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ADD WorldCom to the growing rogues' gallery of corporate miscreants smearing the American economic landscape. The news that WorldCom overstated its cash flow by nearly $4 billion over the past 15 months is the latest in a string of accounting scandals to roil U.S. equity markets.
Money managers wait nervously for the next scandal. Consumer confidence, and with it the tentative economic recovery, seems at risk with each day's tally in the stock market.
Broad market indexes like the Wilshire 5000 show that U.S. stockholders have lost over a third of their portfolio value since the all-time high in March 2000. In the past four months, stocks have shed 16 percent of value. The losses in personal wealth are measured in trillions of dollars. Yet, focusing on these magnitudes misses the point.
Changes in wealth affect consumer spending, but it turns out that the wealth that matters is the value of your house, and the housing market remains quite healthy. The direct impact of changes in stock prices on consumer spending is negligible. This may be because of the more volatile behavior of stock prices - what's lost today will be regained tomorrow.
It's worth noting that the market today has no less value than it had in late summer 1998. In any case, the effects of the stock slide this year could easily be offset by another small stimulus package.
Far more worrisome is the prospect that we will lose faith in the accounting system that underpins modern financial markets. People are willing to hold financial assets in part because they trust the information that allows them to make tolerably accurate assessments of risk.
Two developments threaten that trust.
The first is the WorldCom or Enron problem: complicity between companies and accountants to fudge the rules.
The second is the tendency for financial innovations to make existing accounting practices obsolete.
The stock options frenzy, for instance, makes it difficult for an average investor to figure out how well a company is doing by looking at standard measures such as the price-earnings ratio. The options represent an implicit obligation of the company that never makes it onto the books.
If people cannot glean reliable information from a company's accounts, bad risks and good risks will be lumped together. At some point, investors might flee financial assets, especially long-term ones like stocks and corporate bonds, seeking safety in cash and other assets such as government bonds and metals.
In addition to sending the Dow down a few thousand more points, this final unwinding of the stock market bubble could create a liquidity crisis for all companies that use equity markets to raise capital. Gold bugs may smile (the yellow stuff is up 14 percent this year), but a dysfunctional capital market would choke off an important source of American innovation and growth. More immediately, the effect on the current recovery of another decline in business investment could be quite significant.
The American consumer never stopped spending despite the pre- and post-9/11 declines in consumer confidence. That is why the recession proved rather shallow, despite steep declines in business investment and manufacturing activity. But consumers have done their part. Today, households are spending more of their income to service debt than at any time in the past 20 years. A real recovery requires more business optimism, and that is in short supply.
Finally, our accounting scandals might have international consequences. The deep U.S. capital market has been a magnet for foreign investors. In addition to the jobs, technologies and new business techniques that this investment brings, the foreign appetite for investing in the United States makes up in part for the low propensity of Americans to save. Foreign investment is what permits the United States to run a trade deficit and a government budget deficit (remember those tax cuts) at the same time.
If foreign investors flee U.S. capital markets as well, we could be in for what is sometimes called a hard landing. With government and business competing for increasingly scarce funds, interest rates would rise and investment would suffer. Foreign sales of dollar assets could lead to a precipitous drop in the dollar. The dollar is falling against the yen and euro, and Federal Reserve Chairman Alan Greenspan has worried publicly about the consequences.
Small depreciations can stimulate exports, but a large, confidence-driven dollar free fall would soak up consumer purchasing power by raising the dollar prices of most goods.
Throwing the bums in jail might satisfy a public craving for economic justice, but the Bush administration needs to make a strong public case for accounting reforms and strengthened oversight procedures.
Making business balance sheets again a reliable source of information for average investors is the best way to sustain consumer and business confidence alike.
David H. Feldman is a professor of economics at the College of William & Mary in Williamsburg, Va.
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