October, 2002

The U.S. Economy: Caught between Corruption and Globalisation

Khalil Al-Anani

The bankruptcies of WorldCom in July 2002 and Enron Corp. in December 2001 are the biggest in the history of the United States. Both came as a result of bad management and accounting flaws, and reveal the nature of the major crisis in corporate governance. The resulting losses could reach between $37 billion and $42 billion of the United States’ GDP in the first year, according to estimates from the Washington DC-based Brookings Institution, which specialises in economic affairs.

A series of financial collapses started last autumn when Enron, which took about $100 billion in 2000, announced its bankruptcy. Enron achieved huge profits during the 1990s and expanded to become the second largest company in the energy field, accounting for about 20 per cent of the US energy market. Successive financial collapses followed, the first of which was Arthur Anderson, which was accused, along with Enron, of forging data and damaging documents from both companies, which resulted in enormous losses for pension beneficiaries, who had invested large amounts of money in company shares.

It was only a few months later when WorldCom, the world’s second largest communications company, announced its bankruptcy as a result of a financial scandal to the tune of around $7.8 billion. The company’s debts stood at about $41 billion. The series of scandals also included Xerox, while there were rumours also about the involvement of JP Morgan Chase in financial scandals with Enron, and accusations were made against Merrill Lynch, Global Crossing and Adelphia Communications.

Three main questions need to be considered here: What is the cost of the crisis? What are the economic repercussions for the United States and the rest of the world? And how much time will it take to restore confidence in the US economy?

The crisis, which is rooted in a number of political, ethical and intellectual factors, is still damaging the US economy, and particularly in the financial sector where stock-market indices respond quickly to financial scandals. Prices slumped on the New York exchange to rates not seen since 1997. The Dow Jones index of the big 30 industrial companies lost about 25 per cent of its value, registering about 8639 points on 15 July 2002. Only around four months earlier, on 19 March, it had peaked at 10635 points. The Standard & Poor’s -S&P- 500 Index, meanwhile, lost around 28 per cent of its value, sinking to its lowest level for two years.

This slump is having a double impact on the market. First, it affects the wealth of consumers, who constitute the primary source of capital flow in the US economy. Second, it affects the difference in value and cost of capital. The US Federal Reserve Council estimates that if the slump continues, the losses could reach about $35 billion, or 0.34 per cent of GDP, during the first year. Brookings has estimated the losses at about 15.6 per cent of the market’s value, or 0.31 per cent of GDP -equivalent to $32.8 billion-, for the first year of the crisis.

The crisis has affected around 80 million US investors, whose losses stand at $8.6 trillion, according to some estimates. Yet perhaps what is more dangerous is the harm represented in a ‘double contradiction,’ where investment disappears amid companies’ measures for rectification. The contradiction lies in the fact that companies’ attempts to limit their costs for the sake of expansion do not guarantee the restoration of consumer confidence, which plays a vital role in determining levels of investment.

The crisis in corporate governance has also had a negative impact on foreign investment, which has already decreased as a result of the lack of confidence brought about by the current situation. These scandals also affected stock markets in Europe, developing countries and the recently transformed Eastern European nations.

While it is hard to determine the time span needed for the market to recover fully, other financial crises, such as those of October 1978, October 1989 and September 2001, took from between 11 months and four years to be resolved.