On 19 October, 1987 – so-called, ‘Black Monday’ - the world’s stock exchanges suffered very sharp price falls. The worst, since the Great Crash of 1929.
On that one day, the Dow Jones Industrial Average slumped by 23%, and in the few weeks of October and early November, prices on the exchanges in London, Frankfurt, Zurich and Paris all fell by 34-40% (the Nikkei in Tokyo was down 19%). Thus came to an end five years of strong bull market activity.
Anxieties about US deficits, a declining dollar, the threat of rising interest rates in the face of inflationary pressures and growing US-Iranian tensions were the backdrop to growing market jitters, but analysts have still not been able to come up with a convincing explanation for the severity of the security price falls.
In the immediate aftermath of the crash some pointed – again, without any great conviction - to the possible destabilising effects of recent regulatory changes (such as London’s ‘Big Bang’ of 1986, which allowed greater freedom to financial institutions to move into new areas of business) and to institutions’ growing reliance on computer modelling to determine the timing of buying and selling shares.
Technology has moved on since then, but in today’s turbulent markets, real concerns continue to be expressed about the risk assessment quantitative computer models used by the global financial institutions, particularly the hedge funds.
The fear is that while these models may be fine in processing frequent, short-term variations in the markets, they still seem unable to cope with the infrequent, sharp changes that denote crises.
Despite the severity of the 1987 crash, its most notable characteristic was the relatively mild impact it had on the real economy. In the UK, the National Institute for Economic Research estimated that consumption fell by no more than 0.3% in the first twelve months as a result of the collapse in the equity markets.
There may have been a crash on the stock market, but for jobs and growth there was relatively little fallout. Here, the role of the central banks was benign.
Central bankers are the guardians of systemic financial stability and, in this, their lender of last resort (LOLR) function can be critical during a perceived crisis. However, the task calls for careful judgement and - as we have seen in recent events - central banks will be condemned if they do act; and condemned if they do not.
These public servants are responsible not only for the stability of the financial system but also for monetary stability (especially for moderating inflation). They are also anxious to avoid their actions giving rise to ‘moral hazards’.
An example of such a hazard would be if a central bank was widely perceived as bailing out the incompetent management of a bank by providing LOLR loans on unduly lenient terms. It is for such a reason, that normally, neither fraudulent nor insolvent banks are offered LOLR facilities – in the case of Northern Rock in 2007, of course, the bank was solvent but was suffering from a shortage of liquidity because of its over-reliance on interbank markets that were no longer lending freely.
For central banks, it is a tightrope balancing act. In 1987 the central banks, led by the actions of the then newly-appointed Chairman of the Federal Reserve, Alan Greenspan, had been widely praised for limiting the effects of the stock market collapse on the monetary system (and, thus, the real economy) by supplying the banks with liquidity and keeping interest rates down.
In contrast, the same Greenspan was criticised for prolonging the dotcom boom mentality (or ‘irrational exuberance’ in Shiller’s words) of the 1990s when the Fed followed a similarly liberal policy as it tried to neutralise the effects of the collapse of the leading US hedge fund, Long Term Capital Management, in 1998.
In 2007, the Bank of England’s hard stand against ‘moral hazard’ came unstuck when Northern Rock depositors were unconvinced, confidence evaporated and sparked the first run on a significant British bank since 1878 (not 1866 as has been widely but incorrectly reported).
But this was an error of execution, not of principle. The Bank’s LOLR intervention is wholly justified. So far in the current market turbulence, stock market prices have been rebounding after each sharp fall, but the lesson of previous corrections - including 1987 - is that the end of a run of bull years is usually marked by a phase of oscillation (of the type we have had this year), followed by a sharp downturn.
If it should come, let us hope that the impact on growth and jobs is as mild as in 1987.