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Henry C.K. Liu - The Unlearned Lesson of the 1987 Crash
Henry Liu revisits the stock market crash of 1987 to dispel free market fundamentalism and the neo-conservative lust for deregulation.
In the 1980s, to counter stagflation in the US economy, the Fed under Paul Volcker, (August 6, 1979 - August 11, 1987), fearless slayer of the inflation dragon, kept the discount rate in the double digit range from July 20, 1979 to August 27 1982, peaking at 14% on May 4, 1981. From August 1982 to its peak in August 1987, the Dow Jones Industrial Average (DJIA) grew from 776 to 2,722. The rise in market indices for the 19 largest markets in the world averaged 296% during this period.
Volcker, as chairman of the Fed before Greenspan, caused a “double-dip” recession in 1979-80 and 1981-82 to cure double-digit inflation, in the process bringing the unemployment rate into double digits for the first time since 1940. Volcker then piloted the economy through its slow long recovery that ended with the 1987 crash right after his departure from the Fed. To his credit, Volcker did manage to bring unemployment to 5.5%, half a point lower than during the 1978-79 boom, and the accepted structural unemployment rate of 6%.
Two months after Volcker left the Fed, to be succeeded by Alan Greenspan, the high interest rate left by Volcker, inter alia, led to Black Monday, October 19, 1987, when stock markets around the world crashed mercilessly, beginning in Hong Kong, spreading west to Tokyo and Europe as markets opened across global time zones, hitting New York only after markets in other time zones had already declined by a significant margin. The DJIA dropped 22.61%, by 508 points, to 1,738.74 on Black Monday 1987. On October 11, 2007, the DJIA hit a high of 14,198.10. On March 2, 2009, it lost almost 300 points, or 4.2%, to end at 6,763.29, its lowest point since April 25, 1997.
By the end of October, 1987, stock markets in Hong Kong had fallen 45.8%, Australia 41.8%, New Zealand 60%, Spain 31%, the United Kingdom 26.4%, the United States 22.68%, and Canada 22.5%. Fundamental assumptions such as market fundamentalism, efficient market hypothesis and market equilibrium were challenged by events. Despite that dismal record in the 1980s, Volcker was appointed by President Obama two decades later as first Chair of the President’s Economic Recovery Advisory Board on February 6, 2009.
The 1987 stock-market crash was unleashed by the sudden collapse of the safety dam of portfolio insurance, a hedging strategy made possible by the new option pricing theory advanced by Nobel laureates Robert C Merton and Myron S Scholes. Institutional investors found it possible to manage risk better by protecting their portfolios from unexpected losses with positions in stock-index futures. Any fall in stock prices could be compensated by selling futures bought when stock prices were higher.
This strategy, while operative for each individual portfolio, actually caused the entire market to collapse from the dynamics of automatic herd-selling of futures. Investors could afford to take greater risks in rising markets because portfolio insurance offered a disciplined way of avoiding risk in declines, albeit only individually. But the reduction in individual risk was achieved by an increase in systemic risk.
As some portfolio insurers sold and market prices fell precipitously, the computer programs of other insurers then triggered further sales, causing further declines that in turn caused the first group of insurers to sell even more shares and so on, in a high-speed downward spiral. This in turn electronically generated other computer driven sell orders from the same sources, and the market experienced a computer-generated meltdown at high speed.
The 1987 crash provided clear empirical evidence of the structural flaw in market fundamentalism, which is the belief that the optimum common welfare is only achievable through a market equilibrium created by the effect of countless individual decisions of all market participants each seeking to maximize his own private gain through the efficient market hypothesis, and that such market equilibrium should not be distorted by any collective measures in the name of the common good or systemic stability.
Aggregate individual decisions and actions in unorganized unison can and often do turn into systemic crises that are detrimental to the common good. Unregulated free markets can quickly become failed markets. Markets do not simply grow naturally after a spring rain. Markets are artificial constructs designed collectively by key participants who agree to play by certain rules. All markets are planned with the aim of eliminating any characteristic of being free for all operations. Free market is as much a fantasy as free love.
