Black Monday

Graham Ingham

As people struggle to work out what has been happening on the world’s financial and stock markets over the past few weeks, the two questions which seem to crop up most frequently are: why did the so-called ‘Crash of ’87’ occur; and what happens next? Even in the first few days, the pundits were clamouring to offer answers. Just about everything was blamed by someone – greed, government incompetence, even President Reagan’s difficulties in securing Senate approval for his nominee for the Supreme Court, Robert Bork. Few people have been honest enough to admit that they didn’t really know the answer to either question. After all, those who did know were either the clever market operators who escaped intact before the crash happened; or the Cassandras whose predictions of disaster were happily ignored until it was too late.

It’s easy to be wise after the event. Once the stock markets had plunged, there were no end of people willing to forecast the consequences. The parallels with 1929 have been too tempting to ignore. The rate of the fall, the decision of some big investors to sell well before the collapse, and the protectionist atmosphere in the US Congress, have all been cited as evidence that the pattern was being repeated. Important differences have often, though not always, been conveniently ignored. The links between the 1929 Wall Street crash and the Depression of the Thirties are still much misunderstood. Predictions of a similar US of world-wide recession in 1988 or later are often based on ignorance.

That is not to say that what has happened to stock markets around the world is unimportant, or that the world can rest easy, free from recessionary fears. But the honest answer to ‘why did it happen?’ is that no one really knows. At the simplest level, the crash occurred because more investors suddenly wanted to sell than to buy shares. Prices began to fall, and what Nigel Lawson has called the ‘herd’ instinct of the market ensured that the fall, once started, became self-reinforcing. However, this mechanistic explanation throws no light on why there should have been a sudden reversal of sentiment in the market.

Because our understanding of the workings of the stock market and its impact on the economy is so imperfect, it would be equally honest to admit that what happens next is anyone’s guess. Henry Kaufman, the guru of Wall Street forecasters, has already said as much. We cannot, with any certainty, say what would happen if governments continued to behave much as before; or indeed, if they chose to adopt the same disastrous policies as they did after 1929. As it is, economic policies, at least in the industrial nations, are in a state of flux. According to some, the future of international economic co-operation and co-ordination may hang in the balance.

It might still be worth asking, despite these uncertainties, whether the crash could have been predicted. Here, those who say yes may be on safer ground. There were plenty of reasons for thinking that the bull market could not go on for ever – though to many of those involved it must have seemed that it would. The price of equities had risen far above what many analysts thought to be reasonable in relation to earnings from those shares. Yet some investors had been lulled into thinking that prices could only rise. Critics have blamed governments such as Mrs Thatcher’s for encouraging small investors to enter the stock market without impressing on them the basic fact that prices can fall as well as rise. The strongest reason of all for thinking that a fall was inevitable was the increasing nervousness many stock-market participants displayed, especially in the course of this year. The faster and more steeply prices rose, the more investors had to lose, and consequently, the jumpier they became.

Despite the warning signs, investors, analysts and brokers have all been caught off guard. No one seemed to think that a reversal could be so sudden, or that prices in New York, London and elsewhere could plunge as far as they did. Few were wise before the event. There is no doubt that some observers were not at all unhappy to see the rich kids of Wall Street or the new Porsche-owners in the City of London take a tumble. The greed and the love of conspicuous consumption of many of the newer market operators seem only to have been exceeded by their inexperience. This, along with the new computer and communications technology which has brought about a truly global market, certainly seemed to exacerbate the fall. It makes little sense, however, to attribute the collapse of confidence wholly, or even largely, to these factors.

What is likely to be more interesting in the longer term – and will certainly be more important – is the response of governments to these events. It is widely accepted that government action will play a crucial part in determining the impact which the stock-market crash will ultimately have on the industrial – and developing – economies. In the short term, however, it is difficult to forecast how governments will respond or, indeed, how helpful their response will turn out to be. Much depends on what happens to the stock markets in the next few weeks and even on whether, though this seems unlikely, share prices recover most of their losses.

It is clear already that whatever governments may say, they have had a nasty shock. As conservative economic policies have become the norm in most of the major industrial nations – whatever the political complexion of the government – so has the emphasis on the role of markets, including stock markets, grown. Free markets are seen as the most efficient way of allocating resources in an economy. Stock markets are, it is said, an important element in this process; much is made, for instance, of their role in providing finance for industrial investment. So in Britain, Japan and the US, stock markets and financial institutions have grown rapidly in size and importance. Investors have done well – remarkably well, in some cases. In France, Italy, even Portugal, the stock exchanges have enjoyed unprecedented booms. All over the world, stock markets have gained new life, and newly-established markets have been impressively successful. Political leaders have not been shy to claim credit for the world-wide boom, often arguing that a strong and healthy stock market provides a good demonstration of confidence in their economic policies.

The events of ‘Black Monday’, as the history books seem sure to call 19 October 1987, therefore came as a severe blow to the governments of the industrial nations, and provided them with a dilemma. President Reagan at first insisted that the New York market was undergoing a natural ‘correction’ – though he had said little before about what he now claimed was a normal process. In Britain, government ministers argued forcefully that the London Stock Market’s sudden decline did not reflect the true state of the British economy, which remained healthy, and was one of the fastest-growing of all the OECD economies.

