Inside Story

A new mother tongue

Expanding how economics measures and reports will have enormous benefits, writes Jane Gleeson-White. And it’s already happening

Jane Gleeson-White 17 May 2016 3058 words

Learning your fortune: the Franciscan monk and mathematician Luca Pacioli, who codified the system of double-entry bookkeeping in 1494, shown here with a young man who may be one of his students. Detail from a painting attributed to Jacopo de Barbari/Wikimedia

As Oxford economist Kate Raworth so rightly puts it, economics is the “mother tongue” of public policy – and it is time to reimagine it for the twenty-first century. We need a new language for public policy and debate that brings together the many different critical factors required for human beings and the planet to flourish in the new century, which go beyond the monetary alone. Such a language is emerging.

One of the most telling moments in The Big Short, the film of Michael Lewis’s tale of the subprime mortgage boom and spectacular bust of 2007, is a small note at the bottom of the screen before the credits. It reads: “Michael Burry is focusing all of his trading on one commodity: water.” Burry is the genius who in 2005 saw the inevitability of the collapse. He is not alone in realising that water will be the most precious commodity of the twenty-first century. The problem of water, along with carbon emissions, is driving the conception of a new category of wealth: natural capital.

Speaking to Leigh Sales on the ABC’s 7.30 in December 2015 following the release of his $1.1 billion innovation statement, prime minister Malcolm Turnbull said, “We are in a world where the most valuable capital is human capital and that’s why it’s very important to be able to retain our best brains, to create an environment where they can grow businesses and try things out, use their imagination and innovation.” This “human capital” is another category of wealth critical for the twenty-first century.

The French economist Yann Moulier Boutang, whose book Cognitive Capitalism addresses our epochal transition from the industrial era to the information age, writes of the profound impact this shift is having on business and value: “What a company is worth is now determined outside its walls: its innovative potential, its organisation, its intellectual capital, its human resources overflow and leak in all directions.” “Intellectual capital” – which captures the productivity of knowledge workers, the attention, intensity, creativity, innovation and connectivity of their minds – is a third new category of wealth brought by the information age.

Natural capital, human capital, intellectual capital – along with social capital – are the components of a new language of economics and accounting that’s emerging to value the wealth brought by the information age addressed by Turnbull’s innovation statement, and the wealth being destroyed by the ecological crises, which mainstream economics is at a loss to grapple with. In Cognitive Capitalism, Moulier Boutang calls for a new ecological economics, and “in particular a new accounting system.” He recognised that any new ecological economics must be founded on an accounting system that can both capture the value of the information age and the newly appreciated ecological wealth of the planet, and relate this to the financial and industrial worth our current accounting system evolved to measure.

Such a system is already on the horizon, emerging simultaneously in several places from South Africa and Brazil to Scandinavia and Canada early in the new millennium. The first attempt to codify the new system, known as “integrated reporting,” was made by the International Integrated Reporting Council, or IIRC, and published in December 2013. Integrated reporting brings together information that has never been considered by financial reporting before, including the intangible value of the information age and the value of nature and society. For the first time, accountants and businesses are attempting to understand how their pursuit of profits affects the world around them, and how that world affects their ability to make profits.

At its simplest, integrated reporting is about getting businesses to tell their story, which they do by addressing six different capitals, or stores of value, they use to produce goods or services, and which their activities either enhance or deplete. The six capitals are financial, manufactured, intellectual, human, social and natural.

The urgent need for a new approach to accounting becomes apparent when you consider that our current system emerged in medieval Italy around 1300 to deal with an economic boom brought by the Crusades. This system, now known as double-entry bookkeeping, was codified by the Franciscan monk and mathematician Luca Pacioli, who published a treatise on Venetian bookkeeping in 1494. It’s worth remembering that the word capital itself was first used in its modern sense by the merchants of medieval Genoa, Florence and Venice to describe their worldly goods, which they recorded in their capital account.

The calculation of capital and its fluctuations (profits and losses) is central to the double-entry system. As Pacioli said, from the capital account “you may always learn what your fortune is.” For a typical Venetian merchant in November 1493 this fortune included papal florins; cash in gold and coin from Venice, Hungary and Florence; ginger, pepper, cinnamon and cloves; fox and chamois skins; and a large house over the canal. For the first time in history, merchants could measure their profits and losses, which they increasingly expressed in a language long banned by both the Church and the guilds: Hindu-Arabic mathematics.

Because he was writing at a time when the idea of profit-making and the tools to measure it were so brand new, Pacioli makes it clear in his treatise that the purpose of every merchant is “to make a lawful and reasonable profit so as to keep up his business.” This system made possible the measurement of financial capital.

Courtesy of Pacioli’s printed treatise, the double-entry system spread from Italy to the Netherlands and England, where the next great advance in accounting was made. In 1769, in the north of England, Her Majesty’s potter Josiah Wedgwood applied this double-entry system to solve a problem: despite the enormous popularity of his vases, he had a cash-flow problem and an accumulation of stock. So he asked himself, should he cut prices or cut production?

