Stock Shock and After Shock

A week of turmoil in the world’s financial markets has left both experts and ordinary citizens fearful and stunned. The abyss that opened up briefly on Black Monday seems to have closed; there were no more 500-point drops in the Dow. But aftershocks from Monday’s quake were felt all week long and for some months to come we will all be treading cautiously, like earthquake survivors.

Last week’s financial earthquake was not completely unexpected. Stock market crashes are no more--and no less--predictable than earthquakes. No one knows the day or the hour, but experts can measure the buildup of pressure along the subterranean faults.

For the last 15 months, voices have been heard warning of the potential for tremors. Business Week magazine warned all who would listen that we have become a “casino society,” vulnerable to sudden financial shocks. Alfred Malabre Jr., economics editor of the Wall Street Journal, wrote “Beyond Our Means” to warn that the forces of instability are growing. Felix G. Rohatyn, Peter G. Peterson (an investment banker who served as Richard M. Nixon’s secretary of commerce), John Kenneth Galbraith and Henry Kaufman have all warned of grave economic peril.

What bothered these figures--some liberal, some conservative--were the growing imbalances in the world economy. On the one hand, surplus countries like Japan poured limitless amounts of capital into world markets. On the other, debt rose to record levels. The U.S. government borrowed $1 trillion in the 1980s; corporations and consumers went on borrowing sprees. Not since Britain lost its nest egg in the war against Hitler has any country gone from being a net creditor to net debtor as quickly as the United States in the 1980s.

Destabilizing surpluses in some countries, destabilizing deficits in others: This is a tried-and-true recipe for economic disaster.

“Japan’s biggest problem today is not trade but too much money and too much industrial capacity,” says one prominent Japanese observer. Personal and corporate savings in Japan amount to $1.5 billion per day--and this money can find no home in productive investments either in Japan or around the world.

“Oversavings” is a concept introduced by John Maynard Keynes to account for the boom-and-bust economic cycle of the 1920s and ‘30s. Then as now there was a basic imbalance between consumption and production. The assembly-line technology of the 1920s made industrial workers more and more productive, but their wages did not keep pace. Each year more cars, refrigerators and radios poured out of the factories--but there weren’t enough customers to absorb the products.

In the short term, corporations made high profits--costs were low and output was high. Those profits--the oversavings of the 1920s--fueled the stock market boom and led many to conclude that the United States was in a recession-proof New Era.

The New Era ended in the Great Crash. Painfully, American business learned that its own prosperity depended on the buying power of its employees. Minimum wage laws, Social Security, unemployment insurance and other programs gradually injected enough buying power into the economy to halt the slide to paralysis.

Government spending also helped; many people define Keynesian policies as deficit spending. In fact, government spending was only one aspect of Keynesian economic policy--the other was keeping wages up.

The U.S. government has been called the “locomotive” of the 1980s global economy. This is a polite way to say the United States has become the world’s consumer of last resort. We are borrowing money to create demand for products of other countries where consumers have less buying power than ours do.

In Japan, for example, manufacturing workers exactly as productive as their U.S. counterparts earn 12.5% less. Low social-security payments and high housing prices force them to save more of what they earn, reducing their buying power even further.

The oversavings from Japan--and from countries where wages are even lower--sloshed into world capital markets and, in an ominous replay of the late 1920s, drove stock prices around the world to record levels. Yet the profitability of the world’s manufacturers depends on U.S. trade and budget deficits that clearly cannot go on forever.

This is an unstable situation, and the longer it continues the more unstable it gets. Historically, in such situations sophisticated investors get nervous. They look for liquid assets, assets that can be sold at the first sign of trouble. They also look to gold with new respect--losing faith in the paper economy, they want something solid.

A quiet rise in the price of gold through 1986 suggested this waning confidence in the paper economy. In the fall of 1986, an event that raised eyebrows in financial circles but attracted little attention beyond them showed that liquidity preference was strengthening. Perpetual floating-rate notes were attractive high-yield investments backed by major banks. They had only one drawback: They weren’t very liquid. Late last year, the market in these notes suddenly collapsed. Investors simply did not want assets that could not be dumped in a hurry.

By April, 1987, Euromoney magazine was reporting that international money managers were turning even more cautious. The markets for innovative financial products dried up; investors wanted tried-and-true products whose performance was more predictable if less spectacular than the razzle-dazzle securities developed during the long financial boom.

The smart money was like someone smelling smoke in a crowded theater. It wasn’t going to start a panic by shouting “fire!”--but it would edge inconspicuously toward the exit. If someone else shouted “fire!” the smart money wanted to be the first out the door.

On Black Monday, someone shouted “fire!” and there was a mad rush for the exits. Many investors were crushed in the pushing and shoving. The whole crowd still hasn’t returned to its seats, not fully reassured--certainly not by Ronald Reagan’s statement, “The underlying economy remains sound.”

At the end of the week, the markets still seemed jittery, and the imbalance of oversavings and overborrowing has not disappeared. Unless we can get the world back on a path of balanced growth--led by consumer demand, not government debt--Black Monday may yet figure in the history books as the first great crash of the Second Great Depression.