Black Monday (1987)

Black Monday refers to Monday, 19 October 1987, when stock markets around the world crashed. The Dow Jones Industrial Average (DJIA) dropped by 508 points to 1738.74 (22.61%).

Progress of the crisis
The stock market crash was the inevitable consequence, of inflationary boom. The Great Inflation of 1982- 87 was fundamentally a monetary phenomenon, orchestrated by the Federal Reserve System and financed by a massive and prolonged increase in the money supply.

The Penn Square bank failure and the threat of default by Mexico and then other developing countries on their international loans in the summer of 1982 underscored the precarious stability of the world financial system, including and especially U.S. money-center banks. These events in conjunction with the continuing recession in the U.S. economy-whose persistence had repeatedly defied official forecasts prompted the Federal Reserve System, in July of that year, to initiate a policy of vigorous monetary expansion. With minor breaks this expansion lasted until 1987.

What enabled the Fed to stoke the fires of monetary inflation as vigorously and as long as it did was the fact that the effects of this inflation were obscured in U.S. consumer-goods markets, especially in 1985 and 1986. For example, in the years 1983-1986, consumer prices, as represented by the CPI, increased at annual rates of 3.8%, 4.0%, 3.8%, and 1.1%, respectively. In the same four years, the fourth quarter-to-fourth quarter rates of increase for TMS were: 38.8%; 4.62%; 13.44%; and 12.7%

The large discrepancy between money inflation and price inflation is attributable to the simultaneous operation of a number of adventitious factors. These include the prolonged appreciation of the dollar on foreign exchange markets, which began in 1980 and propelled the dollar to postwar peaks against the German mark and a trade-weighted basket of foreign currencies in February 1985. The downward pressure that this exerted on the dollar prices of internationally traded goods, and thus on the overall U.S. price level, was reinforced by concurrent developments affecting supplies on various world commodity markets.

For example, the spread of technological advances in food-grain production to developing countries resulted in increased supplies and reduced prices of food products on the U.S. market. The collapse of OPEC and ITA cartel agreements led to supply gluts and sharply lower prices for oil and tin, as well as for substitute fuels and metals. Moreover, the belated and sluggish recovery of Western Europe from recession dampened the world demand for imports of primary commodities at the same time that the supply of these products to world markets was being stepped up by producing nations desperate for foreign exchange, especially dollars, to finance debt repayments. The tendency to higher consumer prices emanating from the "money-side" of the economy was partially offset by temporary price-reducing factors operating concurrently on the "goods-side" of the economy.

Another deflationary influence on prices of consumer goods was an increase in the total demand to hold U.S. dollars, which, ceteris paribus, tends to increase the purchasing power of the dollar in goods markets. One component of this increased demand can be traced to the enormous expansion of the volume of transactions in U.S. financial markets, which, for a variety of reasons, has been under way in the eighties. To finance this growth in transactions, both domestic and foreign investors were required to acquire and hold larger dollar balances. In addition, capital fleeing from hyperinflationary and collapsing currencies abroad, e.g., Mexico and Argentina (see also the Latin American debt crisis), found a "safe haven" in U.S. bank deposits and currency. There had occurred a substantial but unmeasurable leakage of dollar currency out of the U.S. into foreign hoards and to finance transactions in the subterranean economies of foreign nations, especially in Latin America and Asia. There is also evidence that the ever-growing, worldwide drug trade, in 1988 estimated at $100 billion per year, absorbed substantial quantities of U.S. currency and thereby contributed to a rise in the global demand for dollars.

Austrian business cycle theory leads to the expectation that monetary inflation will have an earlier and more intense impact on capital markets than on markets for consumer goods. Stock, credit (bond, commercial paper, commercial bank loan), and real estate markets react most sensitively to monetary expansion, because these are the markets in which ownership titles to capital goods are exchanged.

In the first part of the boom the dollar continued to appreciate against foreign currencies generally, including the Japanese yen and the German mark, reaching its peak in February 1985. The dollar appreciation was due to the fact that the price inflation rate in the U.S. before 1985 was not significantly higher than in Germany and Japan, while relatively high U.S. interest rates, resulting from heavy government borrowing to finance federal budget deficits, attracted a substantial influx of foreign capital. In early 1985, however symptoms of the ongoing dollar inflation finally began to appear in world currency markets as inflationary expectations were kindled by the ballyhoo and publicity surrounding the decision of the Fed to cure the yawning U.S. trade gap by deliberately driving down the foreign-exchange value of the dollar.

As a consequence, the dollar price of a German mark was bid steadily upward from approximately $.31 at its all time low in February 1985 to around $.55 at the end of the boom in April-May 1987, representing a price increase equal to 7.42%. Over the same period, the dollar exchange rate for the yen rose from just under $.004 to just over $.007 per yen, a price inflation of 75%. Against a trade-weighted basket of foreign currencies, the dollar lost about 40% of its market value for the period.

