Brookings 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.

While the authors recognize that there is considerable uncertainty surrounding their estimates and predictions, they posit that investors will likely adopt a “wait and see whether they work” attitude toward current reform initiatives on corporate governance and accounting. They also say that it could be a year or longer before investor confidence in the market is restored. While historically stocks have quickly bounced back after sharp, sudden drops in stocks, stocks have taken years to recover after prices have steadily dropped over time in “drip-drip” fashion. Unfortunately, the recent decline in stocks looks more like past “drip-drips” than one-day wonders.”

The authors also describe the likely effect of the corporate governance scandals on other aspects of the economy, including unemployment, inflation, and foreign investment in the United States as well as possible spillover effects beyond U.S. borders. For example, because the crisis has almost certainly discouraged foreign investment into the United States, the result has been a decline in the value of the dollar. Between March 19 and July 19, the trade-weighted value of the dollar fell by 5.2 percent.

“The Enron and WorldCom bankruptcies resulted from corporate mismanagement and accounting malpractice and symbolize the broader crisis in corporate governance—a crisis that involves top blue chip companies, has reached political leaders at the highest levels of government, and has resulted in high levels of volatility in U.S. stock markets,” write the authors. The report concludes with a timeline of significant corporate disclosure breakdowns since the Enron scandal.

The full report is available online. It is updated periodically to account for market changes.