An Economic Theory for Every Crashing Occasion

When the stock market crashed 156 points on Oct. 26, the second biggest decline since the previous week’s spectacular 508-point drop, everyone had the reason. The fall, by near-universal judgment, was caused by speculation in Europe that the United States had abandoned its policy of a stable dollar and would henceforth allow it to fall.

Two days later the stock market rose 92 points, its third-biggest jump ever. The rise, by near-universal judgment, was caused by speculation on Wall Street that the United States had abandoned its policy of a stable dollar and would henceforth allow it to fall.

The respected Economist magazine, in its Oct. 30 issue, took the U.S. Treasury to task for “spectacular naivete and some arrogance” in abandoning a stable dollar policy and causing the collapse. The same magazine, in its Nov. 6 issue, blamed “stability in the dollar” for the “crash of 1987.”

On a different front, Peter J. Solomon, vice chairman of Shearson-Lehman Bros., said the real problem was lack of “leadership”--the failure of the President and Congress to reach an agreement on a $23-billion deficit-reduction package. He did not mention that the deficit had fallen 35%, or $73 billion, over the past year, or that last year’s deficit forecasting error was greater than $23 billion.

Business economist Edward E. Yardeni said the market fall was caused by the House’s deficit-reduction package, because it included a provision that would raise taxes on corporate takeovers. Congressional budget writer Rep. Dan Rostenkowski (D-Ill.) said he would do his best to get rid of the offending tax proposal.

Amid the deficit-reduction clamor, little note was paid when the Senate and the House passed, by 8-1 and 3-1 margins, a program expanding Medicare coverage--legislation the President will almost certainly sign. The Congressional Budget Office estimates it will require several billions annually in new spending.

A number of market professionals, including the head of the New York Stock Exchange, blamed market instability not on tax policy or the dollar, but on computerized program-trading. Portfolio-hedging strategies can generate large, sudden sales of poorly understood new instruments like index options. Most academic research has concluded that such instruments smooth market fluctuations, but no one knows for sure. On Oct. 19, Black Monday, program trading was actually lower than normal.

Policy-makers rushing among crisis meetings may have been even more confused to realize that the crash came amid some of the cheeriest economic news in months. The economy, which had appeared to be lagging, grew by a spanking 3.8% in the third quarter. Inflation, instead of rekindling, proved decidedly tame. Capital goods spending was accelerating, consumer income was totting up big gains and manufacturing profits looked to be the best in years.

The controversy over management of the dollar, to take just one conflicting cry from the clamor of advice, is a good example of how two perfectly plausible and internally consistent views of the world can lead to opposite conclusions.

A sharply lower dollar will presumably stifle expensive U.S. importing habits and, coupled with federal fiscal restraint, reduce the need for borrowing overseas. Interest rates will fall, as will the cost of servicing federal debt. The federal deficit will then fall even faster, and economic activity of every variety will be on a sounder footing. Herbert M. Stein and Martin S. Feldstein are among the leading economists who espouse this view.

Stable-dollar advocates argue that the world economy depends on a stable reserve currency that, like it or not, is the dollar for the foreseeable future. A lower dollar will penalize foreigners who have had the confidence to invest in the United States, will trigger protectionist trade legislation in other countries and will cause a worldwide recession.

Stable-dollar advocates suggest that in an integrated U.S.-German-Japanese economy of some $7 trillion, “local” imbalances in the $150-billion range don’t seem that threatening. The Wall Street Journal and others point to the disastrous results of Jimmy Carter’s efforts to “talk down the dollar” in the late ‘70s.

It is entirely plausible that none of these issues--the dollar, the deficits, taxes or program trading--had anything to do with the crash, except to give nervous traders an intellectually respectable excuse to bolt the market.

Prosaically enough, the market may have fallen because it was too high. The Dow Jones industrial average was about 850 when the bull market began five years ago. A year or so ago, 2,000 seemed an impossible dream. If the markets had roared to 2,000 and stopped, most investors would have been delighted.

There was a “crash” only because the skin of the bubble stretched to 2,700. The “wealth” blown away was a wholly artificial phenomenon. Stock prices of the Standard & Poor’s index averaged 22 times earnings in August, a historic high. Japanese stocks were selling at 60 times earnings, and the value of stocks on the Hong Kong Exchange had risen to 145% of the country’s entire national product, grossly out of proportion to any conceivable measure of economic value.

When the Asian stock markets took off in 1986, U.S. and European institutions poured billions into relatively thinly capitalized markets such as Hong Kong. “Asian funds” enjoyed growths of 50%-75% a year, making fund managers look like geniuses, and drawing more money into stocks of all kinds. The real damage of the Crash of 1987, at least so far, is that people who thought they were rich beyond their wildest dreams found out they are merely rich.

Stock values, by this argument, have done little more than return to near-sensible levels--AT&T; is still at 17 times earnings. That does not mean the stock market’s slide is unimportant. The financial wizards who drove the speculative boom by betting that takeover stocks would rise forever, were betting not with their own money, but with the balance sheets of their employers, Wall Street investment houses.

A Wall Street credit crunch caused by collapsing investment bank portfolios could cause problems we would all wish we had never heard of. Not least of which would be the proliferation of new economic insights to explain them.