TIMES BOARD OF ECONOMISTS : Brady Recommendations Would Create Much-Needed Market Stability

GEORGE L. PERRY is a senior fellow at the Brookings Institution research organization in Washington

As new techniques for trading in stocks were developed during the 1980s, many seasoned investment professionals worried that these could destabilize markets. The development of financial futures, in which contracts representing the future average price of a large bundle of stocks could be bought and sold with very low margin requirements, was one source of concern. The other, which developed from the availability of financial futures, was "portfolio insurance," whereby selling of financial futures is triggered if stock prices decline by some predetermined amount.

Yet, for a long time, the feared increase in the volatility of stock prices did not emerge, or if it did, appeared only in the pleasant form of stock prices that kept exceeding expectations by rising so much.

The events of mid-October changed all that. On Monday, Oct. 19, the Dow Jones industrial average culminated a weeklong period of decline by dropping more than 500 points. The bewildering crash was paralleled only by the stock market of 1929, a fact that merely added to the fears of the investment community. Since then, the volatility of stock prices has been exceptionally high and the fear of another collapse has been ever-present in the minds of investors.

Contrary to the portrayal in the hit movie "Wall Street," most investment professionals work at anticipating the trends and cycles in the economy and at picking stocks that appear undervalued in price in light of the business prospects of their companies. Even these professionals, who manage pension and mutual fund money, are shaken by the increased uncertainty of today's stock market where, with some regularity now, gains or losses in a single day can swamp the benefits of a year of careful analysis and stock selection.

Investments Would Suffer

If their clients--individuals and those responsible for pension funds--get frightened of a market whose volatility they cannot comprehend, they will take their money out of stocks altogether. Eventually, this will bring stock prices down to the point where the return that can be expected from stock investing is more nearly commensurate with the increased risk.

A world of chronically lower stock prices will make it more expensive for firms to raise equity capital, and real investment in plant, equipment and new business ventures will suffer. As a further side effect, foreigners may be less willing to invest in U.S. stocks, making it harder to finance the U.S. trade deficits that are inevitable for at least several more years.

In light of all this, it is discouraging that the recent report by the Brady Commission, the presidential task force assigned to analyze the stock market crash, did not get stronger support from Wall Street. The report carefully documented and analyzed trading activity in the period surrounding the crash and concluded that portfolio insurance activities contributed both directly and indirectly to the severity of the crash. Furthermore, the commission warned that, without some new safeguards, the market is vulnerable to a repeat of last October.

Given these deep concerns, the commission's recommendations were notably mild. Two seem most directly concerned with reducing price volatility. The first would narrow or close the discrepancy between the 50% margin now required to buy stocks and the margin of only 12% required to buy futures contracts on a bundle of stocks. The second would give a central regulator, with authority over all markets that relate to stocks, the ability to suspend trading under certain conditions. Both these suggestions deserve serious consideration.

Higher margin requirements are stabilizing because they reduce the circumstances under which selling is forced. If I own financial futures contracts on 10% margin, a drop of only 10% in the price of my contracts loses all the money I have put up. Even before I have lost it all, my broker will require more money, immediately, or will sell out my position. Such forced selling then adds to the general decline in stock prices. (Particularly in futures markets, where speculators are likely to be short as well as long, the same can happen in reverse, with speculators forced to buy to cover short positions in a rapidly rising market.)

Controversial Proposal

Increasing margins on futures should be stabilizing in another way as well. By raising the cost of participating in financial futures, it would make portfolio insurance programs more costly, thus discouraging their use and reducing the contribution they make to exaggerating price swings in the market.

Putting a halt to all trading under certain conditions is a more controversial proposal and one whose effects are harder to predict. However, it is likely to be useful because the herd instinct is so strong in risky markets. If many participants think that others are about to sell, they will sell to get ahead of them, in the process creating or adding to the decline that they fear. In extreme conditions of this sort, stopping all trading would provide time for investors to digest the situation and to assess whether any genuine changes have occurred that would warrant a steep decline in prices. The hope is that this time for reflection might keep the herd from stampeding. Recommendations such as these will meet stiff opposition from those with a stake in markets that would be restrained, as well as from those economists who simply believe that all markets should be free of any regulation or government interference. But a broader view of why society needs markets points to the need for some changes.

Society has a stake in a well-functioning equity market as a way of directing investment funds where they are most needed and of providing individuals with a way to participate in the growth and prosperity of companies. Stock markets provide these highly useful functions.

As a side effect, they also provide opportunities for short-term speculation, which, however fascinating or important to the people involved, makes no particular contribution to the economic or social welfare of the country. As a matter of free choice, these activities are perfectly appropriate, and I enjoy them myself. But if they come to dominate markets and add greatly to their volatility, then they take away from the much more important advantages that more stable financial markets offer.

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