Throughout the last hundreds of years, the essence of the financial markets has never changed, and the investors repeatedly experience absurd financial bubbles of the common root.
This perhaps gives this article some significance, as we explain here the cause of Black Monday in 1987. Many say there was no specific reason of the market crash, or it is difficult to identify the cause, but some great investors indeed predicted the collapse in advance, as there were the definite causes of the bubble we can explain here.
The beginning was Reaganomics
To explain, we must start with Reaganomics. Ronald Reagan became the 40th president of the US in 1981 and then initiated his economic policies called Reaganomics.
Then, the US had been suffering from the stagflation. The inflation had been elevated despite the high unemployment rate. The Fed had been raising the interest rate, which was almost at its peak when he became a president.
To deal with the stagflation, President Reagan confirmed to restrict the base money to moderate the inflation, whilst he also cut taxes to stimulate the consumption. As he also expanded the military spending, the US budget deficit continued to increase.
The strong dollar
In order to finance the increased deficit, the interest rate had to rise, and the high interest rate actually made the dollar strong. The following charts would illustrate the situation:
- High unemployed rate -> large budget deficit -> high interest rate -> strong dollar
- High inflation rate -> restricted base money -> strong dollar
Some economically-minded readers might doubt if the increased budget deficit should be a reason for the strong currency, but in this case the high interest rate combined with the confident image of President Reagan actually made the dollar strong. The financial markets sometimes ignore a significant factor, and, as proved this time, too, they must eventually pay back.
The ignored fundamentals
Anyway, the dollar continued to become stronger, ignoring some fundamentals. Furthermore, the enormous budget deficit wasn’t the only issue. Due to the strong currency, Japan and Germany expanded their exports, and as a result the trade deficit of the US was also reaching the unacceptable level.
Despite the twin deficits, the dollar was at its all-time high, increasing its value by more than 50% against the German mark. Consequently, the US government finally decided to moderate the strong dollar.
The Plaza Accord
On the 22nd of September, 1985, the finance ministers and the governors of the central bank of the Group of Five had a meeting in Plaza Hotel in New York and agreed to cooperate as to adjust the strong dollar. The US government insisted the strong dollar should be modified as it ignores the fundamentals such as the twin deficits. Mr Gorge Soros describes this event in his book:
We live in exiting times. The emergency meeting of the Group of Five finance ministers and heads of central banks at the Plaza Hotel last Sunday constitutes a historic event. It marks the official transition from a system of free floating to a system of managed floating. (…). I managed to hang on to my currency positions by the skin of my teeth and after the meeting of the Group of Five last Sunday, I made the killing of a lifetime. I plunged in, buying additional yen on Sunday night (Monday morning in Hong Kong) and hung on to them through a rising market. The profits of the last week more than made up for the accumulated losses on currency trading in the last four years, and overall I am now well ahead. (“The Alchemy of Finance“, George Soros)
At that time, the dollar had already passed its peak, and the Japanese yen and the German mark were going up. The downtrend of the dollar was critically dictated by the Plaza Accord. This new trend of the weak dollar eventually lasted until Black Monday in 1987.
The rate cuts and the weak dollar
Meanwhile, the Fed was working on rate cuts as the strong dollar had already suppressed the inflation. The US stock market was booming due to the falling dollar helping exports and the rate cuts started in 1982. This bull market of stocks, which was supported by these two factors, was therefore to eventually end when investors had to doubt the continuation of the two factors.
The Louvre Accord
After the Plaza Accord, the dollar was rapidly falling against the yen and the mark. The US government finally considered the depreciation of the dollar was overdone, holding a meeting of the Group of Seven in Louvre Palace on the 22nd of February, 1987, to agree to cooperate to correct the situation.
The agreement was that Japan and Germany, which had the strong currencies, were to cut the interest rate whilst the US would raise the rate, preventing the dollar from falling.
However, Germany, which once agreed to the Louvre Accord, feared the potential inflation and decided to raise the interest rate in September, 1987.
This action of Germany wasn’t acceptable for the US, which was worried about the falling dollar. The investors considered that due to the German rate hike, the US would be forced to raise the rate more rapidly than expected. This meant the end of the weak dollar and the low interest rate, which had been supporting the stock market since 1982.
The dollar or the stocks, which is to fall?
The bull market of the US stocks, which had been lasting despite the twin deficits, finally faced the situation where it had nowhere to go. If the Fed raised the rate, the stock market would crash. If not, the dollar would fall further.
This was the ultimate choice for American stock investors, most of whom were investing without currency hedging, as in either way their assets would decrease. The only choice left for them was just to dump the stocks.
The US stock market, which lost its last resort by the German rate hike, lost its direction and went on an unstable downtrend. The extent of the fall increased everyday, and on the 19th of October, the US stock market finally recorded the fall of 22.6%. Some researchers say Black Monday was caused by automatic trading, but the truth is that the investors were cornered, both in the stock and currency markets, by the decreased liquidity caused by the rate hike.
Financial bubbles happen when the flow of money cannot find anywhere to go, and it’s often caused by the political or economic conflicts between some groups or countries.
In case of 2015, for example, it’s not possible that both of the stocks and bonds simultaneously rise for a long term, and money eventually has to go out of one of them, as we explained in the following article:
To understand the background of Black Monday further, you may read The Alchemy of Finance by George Soros, who in the book published his actual trading records in 1980s, explaining how he predicted the Plaza Accord. This book also explains about his theory of reflexivity, which would be useful for readers who would like to learn about global-macro investment.