Have We Learned the Lessons of Black Monday?

MARK WILSON/Getty ImagesFear in his eyes? Fed Chairman Ben Bernanke looks worried. He should be.

Twenty years ago this week, the U.S. stock market tumbled in the worst single-day decline in history. Looking back at the economic circumstances surrounding Black Monday, one cant help but wonder: Could such a dramatic stock-market crash happen again?

Indeed, there are many parallels between the macroeconomic and financial conditions of late 1987 and the market conditions of today. Both times there has been new leadership at the Fed. In 1987, Alan Greenspan was newly minted as chairman of the Federal Reserve. Inflation was rising, and Greenspan responded by raising the fed funds interest rate by 50 basis points. Nevertheless, investors were skeptical about his ability to be a strong leader in difficult times. For example, on a Sunday television news show early in his tenure, he expressed his concerns about inflation; the next day stock markets sharply wobbled. Greenspan learned his lesson, realized the risks to his reputation, and never again gave a television interview on the economy, instead gaining a reputation for becoming altogether Delphic in his public pronunciations.

Similarly, relatively new Chairman Ben Bernanke also inherited an economy with high and rising inflation, and has responded by raising interest rates three times for a total of 75 basis points since he became Fed chairman last year. And like Greenspan, he too has had missteps with the media. Last spring, after making comments in front of Congress that investors interpreted as dovish, he told CNBC anchor Maria Bartiromo that he had been misunderstood and was more hawkish than the market perceived him. The next day, equity markets sharply contracted and Bernankes reputation was shaken. You can be sure that, like Greenspan, Bernanke will likely never speak to any TV reporter again.

The similarities between 1987 and today go far deeper than media dust-ups. Take, for example, twin deficitsthe existence of both large and unsustainable budget deficits and current account deficits that are leading to an accumulation of a large stock of public debt and foreign debt in the United States. In the years leading up to Black Monday, unsustainable tax cuts and excessive military spending during President Ronald Reagans first term led to a strong dollar and a large current account deficit. After 1985, driven by the unsustainable external imbalance, the dollar started to fall. Likewise, today we bear the consequences of unsustainable tax cuts and runaway military spending. And since 2002, the dollar has started to fall under the pressure of the external imbalance.

Most notably, there are troubling parallels between 1987 and the present in trade. In the months leading up to Black Monday, the United States blamed Germanys and Japans weak currencies for the continued U.S. trade deficit. In particular, American politicians stoked fears that a rising export giant like Japan would hollow out the U.S. manufacturing sector. The tensions came to a boil on October 18, when Treasury Secretary James Baker strongly suggested the need for a further fall in the dollar and implied that the reluctance of Germany and Japan to let the mark and yen appreciate could be met with retaliatory trade actions. The following day, the infamous Black Monday of October 19, 1987, the stock market crashed: The Dow Jones industrial average went into a free fall, losing 22.6 percent of its total value. The SP 500 collapsed by 20.4 percent. This was the largest loss that Wall Street had ever experienced in a single day.

The risks of such a systemic financial crisis are just as serious today. Todays scaremongering about unfair trade practices focuses not on Germany and Japan, but on China. U.S. politicians blame China for the United States low savings and external deficit. And American manufacturers fear that China will hollow out the U.S. traded sector (textiles, apparel, labor-intensive consumer products, auto parts and, soon enough, even cars) with its unstoppable export boom. There are several bills in Congress to slap tariffs against China if it does not allow its currency to sharply appreciate. The slowing growth of the U.S. economy and the upcoming presidential election in 2008 are increasing the protectionist mood in Congress regarding trade in goods. Markets are skittish and investors more risk averse after this summers financial volatility. And the growth of derivative instruments is much more massive than 20 years ago: These instruments can be used to hedge risks (such as the default risk on mortgages or corporate debt) but, in conjunction with high leverage, they are often used for highly risky speculative bets on risky assets, and thus they contribute to greater systemic risk.

In these conditions, it usually doesnt take much to rattle markets and trigger a meltdown. Hopefully, Treasury Secretary Hank Paulson will avoid bullying China and the countries that are financing the U.S. current account deficit. It is not only bad manners to bite the hand that feeds you, but its also dangerous financial behavior: The United States badly needs this cheap foreign financing. The United States still needs to borrow about $800 billion every yearon top of all the previous stock of past borrowingto finance its still increasing external deficit.

All these factors mean that theres an even greater risk today than in 1987 that things will get out of hand and trigger a financial free fall. Today you have the following: trade protectionism and asset protectionism (the increasing restrictions to foreign direct investments in the United States); hedgy and trigger-happy investors and rising geopolitical risks; the risk of a disorderly fall in the U.S. dollar that is now sharply weakening; a slush of financial and credit derivatives that are a black box of opaque financial innovation that no one truly understands; increasingly risky investment strategies based on growing levels of leverage (i.e. the ability to multiply risk bets by borrowing a lot to finance such bets); frothy markets where years of easy money created bubbles galorethe latest in housingthat have now started to burst; greater opacity and lack of transparency as there is no supervision or regulation of the activities of many highly leveraged and opaque financial institutions; risk management techniques in financial institutions that fail to truly test the risk of large losses in extremely rare events (such as a major market meltdown like in 1987 or in 1998 at the time of the near collapse of Long-Term Capital Management, then the biggest U.S. hedge fund); risk-hedging strategies thatlike in 1987can hedge nothing once everyone is rushing to the doors and dumping assets at the same time (with this summers liquidity crunch a perfect example of the vulnerabilities associated with the poor management of liquidity risk); a housing market whose rout has already triggered systemic effects through the subprime carnage; and the fact that subprime mortgages had been pooled in mortgage-backed securities and that these in turn were repackaged in other risky, complex, and illiquid securities (the various tranches of collateralized debt obligations) that were then given a misleadingly high rating by the rating agencies.

The credit and liquidity crunch of this past summer was just the first sign that this toxic and combustible mix of elements could lead to a financial meltdown. It may only take any small match to trigger it: the collapse of a large hedge fund, a bankruptcy declaration by a large U.S. corporation, a trade war with China, a further spike in oil prices, a major terrorist incident, or wider conflict in the Middle East. There is indeed an embarrassment of riches in events that could trigger a systemic financial-risk episode. A single factor among those discussed above may not be enough to trigger it, but the risk that a variety of such factors may simultaneously emerge is increasing. To avoid such a meltdown, we need many reforms: better regulation and supervision of mortgages and of financial institutions, including the lightly or unregulated hedge funds; more transparency on who is holding which risky assets; better risk management by investors; avoidance of a bailout of reckless lenders and investors; a more competitive market for ratings as the small set of only three rating agencies seriously misread very complex and risky instruments; and hopefully a modest and softrather than hardlanding for the U.S. economy. We need these and other reforms. Otherwise, the next Black Monday will be a whole lot darker.