How the 1987 crash brought us back to the 1800s

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Today’s the big day! The 20th anniversary of the Crash of 1987! We’ve already been deluged with reminiscences and will-it-happen-agains. If you want more, my friend and fellow Acalanes High School graduate Matthew Rees’s recounting in The American is the most thoughtful and exhaustive I’ve seen.

But, uh, will it happen again? Depends what it is. If it’s a 20+% one-day drop in the stock market, maybe not. If it’s a financial system freakout, where suddenly everybody stops trusting each other and lending each other money, well, that happened a couple of months ago. It happened in 1998, too.

In 1987, matters were at their worst the morning after the stock market crash. That’s when the global banking system threatened to freeze up and lots of people involved with Wall Street started worrying that modern capitalism was about to come to an end. Only the soothing words of Fed chairman Alan Greenspan and the determined arm-twisting of New York Fed president Gerry Corrigan kept us from a 1930s-style debacle. The Fed came to the rescue in 1998 and this summer, too.

This appears to have become our new financial market reality. Every ten years or so a crisis, usually brought on by some financial innovation that not everybody has figured out how to use wisely.

This also happens to have been our old financial reality. In the 19th century, financial-system lockups occurred with such regularity (every 10 or 11 years) that English economist William Stanley Jevons tried to explain them as a product of the 11-year sunspot cycle. After the Depression, tight regulation of financial markets put a halt to those crises for a few decades. In 1987, with markets freed of many of their fetters, the crisis cycle made its return.

Is that such a bad thing? Maybe not. A few weeks ago, Princeton historian Harold James wrote:

If today’s credit crunch has historical parallels, they are closer to nineteenth-century “normal crises” like 1837, 1847, or 1857. In those panics, financial innovation caused uncertainty and nervousness, but also induced an important and beneficial learning process. The financial institutions that survived the crises went on to play a crucial role in pushing further development, and they had enhanced reputations because they withstood a crisis.

That raises the question, though, of what role the Fed and other central banks ought to play. Hardly anybody second-guesses what Greenspan and Corrigan did in 1987. The Fed’s actions in 1998 and today have many more critics. The argument is that they’re standing in the way of that “important and beneficial learning process.” It’s the possibility that they may also be standing in the way of the abyss that makes things complicated.

Update: Nice of the Dow to commemorate the big anniversary by falling 367 points, don’t you think? (That’s not all that far off the 508-point drop of 20 years ago, but is only a 2.64% decline, compared with 22.6% in 1987.) A few more interesting 1987-related links: Nouriel Roubini argues that it could happen again, Barry Ritholtz gawks at a WSJ chart of how the Dow stocks have performed since the 1987 crash, and Herb Greenberg tells how the crash sent him back into journalism.

As for the whole “peak oil” discussion in the comments below, the lessons of the 1987 crash would seem to be that:
(1) Unimaginable things do in fact happen. According to the risk models of the day, a 20% one-day drop in stock prices was only supposed to happen once in a billion billion years. So I wouldn’t entirely rule out any worst-case scenario.
2) Nothing is inevitable. If economists and central bankers hadn’t learned anything from the experience of the early 1930s, the 1987 crash might have led to an economic disaster. But we humans are in fact capable of learning and adapting.

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