The Virginian-Pilot, Thursday, July 11, 2002 (B9)

Full style points to President Bush for Tuesday’s fire and brimstone Wall Street speech. He clearly recognized the danger to the nation’s limp economic recovery, and to his party’s mid-term election chances, of the continuing scandals roiling U.S. equity markets. The substance of his talk, however, was less reassuring.

The President called for a new ethic of personal responsibility in the business community, and where that fails he wants harsher prison sentences for corporate managers convicted of fraud. A nice start, perhaps, but one that is unlikely to restore investor confidence as widely held firms like WorldCom get added to the growing rogues’ gallery of corporate miscreants smearing the American economic landscape.

Broad market indexes like the Wilshire 5000 indeed show that U.S. stockholders have lost over a third of their portfolio value since the all-time high back in March of 2000. In just the past four months, stocks have shed sixteen percent. In dollar terms, the losses in personal wealth are measured in trillions. Yet focusing on these magnitudes misses the point.

Changes in wealth do 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.

A far greater danger is the prospect that we will lose faith in the entire 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 firms and accountants to fudge the rules. The President’s answer is his 10-point accountability program for American business. This proposal is old news -- the Dow actually fell after the speech -- and it’s longer on exhortation than specifics. We should all sleep better knowing that the leaders of one thousand large corporations have been asked to verify that their financial information from last year is "fair and accurate."

Threats of harsh punishment may or may not deter CEO shenanigans in the future. Building a new case law takes time, and we have yet to see a single indictment in what are inherently complicated legal cases.

In any case, prevention is more effective than prison, and here the President ducked the hard decisions. Adding an extra hundred million dollars for the Securities and Exchange Commission is a nice down payment, but it is several hundred million short of Congressional proposals. And he declined to endorse Senator Paul Sarbanes' (D-MD) sensible proposal for an independent oversight board for the accounting industry.

The second ominous development is the tendency for financial innovations to make existing accounting practices obsolete. The stock options frenzy, for instance, makes it very difficult for an average investor to figure out how well a firm is doing by looking at standard measures like the price-earnings ratio. The options represent an implicit obligation of the firm that never makes it onto the books. The President’s only mention of this is a tepid plea for all stock options plans to be approved by the shareholders.

If people cannot glean reliable information from a firm’s accounts, bad risks and good risks will be lumped together. At some point, investors may flee financial assets, especially long term ones like stocks and corporate bonds, seeking safety in cash and other assets like 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 firms that use equity markets to raise capital. Gold bugs may smile (the yellow stuff is up fourteen percent so far 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.

Throwing the bums in jail may satisfy a public craving for economic justice, but the Bush administration needed to make a stronger 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.