Spillover From Corporate Fraud Will Cost Economy Billion$, Report says

by Emad Mekay

Besides pummelling the stock markets, the accounting frauds at corporate giants Enron, WorldCom and others will have spillover effects throughout the economy, affecting employment, inflation, and foreign investment in the United States, says the study by the Washington-based Brookings Institution.

The effects will possibly be felt beyond U.S. borders, it adds.

"Our assumptions about the costs of the scandal suggest that the economic price that we will pay will be fairly large and may last for a prolonged period of time," write the authors of the report, "The Bigger They Are, The Harder They Fall: An Estimate of the Costs of the Crisis in Corporate Governance."

A Labor Department report released August 2 seems to vindicate the study. It says only 6,000 jobs were created this month, way below the anticipated figure of 60,000.

Earlier this week, figures revealed that the U.S. economy grew at an annual rate of 1.1 percent during April, May and June -- much slower than the five-percent growth during the previous three months.

The Brookings report attributes much of the current problems to the two largest bankruptcies in U.S. history: Enron in December 2001, and telecommunications giant WorldCom this July.

Yesterday, FBI agents in New York arrested WorldCom's former chief financial office and its chief controller for their alleged role in the $3.9-billion accounting fraud.

The report says the bankruptcies symbolize a broader crisis in corporate governance and that their impacts on consumption and investment could shave up to $42 billion off the country's Gross Domestic Product (GDP).

A conservative assumption is that "at least half of the drop" in the stock market's value since March can be attributed to the Enron crisis, and that "roughly 80 percent" of the decline since June 2002 can be attributed to WorldCom and subsequent scandals.

"Several months down the road, Enron symbolizes the opening of a deep and dark Pandora's box, the end of which seems nowhere in sight," the report says.

Consumption will be dampened by the so-called "wealth effect" -- feeling poorer, consumers will spend less, which discourages investment and employment. Anticipation of less consumer spending will also cause firms to slow investment.

The report also says that revelations of subsequent accounting scandals, including Xerox, and Bristol Myers-Squibb, will start sending negative signals to other parts of the world about the free market economy.

"Until recently, U.S. accounting and other corporate management standards served as a 'gold standard' for many developing economies, and our stock market as the 'best of breed' example of a developed equity market," it says. "Yet in recent months, the turn to the market has also met increasing public frustration in these countries."

Wall Street also appeared unreceptive to last month's buoyant speeches by President George W. Bush and Federal Reserve Chairman Alan Greenspan and the Senate's unanimous approval of a bill to reform accounting and corporate governance.

"Part of the problem stems from the public perception that the scandal is situated at the centre rather than the periphery of the system," says the report. "It hinges on companies misreporting their earnings, skewing the price-earnings ratio, a measure which is at the core of most decisions investors make about where and when to invest."

Almost 50 percent of U.S. households own some form of stock, says the report.

The broad-based Wilshire 5000 Index, which tries to capture all publicly traded U.S. companies, shows that the market lost seven trillion dollars from its peak on Mar. 24, 2000 to July 18, 2002.

The report says without action to correct the problems, investors and consumers may not respond to words of comfort from officials and executives.

"In short, investors want more than words. They want earnings figures they can trust, as well as evidence that those figures are on their way up," it says.

The authors say that investors are likely to take a "wait and see" attitude... Based on past stock price downturns, that period is likely to be at least a year, and "perhaps substantially longer than that".

"Recognition of these costs should give impetus to new reforms in accounting and corporate governance, reforms which in turn can restore a sense of security in our stock market so that the costs are short-lived," concludes the study.