More Beltway Madness

This article orignally appeared on National Review Online on August 6, 2002.

The Brookings Institution website features a paper called “The Bigger They Are, the Harder They Fall” by Carol Graham, Robert Litan, and Sandip Sukhtankar. The title is terrific. But the paper shows just why beltway pundits should avoid trying to explain the stock market.

The purpose of the paper, aside from politics, is to estimate the effects on the overall economy of accounting scandals. The authors begin that chore by assuming that (1) giant bankruptcies were caused by bad accounting rather than the other way around, and that (2) stock prices fell after May 19 largely because the market suddenly noticed that Enron had gone bankrupt the previous December.

When they speak of Enron and WorldCom, the authors assert that, “both bankruptcies resulted from accounting malpractice.” That is such an indefensible claim that the authors do not bother trying to defend it. Accounting scandals were efforts to conceal failure, not the cause of failure.

With more honest accounting we would have learned that Enron had larger debts and smaller assets and revenue than we thought, and the bankruptcy would have occurred months before it did. With more honest accounting we would have learned that WorldCom’s small earnings (which had already driven the stock below a dollar) were actually small losses, and that too would have resulted in an earlier bankruptcy. Airing these problems sooner would have been better than letting them fester, but it is transparent nonsense to pretend the bankruptcies could have been avoided by simply coming clean sooner about financial meltdowns.

The authors go on to make what they describe as a “conservative assumption” that “at least half of the drop in the stock market’s value since March can be attributed to the Enron crisis.” Conservative or not, that assumption is untenable. The timing is all wrong. Enron’s bankruptcy on December 2 of last year was old news by March 20, 2002, when the market began an initially modest slide. Whatever news updates we may have received on Enron after March 19 could not possibly be compared to the shocking news of Enron’s bankruptcy in late 2001 when stocks were rising.

Despite assuming that half of the market’s recent decline was due to old news about Enron, the authors nonetheless say, “Enron in isolation had a limited effect on the market.” Adding to that confusion, they assume that “roughly 80% of the drop in the market’s value since June 2002 can be attributed to WorldCom and subsequent scandals.” Unfortunately, the WorldCom story also requires that the market react only to last month’s headlines. Anderson, which is not even publicly traded, was convicted on June 15. Troubles at ImClone and Tyco were old news by mid-June and had to do with personal insider trading and personal tax evasion — not accounting.

WorldCom, the last big shoe to drop, was formally charged on June 26. Yet the market’s steepest drop began on July 8 and continued for weeks. There were no “further scandals” in July, aside from an unconvincing Washington Post story questioning a few advertising transactions at AOL. News of the related SEC investigation pushed AOL stock down on July 24, but that was a terrific day for the market.

The only big news after July 8 was that the White House and Senate were about to pass new laws that promised to enlarge corporate legal bills and add to regulatory uncertainty. The fact that the market fell sharply only after the government got serious about “restoring investor confidence” is powerful evidence against this paper’s basic premise. The authors therefore feel compelled to claim the “downward tailspin … seems impervious to the recent speeches by President Bush and Federal Reserve Chairman Greenspan and the unanimous passage in the Senate of accounting and corporate governance legislation.” The market did not seem “impervious” to Washington’s efforts; it seemed properly terrified.

The authors managed to yank yet another odd assumption out of this mess; they concluded that “accounting episodes” alone have reduced stock-market wealth by 17.5 %. That decimal point precision is supported by the fact that “credible predictions” from “leading securities firms such as Merrill Lynch” turned out too bullish. Since nobody except New York Attorney General Elliot Spitzer ever imagined that Wall Street estimates had a bullish bias, the authors deduce that stocks must have fallen because of accounting scandals. What other explanation could there be?

Well, even aside from all the anti-business zealotry in Washington lately, couldn’t the market have noticed that growth of final sales slowed to zero in the second quarter? Wouldn’t investors be at all concerned that second-quarter earnings of S&P 500 firms were virtually unchanged since the deepest part of the recession a year ago?

There is one footnote noticing that the market still goes up on rare good news about earnings, regardless of how those earnings are measured, but the rest of the paper assumes investors are totally obsessed with the bookkeeping of two bankrupt firms.

The authors’ conclusion that the economy will be badly damaged by the loss of household wealth is almost as flawed as the assumptions. They fail to take into account the portfolio switch from stocks to bonds, which pushed bond prices up as stock prices fell. They note that “stock market wealth currently accounts for roughly one-third of household net worth” yet ignore the other two-thirds — mostly bonds and homes, which are both up.

The only thing useful that anyone might learn from this Brookings Institution paper is this: Those who start out with incredible assumptions are doomed to end with unbelievable conclusions.

Alan Reynolds is a senior fellow with the Cato Institute.