In response to the 1987 crash, the US Federal Reserve under its newly installed chairman, Alan Greenspan, with merely nine weeks in the powerful office, immediately flooded the banking system with new reserves, by having the Fed Open Market Committee (FOMC) buy massive quantities of government securities from the repo market. He announced the day after the crash that the Fed would “serve as a source of liquidity to support the economic and financial system.” Greenspan created $12 billion of new bank reserves by buying up government securities from the market, the proceeds from which would enter the banking system.
The $12 billion injection of “high-power money” in one day caused the Fed funds rate to fall by 75 basis points and halted the financial panic, though it did not cure the financial problem, which caused the US economy to plunge into a recession that persisted for five subsequent years. Worst of all, the monetarist cure for systemic collapse put the financial world in a pattern of crisis every decade: the 1987 crash, the 1997 Asian financial crisis and the financial crisis of 2007.
High-power money injected into the banking system enables banks to create more bank money through multiple credit-recycling, lending repeatedly the same funds minus the amount of required bank reserves at each turn. At a 10% reserve requirement, $12 billion of new high-power money could generate in theory up to $120 billion of new bank money in the form of recycled bank loans from new deposits by borrowers.
The Brady Commission investigation of the 1987 crash showed that on October 19, 1987, portfolio insurance trades in S&P 500 Index futures and New York Exchange stocks that crashed the market amounted to only $6 billion by a few large traders, out of a market trading total of $42 billion. The Fed’s injection of $120 billion was three times the market trading total and 20 times the trades executed by portfolio insurance.
Yet post-mortem analyses of the 1987 crash suggest that though portfolio insurance strategies were designed to be interest-rate-neutral, the declining Fed funds rate was actually causing financial firms that used these strategies globally to lose money from exchange-rate effects. The belated awareness of this effect caused many institutions that had not understood the full dynamics of the strategies to shut down their previously highly profitable bond arbitrage units.
This move later led to the migratory birth of new, stand-alone hedge funds such as Long Term Capital Management (LTCM), which continued to apply similar highly leveraged strategies for spectacular trading profit of more than 70% returns on equity that eventual led it to the edge of insolvency when Russia unexpectedly defaulted on its dollar bonds in the summer of 1998. The Fed had to orchestrate a private-sector creditor bailout of LTCM to limit systemic damage to the financial markets. The net effect was to extend the liquidity bubble further - causing it to migrate from a distressed sector to a healthy sector.
The 1987 crash reflected a stock-market bubble burst the liquidity cure for which led to a property bubble that, when it also burst, in turn caused the savings-and-loan (S&L) crisis.
While the 1987 crash was technically induced by program trading, the falling dollar was also a major factor. Although the dollar had started to decline in exchange value by late February, 1985 due to US fiscal deficit, that decline had yet to reduce the US trade deficit, causing protectionist sentiment in the US to mount as the trade deficit swelled to an annual rate of $120 billion in the summer of 1985.
In part to deflect protectionist legislation, US officials arranged a meeting of G-5 officials at the Plaza Hotel in New York on September 22, 1985 with the purpose of ratifying an initiative to bring about an orderly decline in the dollar, observing that “recent shifts in fundamental economic conditions among their countries, together with policy commitments for the future, have not been fully reflected in exchange markets,” and concluded that “further orderly appreciation of the main non-dollar currencies against the dollar is desirable,” and that the G5 members “stand ready to cooperate more closely to encourage this.” During the seven weeks following the Plaza Accord, G-5 authorities sold nearly $9 billion, of which the US sold $3.3 billion for other currencies, while speculators profited by shorting the dollar.
The dollar had declined to seven-year lows in early 1987 amid signs of weakness in the US economy while the US trade deficit continued to grow. Demand was sustained not by income but by debt. Public statements by Reagan Administration officials were interpreted in exchange markets as indicating a lack of official concern about the ramifications of further declines in the dollar.
