Memo To: Students of SSU
From: Jude Wanniski
Re: Crash of 1987, a Case Study
This lecture was originally posted at SSU on December 1, 2000. It is a perfect extension of the three previous lessons this semester on the interaction of money and taxation in causing convulsions in the financial markets and by extension altering the growth path of the real economy. Very few economists agree with the analysis presented here, as it does not make sense in a demand-side economic model of the economy. The “demand-side” economists at the time explained the Crash of 1987 as a “bubble” being burst, which is almost always the explanation they give when they don’t understand an economic event.
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On Monday, October 19, 1987, the Dow Jones Industrial Average had the largest one-day percentage decline in its history, then or now -- a 508-point decline that represented 22.6% of the market capitalization of the 30 stocks comprising the DJIA. A trillion dollars of the nation’s wealth, as valued by the marketplace, had been wiped out. In his new book, Maestro, about Greenspan’s Fed and the American Boom, Bob Woodward of The Washington Post and one of the best reporters of our time, writes about the swirl of activity in Washington as the Crash was underway, but offers no theory on why it occurred. He also notes that “even 10 years later, [Greenspan] could find no credible explanation for the abrupt one-day decline in stock values that had been built up over years.” Alan Greenspan had been Fed Chairman for only days when the Crash occurred. In the 15 years since, he surely knows the conventional theories on what happened, almost all of them in one way or another involving a dispute that Treasury Secretary James Baker III had with the German central bank, the Bundesbank. I’ve written many times about the Crash, at the time it happened and later as I added other pieces to the puzzle. It now seems a good time, after our recent lessons on the interplay between monetary and tax policies, to go over the year as a case study. There is a book -- and a doctoral thesis -- to be written about the Crash. What follows is simply an outline, never before published.
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To begin with, if the government had been on a gold standard, the Crash could not have occurred, precisely because it was the freely floating dollar that was at the heart of the event. This lecture will not attempt to assign “blame” to anyone, for as you will see it came about because of a general intellectual misunderstanding -- mine included -- of the forces at play. I think I saw more of the forces at the time and conveyed them in letters, memos and client letters that are available for historians, but it was another few years before I came to understand it all.
When the Crash occurred, it was almost as if it were the Wall Street equivalent of the Titanic, whose problems began not when it hit the iceberg, but when it set out to sea. In the Crash, the initial incident was the Reagan tax reform of 1986, which passed with overwhelming bipartisan support. A compromise had been struck in the Senate Finance Committee to make this possible, with Chairman Bob Packwood [R-OR] making a deal with Sen. Bill Bradley [D-NJ] a member of the finance committee who had co-sponsored a major tax-reform bill with Rep. Dick Gephardt [D-MO]. Packwood wanted to cut the marginal tax rates on ordinary income from a top rate of 46% to 28%. Bradley and Gephardt were willing to do so if the Republicans would agree to “pay” for the reductions in those rates by a closing of tax “loopholes” that benefitted “the rich.” In their negotiations, which occurred weeks before the November 1986 elections -- when the Republicans lost the Senate -- they agreed to drop the top income-tax rate to 28% and raise the capital gains tax to 28% from 20%. Supply-siders were horrified at the increase in the capital gains rate, but we could do nothing about it except plan to win the White House in 1988 and roll it back, to at least 15% from 28%. Meanwhile, we had to console ourselves with the fact that the capital gains tax is discretionary, in that you do not pay the capital gains tax until you sell the asset that embodies the gain. The one thing that did concern us all at the time was that the deal did not include the indexation of capital gains. In other words, while labor income was protected from inflationary bracket creep, capital income was not. The total package signed into law by President Ronald Reagan was front-loaded with good things, back-loaded with bad things.
As 1987 began, the price of gold was in the $400 range, which was acceptable to most supply-siders even though it meant there would have to be an increase in the general price level to reach an equilibrium with gold at that level. The stock market rose strongly as 1987 opened, reflecting the sharp decline in the tax rates on ordinary income. We have to bear in mind, as noted, that while the higher capgains rate was pulling the market down, the lower rates on labor were pulling in a positive direction. The problem, though, was that in the broad economy, businesses were demanding less liquidity from the banking system because of the longer-term discouragement about capital gains taxes -- with no inflation protection. When there is a decline in the demand for liquidity, remember, the central bank must drain that liquidity through the sales of interest-bearing government bonds from its portfolio. If it fails to do so, the excess liquidity first bids up the price of gold, then other commodities.
There was, however, an interruption in the risk of inflation to unprotected capital gains. It took place in February 1987 in Paris, where Federal Reserve Chairman Paul Volcker and Treasury Secretary Baker worked out an “accord” -- which is not a “Treaty” that needs ratification by the U.S. Senate. The “accord,” at Volcker’s initiative, was meant to get the United States, Germany, and Japan to manage their currencies in a way that kept them roughly stable. If those three key currencies were stable, the other currencies of the world could link into the system and world currencies could more or less stabilize. The meetings took place at the Louvre, so their agreement was called the “Louvre Accord.”