To answer this question, Wedgwood did something unprecedented: he turned to his double-entry accounts. Because they showed him the distinction between fixed and variable costs, his accounts told him to produce as many vases as possible. By studying his books, Wedgwood realised that his greatest costs were fixed costs, like moulds, rent, fuel and wages, and because these fixed costs remained the same regardless of how much was produced, the more his factory produced the cheaper these fixed costs would be per unit of production. As Wedgwood said to his partner, “You will see the vast consequence in most manufactures of making the greatest quantity possible in a given time.” And so the era of mass production and consumption was inaugurated and the second of the six capitals came into being: manufactured capital.

The industrial era also saw the rise of a new business form, the corporation, which was used to raise the unprecedented sums required to finance the titanic ventures of the industrial age, such as railways and canals. From 1844 in Britain and subsequently elsewhere, corporations were legally required to report to their capital providers what had been done with their money in the past year, and whether it had made a profit or a loss. To do this they used double-entry bookkeeping.

We still use this medieval bookkeeping system adapted for the industrial age to account for our wealth today – and yet, as you can see from the wealth of the Venetian merchant that included the treasures of pepper, ginger and papal florins, and Wedgwood’s treasure of manufactured vases, the things we consider valuable and that make up our wealth change over time. In our twenty-first-century world, so vastly different from Pacioli’s Renaissance Italy and Wedgwood’s agrarian England, two broad new forms of wealth have emerged. Brought by the networked computer and the various ecological crises from environmental degradation and resource depletion to extreme weather events and climate change, this wealth lies beyond the conceptual bounds of our current accounting and therefore economic systems.

The first new form of wealth has given rise to the idea of intangible or immaterial value, which comprises the products of the information age; the second to the wealth of nature and society, the concerns of sustainability. It is these new forms of wealth, conceived as capitals, that the new accounting paradigm seeks to consider and to integrate with financial information.

The first two new capitals, intellectual capital and human capital, came to the attention of accountants in the 1990s with the dotcom boom. Their invisible presence is best seen when information-age companies such as Twitter are listed on stock exchanges: their shares trade for astronomical amounts despite the fact these companies have nothing on their balance sheets. In traditional financial accounting terms, they are worthless. But that’s because the value of these companies can’t be seen in traditional financial reports, which measure only financial and manufactured capital, the tangible assets of the industrial era. Instead it’s in geeks and their software – or, in accounting terms, in human capital and intellectual capital, such as software, data, knowledge, networks and patents for new drugs.

The rise of intangible wealth is shown by a study published in 2010, which found that in 1975 a company’s balance sheet showed a sound 83 per cent of its value, with only 17 per cent in intangibles. This reflects the fact that its value was deeply rooted in industrial-age tangible assets, like cars, jeans and washing machines. Thirty-four years later, in 2009, intangible value spiked to 81 per cent of market value. This meant that a company’s financial accounts captured only 19 per cent of its value. A huge 81 per cent of its value was in its people and the products of their minds. This shift from tangible to intangible prompted management guru Peter Drucker to say in 1999, “The most valuable assets of a twentieth-century company were its production equipment. The most valuable asset of a twenty-first-century institution… will be its knowledge workers and their productivity.”

The second great force that has expanded concepts of wealth and value can be dated to the late 1980s. When the Exxon Valdez oil tanker ran aground in Prince William Sound and contaminated 2500 kilometres of coast with crude oil in 1989, the environmental cost of doing business was made shockingly clear.

In response to this catastrophe, US investment analyst Joan Bavaria brought together a group of environmental activists and social investors to ask companies to practise what she termed an “environmental ethic.” This required going beyond the profit-focused principle of US case law established in a case brought by the Dodge brothers against Henry Ford. In 1919 the Ford Motor Company was taken to court by two of its shareholders, John and Horace Dodge, when Ford decided to spend some of his enormous profits on employees and factories rather than paying dividends to his shareholders. But John and Horace wanted their money.

At the trial, Ford described his vision for his company in terms of social good, calling his business “an instrument of service rather than a machine for making money.” The Michigan Supreme Court rejected Ford’s reasoning and found in favour of the Dodge brothers. It ruled that the Ford Motor Company could not be run as a charity and held that a corporation is organised primarily for the profit of its shareholders. Ford was ordered to pay US$19 million to the brothers.

This landmark case created a culture in which profit maximisation became the sole purpose of commercial activity, epitomised by the influential economics of Milton Friedman and summed up in his 1970 essay emphatically titled “The Social Responsibility of Business Is to Increase Its Profits.”

