The World Economy is still Flying High After the Crash

One year later, the October, 1987, stock market crash is just another financial panic. The history of capitalism is in fact littered with financial crashes. Tulip mania, the South Sea Bubble, the Great Crash of 1929 all have become part of our colorful history.

Many more crashes have been forgotten. In the 19th Century, financial panic occurred at a rate of better than one a decade. Several panics, crashes, manias or bubbles occurred between 1900 and 1929. They have been forgotten since nothing very serious followed in their aftermath. In this sense, the 1987 crash was a normal crash and will soon fade out of our collective memories.

It had few effects on the real economy. The constant dollar gross national product grew at an annual rate of 6.1% in the quarter of the crash. In the two following quarters since, it has averaged a 3.25% growth rate. If anything, the lower interest rates engendered by the crash helped the economy more than the adverse wealth effects hurt the economy.

What was the difference between 1929 and 1987? The banking system. In the spring of 1930, banks started to go broke, and the government let them fail. The collapse of the banking system led, in turn, to a collapsing economy. The stock market then followed the economy down. (By Jan. 1, 1930, the stock market had recovered most of what it had lost in the October, 1929, crash.) Without depositors’ insurance, every bank failure led to multiple failures as individuals and businesses found themselves without liquid assets.

The ripple effects of a collapsing banking system are simply much larger than those of a collapsing stock market. Only the richest 5% of the population have any significant fraction of their wealth in the stock market. These people also have other sources of income and don’t cut back on their consumption simply because they have suffered a 23% reduction in the value of their portfolio.

In contrast, most Americans have most of their liquid wealth in the banking system. When they lose liquidity, it is a disaster.

In October, 1987, the Federal Reserve pumped money into the economy to prevent the banking system from collapsing. In this effort, officials were aided by depositor insurance. There were no runs on banks since the public was confident that a collapsing stock market did not mean that the banks would close their doors.

The major lesson of the 1987 crash is to remind us that today’s festering problems in the banking and savings and loan industries are much more worrisome than what happened last October. If you want to lose sleep worrying about financial disasters, that’s where you should look.

There is also another lesson from last October’s crash, a lesson that comes out of all crashes. The question is not why did the price of tulips come down suddenly, but why did they go to levels that, at least by the hindsight of history, are absurd?

Crashes are rational market adjustments. What is irrational are the prices before the crash. What was true in tulip mania has been true in every crash since. The post-crash prices are sane; the pre-crash prices are insane. Stocks’ price-to-earnings ratios in September, 1987, simply were unsustainable. The October crash was rational.

So why do intelligent people pay irrationally high prices for some assets? This just doesn’t happen in the stock market. A few years ago Iowa farm land was selling for values that could not be justified given any conceivable value of corn and soybeans. Those land values collapsed just like the stock market collapsed.

The answer is everyone knows that the values are too high but there is a lot of money to be made if they go yet higher. And no one knows where the end is. What seems absurdly high may not yet be the peak. Everyone dreams that he or she will be the first to dash for the door when the end comes, but few will be so lucky. Most will be unable to get out of the market fast enough and suffer their losses along with everyone else.

To see with the hindsight of history that a price is absurd is easy, of course. What’s difficult is recognizing when current prices are absurd. For those who like to test their ability to tell the difference between a rational price and an absurdly high price, consider the Tokyo stock market. Is it or isn’t it insane? Will it someday be put in the same category as tulip mania? Or is there something different about that market?

Another issue was cleared up in the aftermath of last year’s crash. Previously, there was a debate about whether international economic coordination could successfully accelerate growth. Now there is no debate. In the year after the crash, the economy of the whole world has grown much faster than it did the year before, and much, much faster than was forecast late last year.

The reasons for this unexpected acceleration of world growth are clear. After the crash, governments around the world worried that their economies would sink into recessions. Consequently, they simultaneously stimulated their economies with faster monetary growth and lower interest rates. And the world economy, much like a finely tuned expensive sports car, responded when the world stepped on the monetary accelerators.

In normal times, it may be difficult or impossible to orchestrate economic policies internationally, but when economic policies are orchestrated it works.

But now most forecasters see much lower growth rates for almost every country in the world by late 1989. The stimulus applied in the months immediately after the crash will have worn off by then and we will be back to a world of uncoordinated policies, with some countries stimulating their economies and others braking theirs. Most sports cars don’t work very well with one foot on the brakes and the other on the accelerator, and neither does the world economy.