The markets loved the Louvre Accord because it seemed to mean the governments were getting more serious about stabilizing the major currencies, thereby cutting out the steepening financial costs in exchange-rate transactions. How could you guess what direction the currencies were going when you were selling goods for delivery in the future? You had to buy insurance by currency hedging, which took big bites out of prospective profits and as a result aborted deals before they could get to the contract stage. In essence, the Louvre Accord was the equivalent of indexing capital gains in the United States and other countries that joined in. Indexation would subtract annually the percentage of the inflation rate from the price at which a capital asset is sold, so no actual “capital” is taxed. Who needs inflation protection if there is no inflation?
Unfortunately, the Louvre Accord did not include an independent “reference point” that would tell the Federal Reserve, the Bundesbank and the Bank of Japan which of them had the responsibility of “tightening” up on bank reserves. If the reference point were gold, then a rising gold price in dollars would mean the Fed had to tighten, a rising Deutschmark price would indicate the Bundesbank had to tighten, a rising yen price would mean the BOJ would have to do the same. With no such agreement, the Accord was inherently unstable. What was happening in the early months of 1987? The gold price was stable in DM and yen, but rising in dollars. Why? Because as the days rolled by, the higher capital gains tax in the U.S. was cutting inexorably into the demand for liquidity and the Federal Reserve was not draining the surplus out of the banking system. As is always the case, a surplus of liquidity over demand will first trigger a rise in the price of gold. Under a gold standard, this instantly signals the bank that it must drain reserves to keep gold from rising, gaining value against the dollar as the first stage of what becomes “inflation.”
The record I have is sketchy, but it does indicate that Volcker, still Fed chairman in the spring of 1987, was arguing for a tightening of monetary policy through the draining of reserves, but the other members of the board -- particularly Vice Chairman Manley Johnson -- were reluctant to go beyond “jawboning,” i.e., talking about the need to defend the dollar, but doing nothing that would make the dollar stronger. Tightening under the operating procedures of the Fed would require the raising of the overnight interest rate, the fed funds rate, although Volcker did argue specifically for a lower reserve base. Jim Baker did not like the idea of higher rates and this doubt may have been the reason why Johnson was wary of supporting higher rates. The difference of opinion clearly led to Baker’s decision to oppose the reappointment of Volcker, whose term was coming to an end that spring. Volcker still was viewed as a Democrat who might tilt toward tightening during the 1988 presidential election year, when Baker’s close friend, Vice President George Bush, would be running. (The conventional wisdom at the time held that Richard Nixon would have defeated John F. Kennedy in 1960 if the Fed Chairman at that time, William McChesney Martin, a Democrat, had not “tightened” on the eve of the election.)
This confluence led to the appointment of Alan Greenspan as Fed chairman. Greenspan had been chairman of the President’s Council of Economic Advisors at the end of the Nixon administration and throughout the Ford administration. I had known Greenspan from my days as editorial writer for the WSJournal in the 1970s, but while he had some supply-side tendencies, he was basically an old-school fiscal conservative who believed in balancing the budget. I’d opposed his nomination to the Fed chairmanship because of his stated beliefs that the inflation then underway was the result of a wage spiral, which could only be broken with a recession that would break “inflation expectations.” He had an appreciation of a gold standard but also thought it impossible to maintain one in a welfare state with high budget deficits.
In early August 1987, Greenspan was sworn in as Fed Chairman with much of the discussion in Washington on economic policy turning on the trade deficit, especially the trade deficit with Japan. That same issue led Richard Nixon in 1971 to take the dollar off the gold standard and devalue the currency, believing it would help U.S. exporters, increase employment, and help him win re-election in 1972. Greenspan’s expertise was always in the workings of the domestic economy and his views on exchange rates were not dominant. Still, in the spring of 1987 he had been telling his clients that the dollar was probably overvalued by 10% against the yen, which of course was counter to Volcker’s attempt to hold the Louvre Accord together. The Louvre Accord, after all, was Volcker’s baby, not Greenspan’s, and we have no evidence he paid it any mind.
In early September, a month after he was sworn in, the Dow Jones Industrial Average hit its peak for the year and began its slow slide toward the Crash. The Fed was doing nothing to drain the surplus reserves building up, so the dollar price of gold continued its rise and the dollar lost ground against the DM and the yen. Ironically, Secretary Baker in September was the host in Washington of the annual meeting of the International Monetary Fund. In his speech to the Fund, he proposed an international monetary reform to cement in place the Louvre Accord, but with a “reference point.” This is the term I suggested to his Treasury team, which included Robert Zoellick, who wrote the speech, and Richard Darman, who had come to appreciate the arguments for a gold “reference point” if the Louvre Accord were to work. Darman, though, had left Treasury for a job on Wall Street in April. The Darman loss was critical because it left Baker leaning on Charles Dallara, another Treasury official who was a believer in weak currencies as a spur to the export trade. Dallara was a Democrat who had come into Treasury in the Carter administration and stayed on. The Carter administration, by the way, was destroyed by Treasury’s weak dollar policy, built around the ideas of the late James Tobin of Yale and his protégé, Fred Bergsten, who in turn was Dallara’s mentor. (Gold hit its peak of $850 on February 1, 1980 and the bank prime rates topped 20%; Jimmy Carter never knew what hit him.)
