2012-10-24 06:46:44
A big market crash happened 25 years ago this week. The wrong lessons were taken from it
Oct 20th 2012 | from the print edition
TWENTY-FIVE years ago, on October 19th 1987, global stockmarkets suddenly, and unexpectedly, collapsed on what instantly became known as Black Monday. The Dow Jones Industrial Average fell by almost 23% in a single session, still a record decline. At the time analysts rushed to look backwards. Parallels with the 1929 crash, which preceded the Great Depression, were immediately made. In fact they should have been looking forward. Three of the main reasons why the crunch happened in 2007 date back to 1987.
The biggest mistake was to do with monetary policy. Central banks around the world responded quickly to the crash, some cutting interest rates, others pumping money into the system. The Federal Reserve, consistent with its responsibilities as the nation s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system, said Alan Greenspan, recently appointed as head of the Fed. Calming a fraught financial system made sense at the time, but it introduced the idea of the Greenspan put , the notion that central banks would always intervene to support the markets when they fell sharply.
This was compounded by Mr Greenspan taking the opposite position when it came to asset bubbles: that even when prices were sky-high, it was not the job of central banks to outguess markets by trying to bring them back to earth. The one-day price fall of 23% in 1987, seemingly unconnected to economic fundamentals, gave a hint that markets are not always efficient. But Mr Greenspan declined this newspaper s advice to intervene both when dotcom stocks surged in the late 1990s and when house prices rocketed in the early 2000s. For investors, markets became a one-way bet: central banks would intervene when markets were falling, but not when they were rising. The great moderation was a long period of steady growth and low inflation and a huge build-up of debt.
The second mistake was to enlarge the protected part of finance. Before 1987 the focus was on the big deposit-taking banks: stockbrokers and investment banks were relatively unimportant players in the system. But after Black Monday, with equity markets dominating the headlines, policymakers expanded the concept of systemic risk to other forms of finance which encouraged banks and others to sprawl. By 2007 banks like Citigroup and insurance companies like American International Group had grown too big to fail .
The third mistake was to do with trading. In the mid-1980s many institutional investors adopted portfolio insurance , a way of hedging against market declines. It involved selling stockmarket futures so that investors gains in the derivatives market offset their losses on their equity portfolios. But the technique exacerbated the market s decline, as waves of futures-selling alarmed equity investors. The lesson that should have been learned was that the market cannot insure itself: if most investors want to sell assets, there will be no one on the other side of the trade with a big enough wallet to buy them. Twenty years later, the same problem was demonstrated when investors stampeded for the exits in the securitised mortgage market. With no willing buyers, prices collapsed.
Put in its place
With trading, then, investors (and their regulators) simply failed to learn anything, and made the same mistake again. But the other two errors sprang more from policymakers opting for a solution that itself created problems. Perhaps the biggest conclusion of all is that any extended period of rapidly rising prices is an indication of a bubble and that sadly there is no painless way to clean up the mess after the bubble pops.