioned better when accounting was seen not simply as part of a financial transaction but also as part of a moral and cultural framework. From the Middle Ages to the early 20th century, those societies that managed to harness accounting and long-term traditions of financial accountability and trust did so by full cultural engagement: Republican Italian city-states like Florence and Genoa, Golden Age Holland, and 18th- and 19th-century Britain and America all integrated accounting into their educational curriculum, religious and moral thought, art, philosophy and political theory. Accounting became the subject of theological and political works, great paintings, social and scientific theories, and novels, from Dante and the Dutch Masters to Auguste Comte, Thomas Malthus, Charles Dickens, Charles Darwin, Henry David Thoreau, Louisa May Alcott and Max Weber. In a virtuous circle, the elevation of practical, business-minded mathematics into the spheres of high and humane thinking allowed these societies not only to maximize their use of accounting but also to build complex cultures of accountability and awareness of the difficulties posed by such a culture. With this culture of accountability came capitalism and representative government.
The delicate interplay between accounting and accountability can decide the fate of a company or, indeed, a nation. Financial history, therefore, is not only about cyclical crises or trends in numbers. It is also a story about individuals and societies that become adept at mastering the interplay between accounting and cultural life, yet often lose this capacity and find themselves facing unexpected, avoidable, and sometimes cataclysmic financial crises. In this long history, accounting and financial accountability emerge as both mundane and, at the same time, difficult to control. What is remarkable is that the basic lessons of medieval Italian accounting — that it is essential to wealth and political stability but incredibly difficult, frail, and even perilous — are still as pertinent today as they were 700 years ago.