Looking for similarities to the stock market crash of 1987? Look no further.
Bio: Nouriel Roubini, is a Professor of Economics at the Stern School of Business at New York University. His applied academic research includes seminal work in international macroeconomics, global macro policies, financial crises in emerging markets and their resolution, and the reform of the international financial architecture. As a leading economist in the field of international macroeconomics, Nouriel has had significant senior level policy experience. Numerous policy appointments include former assignments as Senior Economist for International Economics at the White House Council of Economic Advisors, Senior Advisor to the Under Secretary for International Affairs at the U.S. Treasury, Director of the Office of Policy Development and Review at the U.S. Treasury. He has been a policy and research consultant at the IMF since 1985, and is a member of many leading policy forums and organizations including the Bretton Woods Committee, the International Roundtable of the Council of Foreign Relations, the NBER and the CEPR. Nouriel is a consultant for a wide range of policy institutions, Central Banks, and a number of senior executives from major financial institutions.
Nouriel Roubini | Aug 12, 2006
In my recent “recession call” blog I made the observation that current economic and financial conditions in the U.S. eerily resemble those that led to the stock market crash in October 1987. Let me elaborate on the quite worrisome and scary similarities between 2006 and 1987.
In 1987, like in 2006, a new Fed Chairman had been chosen; then Alan Greenspan this year Ben Bernanke.
In 1987, the new Fed Chairman was initially viewed with skepticism by markets and investors; the same for Bernanke today. The lionization of Greenspan as the “Maestro” or his "God-on-Earth" reputation was a much later phenomenon that emerged only in the 1990s; in 1987 investors were extremely skeptical of his skills and ability to be a strong leader of the Fed in difficult times. Ditto for Bernanke today who still needs to establish his credibility and gain the full respect of markets and investors.
In 1987, Greenspan started his term in a period when inflation was rising and there were concerns about inflationary pressure becoming excessive. That is why in 1987 he started his term by raising the Fed Funds rate by 100bps. Ditto for Bernanke who inherited high and rising inflation and raised rates three times, by 75bps, since he became Fed Chairman earlier this year.
In 1987, the relatively inexperienced Greenspan did not know how to properly communicate his message and he rattled markets. He presented his views in the wrong forum by giving an interview to a Sunday television news show where he expressed his concerns about inflation; the next day stock markets sharply wobbled. He learned his lesson, realized the risks to his reputation, made a mea culpa, never gave again a TV interview for the following 20 years and became altogether Delphic in his public pronunciations. Ditto for Bernanke: after a congressional testimony on April 27th that was read by investors as dovish, he made the famous flap with CNBC anchor Maria Bartimoro telling her that he had been misunderstood and was more hawkish than market perceived him. The next day – when Bartimoro reported this – equity markets sharply contracted and Bernanke’s reputation was shaken. Bernanke then made his own public mea culpa and you can be sure that - like Greenspan - he will never speak again to any TV reporter, either in private or in public.
In 1987, the biggest external problem of the U.S. was the large current account deficit that had been the result of the twin deficits of the Reagan years. Unsustainable tax cuts and excessive military spending (remember the pie-in-the-sky Star Wars project) in the Reagan I administration led to a strong dollar and a large current account deficit; after 1985 the dollar started to fall driven by the unsustainable external imbalance. In 2006, we bear the consequences of the reckless fiscal policies – unsustainable tax cuts and runaway military spending in reckless foreign adventures like Iraq (pie-in-the-sky dreams of imposing "democracy" in the Middle East) – that led to large twin deficits since 2001. And since 2002 the dollar has started to fall under the pressure of the external imbalance.
In 1987, in spite of the fall of the dollar since the Plaza agreement of 1985, the current account deficit was still large because of the delayed – J-curve – effects of the depreciation and because the still large fiscal deficits and low private savings kept national savings low. Then, the U.S. started to blame its trading partners, Germany and Japan, and their "weak" currencies for being at fault for the continued US trade deficit. The political scare mongering in the US was that a rising export giant like Japan would leading to the hollowing out of the US manufacturing sector; trade frictions with Japan – on cars, semiconductors, etc. – became heated and accusations of “unfair” trade were rampant. Then, the US started to put pressure on Germany and Japan to let their currencies – the mark and the yen – to appreciate significantly more relative to the US dollar. Today, the scare mongering on “unfair” trade has China as its scapegoat and victim. The US, instead of blaming its own policies that led to low private and public savings for its external deficit, is blaming China and its currency policies for these external imbalances. As in 1987 there is the terror that China will hollow out the US traded sector with its unstoppable export boom. And trade tensions are boiling.
