Market Jitters and Memories of the Crash of '87 Jude Wanniski October 17, 1997

The stock market has been sliding all day because nobody really knows anything definitive about how this trade dispute with Japan will be resolved. At first, it looked like a trivial dispute involving a relatively trivial amount of money and some technical arguments between our Maritime Commission and three Japanese shippers. As the day wore on, with no signs from Treasury or the White House that the dispute would not escalate, the Wall Street bears had a field day, suggesting deep, calculated strategies by the Clinton team to cook up a trade war with Japan. Of course, there are also the reports of disappointing earnings in the high-tech sector, which was hammered along with NASDAQ today. The low-cap stocks would be set back more than the blue chips by any escalation of trade problems with Japan, because they face higher risks over short periods while the blue chips can sit back with their reserves and wait things out. The fact that we are now at the 10th anniversary of the Crash of ’87 adds to the jitters.

To those of you who called, we could only suggest it was most likely to be a minor, legitimate argument regarding rules of the sea that the respective bureaucracies could not resolve, and it took this turn so that it could be resolved by the politicians. The 3 p.m. report today about a deal eventually cooled things down a bit. We don’t know any more than the market about what happened, but must wait until we see what The New York Times comes up with tomorrow. We expect David A. Sanger, who covers Treasury for the Times and previously worked as a Times Tokyo correspondent, will have the straight poop; he is one of the best reporters around. There might even be a silver lining in the story, if it throws some more attention on the difficulties Japan is having in dealing with its economic recession. David Gitlitz, who has been pondering this all week, will have a report for our Global clients on Monday. The weakness in the Japanese economy, which the Nikkei at 17,500 is suggesting will get worse, not better, is not good for our economy either.

The anniversary of the ’87 Crash lends an added chill to the market jitters today, with several commentaries comparing the parallels with today and ten years ago. The best of them was Alan Reynolds’s op-ed in today’s Wall Street Journal on the causes of the 1987 crash, with Reynolds noting some similarities of conditions then and now. He is correct as far as he goes, but some important details are omitted. The most important omission is his failure to mention that as 1987 began, Treasury Secretary James Baker III negotiated the “Louvre Accord” with our major trading partners, essentially agreeing to maintain the stability of the dollar against the DM and the yen. This made de jure the de facto policy instituted in 1985, when Baker ended the period of “benign neglect” of exchange rates after replacing Donald Regan. Gold stabilized around $350 in 1986, with Wayne Angell, a gold advocate, joining the Fed board of governors in February 1986 when gold was almost exactly at that price.

Reynolds also does not mention the capital gains tax being increased in 1987 as a result of the 1986 tax act. It went to 28% from 20%, and was left unprotected against inflation. With the Louvre agreement to maintain the exchange rates, though, the impact of inflation on capital gains would be sharply reduced. In June of 1987, Greenspan was named chairman of the Fed. Alan Reynolds, who was chief economist at Polyconomics at the time, should have recalled that on October 13, 1987,  I met with Jim Baker in his office for an hour, urging him to do everything in his power, even selling gold out of Fort Knox, to defend the dollar. I’d arranged the meeting on short notice after discussing with Professor Robert Mundell at Columbia the perils that faced Baker, and I told Baker that my warning and advice essentially were those of Mundell. Had Richard Darman still been at Treasury as Baker’s chief aide, he would have understood Mundell’s grave concerns of where things were headed, but Darman had departed for a Wall Street job, leaving Charles Dallara, a devaluationist, to fill the void.

Reynolds is correct in citing Treasury’s dispute with Germany over the Bundesbank’s plan to raise interest rates, which Treasury assumed would force us to replicate in order to maintain the dollar/DM rate. Because the gold price had risen in dollar terms, we should have taken this as a signal of excess liquidity in the banking system and drained it. Darman understood this, and I thought Baker did too, as in September he had told the annual meeting of the International Monetary Fund that we should strike an agreement that would provide a “reference point” of a “commodity basket including gold,” which would resolve any argument between the United States and Germany. In other words, with the gold price rising in all currencies that October, Germany was correct in insisting upon a tightening of monetary policy.

Baker, though, was talked into a strategy of signaling abandonment of the Louvre Accord, if the Germans insisted upon doing what gold was saying had to be done. At the time, the monetarists were furiously trying to undermine the Louvre Accord, with Beryl Sprinkel as chairman of the Council of Economic Advisors in the lead. When Baker brought gold into the equation, they redoubled their efforts. My hopes that Baker would hold firm hung by a thread when the market closed on Friday the 16th, and I called Angell to discuss the situation with him. Angell said of the Treasury team: “They are playing with fire.” Neither Angell nor I found out until the following Tuesday that the new issue of Fortune had begun circulating the Friday before Black Monday. The magazine contained an exclusive interview with Alan Greenspan, who carelessly suggested the possibility that the dollar might have to devalue by 2% a year for several years. The markets had to assume both the Treasury and the Fed were killing the Louvre Accord, which of course was the result. The threat of inflation was back and the unindexed capital gains tax rate had to be discounted into equities. Hence, the crash.

Never again has Greenspan suggested the need to devalue. Nor has he ever again given an exclusive interview to a business magazine. The Crash of ’87 propelled him into the arms of Wayne Angell, and in the years that followed, until Angell left the Fed in 1995, they teamed up to stabilize gold in the $350 range (although Angell leaned toward $330 as the better equilibrium point). It is nice when people learn from their mistakes, especially when they make whoppers. The chance of a Crash of ’97 at the anniversary of ’87 is so small as to be negligible. Even if Greenspan were hit by a truck while rushing home to his new bride, there would be no Crash, because institutional memory has also absorbed those lessons.