The group Bavaria founded in 1989 to think beyond this profit imperative was called Ceres. In 1997 the head of Ceres, Bob Massie, and his colleague Allen White decided to create a global framework to report the environmental, social and economic impacts of corporations, which they called the Global Reporting Initiative, or GRI. Their aim was to transform the global accounting system. Since 2000 the GRI’s guidelines have led efforts to measure the last two of the new capitals: social capital and natural capital.

One person who understands the crucial importance of this new approach and the need to connect it meaningfully with financial information is British accountant Michael Peat. Peat believes accountants have a crucial role to play in introducing sustainability into business behaviour because they can provide the practical tools businesses need to respond to such massive issues as global warming, water shortages and deforestation. As he says, accountants can develop the information, methodologies and systems to move “being green” from “being trendy and fashionable to being core and mainstream.” It was Peat and the then chair of the GRI, Mervyn King, who founded the IIRC to create “a globally accepted framework for accounting for sustainability,” which they call integrated reporting.

The adoption of integrated reporting and thinking by companies and governments is being driven by the rapid rise of natural capital. In 2012 the United Nations gave natural capital equal status to the GDP when it adopted a new statistical standard to account for natural capital. The same year, forty financial institutions, including the National Australia Bank, signed the Natural Capital Declaration to promote the private sector’s use of natural capital. In November 2015, at the second World Forum on Natural Capital in Edinburgh, the Natural Capital Protocol was launched for consultation.

The new accounting system is the logical outcome of this long history. While it is still embryonic, it is the future. Its importance lies in the fact that it diagnoses from within the business community the big problem of our age: the fact that the daily operations of businesses are destroying the planet and human societies because they are governed by a sole legal obligation – profit maximisation. Integrated reporting creates a language that connects commercial activities with the natural and social world within which they so evidently operate. In this way, it begins to take account of the many “non-financial” values we must consider in the twenty-first century, and that increasing numbers of people now want to consider when doing business, working, shopping, investing, building, travelling and electing political representatives.

It was their desire to consider these non-financial values that prompted three friends and entrepreneurs in Philadelphia to reimagine the corporation for the twenty-first century. Jay Coen Gilbert, Bart Houlahan and Andrew Kassoy believe that business is the most powerful human-made force on the planet, and in 2006 they decided to harness its potential. They realised there was a growing number of entrepreneurs like themselves who were trying to address enormous social and environmental problems but struggling to do so because business structures don’t make it legally possible to pursue purposes other than profits. So they invented a for-profit company that is also legally obliged to make a material contribution to society and the environment. They called it the B Corporation, where “B” stands for “benefit” to workers, the community and the planet.

Ten years later, thirty-one US states have passed benefit corporation legislation to make this evolution in corporate purpose legally possible. Speaking at the public ceremony for the passing of benefit legislation in Delaware, the leading US state for incorporation, New York investment analyst Albert Wenger acknowledged the significance of the new corporate form. “The critical challenge for capitalism today,” he said, “is not to make more stuff but to work out how we can live in harmony with the environment, and what we can do about disappearing jobs, income inequality and providing better access to affordable good-quality healthcare and education.”

Benefit corporations address these urgent social and environmental issues, and if they’d been around in 1919 the Dodge brothers would have lost their case against Henry Ford. B Corporations are spreading around the world. In August 2014 B Lab Australia & New Zealand was launched in Melbourne and eighty-two B Corporations are now operating in the region, ranging from professional service firms and media organisations to producers of consumer goods, builders and property developers. B Lab ANZ is currently working to make the legislative changes Australia requires to enshrine the B Corp in statute.

The implications of this evolution in accounting and business are profound for the material world and its cultures, including economics and the way it’s framed. Economics must now include within its ambit entities previously considered to be outside its bounds, such as “society” and “nature.”

Kate Raworth is rethinking economics for the twenty-first century by envisioning its new bounds as two circles shaped like a ring. The ring is made from two sets of boundaries: the outer circle, or “environmental ceiling,” is the boundary beyond which the earth’s ecological systems cannot be pushed if it is to continue to sustain human life; and the inner circle, or “social foundation,” is the boundary below which lie many dimensions of human deprivation. “Between the two boundaries lies an area – shaped like a doughnut – which represents an environmentally safe and socially just space for humanity to thrive in,” Raworth explains. “It is also the space in which inclusive and sustainable economic development takes place.”

Raworth’s reimagining is a powerful new way of understanding economic activity in a planetary framework that considers ecological and social systems and limits. Analogously, at a community level the idea of a circular economy is taking hold around the world. In Australia the Cowra Low Emissions Action Network, or CLEAN, is working to create a circular economy in which all waste is recycled and reused through alternative energy generation, resource efficiency and remanufactured value-added products for the benefit of the community.

These new economic and accounting languages and frames, which consider wealth beyond the financial with material limits and social and ecological purposes, are the beginnings of a new economic and accounting imaginary for the twenty-first century. •

This essay appears in Griffith Review 52: Imagining the Future, edited by Julianne Schultz and the Melbourne Sustainable Society Institute’s Brendan Gleeson.