October 26, 1987
"Market Offers a (Crash, Bang) Word of Caution"
San Jose Mercury News
By Timothy Taylor
<< Back to 1987 menu

STANDARD economic theories are not very good at explaining stock market crashes, although it can be amusing to watch people try.

According to the standard theory, stock values adjust each day according to whatever new information reaches the market. So last Monday, when the total value of stock fell by $500 billion, eager Democrats could claim that "the market" had suddenly realized that Republican economic policies are a fraud.

When stocks recouped part of their losses and made a record gain on Wednesday, Republicans could claim that "the market" was recognizing the underlying strength and stability of Republican policies.

Both explanations are basically blather; when stock prices bounce like a rubber ball on an elastic string, it doesn't carry a lot of deep economic meaning. Sure, there has been some shaky economic news the past few weeks, but nothing that justified a 22.6 percent drop in the total value of U.S. corporations one day, and then a partial reversal the rest of the week.

Psychology, the ability of computers to trade extraordinary amounts in short times, and blind chance must all have played a role. Who can explain the exact timing of an avalanche or the precise route followed by a stampede?

But even if their immediate causes may be impossible to discern, stock market crashes do carry a meaning. That meaning says less about the economic impact of the crash itself than it does about the necessity for good sense in economic policy making.

Presume for a moment that stock prices will not immediately rise to wipe out last Monday's decline. (If I knew for sure what would happen, I certainly wouldn't give away the information in the newspaper.) How does the decline affect the economy?

Remember, a decline in stock prices doesn't destroy a single factory, or cause a single invention to be un-invented. Instead, it decreases the amount of the wealth in the economy. So ask yourself: How would you react if your personal wealth were unexpectedly decreased? What if you woke up one morning and found out that the value of your house or your savings account had declined by 20 percent? What would you do differently?

Well, if you weren't planning to sell your house or empty your savings in the near future, not much would change. You'd have the same take-home pay and the same bills. Maybe you'd try to save a little more to make up for the loss, but the effect on day-to-day life would not be huge.

Obviously, those who were planning to sell stock or who depend on income from stock investments would be hit more immediately, but they don't deserve too much sympathy, either.

After all, investors in the stock market have done extremely well the past few years. In 1982, the Dow Jones was at 776. If it now levels out at around 2,000, investors in stocks will have gained over 150 percent in five years. It's human nature to take gains for granted and anguish over losses, but the fact that gains are lower than hoped won't drive the economy into recession.

But while a fall in the market doesn't mean that doom has arrived, it means that a lot of sensible people are edgy about the possibility. Investors buy and sell stocks on the basis of how much money they expect the company to make in the not-too- distant future. Their expectations of what will happen in the economy have historically been pretty accurate. So the gymnastics and gyrations of the market should be thought of as a warning.

Of course, there is no assurance that warning will be heeded. The stock market plunged in October 1929, too, warning of the possibility of recession. But it took a series of bone- headed acts by the government -- like passing the protectionist Smoot-Hawley trade bill, restricting the money supply when it should have been increased to stimulate the economy, choosing that time to pass wage floors and price ceilings, and so on -- to turn a typical recession into the Depression with a capital D.

Politicians are perfectly capable of getting the message of the market just as wrong today. Of deciding to shut down the stock market temporarily and silencing the unwelcome messenger. Of deciding to play at protectionism, despite the lesson of the 1930s. Of deciding to meet and consult and deplore and do nothing at all about cutting the budget deficit. Of deciding that a Reagan recession would scratch up the Teflon president and make good election fodder.

Even if stock prices soon recover to their previous levels, the crash of Oct. 19 seems to have captured the imagination of the public in a way that the more dreary economic statistics cannot match.

But whether one looks at the crash of last Monday, the huge budget deficits, the hints of a resurgence of inflation, or the decline in American competitiveness, the cautionary lesson is the same.

<< Back to 1987 menu