The costs of book-cooking

Just months after the end of the longest period of prosperity in US history, the news is all about the falling stock market.

The two largest bankruptcy petitions in our history – both caused by corporate mismanagement – occurred back to back. The stock market has been spooked by scandals involving blue-chip firms. Stocks are down substantially from three months ago and remain volatile. A nascent economic recovery is jeopardized by a loss of confidence in the markets as well as by the "paradox of thrift" – investors' wariness about investing too soon.

The crisis in corporate governance has so shaken public confidence because it is at the center of the system. It hinges on misreporting of company earnings, skewing the price-earnings ratio, which is a measure at the core of most decisions investors make about where and when to invest. It has also touched actors at the highest levels of our political system.

Our full analysis of the costs of the corporate governance crisis for the US economy can be found at www.brookings.edu. We take a range of assumptions about the portions of the drop in stock-market value attributable to the crisis – based on trends in the S&P 500 – and then use the parameters in the macroeconomic model developed at the Federal Reserve Board. With our base assumption – 17 percent of the drop in stocks – we estimate that the current crisis will likely reduce the gross domestic product by about $35 billion, or 0.34 percent, over the next year. This estimate assumes that stocks remain near their July 19 closing level, when the Dow was about 8000.

How much is $35 billion? Roughly what US consumers would pay in import costs if crude oil rose by $10 a barrel. If markets fall further – say, to their July 22 level (a 7785 Dow) – the costs would be $39 billion. If they stay higher, such as the July 30 Dow of 8680, the costs would be $28 billion. There is considerable uncertainty surrounding our estimates. Economists continually debate the magnitude and timing of the "wealth effect" of the value of stockholdings on consumption and investment.

The market eventually will recover, when earnings figures that investors trust turn higher. While, historically, stocks have bounced back after sharp, sudden drops (such as October 1987 or last Sept. 11), stocks have taken years to recover after prices have dropped steadily over time in drip-drip fashion. The recent decline looks a lot more like past drip-drips than prior one-day wonders. Congress has wisely given the Securities and Exchange Commission more funds, and the SEC probably will uncover even more accounting misdeeds, which could rock investor confidence again.

Wall Street's woes have other important implications. The drop in stocks has shown retirees the fragility of defined contribution plans. The crisis also is having significant effects abroad, as in the downturn in the stock markets in Europe and Japan. Effects that are more difficult to measure are those in developing countries, most notably in our hemisphere, that have recently turned to market economies. The US has, for the most part, served as a model, with its corporate management a "gold standard" and stock market a "best of breed" example of a developed equity market.

There is growing public frustration in these developing countries, owing to mixed economic results in some and to sharp downturns exacerbated by fluctuations in financial markets in others. Argentina, in a financial crisis of epic proportions, is the most extreme case. There is a more general public questioning of markets and of wide-scale privatization of pension funds.

In a regionwide survey in Latin America in early 2002, after the exposure of Enron but before the broader crisis, only 26 percent of respondents answered that they were satisfied with how the market economy was working. In contrast, in 2000, more than 50 percent of respondents approved of the market economy.

Until recently, US policy toward the region was, kindly put, one of benign neglect. This summer, after much criticism of IMF bailouts, the administration approved a $4 billion loan for Uruguay. All eyes are now on Brazil, where the hopes are that the recently approved $30 billion IMF bailout will calm the fears of investors jittery about the October elections, fears that could drive a default, with huge costs for the region and beyond.

The broader crisis of confidence in US markets undoubtedly will have effects on politics in a region that offers alternatives ranging from an ungovernable Argentina to a stable, market-friendly Chile. The US plays a critical role in an increasingly integrated world economy. The July 24 passage of legislation on corporate governance was a welcome response from our political system. We hope the US can marshal the same resolve to address the equally pressing problems in markets abroad.

• Carol Graham is vice president and director of governance studies and Robert Litan is vice president and director of economic studies, both at the Brookings Institution.