Black Monday and the Greenspan put
The big milestone the past week is not the 25th anniversary of the Black Monday crash but falls a day later when we mark the far darker advent of the Greenspan put.
The Greenspan put, the now long-established policy of easing and appeasing when markets go cold, arguably created the world in which we live - one of low growth, bubbles and, every once in a while, huge busts.
On Monday, Oct. 19, 1987, the U.S. stock market crashed, along with falls in Asia and Europe, culminating in a 22 percent tumble in the Dow.
The exact causes are still in dispute, but currency tensions played a role, as did proposed legislation to take away some of the tax advantages of high-yield merger financings.
Margin calls, as ever, exacerbated falls, as did a then-new phenomenon, the program trade, which helped to drive volumes to then stratospheric levels and gave rise to a feeling that the machines had taken over.
Into the breach stepped Alan Greenspan, just months into an 18-year tenure as chairman of the Federal Reserve. Early the following Tuesday, the Fed came out with a statement, one which will seem very familiar to those who participated in the other crashes, panics and simple malaises which have been the defining financial feature of the past 25 years:
“The Federal Reserve, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.”
The Fed followed up by using open market operations to drive interest rates down to just below 7 percent, a fall of more than 50 basis points on the day. (At the time the Fed didn’t announce interest rate changes, it simply went into the market and transacted them into being.)
The response, like a kid given its first sugary soda, was electric, with a strong rally winning back a small portion of the earlier losses. The Fed kept at it in the coming months, operating quite publicly, and often giving trading desks advance notice, and repeatedly taking overnight interest rates lower.
These actions helped to deaden some of the negative effects of the crash, but helped to set a pattern which leads to where we are today: in a world with fewer and fewer accurate price signals.
Price signal masking
One easing campaign does not make an appeasement, so Greenspan over the coming decades kept at it, stepping in time and again when markets grew fretful.
In what came to be known as the “irrational exuberance” speech in 1996, Greenspan made plain, by statement and by omission, that his was to be an asymmetric policy, one which meets tumbles by putting out a safety net but which doesn’t seek to stem bubbles when they are brewing.
“How do we know when irrational exuberance had unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?” he said in his speech at the American Enterprise Institute.
“We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs and price stability.”
But whenever Greenspan was actually confronted with a bust, he recognised that it did threaten to impair growth and price stability. That fact was obvious from 1987: if you will cut to ease a panic, of course you will do it again.
Greenspan cut rates sharply following the Russian default and the Long Term Capital Management crisis in 1998, and again in 2001 when the Internet bubble popped.
The problem with this policy, which Bernanke has largely pursued, is that it is a trap for those who make policy and a reaction-numbing drug for those who are affected by it.
The real impact, for investors and for the economy, is to substantially lessen and obscure the price signals that the economy and markets should normally generate.
Crashes, while destructive, tell us things, like, in the case of the housing crash, to stop lending people money they had no hope of paying back to buy houses they could not afford.
Or take a current example: U.S. Treasuries, some of which virtually guarantee that the buyer will lose purchasing power over time. Is the price telling us that growth and inflation will fail to appear? Or simply that the Fed, with about a tenth of the outstanding stock of Treasuries on its books, is an 800-pound gorilla?
An economy without feedback from price signals is like a body which can’t feel pain, the little things bother you less but the big things may very well kill you.
(At the time of publication, James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at email@example.com)