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Lessons from the great crashes

The intensity of the recent financial calamity had been similar to 1987, but central banks were timid
THE CURRENT STATE of turmoil in world financial markets only has two precedents this century - 1929 and 1987. Before last week's rally in share prices, the loss in global financial wealth since the stockmarket peak in July was equivalent to almost one-fifth of the annual total of consumers' expenditure in the developed world. This is almost identical to the loss which occurred over the same period in 1987, and probably rather larger than the loss of wealth in 1929.

What can we learn from the history of these past two episodes? Unfortunately, they could scarcely be more different. In 1929, the stockmarket crash marked the start of the Great Depression which, in some countries, lasted until the outbreak of the Second World War.

In sharp contrast, the world economy shrugged off the 1987 stockmarket crash with barely a tremor, and it became an accepted part of folklore that the central banks had been seriously mistaken in easing monetary policy immediately after Black Monday.

Of course, policy-makers in 1987 were motivated by one overpowering psychological force - an utter determination to avoid repeating the mistakes of 1929. This time, they may be more concerned with avoiding the mistakes of 1987, which probably explains their relatively timid reaction to the current crisis.

After prolonged debate, economic historians have decided that excessively tight monetary policy should bear much of the blame for the Great Depression. Certainly, as Keynes argued, fiscal policy was too tight as well. But the scholarship of Milton Friedman and Anna Schwartz has since established a clear consensus that the Federal Reserve should not have permitted the growth in the money supply to implode as rapidly as it did in the early 1930s.

Remembering these lessons, Alan Greenspan ordered a dramatic easing in monetary policy immediately after the 1987 crash. Interest rates were reduced by a full percentage point in a matter of weeks and, even more important, the Fed made it crystal clear that it would inject sufficient liquidity, in its role as lender of last resort, to ensure the integrity of the financial system.

At 9am on the day following the crash, a terse but telling statement hit the tapes: "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." This may sound somewhat vague, but it clearly meant that the central bank, cogniscent of the lessons of 1929, would not allow basically solvent financial institutions to go under because of a loss of liquidity. The clear hint was that the Fed would use the "discount window" to inject money directly into institutions which fell into that category.

By clarifying this point from the outset, the Fed short-circuited an impending financial panic, and prevented a credit implosion in the financial system. In the event, the Fed did not need to use the discount window in any significant way, but its generous provision of liquidity in the money markets crucially ensured that the private sector remained solvent.

Much criticised since, the Fed's decisive action in fact proved a stellar success. Financial institutions remained sound, so there was no painful process of deleveraging (in which investors are forced to dump assets in order to pay down their debt). This was crucial in the rapid restoration of confidence which took place in the financial sector, and that in turn ensured that businesses and consumers could ignore the turmoil in the financial markets.

What started as a Wall Street event was never translated into a Main Street event. And even the debacle on Wall Street was quickly reversed, with markets returning close to their previous peaks over a six-month period. The world economy was therefore able to return rapidly to its pre-crash condition, which was one of strong upward momentum, fuelled by synchronised growth in most geographical regions.

This happy outcome could not have been more different from developments in the early 1930s. Contrary to the impression of many in the markets today, it is untrue to argue that the Fed failed to ease policy in the immediate aftermath of the 1929 crash. In fact, they did ease by around 2 percentage points, but that was insufficient to offset the contractionary forces which had been unleashed in the economy. It was also insufficient to offset the general increase in credit spreads which occurred at the same time, so despite the Fed's efforts the cost of borrowing for most households and corporations actually increased. The result was a collapse in spending on plant and equipment, and on consumer durables, which triggered the recession.

Now let us fast forward to 1998. The intensity of the recent financial market calamity has been similar to that of 1987, yet the early response from the central banks has been very timid. Several key US officials have gone on record arguing that the financial system faces "its most serious threat for 50 years", but until last week the Fed had reduced interest rates by only a quarter of a percentage point.

How can anyone have thought this would be sufficient? The rise in risk aversion in the financial markets has run out of control, so banks and other financial companies are facing sharply increased charges on the borrowing they need to finance themselves. The capital markets have dried up completely, so large American companies - which are increasingly reliant on these sources for funding - are returning to more traditional banking sources for credit. But banks seem unwilling or unable to respond, since they are facing severe headaches over their own capital adequacy and increasingly see small companies and households as more attractive customers. There is therefore a risk of a severe credit crunch, paradoxically affecting mainly large companies, with the Fed losing control over monetary conditions, just as it did in 1929.

For several weeks, the Fed allowed this mayhem to develop unchecked. Share prices rebounded last week, but there were still ominous signs of widening spreads in the commercial paper market (crucial for bank finance) and indications that the desperate scramble for liquidity was making it difficult for the Fed to prevent its own Fed funds rate from rising in the money markets. Enough was enough, and on Thursday Alan Greenspan apparently decided himself to take the unusual step of reducing interest rates outside the Fed's normal meeting schedule.

Belated it may have been, but will the Fed's action now prove sufficient? The early market response was mixed, with equities rising further, but credit spreads in the money markets remaining high. Apart from its unusual timing, this was nothing more than a "plain vanilla" monetary easing, with no statement of the type which calmed markets so decisively in 1987. The lender of last resort - an actor whose impending presence on the stage was predicted here last week - is still shuffling around rather apologetically in the wings.

Clearly, Chairman Greenspan's action last week is not to be sneezed at, since it indicates that the Fed is now willing to help the private sector get out of its current mess. But something more dramatic may be needed from the central banks before we can conclude with any confidence that the world is now safe from recession.