The monetary deflation of 1987 was motivated by the Fed's desire to arrest the decline in the external value of the dollar. In late January, the U.S. and Japan undertook "coordinated intervention" into the foreign exchange markets to support the dollar. Under the terms of the Louvre accord, concluded in late February, monetary authorities of six industrial countries including the U.S. agreed ". . . to cooperate closely to foster stability of exchange rates around current levels". The decision to prevent further depreciation of the dollar on foreign exchange markets and to stabilize its exchange rates with the mark and yen within "narrow bands" established by the Louvre accord brought monetary inflation to a screeching, if only temporary, halt in February 1987.

Suddenly, monetary policy was thrown into reverse as the Fed sold $8.4 billion of government securities--disgorging almost 4% of its entire stock in one month - producing a virtual halt in the growth of bank reserves and a collapse of TMS. The result was that from late January to early March, dollar exchange rates held firm.

With the onset of the bond market collapse in April, however, the Fed turned expansionary, swelling its stock of government securities by 4% and driving up adjusted reserves and annual rates of 24.6% and 27.7%, respectively. Predictably, the dollar once again depreciated sharply on foreign exchange markets from mid-March through April despite active and strong intervention by the U.S. and foreign central banks.

Alarmed at the accelerating free fall of the dollar, Paul Volcker announced in late April that the Fed had "snugged up" monetary policy to counteract exchange rate pressure. Thus in May, reserve growth virtually ceased and TMS increased at an annual rate of 2.2%, with the dollar falling to near a 40-year low against the yen and to a seven-year low against the mark before beginning to sharply appreciate in late May. The Fed continued efforts to bolster the external value of the dollar through the next three months by contractionary open market operations, which saw it shrink its government securities portfolio by 4.2%. The deflationary policy came to an end in September when the Fed reinstituted expansionary open market operations (although adjusted reserves declined for the month) and TMS increased at a 6.3% annual rate, fueled mainly by a large increase in U.S. Government Deposits.

After relative stability through June, July and most of August, credit markets became firmly convinced that the monetary inflation was at an end and interest rates resumed their steep ascent, which continued until the October crash. By October 16, the corporate bond rate had reached 10.73%, over one percentage point higher than its rate on August 28. Likewise, short-term interest rates rose rapidly between these two dates, with the commercial paper rate jumping from 6.64% to 7.86% and the prime rising from 8.25% to 9.25%.

Equities markets followed a different pattern than credit markets in 1987. During the steep run-up in interest rates that occurred during March-May, the stock market experienced only a temporary pause, with the S&P 400 Industrials averaging 334.65 in March and 336.10 in May. While conditions stabilized in credit markets during the summer months, the stock market resumed its boom, the S&P index averaging 14.53% higher in August than in May. The deflationary monetary policy of the summer months finally brought the stock market boom to an end in August. However, it took another month and one-half and a series of further events to fully break the back of inflationary expectations in the stock market. Against the background of further weakening of the dollar in early October, Treasury Secretary James Baker's desperate bashing of and threats against the West Germans for raising the discount rate in the week before the crash at long last galvanized investors into the realization that tight monetary policy was here to stay and that the Fed was not about to reignite boom conditions.

The result of the divergent movements in credit and equities markets during April-September 1987 was to create a growing differential between bond and stock yields. Thus, between 1981 and Spring 1987 stock and bond prices and yields tracked one another quite closely. However, from April to September 1987, the average yield for S&P's 400 Industrial stocks fell from 2.52% to 2.33%, while the yield on Triple A bonds rose from 8.85% to 10.18%. With inflationary expectations no longer operative in the stock market, this unprecedented yield differential became unsustainable. During the boom--but especially from early 1985 onward--stock P/E ratios were driven to dizzying heights by investors' expectations of a continuation of low interest rates and of the imminent arrival of price inflation and inflated corporate earnings.

The dramatic fall of stock prices on Meltdown Monday thus represented a fundamentally rational, if delayed, adjustment of the market to the termination of the Fed-induced inflationary boom.

The investor fallout was catastrophic to brokers. In the three months between August and November, the number of individual share owners dropped from 53 million to 33 million. Many of the remaining investors became inactive. As a result, many big brokerage firms laid off thousands of employees in the late 1980s. One of them, Drexel Burnham, failed, largely due to government harassment over their junk bond financing.

Links

 * Nine Myths About The Crash by Murray Rothbard (Chapter 48 from "Making Economic Sense")
 * The Great Inflation of the Seventies: What Really Happened? (pdf) by Edward Nelson, January 2004, Federal Reserve Bank of St. Louis
 * It's The Economy, Stupid: Rudy Giuliani, The Wall Street Prosecutions and the Recession of 1990-91 (pdf), William L. Anderson and Candice E. Jackson