The tensions on trade came to a boil in October 1987 when the markets were already nervous about the economy, inflation, higher interest rates, an inexperienced and initially clumsy Fed Chairman and a soaring trade deficit. The announcement of a large U.S. trade deficit on October 14 was the tipping point. Following this news, Treasury Secretary James Baker strongly suggested the need for a fall in the dollar and made implicit threat that the reluctance of Germany and Japan to let the mark and yen to appreciate could be met with retaliatory trade actions. The following day – the infamous Black Monday of October 19th 1987, the stock market crashed: the Dow Jones Industrial Average went into a free fall, down 508 points, losing 22.6% of its total value. The S&P 500 collapsed by 20.4%, dropping from 282.7 to 225.06. This was the largest loss that Wall Street had ever experienced in a single day. Technical factors, such as the growth of derivative instruments trading and inappropriate risk management tools (delta hedging that could hedge little in a fat-tail event of systemic turmoil and instead exacerbated the herding reaction of the market) added to the disorderly financial meltdown.
Today, the tensions with China on the trade deficit and the RMB revaluation are reaching a similar tipping point. China is dragging its feet on the currency issue while its trade surplus with the US is rising; Hank Paulson was chosen as Treasury Secretary principally to nudge China into moving; Schumer is bringing his 27.5% China tariff bill to a vote by the end of September and the Treasury has to present another “China Manipulation” report in the fall; the economy is slowing and mid-term elections are increasing the protectionist mood of Congress both for what concerns trade in goods and asset protectionism (see the CNOOC-Unocal case, the Dubai Ports case; and the pressure to reform the CFIUS process in ways that will be highly restrictive towards inward FDI); markets are hedgy and nervous and investors more risk averse after the May-June financial markets turmoil; the growth of derivative instruments is much more massive than 20 years ago; and wishful and self-serving arguments that such derivative instruments allow to hedge and distribute risk rather than concentrate it more are even more senseless today than they were two decades ago. So, the risks of a systemic crisis are serious and grave.
In these conditions it usually takes little to rattle markets and trigger a meltdown. Hopefully Paulson will be smarter and more discrete than Baker in avoiding bullying China and the countries that are financing the US current account deficit; it is both bad manner to bite the hand that feeds you (or, as Italians say, to spit into the plate from which you are happily eating) and also reckless financial behavior as the US badly needs this cheap foreign financing. Markets are already hedgy on their own and international investors are increasingly risk averse. The US needs to borrow every year almost another trillion US dollars – on top of all the previous stock of past borrowing - to finance its still increasing external deficit. Thus, the risks that things will get out of hand and trigger a financial meltdown of the scale that was experienced in 1987 are serious.
Today you have trade protectionism and asset protectionism; hedgy and trigger-happy investors and rising geopolitical risks; the risk of a disorderly fall in the US dollar; a slush of financial derivatives that are a black box that no one truly understands (the operational risk in credit derivatives is only the tip of much larger systemic risk iceberg in these instruments, as the pricing of these instruments has not been tested in a real cycle of increasing corporate bankruptcies); increasing VARs and growing levels of leverage; frothy markets where years of too easy money have created bubbles galore - the latest in housing - that are ready to burst; a bubble of thousands of new hedge funds with inexperienced managers that have no supervision or regulation of their activities; risk management techniques in financial institutions that miserably fail to truly stress test for fat tail events; hedging strategies that – like in 1987 – can hedge nothing once everyone is rushing to the doors and dumping assets at the same time; and a housing markets whose rout may trigger systemic effects through the mortgage backed securities market and the non-transparent hedging activities of the GSEs.
This is a toxic and combustive mix of volatile elements that can lead to a financial explosion and meltdown. And it may take any small match to trigger it: a trade war scare mongering, scorning the foreigners that finance you with restrictions to inward FDI, talking down the dollar to bully China and the US trade partners, a flip-flopping monetary policy, a further spike in oil prices, an event of terrorism or a wider Mid East conflict, a housing market rout rattling the MBS market, the collapse of a large and systemically- relevant hedge fund or of another highly-leveraged financial institution, a Chapter 11 event for a major US corporation such as Ford or GM leading to systemic effects in the credit derivatives market. There is indeed an embarrassment of riches in terms of factors that can trigger a financial meltdown. A single factor among those discussed above may be enough to trigger it; and the risk that a variety of such factors may simultaneously emerge is increasing.
So, to paraphrase Bette Davis in "All About Eve": Fasten your seat belts; it’s gonna be a bumpy ride ahead for financial markets and the global economy…
