NEW YORK -- Last October, a brush with financial disaster in the world's stock markets wiped out $1.7 trillion in equity values, including $700 billion in the United States. Fortunately, this shock did not spread to the currency and fixed-income markets, as it easily might have under not too different circumstances, and we were able to pull back from the precipice of a potential worldwide economic disaster.
The president of the New York Stock Exchange called the stock market crash a "near-meltdown"; others have described it as an "act of God" or a "volcanic eruption." However it is characterized, the chilling event should certainly not be viewed as an isolated phenomenon, perhaps never to recur.
It was a warning that we should begin to examine, with some sense of urgency, the reasons that the scare developed and what we can do to prevent another that could possibly have even more serious consequences.
Volatility of securities prices, spectacularly in evidence in October, is, in fact, a deeply rooted feature of our new financial world. Then, the focus was on stock prices, but this volatility has also been a conspicuous feature of both the bond and currency markets. I believe this price instability in the financial markets will persist and, occasionally perhaps, intensify, given the new structure and ongoing developments in our domestic and international financial markets.
The wide movements in the values of securities have not abated but have actually increased, with daily swings in currencies and securities growing since late October compared with the months immediately preceding the stock market crash. In a longer perspective, the daily highs and lows of securities prices these days often exceed the daily highs and lows for a whole month or even a whole year only a decade or two ago.
There are at least five root causes for this dangerous volatility in securities and currency prices. Understanding them is critical to our economic and financial future.
1. and 2. Financial deregulation and innovation -- two of these causes -- have combined to make money and credit highly mobile. Many securities today are deemed marketable and readily priced; portfolio performance is monitored closely; and many derivative instruments -- the simplest of which are futures and options -- have been created and can garner large rates of return (and also losses) through only moderate price movements. And as the Brady Commission report pointed out, some of the new techniques, such as portfolio insurance, can exaggerate a near-term price trend even though the approach is supposed to limit the risk of the user.
3. The globalization of financial markets has been a major factor in increased volatility. The U.S. stock market did not collapse in a vacuum on Oct. 19. On the contrary, major markets abroad all fell, and some plunged even more than ours did. The withdrawal of investors from foreign markets had a significant negative impact around the world. Similarly, the foreign bond buyer exerts a powerful influence on the U.S. bond market. For example, when Japanese institutions are large buyers in the U.S. Treasury quarterly financing operations, the bond market strengthens. When they and other foreigners abroad hesitate, as they have when the financing occurs during a period of U.S. dollar pressure in foreign exchange markets, the bond market quickly gives ground. Even when foreign official institutions buy dollars to stabilize the price, such action does not necessarily steady the price swings in securities markets: first, the official intervention does not cure the fundamental underlying disequilibrium, and second, market participants may sell securities in anticipation of a tighter monetary policy in the United States to ameliorate the imbalance.
4. There is the secular underlying trend of the "institutionalization" of savings, which, combined with the increasing "securitization" of markets, will continue to contribute to big swings in market prices. Securitization is the vehicle through which financial assets can move in and out of institutional portfolios, and the institutionalization of savings is concentrating portfolio and investment decisions in the hands of fewer participants. Thus, we have a fundamental anomaly: on the one hand, the market, through securitization, has created an increasing proportion of supposedly marketable credit instruments; on the other hand, the investment decision rests with large institutions rather than with a wide range of participants who may hold diverse market views. The Brady Commission report hinted at this phenomenon when it described the hectic trading activities of last October. As this concentration of investment decision-making continues through the institutionalization of savings, marketability, in its truest sense, will regress, and volatility will continue to rise until institutions and markets take on new forms and structures.
5. Finally, in our new financial world, the prices of securities have become much more a vehicle for trying to achieve economic stability. At first blush, this seems incongruous: the quest for economic stability through financial market volatility. But let us recognize that, today, there are no real financial circuit breakers that will assist the Federal Reserve in its task of stabilizing economic activity. Obviously, fiscal policy is not timely enough. Therefore, market participants have become extremely sensitive to the slightest shifts in monetary policy, both in the United States and abroad, as they try to benefit by anticipating whether the Federal Reserve is moving toward higher or lower interest rates. As a result, we will continue to have dramatic responses in market prices when the Fed eases or tightens.
In the current situation, this raises the perplexing issue of whether the Federal Reserve can correctly gauge both the market's response to a tightening of policy and the consequences for the economy of such tightening actions. When the Fed firmed policy last year in response to the weakening dollar and heightening inflation expectations, the negative market reaction was concentrated in the fixed-income markets for nearly half a year, while the stock market crumbled only belatedly. The quick, substantial monetary easing that followed in late October and other factors muted the impact on the economy. A business recession was averted, and inflation expectations were dampened.
However, the likely firming in monetary policy this year will take place under somewhat different circumstances. Considering the political realities of 1988 and the current uncertainties about the economy, a firming in policy will come reluctantly -- and only when resource utilization rises and renewed inflation actually shows up in the numbers. Nevertheless, any delay in monetary firming, or the prospect of a delay, will not be ignored by the bond market. And given the different environment this year, the stock market may not stand idly by as long as it did in 1987 before it reacts adversely again. A synchronized drop of bond and stock prices may thus provide the early warning sign of another business recession.
Concern about financial market volatility has heightened since the sharp decline in stock prices in October. The Brady Commission report made an initial investigation into this problem, and its recommendations, which on the whole deserve support, are not broad enough to stabilize the markets. For example, the report recommends that "one agency should coordinate the few, but critical, regulatory issues which have an impact across the related market segments and throughout the financial system."
This approach is too narrow. Today, major financial markets and institutions are linked; they are no longer segmented. They all bid aggressively in borrowing funds, buy and sell securities and are increasingly intertwined in their activities. Consequently, I continue to urge the establishment of a Federal Board of Overseers of Financial Institutions and Markets as one of the ways through which this continuing volatility in securities prices can be brought under control. It should have responsibility for setting disclosure, capital and margin requirements, and trading and accounting standards, among other things. The fragmented official supervisory and regulatory agency approach that still operates in the U.S. markets today is a vestige of a past financial system and is not capable of meeting current needs.
Furthermore, although the Brady Commission report recognizes the increasing link between the U.S. equity market and those in other financial centers, it fails to cope with that fact. Today, all major institutions and markets exhibit the complex interplay of money and credit. The informal cooperation among central banks in the industrial countries, while helpful, is inadequate to deal with the vicissitudes in the international financial arena. What is needed is an official international institution made up of representatives of the key industrial countries. At a minimum, the organization should have the power to set uniform trading, accounting, capital and disclosure standards for major markets and institutions throughout the world. Making these changes will require an extraordinary political will and a shift away from a near- to an intermediate-term perspective by market participants. Otherwise, increasingly large swings in the value of financial assets will produce changes that may not be to our liking.
The writer is managing director of Salomon Brothers.