The lessons of Black Monday

USPresident Donald Trump has regularly pointed to the stock market as asource 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 wasdue to the president’s policies is uncertain. What is certain, as wehave recently been reminded, is that what goes up can come down.Wheninterpreting sharp drops in stock prices and their impact, many willthink back to 2008 and the market turbulence surrounding LehmanBrothers’ bankruptcy filing. But a better historical precedent forcurrent conditions is Black Monday: October 19, 1987.Black Mondaywas a big deal: the 22.6% price collapse is still the largest one-daypercentage drop in the DJIA on record. The equivalent today would be –wait for it – 6,000 points on the Dow.In addition, the 1987 crashoccurred against the backdrop of monetary-policy tightening by the USFederal Reserve. Between January and October 1987, the Fed pushed up theeffective federal funds rate by nearly 100 basis points, making it moreexpensive to borrow and purchase shares. In the run-up to October 2008,by contrast, interest rates fell sharply, reflecting a deterioratingeconomy. That is hardly the case now, of course, which makes 1987 thebetter analogy.The 1987 crash also occurred in a period of dollarweakness. Late in the preceding week, Treasury Secretary James Bakermade some remarks that were interpreted as a threat to devalue thedollar. Like current Treasury Secretary Steven Mnuchin at Davos thisyear, Baker could complain that his comments were taken out of context.But it is revealing that the sell-off on Black Monday began overseas, incountries likely to be adversely affected by a weak dollar, beforespreading to the US.Finally, algorithmic trading played a role. Thealgorithms in question, developed at the University of California,Berkeley, were known as “portfolio insurance.” Using computer modellingto optimise stock-to-cash ratios, portfolio insurance told investors toreduce the weight on stocks in falling markets as a way of limitingdownside risk. These models thus encouraged investors to sell into aweak market, amplifying price swings.Although the role of portfolioinsurance is disputed, it’s hard to see how the market could have fallenby such a large amount without its influence. Twenty-first-centuryalgorithmic trading may be more complex, but it, too, has unintendedconsequences, and it, too, can amplify volatility.Despite all thedrama on Wall Street in 1987, the impact on economic activity was muted.Consumer spending dropped sharply in October, owing to negative wealtheffects and heightened uncertainty, but it quickly stabilised andrecovered, while investment spending remained essentially unchanged.Whataccounted for the limited fallout? First, the Fed, under its brand-newchairman, Alan Greenspan, loosened monetary policy, reassuring investorsthat the crash would not create serious liquidity problems. Marketvolatility declined, as did the associated uncertainty, buttressingconsumer confidence.Second, the crash did not destabilisesystemically important financial institutions. The big money-centrebanks had used the five years since the outbreak of the Latin Americandebt crisis to strengthen their balance sheets. Although the Savings& Loan crisis continued to simmer, S&Ls were too small, even as agroup, for their troubles to impact the economy significantly.What,then, would be the effects of an analogous crash today? Currently, theUS banking system looks sufficiently robust to absorb the strain. But weknow that banks that are healthy when the market is rising can quicklyfall sick when it reverses. Congressional moves to weaken the Dodd-FrankAct, relieving many banks of the requirement to undergo regular stresstesting, 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 thefed funds rate exceeded 6% and the prime rate charged by big banks wasabove 9%. To be sure, if the market fell sharply, the Fed would activatethe “Greenspan-Bernanke Put,” providing large amounts of liquidity todistressed intermediaries. But whether Jay Powell’s Fed would respond ascreatively as Bernanke’s in 2008 – providing “back-to-back” loans tonon-member banks in distress, for example – is an open question.Muchwill hinge, finally, on the president’s reaction. Will Trump respondlike FDR in 1933, reassuring the public that the only thing we have tofear is fear itself? Or will he look for someone to blame for thecollapse in his favourite economic indicator and lash out at theDemocrats, foreign governments, and the Fed? A president who plays theblame game would only further aggravate the problem. – Project Syndicate* BarryEichengreen is a professor at the University of California, Berkeley.His latest book is Hall of Mirrors: The Great Depression, the GreatRecession, and the Uses – and Misuses – of History.