The 1987 Stock Market Crash; Myths and Reality

Today’s the 26th anniversary. Here are some myths:

1. The October 19, 1987 crash was caused by . . .

It doesn’t matter what you put next, it’s wrong. Every theory of the October 19, 1987 crash that has ever been put forward has a fatal flaw. The theories always imply other similar crashes should have occurred on other occasions. But the October 19, 1987 crash is totally unique—nothing remotely like it has ever happened before or since (in the US.) Thus all theories of its cause are wrong. Or perhaps I should say “useless,” which is actually what we mean by “wrong.”

2. The crash reduced wealth, and hence reduced aggregate demand. The economy slowed.

Nope, the Fed determines aggregate demand. Fed policy remained expansionary and thus the economy boomed after the crash, even though the decline of August – October 1987 was virtually identical to 1929 in almost every respect. The 1929 crash was followed by tight money, and that is why the economy did much better in 1988 than 1930.

3. Unlike the 1929 crash, the Fed cut interest rates sharply after the 1987 crash.

No, the Fed cut interest rates sharply during 1929-30. Interest rates tell us nothing about the stance of monetary policy.

4. Unlike 1929, stocks quickly recovered from the 1987 crash.

This is highly misleading, in a very interesting way. People sometimes cite this as a reason for the contrast between the severe recession of 1929-30 and the big boom of 1987-88. But that can’t be right, because the initial bounce back was quite similar in both cases. In December 4, 1987, stocks actually closed lower than on October 19. Stocks rose in the first 3 1/2 months of 1988, but they rose about the same amount in the first 3 1/2 months of 1930. So the first 6 months after each crash was quite similar, and yet the macro performance of the economy was already radically different. So you can’t use stock price bounce back to explain why 1930 was a deep depression and 1988 was a boom. The two crashes were also similar in that each had been preceded by a big multiyear stock price boom.

5. JK Galbraith correctly forecast the 1987 stock market crash.

Nope, he forecast a crash at the beginning of 1987, when stocks were about at the level they fell to after the crash. Useless “forecast.”

The stock market is correlated with RGDP, so stock market crashes do contain useful information. But they aren’t infallible. The stock market sometimes gets it wrong. And 1987 was one of those times.

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