The mysterious case of the missing decimal point

As Alan Greenspan stepped off a plane on the evening of Black Monday, the first question he asked waiting officials was where did the Dow Jones index finish? Down five zero eight was the reply. Greenspan looked relieved.

After all, five point zero eight was not such a bad performance, given how much the market had fallen the previous week. Seeing the chairman of the US Federal Reserve had clearly misunderstood, the officials hurriedly put the record straight. No, five hundred and eight, not five point zero eight, they said. Relief was replaced by shock and horror.

This story from the 1987 stockmarket crash catches the disbelief with which most people in the financial markets, and not just Alan Greenspan, reacted to events.

The stockmarket crash occurred on 19 October, Black Monday. It followed weeks when the major stockmarkets, with the exception of Tokyo, had been hit by nerves, after what had until then been a good year.

In the third quarter of 1987 economic growth in the major industrialised countries had reached its strongest pace since the start of 1984 and corporate profits were rising steadily, up by an annual rate of 23% in the UK. Despite this, economic problems were brewing and equity markets were vulnerable.

Three related issues triggered the fall.

The first was concern that global co-ordination of macro-economic policy, which had been a hallmark of the previous two years, was breaking down.

There was public disagreement between the Germans and Americans over who should do more to lower their budget deficit. German interest rates rose on 6 October, highlighting that domestic needs and not global concerns were the key influence on policy.

The mid-1980s had been the hey day of modern policy co-ordination. Problems had been brewing because of growing trade balances. Japan and Germany had large current account surpluses, making them the world’s largest creditor nations. By contrast, America was cast in the role of debtor, plagued by a deteriorating trade deficit. The scale of these imbalances prompted the Group of Seven (G7) industrial countries into action. Two solutions were identified: currency adjustment through a weaker dollar and macro-economic justment, with America reducing its huge budget deficit.

These issues dominated global markets during the mid-1980s. At the Plaza Accord in September 1985 the G7 decided the dollar had fallen far enough, and they sought to stabilise it. Ahead of the crash, a fear that policy co-ordination was breaking down alarmed the markets and focused attention on the US twin deficits.

The second trigger was the US trade deficit. On the Wednesday preceding the crash a poor August trade figure caused the Dow to crack, with the index falling a record 95 points. On Thursday the market fell 58 points and on Friday another record 108 points, before Black Monday’s 23% collapse of 508 points.

A third factor was a deterioration in US inflation expectations, which pushed US bond yields higher, making the Dow Jones index look increasingly overvalued.

So a breakdown of policy co-ordination, concern about trade problems and higher bond yields all dented global stockmarket confidence. New York and London were hardest hit. London fell 11% on Black Monday and 12% on the Tuesday. In the weeks that followed there was excessive volatility and many investors ran for cover.

Monetary authorities responded quickly and sensibly to the stockmarket crash, in order to minimise any damage to the economy and financial sector.

One concern was the fall could have a negative wealth effect, dampening economic growth. A second concern was that some financial institutions could face liquidity problems.

The US Federal Reserve eased. The Bundesbank cut its discount rate to an all-time low of 2.5%, and there was a series of co-ordinated rate cuts throughout Europe. UK rates fell twice in the immediate aftermath of the crash, 0.5% on both 23 October and 4 November. On 3 December, there was a further 0.5% reduction. In addition, the government refrained from issuing gilts, so as not to drain liquidity. In the event the negative wealth effect proved small. The British economy was resilient and, if anything, benefited from the subsequent interest rate cuts, feeding an already buoyant economy.

There were spillover effects from the crash into currency markets, with the dollar’s trade weighted index falling sharply by 11% in the fourth quarter. Consequently, G7 reaffirmed their commitment to the Louvre Accord in December, and supported this with intervention, thus giving a new lease of life to policy co-ordination.

A number of economic lessons can be learnt from 1987. First, stockmarkets can clearly overshoot, discounting too much positive economic news. This helps explain some of the present nervousness towards buoyant stockmarkets.

Second, markets will always be vulnerable to policy conflicts. In 1987 it was a conflict between Germany and the US, but policy conflicts can be seen in other respects, the most obvious being when countries pursue exchange rate objectives at the expense of domestic needs.

Third, when underlying economic imbalances persist this will eventually cause problems for the financial markets.

Fourth, the response of central banks was correct. Their immediate accommodating policy action helped reduce any problems. Yet, once it became clear that the problems arising from the crash were minimal then central banks should have reversed their action, particularly in view of the strength of the global economy at that time.

The crash brought to an end a Golden era for the London market which had lasted since the previous year’s Big Bang. An injection of new capital into the City at the time of Big Bang had created excess capacity in the financial sector, but the rise in the stockmarket boosted business and delayed any fall-out. Following the crash, stockmarket volume fell and the necessary shake-out started. It was painful, but eventually contributed to a leaner and fitter City.

Dr Gerard Lyons is chief economist of Dai-Ichi Kangyo Bank (DKB) International.