On February 22, 1987, officials of the G5 plus Canada and Italy met at the Louvre in Paris to announce that the dollar had fallen enough. But despite heavy intervention purchases of dollars following the Louvre Accord, the dollar continued to decline, particularly against the yen. Market participants perceived delays in the implementation of expansionary fiscal measures in Japan expected after the Louvre Accord and talks of trade sanctions on some Japanese products heightened concern about tension in US-Japanese trade relations.
Following the Louvre Accord, the G-7 authorities intervened heavily in support of the dollar throughout the episodes of dollar weakness in 1987, and sold dollars on several occasions when the dollar strengthened significantly. Net official dollar purchases by the G-7 and other major central banks effectively financed more than two-thirds of the $144 billion US current account deficit in 1987. The US share of these purchases was $8.5 billion, and the share of the other G-7 countries was $82 billion, since the non-dollar export-dependent governments wanted desperately to halt the appreciation of their currencies.
Record US trade deficits and market perceptions that the G-7 authorities were pursuing monetary measures best suited to their own separate domestic economic objectives soon sparked a further sell-off of the dollar. This contributed to a worldwide collapse of equity prices which had risen to levels unsupported by fundamentals. The dollar’s decline gathered new momentum when the Federal Reserve under its new chairman Alan Greenspan moved more aggressively than its foreign counterparts to supply liquidity in the aftermath of the 1987 stock market crash which had been triggered by program trading on portfolio insurance derivatives arbitraging on macroeconomic instability in exchange rates and interest rates.
The Federal Reserve’s actions under Greenspan in 1987 led market participants to conclude that the Fed would emphasize domestic market objectives with accommodative monetary stance, if necessary at the cost of a further decline in the dollar. By year-end, the dollar’s value had fallen 21% against the yen and 14% against the mark from its levels at the time of the Louvre Accord while Greenspan, the wizard of bubble-land, was on his way to being hailed as the greatest central banker in history. Two decades later, by 2007, the Greenspan put was called by the market and trillions of dollars were lost.
In the 1980s, to counter stagflation in the US economy, the Fed under Paul Volcker, (August 6, 1979 - August 11, 1987), fearless slayer of the inflation dragon, kept the discount rate in the double digit range from July 20, 1979 to August 27 1982, peaking at 14% on May 4, 1981. From August 1982 to its peak in August 1987, the Dow Jones Industrial Average (DJIA) grew from 776 to 2,722. The rise in market indices for the 19 largest markets in the world averaged 296% during this period.
Volcker, as chairman of the Fed before Greenspan, caused a “double-dip” recession in 1979-80 and 1981-82 to cure double-digit inflation, in the process bringing the unemployment rate into double digits for the first time since 1940. Volcker then piloted the economy through its slow long recovery that ended with the 1987 crash right after his departure from the Fed. To his credit, Volcker did manage to bring unemployment to 5.5%, half a point lower than during the 1978-79 boom, and the accepted structural unemployment rate of 6%.
Two months after Volcker left the Fed, to be succeeded by Alan Greenspan, the high interest rate left by Volcker, inter alia, led to Black Monday, October 19, 1987, when stock markets around the world crashed mercilessly, beginning in Hong Kong, spreading west to Tokyo and Europe as markets opened across global time zones, hitting New York only after markets in other time zones had already declined by a significant margin. The DJIA dropped 22.61%, by 508 points, to 1,738.74 on Black Monday 1987. On October 11, 2007, the DJIA hit a high of 14,198.10. On March 2, 2009, it lost almost 300 points, or 4.2%, to end at 6,763.29, its lowest point since April 25, 1997.
By the end of October, 1987, stock markets in Hong Kong had fallen 45.8%, Australia 41.8%, New Zealand 60%, Spain 31%, the United Kingdom 26.4%, the United States 22.68%, and Canada 22.5%. Fundamental assumptions such as market fundamentalism, efficient market hypothesis and market equilibrium were challenged by events. Despite that dismal record in the 1980s, Volcker was appointed by President Obama two decades later as first Chair of the President’s Economic Recovery Advisory Board on February 6, 2009.
