On Oct. 19, the stock market gave us warning. The Great Crash of 1987 scored only about a 5.0 on the Richter scale of financial earthquakes. But it showed us where the fault lines are, and it signaled much more damaging quakes ahead unless we build a sturdier system.
Wall Street, however, dismissed the event. Financiers blamed the crash on the federal budget deficit, on pending trade legislation, on the coming end of the Reagan Administration, on anything but Wall Street itself. There's nothing wrong with our financial markets, they told us. No need for new federal regulation.
Now comes the report of the panel set up by President Reagan to investigate the Oct. 19 quake and what should be done about it. The Brady Commission tells of a financial system that spun out of control on Oct. 19, and "approached breakdown" on Oct. 20. The only thing preventing complete collapse was quick action by the Federal Reserve to reassure securities houses that money would be available if they needed it and announcements by major corporations that they would buy back their stock. Next time, the report warns, we may not be so lucky.
On Black Monday, according to the report, as downward momentum began to build, the biggest investors automatically sold stock index futures (linked to the value of the stock that makes up the Standard & Poor's 500 stock index) to protect themselves against further losses. But this ploy--which under normal circumstances would have worked just fine--was almost immediately copied by other big investors. Suddenly, stock index futures were in free fall.
As computers clicked in, stocks went tumbling too. Soon, the chain reaction was out of control. The big boys--portfolio insurers, major institutional investors, large investment banks and stock exchange specialists--rushed to protect their own interests as smaller investors foundered.
Panic built upon panic, greed upon greed. The next day things got even more tangled. Losses mounted. Banks stopped advancing credit. No one wanted to be left holding the bag. The system approached gridlock.
The Brady Commission calls for three big Band-Aids: limits on how far the prices of stock index futures can change in a given day possibly coupled with trading halts in highly volatile stocks, thus creating "circuit breakers" to contain future chain reactions; higher down payments (margin requirements) on the purchase of stock index futures, thus reducing the danger that losers won't be able to pay off their debts, and overall control by one agency, preferably the Federal Reserve Board, over stocks, options and futures, thus recognizing the interdependence of these markets.
These proposals are mild, to say the least. But because they involve more regulation, the White House already has given them the cold shoulder. The Administration says that it wants to see "other studies" before taking action, which translated from bureaucratese means "we won't move until we have to."
In fact, the Brady Commission doesn't go nearly far enough.
The essential problem is that our financial markets have become a single giant casino in which vast sums of money are made by fast operators--armed with computers--who beat one another to the punch. He who moves money to where the rest of the money is moving before the rest of the money gets there becomes immensely rich. (Or at least avoids losing his shirt). The laggards lose much more than their shirts.
Small Guys Leaving
The game is exciting, fast-paced, addictive. It has attracted among our brightest young people. It has spawned some of the most innovative maneuvers found anywhere in the American economy. The problem is, it's just paper. The innovations have made some people very rich, but just as many very poor. They add nothing to America.
Worse yet, the game is getting faster and more volatile. The ups are higher and the downs are lower, and the ups and downs both occur at extraordinary speeds. Small investors don't have a chance and they know it. The small guys are leaving the market in droves.
It's also showing signs of being rigged. With all the speed and volatility, those with inside knowledge of where money is likely to move make a bundle. Occasionally they get caught and go to jail, but the lure of vast wealth has outweighed the slim possibility. And the game is getting ever more dangerous.
The sky's the limit for a lucky trader who bets everything on a certain hunch. If he's unlikely, the worst that can happen is he's fired or he goes bankrupt and has to start over.
But the downside risk to the financial system--to banks, insurance companies, pension funds, corporations and to all of us who depend on these institutions for our livelihoods and our retirements--is enormous.
The financial quake on Oct. 19, and the aftershock on Oct. 20, brought us as close to calamity as we've been in over 50 years. It's time we got serious about financial reform.
What should be done?
First, it's not enough to have "circuit breakers" on stock index futures or vague instructions for trading halts on volatile stocks. Limits should be placed on how high or low stock prices can move in a short span of time. If movement exceeds these bans, trading should be automatically halted in the stock.
Second, don't give overall jurisdiction to the Fed. The Federal Reserve Board is good at watching aggregate economic data and supplying the financial system with extra money when needed. But it's not an enforcement agency. It has no experience investigating shady deals, prosecuting offenders and sending people to jail. Instead, give authority over all the financial markets to the Securities and Exchange Commission, and dramatically increase its enforcement budget.
Third, get at the underlying problems of speculative excess. Change the tax laws so that financial assets traded within a short time are penalized with a substantially higher capital gains tax; assets traded after a decent interval--say, four months--are rewarded with a much lower tax on capital gains.
Fourth, take away the tax advantages that go with hostile takeovers--which, in turn, have fueled the frantic speculation of recent years. Don't ban hostile takeovers altogether; some are efficient means of deposing bad managers. But there's no reason to allow raiders to deduct interest charges on the Gargantuan loans raised to finance these adventures. If they're efficient, they don't need the extra tax sweetener.
Finally, understand that it's not just America's financial markets that have merged into one casino: The financial casino is now worldwide. Thus, any steps we take to control the tremors in New York and Chicago have to be coordinated with steps to control them in London, Paris, Tokyo and Bonn.
But control them we must. Oct. 19 was a small warning of bigger things to come. The Brady Commission's recommendations are in the right direction, but hardly adequate to the task. Let's take action before the next financial earthquake topples everything.