Tuesday, December 02, 2008

Irrational Exuberance

I remember the period of late October 1987 for primarily one thing, the Twins winning the World Series. That is what dominated my thoughts day and night back then and it is still recalled as a time of great anticipation and happiness.

According to reports, on Monday October 19, 1987, the day after the Twins completed a sweep of the first two games over the Cardinals, something else happened. Black Monday, the largest one day drop in the history of the Dow Jones Industrial Average. In one day, 22.61% of its value disappeared. This is more than twice as large as any other one day percentage drop ever recorded. More than three times as large as any one day drop during the current spiral of stock value death.

During that time in '87, I do recall hearing about things about the stock market on the news. Lots of media people waking up the ghosts of the Great Depression. The "watch for falling stock brokers" signs popping up in the morbidly amused sectors of town. People "in the know" were generally spooked and bewildered.

On the other hand, I was decidedly "out of the know." Still an irrational post-adolescent enjoying my first year of college. If I did think about what people were saying, allowing the cold fingers of anxiety to start to grasp my internal organs, there were many, many other distractions available. Not the least of which was mentally going over the pitching match-ups and line-ups for the next World Series game. For me, the financial crisis of 1987 was soft background music. I didn't own any stocks, no one in my family really did, nobody's employment or individual retirement account depended on it. The causes and consequences were out of my control, so I largely dismissed it.

Time has proven my irresponsible disregard to be correct. There were no significant consequences of this event for the economy. In 1987, the Dow Jones actually finished higher on the year than it started (although the pre-crash levels weren't realized again for two years). Over the next 20 years, both the volume of the Dow Jones and the percentage of Americans owning stocks skyrocketed.

Recently, I was passed along a copy of the October 25, 1987 Star Tribune business section, published about a week after the crash. Its lead article was a reprint from the New York Times summarizing the economic state of the nation. (The extensive NY Times online archive has it here).

In hindsight, it reads as comedy. And a lesson on the herd mentality and reliability of the elite economic opinion makers, then and now. Excerpts:

Stock crash transforms economy from top to bottom
by William Glaberson
New York Times

The economy will never be the same. No matter where the stock market heads in coming months, the whole process of doing business, making a living, choosing investments - even buying a house - has been radically transformed. Last Monday's market collapse was one of those pivotal events that shape everything that comes afterward.

All last week, the collapse of the market and its breathtaking ups and downs, were the national obsession. There had been warnings about economic danger signs before, but Wall Street's free-fall delivered the message more clearly than all the talk: Good times can end. For two generations of Americans who know about economic disasters only from history books, the collapse of '87 marks the end of an era of economic optimism.

Even if the economy stays on a basically steady course, as most experts predict, the tumble was "a little like seeing the atom bomb go off," said Richard R. West, dean of New York University's Graduate School of Business. "Once you've seen it, you know it could happen again. The world has changed."

After the 235-point drop the previous week, said Robert L. Pelz, 33, a grain broker with his own firm in Leewood, Kan., he went home and said to his wife, "I think the world as you and I know it has changed."

Monday's debacle, Mr. Pelz said, shook him profoundly. "What people will say, I think, is that that day in October 1987 taught a lot of people in our generation that what is here today may be gone today."

But even before the market plunge, the long-running American psychology of affluence that has for so long been the foundation of the consumer-driven economy was beginning to erode, said the pollster Daniel Yankelovich. The sudden focus on the market's instability, he said, is likely to be the shock that snaps many people out of the optimism that made them believe troubling recessions and periods of sharp inflation would be mere temporary setbacks.

Many analysts predict that small investors, who have already left much of the market to big institutions, will abandon it in droves. "You don't shock small investors with a decline of this magnitude or with volatility of this dimension without badly damaging their confidence," said Hugh A. Johnson Jr., an economist and the chief investment officer of the First Albany Corporation. "It will take an enormous amount of time to restore that confidence." That will damage the economy, he said, because it may take huge amounts of money away from productive enterprises.

Because all of these people were wrong 20 years ago, that doesn't necessarily mean the doom and gloom of today's punditry can be casually dismissed. I believe the causes of the current financial crisis to be much more serious, and systemic, than in 1987. (Perhaps that's just because I don't have a World Series to distract me this time. I'm doing too much of that thinkin' Eric Bogosian warned me about.)

Lest you believe everything The New York Times wrote about the story in 1987 was bunk, they did include a contrary opinion at the end of this article, one with perhaps more relevant implications for us in 2008.

Among the country's sage minds, there are some who hope that this week will not bring too rapid a recovery from the crisis. "Our problem is not simply to put Wall Street in order, our problem is to put the economy in order," said Nobel economist Wassily Leontief.

Too quick a bounce-back, Mr. Leontief said, could compound the fundamental problems that he and others say still threaten the future: economic imbalances, the nation's drift away from productivity, its high consumption and low savings histories.

But even more serious, he said, was the attitude of invulnerability that made so many people believe that the bull market - and the economy - would climb, regardless of the warning signs." If we recover quickly now," Mr. Leontief said, "everybody will forget about it." Then, he said, the fear Americans felt briefly last week may only be a taste of what is to come.

Attitude of invulnerability you say? Gulp.

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