US
President Donald Trump has regularly pointed to the stock market as a
source of validation of his administration’s economic programme. But,
while the Dow Jones Industrial Average (DJIA) has risen by roughly 30%
since Trump’s inauguration, the extent to which the market’s rise was
due to the president’s policies is uncertain. What is certain, as we
have recently been reminded, is that what goes up can come down.
When
interpreting sharp drops in stock prices and their impact, many will
think back to 2008 and the market turbulence surrounding Lehman
Brothers’ bankruptcy filing. But a better historical precedent for
current conditions is Black Monday: October 19, 1987.
Black Monday
was a big deal: the 22.6% price collapse is still the largest one-day
percentage drop in the DJIA on record. The equivalent today would be –
wait for it – 6,000 points on the Dow.
In addition, the 1987 crash
occurred against the backdrop of monetary-policy tightening by the US
Federal Reserve. Between January and October 1987, the Fed pushed up the
effective federal funds rate by nearly 100 basis points, making it more
expensive to borrow and purchase shares. In the run-up to October 2008,
by contrast, interest rates fell sharply, reflecting a deteriorating
economy. That is hardly the case now, of course, which makes 1987 the
better analogy.
The 1987 crash also occurred in a period of dollar
weakness. Late in the preceding week, Treasury Secretary James Baker
made some remarks that were interpreted as a threat to devalue the
dollar. Like current Treasury Secretary Steven Mnuchin at Davos this
year, Baker could complain that his comments were taken out of context.
But it is revealing that the sell-off on Black Monday began overseas, in
countries likely to be adversely affected by a weak dollar, before
spreading to the US.
Finally, algorithmic trading played a role. The
algorithms in question, developed at the University of California,
Berkeley, were known as “portfolio insurance.” Using computer modelling
to optimise stock-to-cash ratios, portfolio insurance told investors to
reduce the weight on stocks in falling markets as a way of limiting
downside risk. These models thus encouraged investors to sell into a
weak market, amplifying price swings.
Although the role of portfolio
insurance is disputed, it’s hard to see how the market could have fallen
by such a large amount without its influence. Twenty-first-century
algorithmic trading may be more complex, but it, too, has unintended
consequences, and it, too, can amplify volatility.
Despite all the
drama on Wall Street in 1987, the impact on economic activity was muted.
Consumer spending dropped sharply in October, owing to negative wealth
effects and heightened uncertainty, but it quickly stabilised and
recovered, while investment spending remained essentially unchanged.
What
accounted for the limited fallout? First, the Fed, under its brand-new
chairman, Alan Greenspan, loosened monetary policy, reassuring investors
that the crash would not create serious liquidity problems. Market
volatility declined, as did the associated uncertainty, buttressing
consumer confidence.
Second, the crash did not destabilise
systemically important financial institutions. The big money-centre
banks had used the five years since the outbreak of the Latin American
debt crisis to strengthen their balance sheets. Although the Savings
& Loan crisis continued to simmer, S&Ls were too small, even as a
group, for their troubles to impact the economy significantly.
What,
then, would be the effects of an analogous crash today? Currently, the
US banking system looks sufficiently robust to absorb the strain. But we
know that banks that are healthy when the market is rising can quickly
fall sick when it reverses. Congressional moves to weaken the Dodd-Frank
Act, relieving many banks of the requirement to undergo regular stress
testing, suggest that this robust health shouldn’t be taken for granted.
Moreover,
there is less room to cut interest rates today than in 1987, when the
fed funds rate exceeded 6% and the prime rate charged by big banks was
above 9%. To be sure, if the market fell sharply, the Fed would activate
the “Greenspan-Bernanke Put,” providing large amounts of liquidity to
distressed intermediaries. But whether Jay Powell’s Fed would respond as
creatively as Bernanke’s in 2008 – providing “back-to-back” loans to
non-member banks in distress, for example – is an open question.
Much
will hinge, finally, on the president’s reaction. Will Trump respond
like FDR in 1933, reassuring the public that the only thing we have to
fear is fear itself? Or will he look for someone to blame for the
collapse in his favourite economic indicator and lash out at the
Democrats, foreign governments, and the Fed? A president who plays the
blame game would only further aggravate the problem. – Project Syndicate
* Barry
Eichengreen is a professor at the University of California, Berkeley.
His latest book is Hall of Mirrors: The Great Depression, the Great
Recession, and the Uses – and Misuses – of History.
Traders and financial professionals work on the floor of the New York Stock Exchange (NYSE) ahead of the closing bell, on February 12, 2018 in New York City.