Capital Maintenance in Units of Constant Purchasing Power

December 13, 2012 in Uncategorized

Capital Maintenance in Units of Constant Purchasing Power

Capital maintenance in units of constant purchasing power would
(a) – with never implementing the stable measuring unit assumption – automatically maintain the real value of constant real value non-monetary items constant for an indefinite period of time in all entities that at least break even in real value – all else being equal – at all levels of inflation and deflation, including during high inflation and hyper inflation, whether they own any revaluable fixed assets or not
and
(b) – with daily inflation-indexing the entire money supply – compensate 100 percent for the effect of inflation and deflation (including high inflation and hyperinflation) on the real value of only monetary items.
It does exactly what its name states: it automatically maintains the constant purchasing power of capital (equity) constant for an indefinite period of time, but, only in entities that at least break even in real value – all else being equal – at all levels of inflation and deflation, whether they own any revaluable fixed assets or not: i.e., the constant purchasing power (real value) of capital is equal to the real value of net assets under this model – in conformity with FAS 33, Par. 24:
‘It is essential to the credibility of financial reporting to recognize that the recovery of the real cost of investment is not earnings – there can be no earnings unless and until the purchasing power of capital is maintained.’
FAS 33, Par. 24
Daily inflation-indexing the entire money supply does not mean low inflation, high inflation, hyperinflation or deflation would stop, because these economic processes are determined by a number of factors, a very important one being the level of increase or decrease of the money supply. It would, however, always compensate for the effect: it would always be as if there were no low inflation, high inflation, hyperinflation or deflation during low inflation, high inflation, hyperinflation or deflation. It would always result in zero erosion of the real value of monetary items, not zero inflation because using the Daily Consumer Price Index (or daily US Dollar parallel – free market – rate during hyperinflation) would automatically result in eliminating the effect of low inflation, high inflation, hyperinflation or deflation.
(a) Daily inflation-indexing the entire money supply plus (b) capital maintenance in units of constant purchasing power in terms of a daily index means the local currency is used as a constant (not nominal) unit of account: in effect, the constant item and monetary economies would be “dollarized” in terms a constant (not nominal) local currency.
The stabilizing effect of adopting capital maintenance in units of constant purchasing power on real values in the constant item and monetary economies of previously high inflationary and hyperinflationary economies would generally lead to low inflation after adoption of the new accounting model – all else being equal – as it happened after the adoption of the Real Plan in 1994 in Brazil.
Capital maintenance in units of constant purchasing power in terms of a daily index is very similar to Dollarization of a previously high inflationary or hyperinflationary economy. However, under official Dollarization the local Central Bank (1) has no autonomous monetary policy capability and (2) seignorage (the practically 100 percent profit Central Banks / countries make on printing new bank notes and coins as required by their growing economies) continuously accrues to the US economy (a foreign economy) – the Fed prints the new US Dollars required – while under capital maintenance in units of constant purchasing power the local economy (i) gains economic stability similar to being Dollarized, but (ii) the local Central Bank maintains its independent monetary policy capacity and (iii) the local economy continuously benefits from the entire profit from seignorage.
The previous paragraph explains the use of capital maintenance in units of constant purchasing power in terms of a daily index – a freely available IFRS – to stop hyperinflation overnight at no cost instead of with very costly Dollarization or an equally costly currency board, the solutions of Prof. Steve Hanke, the eminent US economics professor who had already been personally involved in stopping 10 hyperinflations in this fashion. Official Dollarization and a currency board both require vast sums of US Dollars to replace the local currency money supply, often a prohibiting factor for a country in hyperinflation.
The very successful Real Plan used by Brazil in 1994 to stop their hyperinflation overnight at no cost was, in essence, capital maintenance in units of constant purchasing power in terms of a daily index although they did not understand it as such at the time.
The option to use a freely available IFRS to stop hyperinflation overnight at no cost obviously makes the Dollarization and currency board solutions obsolete and irrelevant. No country in hyperinflation or high inflation needs to use these solutions any more. (A capital maintenance in units of constant purchasing power IFRS – IFRS ´X` – would thus be of great value to high inflationary and hyperinflationary countries although it obviously can already be done in terms of IFRS authorization in the Conceptual Framework, Par. 4.59 (a).)
Summary
Capital maintenance in units of constant purchasing power would automatically maintain the constant item and monetary economies stable resulting in a stable overall economy at all levels of inflation and deflation (including during high inflation and hyperinflation), which is the basis for real economic growth and increased employment and would result in sustainable economic development.

Nicolaas Smith
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