The 1987 stock-market crash was unleashed by the sudden collapse of the safety dam of portfolio insurance, a hedging strategy made possible by the new option pricing theory advanced by Nobel laureates Robert C Merton and Myron S Scholes. Institutional investors found it possible to manage risk better by protecting their portfolios from unexpected losses with positions in stock-index futures. Any fall in stock prices could be compensated by selling futures bought when stock prices were higher.
This strategy, while operative for each individual portfolio, actually caused the entire market to collapse from the dynamics of automatic herd-selling of futures. Investors could afford to take greater risks in rising markets because portfolio insurance offered a disciplined way of avoiding risk in declines, albeit only individually. But the reduction in individual risk was achieved by an increase in systemic risk.
As some portfolio insurers sold and market prices fell precipitously, the computer programs of other insurers then triggered further sales, causing further declines that in turn caused the first group of insurers to sell even more shares and so on, in a high-speed downward spiral. This in turn electronically generated other computer driven sell orders from the same sources, and the market experienced a computer-generated meltdown at high speed.
The 1987 crash provided clear empirical evidence of the structural flaw in market fundamentalism, which is the belief that the optimum common welfare is only achievable through a market equilibrium created by the effect of countless individual decisions of all market participants each seeking to maximize his own private gain through the efficient market hypothesis, and that such market equilibrium should not be distorted by any collective measures in the name of the common good or systemic stability.
Aggregate individual decisions and actions in unorganized unison can and often do turn into systemic crises that are detrimental to the common good. Unregulated free markets can quickly become failed markets. Markets do not simply grow naturally after a spring rain. Markets are artificial constructs designed collectively by key participants who agree to play by certain rules. All markets are planned with the aim of eliminating any characteristic of being free for all operations. Free market is as much a fantasy as free love.
In response to the 1987 crash, the US Federal Reserve under its newly installed chairman, Alan Greenspan, with merely nine weeks in the powerful office, immediately flooded the banking system with new reserves, by having the Fed Open Market Committee (FOMC) buy massive quantities of government securities from the repo market. He announced the day after the crash that the Fed would “serve as a source of liquidity to support the economic and financial system.” Greenspan created $12 billion of new bank reserves by buying up government securities from the market, the proceeds from which would enter the banking system.
The $12 billion injection of “high-power money” in one day caused the Fed funds rate to fall by 75 basis points and halted the financial panic, though it did not cure the financial problem, which caused the US economy to plunge into a recession that persisted for five subsequent years. Worst of all, the monetarist cure for systemic collapse put the financial world in a pattern of crisis every decade: the 1987 crash, the 1997 Asian financial crisis and the financial crisis of 2007.
High-power money injected into the banking system enables banks to create more bank money through multiple credit-recycling, lending repeatedly the same funds minus the amount of required bank reserves at each turn. At a 10% reserve requirement, $12 billion of new high-power money could generate in theory up to $120 billion of new bank money in the form of recycled bank loans from new deposits by borrowers.
The Brady Commission investigation of the 1987 crash showed that on October 19, 1987, portfolio insurance trades in S&P 500 Index futures and New York Exchange stocks that crashed the market amounted to only $6 billion by a few large traders, out of a market trading total of $42 billion. The Fed’s injection of $120 billion was three times the market trading total and 20 times the trades executed by portfolio insurance.
Yet post-mortem analyses of the 1987 crash suggest that though portfolio insurance strategies were designed to be interest-rate-neutral, the declining Fed funds rate was actually causing financial firms that used these strategies globally to lose money from exchange-rate effects. The belated awareness of this effect caused many institutions that had not understood the full dynamics of the strategies to shut down their previously highly profitable bond arbitrage units.
