A Global Crossing for Enronitis? How Opaque Self-Dealing Damages Financial Markets around the World
Wei, Shang-Jin, Milkiewicz, Heather, Brookings Review
At the beginning of 2002, Enron was the seventh largest company in the United States, with operations extending worldwide. Telecommunications giant Global Crossing operated in 27 countries and 200 cities on five continents. But both fell last year under the weight of financial problems created by the self-dealing of a few corporate insiders and masked by nontransparent accounting. These and other similar corporate failures deprived millions of company employees and shareholders of their lifetime savings and retirement benefits. Stock prices of other U.S. companies also took a beating, partly in response to the revelation of these scandals.
Since January 2002, all major U.S. stock indexes have plummeted. NASDAQ fell almost a third in 2002, and the Dow and S&P 500 tumbled for the third consecutive year, the longest downturn since 1939-41. Foreign markets have also been hit with big losses. Japan's Nikkei 225 closed down 18.6 percent for the year; Britain's FTSE 100, down 24.5 percent.
Of course, the burst of the dot-com bubble, the uncertainty about a war in the Middle East, and a possible rise in oil prices may all have contributed to the stock price decline. It is only natural, however, to suspect that "Enronitis"--opaque self-dealing by a few insiders--has also contributed to this meltdown of the financial markets around the world. In this article, we provide some evidence to substantiate the suspicion.
Roller Coaster Rides
Enronitis has many symptoms. Here we discuss two. One is insider trading--the buying and selling of stock by people who possess nonpublic information relevant to its price. As recent work by Julan Du of the Chinese University and one of the authors (Wei) has shown, insider trading can affect stock prices--and even more important, economic performance--around the world.
Stock markets are volatile. That is not news. But volatility varies greatly from one country to the next. Measured by the standard deviation of the monthly returns of a major market index, stock market volatility is almost twice as high in Italy as it is in the United States. Markets in developing countries are typically even more volatile. The Chinese market is three and a half times more volatile than the U.S. market; the Russian market, six and a half times more volatile.
Excessive volatility matters because it affects people's incentive to save and to invest. In almost any economic model with a representative investor, the more volatile the asset market, holding the average return constant, the less the investor will save and hence invest. A certain degree of market volatility is unavoidable, even desirable. Ideally, changing stock prices signal changing values across economic activities and thereby improve the way resources are allocated. But volatility that is unrelated to market fundamentals results in confusing signals that hamper resource allocation. To the degree that insider trading affects the volatility of a country's stock market, it could thus also affect that country's economic performance.
Some analysts think that because insider trading allows relevant information to be reflected in the stock price faster than it otherwise would be, it should reduce market volatility and improve economic efficiency. That view, however, fails to take into account the ability of insiders to take actions to maximize personal benefits. Access to inside information is most valuable when prices are either rising or falling dramatically. So people in the position to possess inside information love market volatility, and they realize that their actions can increase volatility--through two channels. First, if insiders have a choice of projects or technologies, they may choose the riskier ones. Second, even holding the risk of the technology or project constant, insiders have an incentive to manipulate the timing and content of the information release in a way to maximize volatility. …