As October opened, the market’s confidence in the talk coming out of the Reagan Treasury was not being backed up by the one thing that would cause the dollar to hold its purchasing power against gold and the other currencies -- a draining of reserves from the banks. We wrote our clients on October 1: “Treasury Secretary Baker proposes that major central banks stabilize ‘the relationship among our currencies and a basket of commodities, including gold.’ The U.S. Treasury thus supports the efforts of Federal Reserve Governors Angell, Heller and Johnson to lean against major swings in commodity prices, including gold. Significantly, prices of gold and other commodities dropped on the announcement, and the dollar rose. If continued, this renewed confidence could soon give the Fed some room to lower the fed funds rate, even though Wall Street pundits expect the opposite.”
It did not continue, of course. With nothing but jawboning, gold resumed its climb and the dollar its decline. On October 13, I met with Baker in his Treasury office, telling him I was bringing a message from Robert Mundell. On Friday, October 16, I reported to Polyconomics’ clients that I had met with Baker: “I warned JBIII that the structure he’s achieved at this point would soon be tested, not realizing it would come so soon in the next days. As in the past, I urged him to consider, in addition to Fed interventions, some gold sales (2 or 3 million ounces, or 1% of our stocks) to ‘scald the speculators,’ to use Mundell’s phrase, and at least he was attentive. Fed Governors Manuel Johnson and Wayne Angell are known to favor such a move at the right time, which would occur with gold rising and the dollar/yen ratio about to bump 140, I told JBIII. He was poker-faced, but I’m absolutely positive he understands his achievement to date or his framework for monetary reform would be blown away if he can’t meet this test. I’m sure the reason for his press conference [the day before] was to convey concern about the DM closing in on 1.8, the other key floor in the Louvre agreement, although he left the poor impression that he might lower the floor rather than bash the speculators at the floor.”
Later that afternoon, after the client letter had been sent, I called Angell and discussed the Baker press conference and its implications. Angell said gloomily, “They are playing with fire.” On Sunday morning, October 18, the NYTimes carried an inside story by its Treasury reporter, Peter T. Kilborn, that had no direct quotes, but clearly reflected the thinking of Charles Dallara, indicating that the decision had been made to forget about the 1.8 DM floor for the dollar. On Meet the Press later that Sunday, Baker himself was interviewed and confirmed that there would be no defense of the dollar, putting the blame on the Bundesbank. When the markets opened the next morning, it was as if they had stepped into an open elevator shaft. There is no public record that Greenspan was involved in the decision, yet he had to be. Baker would not have acted without discussing the crisis with Greenspan. A few days after the Crash, I’d learned that Greenspan had given an interview to Fortune for its October 29 issue. The issue was being printed at about the time I was urging Baker on October 13 to defend the dollar. It was already in circulation on Friday, October 16, as clients were telling me about it. The Fed chairman had told Sylvia Nasar of Fortune that he didn’t believe there was a floor to the dollar. Goodbye Louvre Accord. On October 29, I wrote a client letter, “The Monetarists Are Back,” which has an opening that is a fitting conclusion to this quick summation of the Crash of 1987:
The stock market crash has brought the monetarists out of the woodwork, working to dynamite everything Jim Baker III has done since the 1985 Plaza meeting on international monetary coordination. Milton Friedman says recession is on the way and we must sink the dollar and pump up the money supply. His student, Michael Darby, Asst. Secy. of Treasury for economic policy, has been telling JBIII for months that “money is too tight,” which was one of the spurs behind JBIII’s threat to the Bundesbank, Oct. 15, that triggered the global stock market crash. Fed Chairman Alan Greenspan, who helped set this stage by telling Fortune magazine earlier in the week that he saw no floor to the dollar, is also under monetarist influence.
From this perspective of this case study, Greenspan does not really deserve the credit he has been getting ever since for having arrested the collapse of the market on Tuesday, October 20, by issuing a statement that the Fed would supply unlimited liquidity to the banks to see them through the crisis. In Maestro, Bob Woodward swallows that view in his celebration of Greenspan. The problem was not a deficiency of liquidity, but a surplus, and the liquidity the Fed chucked into the banks simply piled up in the vaults for a few weeks, when the Fed took it back.
It is essential that this perspective be seriously considered, as Keynesian and monetarist economists have ever since spread the story to political leaders that if the market crashes, all the Fed has to do is pump liquidity into the banking system and everything will okay. Maybe it will, maybe it won’t.