Add this to the "to read as soon as possible" pile. I suspect that Litan and Graham have missed most of the costs. They focus on the effect of the stock market decline on next year's level of production and aggregate demand. But the big costs will come via a higher long-run cost of capital to investing firms as the breaking of trust in corporate reporting causes savers to shy away from whole classes of investments. Those costs aren't in Litan and Graham's calculations. (Then, again, I have no clue how to quantify them either.)
Posted by DeLong at August 05, 2002 08:08 PM | TrackbackBrookings Study Details Economic Cost of Recent Corporate Crises
A new report from the Brookings Institution estimates that the Enron and WorldCom scandals will cost the U.S. economy approximately $37 to $42 billion off Gross Domestic Product (GDP) in the first year--assuming the market does not recover from its July 19 level or drop substantially below it. Even with the July 24 rebound, the market remains close to that level. The study, "The Bigger They Are, The Harder They Fall: An Estimate of the Costs of the Crisis in Corporate Governance," bases its findings on conservative estimates of the effects of the crisis on stock market wealth which are calibrated according to the Federal Reserve Board's model of the U.S. economy. Carol Graham, vice president and director of Governance Studies, Robert E. Litan, vice president and director of Economic Studies, and Sandip Sukhtankar, research assistant in Economic Studies, co-authored the report...
I'd guess that fear of corporate fraud will manifest in: (1) increased attractiveneess of bonds; (2) increased attractiveness of real estate (until/barring a real estate bubble collapse), and (3) increased attractiveness of foreign investments, particularly European - there is a currency risk, but this may now be offset by an increased US corp. governance risk.
Now that I've done the hard Big Idea work, I'll leave the mundane calculations to others:)
Americans unlike Western Europeans or Japanese are increasingly forced to learn how to invest for retirement. Perhaps the vast bulk of us should simply index and average funds to the index for our working lives. However, at some point bonds will be important. Simply learning how to balance a portfolio will take assistance or finding solid learning tools. This bear market should have shown us how tricky providing for our retirements can be. Imagine if social security were to be "privatized." Where is there responsibility for employers to provide assistance to us in making investment decision? Perhaps there is no employer responsibility. To whom then do we turn for such critical assistance. Are we all supposed to be Wall Street savvy?
Posted by: on August 6, 2002 11:03 AMBrad - There appears to be a growing gulf between yields on government and corporate bonds. You surmise about higher costs of debt maintainence for corporations due to the governance problems may be quite an important cost component.
Posted by: Arthur on August 6, 2002 01:06 PMI do not get it. Hundreds of billions of dollars in stocks and bonds were lost in the Enron and Worldcom disasters. These are real losses. Bond holders may recoup a bit, stock holders will get nothing. Workers were fearfully hurt, pensions and benefits and decent jobs lost. Even if the stock market quickly returns to zero for 2002, Enron and Worldcom will sruely have been disasters.
Posted by: JD on August 7, 2002 11:57 AMBrad,
I enjoy tremendously your website, but I am puzzled that you pretend to have no clue how to quantify the impact on capital cost, which are the weighted sum of equity cost and debt cost. For corporates, equity cost are the sum of real Treasury yield plus expected CPI inflation plus the equity risk premium. Debt cost are the sum of real Treasury bond yield plus expected CPI inflation plus corporate yield spread (plus sovereign yield spread outside the US). Cost changes could be compared for 4/02 and 7/02 (as in the Brookings paper). Am I missing something?
Best regards
Helmut Reisen
OECD Development Centre, Paris