Last week we saw, based on stock market behaviour after President Bush's speech, the limits to what Presidential speeches and proposals not backed by decisive action can do to halt the present stock market decline and loss of investor confidence in the USA. The decline is not only in its third year having started in March 2000 but there is also widespread distrust of the financial reports of US corporations. The greater concern at this stage has to be how to prevent these happenings from spilling over and leading to a wider global financial crisis and recession.
As we have noted, already in the USA these events have adversely affected the US dollar in foreign currency markets. It has also disrupted the US labour market as bankruptcies and pension losses have driven older folk back to work as well as severe pressure on revenues flowing to the federal and state governments. Not surprisingly, therefore, recent job and production figures show a slowing of economic growth in the second quarter of this year, which many believed had started in the first quarter.
Krugman: flavours of fraud
As we all know the base of the present crisis is the unprecedented wave of frauds that have been uncovered. When financial bubbles burst and recession steps in, revelations of fraud are quite common. What is significant in recent episodes in the USA is the magnitude of the frauds and the new directions of accounting manipulation they have taken. In a recent article in the New York Times (June 28), Paul Krugman did a brilliant job showing in simple language how some of these frauds have operated. Using the example of an ice cream parlour that is not very profitable, but in which the manager wants to get rich quickly, he described the various "flavours of fraud" practised by some of the big US corporations that have been recently exposed.
One example he gives is the "Enron flavour." In this case, the manager signs contracts to provide many customers with one ice cream cone a day for thirty years at an attractive price. Having done this, he then deliberately underestimates the cost of providing each cone. This of course makes the profit on each cone larger. He then books the projected profits from all these ice cream sales over the next thirty years into his accounts as part of this year's bottom line. Instantly this makes the business appear highly profitable. He can then go to the public and sell shares for the business at inflated prices. This basic technique was exploited to the hilt by Enron before its collapse.
Another flavour Krugman described was the "Dynegy flavour." Here the manager of the ice cream parlour enters into a confidential agreement with another ice cream parlour down the same street. In this agreement, the two parlours agree to buy the same large number of ice cream cones from each other every day. As readers would have already guessed, since they are buying the same number of cones from each other they do not actually have to send the cones back and forth. All the manager has to do is simply record the sales in the accounts for the ice cream parlour. If this is done then the business appears "highly profitable." Here again he can sell its shares at inflated prices. As Krugman pointed out this was basically the scam that Dynegy pulled.
A third flavour he described is named after the Adelphia Corporation. Here the manager of the ice cream parlour signs contracts with customers and then gets potential investors to focus on the volume of the contracts - not their profitability. The manager even invests imaginary customers to sign some of these contracts. After he does this, the result is that the subscriber base for the ice cream parlour grows rapidly. The business then appears highly profitable and once again the manager can sell shares at inflated prices. This was the scam the Adelphia Corporation practised.
A fourth flavour is named after WorldCom, the largest bankruptcy in the history of the world. In this scam the manager of the ice cream parlour tries to make the costs of his operations disappear! To do this, he classified in the ice cream parlour accounts operating expenses such as milk, sugar, cones, etc, as part of the purchase price of new refrigeration equipment he acquired through a loan. Again this makes the business look profitable on paper because borrowed money appears to be used to finance the purchase of new equipment for expansion. The manager can once again sell shares at highly inflated prices. All these scams focus on accounting manipulation which has led not only to these firms being castigated but the entire accounting profession. As a result both the accounting industry and the preparation of corporate accounts are being legally restructured.
Enter the dragon
Because of the universal pattern of scams surfacing after the bursting of financial bubbles attention has been drawn to the experience of Japan when the financial bubble burst there ten years ago and similar scams were uncovered. To date Japan has not been able to overcome the effects of their stock market collapse where like the USA major corporations had also collapsed at that time. Unlike the USA, however, Japanese corporate executives were found guilty of breaking the law and went to jail for these corporate crimes. This action failed, however, to restore investors' confidence and encourage new investments. The Japanese economy has continued to suffer its worst depression ever. This protracted Japanese crisis has led many analysts to wonder whether the same is in store for the USA.
One important concern is that in both countries stock prices reached astronomical levels based on unrealistic fantasies about future returns. As we noted in the US, the "new economy" was highly touted during the bubble. Then it was argued that in the "new economy" recession and economic reversals would never occur. These were dismissed as aberrations of the past. Technology via the internet was touted as yielding unending returns to businesses. Of course the reality turned out to be very different since from its peak in March/April 2000, stock prices have plunged catastrophically creating one of the worst US bear markets.
For those not familiar with stock market jargon a declining market is a bear market and a rising market, a bull market. A bear market is normally described as a situation when stock prices decline by twenty per cent or more during in an eighteen - twenty-four month period. The present situation, however, is far worse and this has led to frantic searches for signs that the bear market is over. To date non has been forthcoming and the stock market has maintained its bearish erratic character with a strong downward trend.
New legislation
All this has provided strong reaction. To the surprise of many Congress has passed new legislation with severe penalties for fraud. The pressure for quick action has arisen out of both the serious threat to the American economy and businesses, which the present situation entails and the impending mid-term congressional elections due to be held in November.
Next week we shall look at this new legislation as we conclude this topic.