This move later led to the migratory birth of new, stand-alone hedge funds such as Long Term Capital Management (LTCM), which continued to apply similar highly leveraged strategies for spectacular trading profit of more than 70% returns on equity that eventual led it to the edge of insolvency when Russia unexpectedly defaulted on its dollar bonds in the summer of 1998. The Fed had to orchestrate a private-sector creditor bailout of LTCM to limit systemic damage to the financial markets. The net effect was to extend the liquidity bubble further - causing it to migrate from a distressed sector to a healthy sector.
The 1987 crash reflected a stock-market bubble burst the liquidity cure for which led to a property bubble that, when it also burst, in turn caused the savings-and-loan (S&L) crisis.
While the 1987 crash was technically induced by program trading, the falling dollar was also a major factor. Although the dollar had started to decline in exchange value by late February, 1985 due to US fiscal deficit, that decline had yet to reduce the US trade deficit, causing protectionist sentiment in the US to mount as the trade deficit swelled to an annual rate of $120 billion in the summer of 1985.
In part to deflect protectionist legislation, US officials arranged a meeting of G-5 officials at the Plaza Hotel in New York on September 22, 1985 with the purpose of ratifying an initiative to bring about an orderly decline in the dollar, observing that “recent shifts in fundamental economic conditions among their countries, together with policy commitments for the future, have not been fully reflected in exchange markets,” and concluded that “further orderly appreciation of the main non-dollar currencies against the dollar is desirable,” and that the G5 members “stand ready to cooperate more closely to encourage this.” During the seven weeks following the Plaza Accord, G-5 authorities sold nearly $9 billion, of which the US sold $3.3 billion for other currencies, while speculators profited by shorting the dollar.
The dollar had declined to seven-year lows in early 1987 amid signs of weakness in the US economy while the US trade deficit continued to grow. Demand was sustained not by income but by debt. Public statements by Reagan Administration officials were interpreted in exchange markets as indicating a lack of official concern about the ramifications of further declines in the dollar.
On February 22, 1987, officials of the G5 plus Canada and Italy met at the Louvre in Paris to announce that the dollar had fallen enough. But despite heavy intervention purchases of dollars following the Louvre Accord, the dollar continued to decline, particularly against the yen. Market participants perceived delays in the implementation of expansionary fiscal measures in Japan expected after the Louvre Accord and talks of trade sanctions on some Japanese products heightened concern about tension in US-Japanese trade relations.
Following the Louvre Accord, the G-7 authorities intervened heavily in support of the dollar throughout the episodes of dollar weakness in 1987, and sold dollars on several occasions when the dollar strengthened significantly. Net official dollar purchases by the G-7 and other major central banks effectively financed more than two-thirds of the $144 billion US current account deficit in 1987. The US share of these purchases was $8.5 billion, and the share of the other G-7 countries was $82 billion, since the non-dollar export-dependent governments wanted desperately to halt the appreciation of their currencies.
Record US trade deficits and market perceptions that the G-7 authorities were pursuing monetary measures best suited to their own separate domestic economic objectives soon sparked a further sell-off of the dollar. This contributed to a worldwide collapse of equity prices which had risen to levels unsupported by fundamentals. The dollar’s decline gathered new momentum when the Federal Reserve under its new chairman Alan Greenspan moved more aggressively than its foreign counterparts to supply liquidity in the aftermath of the 1987 stock market crash which had been triggered by program trading on portfolio insurance derivatives arbitraging on macroeconomic instability in exchange rates and interest rates.
The Federal Reserve’s actions under Greenspan in 1987 led market participants to conclude that the Fed would emphasize domestic market objectives with accommodative monetary stance, if necessary at the cost of a further decline in the dollar. By year-end, the dollar’s value had fallen 21% against the yen and 14% against the mark from its levels at the time of the Louvre Accord while Greenspan, the wizard of bubble-land, was on his way to being hailed as the greatest central banker in history. Two decades later, by 2007, the Greenspan put was called by the market and trillions of dollars were lost.
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