But wait a minute. Surely stock markets cannot be both efficient and wrong – can they? Why is a rising, buoyant market a reliable indication of economic success, and a collapsing market not an indication of anything at all? Nigel Lawson appeared to have the answer to that. In a speech in London just a week after the crash – delivered, ironically, to mark the first anniversary of the City’s ‘Big Bang’ – the Chancellor admitted that markets were far from perfect. He was not impressed by the herd instinct, he added. But he likened his attitude to the market to Winston Churchill’s attitude to parliamentary democracy: all the alternatives were worse. That is a fair defence of the belief in free markets, although not everyone would accept that a market system was the least unpalatable option. The trouble, at least as far as Mr Lawson’s critics are concerned, is that he made little of the market’s defects when selling off state enterprises like British Telecom, British Gas and British Airways. These have been some of the largest stock-market flotations ever, in which millions of small investors have bought shares for the first time; these investors are now registering losses on their assets (although, at the time of writing, not in most cases, on what they actually paid).

Markets are not perfect. They do not behave rationally. Their participants do not have access to sufficient or sufficiently accurate information. The people involved are more likely to do what the person sitting next to them does than stop and try to make a rational decision. After all, the aim of almost everyone is to make money; at worst, to try to avoid losing it. Given this, the notion that the world’s stock markets fell because everyone suddenly decided that the US Government budget deficit was unacceptably large is difficult to sustain. Some people even find it amusing. The US has been running very large budget deficits almost from the moment President Reagan took office; and the deficit projected for the current fiscal year is not the largest in real terms. Until a few weeks ago, the world’s stock markets had been oblivious of complaints about Mr Reagan’s fiscal policies emanating from just about every other quarter. In a market economy, however, market perceptions are important – as President Reagan soon discovered. Once it had been generally decided that the US budget deficit offered the best explanation for the stock-market collapse, Mr Reagan realised he had to make at least a symbolic gesture in order to restore confidence. This time, vague promises or criticism of Congressional failings would not do. Actual cuts in this year’s deficit would have to be found – which required positive co-operation between the Administration and Congress, however distasteful this was to the President.

The deficit explanation has provided the governments of the other industrial nations with just the solution they were looking for. It has been convenient for them to be able to place the blame for the chaos on the failures of US economic policy. Mrs Thatcher, better-known in her role as President Reagan’s only defender in times of crisis, was quick to jump on the international bandwagon. The US deficit must be cut, she and her Chancellor both cried. The US cannot go on borrowing for ever, they warned. Much of the same sort of thing, in fact, that many economists have been arguing for years. But it is rather odd for Mr Lawson to adopt such a position. He was present at a meeting in Washington on 26 September of the finance ministers of the Group of Seven (the US, Britain, France, West Germany, Japan, Italy and Canada): the communiqué issued at the end of that meeting makes interesting reading in the light of subsequent events. In particular, it speaks warmly about American achievements in cutting the budget deficit for the fiscal year just ended: ‘a very positive step,’ it says.

The credibility of these high-level meetings, once seen as so important, was already being undermined by publicly-aired differences between the US and West Germany after the 26 September meeting – differences which are themselves cited as a cause of the stock-market crash. For years, the US has been trying to persuade West Germany and Japan to share more of the burden of sustaining world economic expansion. Both countries have huge trade surpluses in contrast to the American trade deficit, but both have been reluctant to expand as fast as the US would have liked. West Germany has been especially unwilling to be lectured on economic policy by an Administration which it believes to be fiscally irresponsible. The readiness of many of the participants to blame each other when things go wrong can only further undermine confidence in these meetings, especially when any commitment to economic co-operation is only skin-deep. Co-operation is fine, they seem to imply, as long as you don’t ask or tell me to do something I don’t want to do.

There are two obvious explanations for the about-turn effected by many Group of Seven ministers almost as soon as they got home from the September meeting. The first is that it is easiest to blame someone else when disaster strikes – even if it means a breach of previous understandings. In international economics, as in international politics, everything is fair. The alternative hypothesis is that the recent events have given America’s principal economic partners a rare opportunity to resist US economic imperialism. It may be that Mr Lawson’s only chance to berate the US Administration for its economic policies is when everyone else is doing it as well. Either way, the events of the past few weeks do little to inspire confidence in the world’s leading finance ministers. If America’s partners really believe that the US budget deficit is too big, and dangerously so, they should speak up, at least in private; they should not commit themselves to agreements or promises, either verbal or in writing, which may later prove to be hostages to fortune.

The repercussions of the stock-market collapse will clearly be felt for some time. Recession may be avoided with government effort and a bit of luck (though cutting government borrowing is not normally seen as the recipe for preventing a slump). The stock markets will adjust to changed circumstances in which the global tie-up, by exaggerating every movement, makes them more volatile. Above all, governments may take their commitment to economic co-operation a bit more seriously – at least until the next crisis.