Critique of Central Banking

Henry C K Liu

Part I:       
Monetary theology
Part II:       The European Experience
Part III-a:   The US Experience
Part III-b:   More on the US experience

Part III-c: Still more on the US experience

This article appeared on AToL on December 2, 2002

The selection of the chairman of the US Federal Reserve Board of Governors, who serves four-year terms, is a political process closely linked to ideological preference, subject to Senate confirmation, much like the appointment of the chief justice of the Supreme Court. White House and Treasury support for the chairman is of critical importance for the chairman's exercise of leadership over Board members, who are known for their independence.

The late Arthur Burns (Fed chairman 1970-78) abolished full transcripts of the Fed Open Market Committee (FOMC) meetings after the Freedom of Information Act was enacted by Congress in 1975. The transcripts traditionally were kept secret for five years before public release, but they provided a rich and reliable source for historians who tried to decipher the decision-making process in monetary policy. The interrupted practice was revived after Burns' second term expired without reappointment by president Jimmy Carter. Under a policy announced on January 19, 2000, the FOMC, shortly after each of its meetings, issues a brief statement that includes its assessment of the risks in the foreseeable future to the attainment of its long-run goals of price stability and sustainable economic growth. Nevertheless, the Fed continues to enjoy a level of secrecy on its deliberation that is the envy of the Central Intelligence Agency. Industrialist Henry Ford was reported to have said: "It is well enough that the people of the nation do not understand our banking and monetary system for, if they did, I believe there would be a revolution before tomorrow morning."

Ford of course was a paternalistic entrepreneur with latent socialist leanings whose dislike of the "money trusts" was as passionate as any diehard communist's, albeit from a different angle. Ford understood that to sell his mass-produced products, high wages were necessary, for which he professed a vested interest in promoting (he doubled the market wage to US$5 a day, forcing the rest of the auto industry to follow suit). And he viewed labor unions as having long-term effects in holding wages down with their insistence on short-term gains that hampered production efficiency.

Ford partisans believe to this day that the reason industrial unions are tolerated by management is that management knows that the long-term effect of unionism is to moderate the rise of labor costs. Unionism has been institutionalized in industrial capitalism in the role of the factory foreman, with the job of maximizing labor productivity, which means increasingly lower labor cost per unit of production. Union chiefs are often invited to sit on corporate boards of directors, not to influence management but to deliver management's message to the union rank and file that wage increases can only come from company profits, and not from any restructuring of the basic relationship between labor and capital. What Ford opposed as fervently as he did industrial unionism was the type of financial manipulation that created General Motors through predatory mergers and acquisitions. This view has come to be known as Fordism, which also influenced early Soviet industrialization strategy.

Burns, a conservative Austrian-born economist from Columbia University, was appointed Fed chairman by president Richard Nixon in 1969. Between 1953 and 1956, he served as chairman of the Council of Economic Advisors under president Dwight Eisenhower. He was known as the "No 1 inflation fighter". Burns was reportedly not well liked at the Fed by his colleagues nor by members of his profession. Many accused him of being intellectually dishonest.

The Burns era was the most opportunistically political in Fed history, with Burns' mistimed economic pump-priming designed merely to ensure Nixon a second term, by engineering money growth of a monthly average of 11 percent three months before the election from a monthly average of 3.2 percent in the last quarter of 1971. Nixon's second term was nevertheless aborted by political complications arising from the Watergate scandal, leaving Gerald Ford in the White House. The economy was left to pay for the pre-election boom with runaway inflation that compelled the Fed to tighten with a vengeance, which produced a long and painful post-election recession that in turn contributed to Ford's defeat by Carter. The Fed as an institution above politics has yet to recover fully from the rotten smell of 1972. Burns' sordid catering to Carter in hope of securing a reappointment for a third term was a contributing factor to the Carter inflation. And Carter's defeat by Ronald Reagan was in no small measure caused by his appointment of Paul Volcker as Fed chairman. Some said it was the most politically self-destructive move by Carter.

Volcker, having served four years as president of the New York Federal Reserve Bank, replaced G William Miller as Federal Reserve Board chairman on July 23, 1979. Volcker, as assistant secretary under Treasury secretary John Connally in the Nixon administration, played a key role in 1971 in the dismantling of the Bretton Woods international monetary system formulated by 44 nations that met at Bretton Woods, New Hampshire, in July 1944. Under that system, as worked out by John Maynard Keynes, representing Britain, and Harry Dexter White, an American who later in the McCarthy era was accused unfairly of having been a communist, each country agreed to set with the International Monetary Fund (IMF) a value for its currency and to maintain the exchange rate of its currency within a specified range. The United States, as lead country, pegged its currency to gold, promising to redeem dollars for gold on demand at an official price of $35 an ounce. All other currencies were tied to the dollar and its gold-redemption value. While the value of the dollar was tied strictly to gold at $35 an ounce, other currencies, tied to the dollar, were allowed to vary in a narrow band of 1 percent around their official rates which were expected to change only gradually, if ever. Foreign-exchange control between borders was strictly enforced, the mainstream economics theory at the time being inclined to consider free international flow of funds neither necessary nor desirable for facilitating trade.

Nixon was forced to abandon the Bretton Woods fixed exchange rate system in 1971 because recurring lapses of fiscal discipline on the part of the United States had made the dollar's peg to gold unsustainable. By 1971, US gold stock decline by $10 billion, a 50 percent drop. At the same time, foreign banks held $80 billion, eight times the amount of gold remaining in US possession. Ironically, the problem was not so much US fiscal spending as the unrealistic peg of the dollar to $35 gold.

The Smithsonian Agreement concluded in December 1971 between the Group of Ten of the IMF at a meeting at the Smithsonian Institute in Washington, DC, restored the major currencies to fixed parities but with a wider margin, plus or minus 2.25 percent of permitted fluctuation around their par values. The dollar was effectively devalued by about 8 percent and the dollar price of gold increased to $38 per ounce. Sterling was set at $2.6057. Improved telecommunications and computerized fund-transfer techniques allowed speculators to move funds quickly and efficiently around the world in anticipation of foreign exchange fluctuation and intervention, making it difficult to support even this widened band, which was eventually suspended. Foreign-exchange control was largely abandoned by most governments by the late 1970s, bringing forth the rapid growth of a largely unregulated international exchange market, along with a globalized capital and credit market. Foreign-exchange fluctuation increasingly became subject to financial market pressures not directly related to trade. It has now become a source of high speculative profit for many institutions and hedge funds. The huge size of the market has reduced the effectiveness of central-bank intervention in maintaining the exchange value of currencies.

Miller, after only 17 months at the Fed, had been named Treasury secretary as part of Carter's desperate wholesale cabinet shakeup in response to popular discontent and declining presidential authority. After isolating himself for 10 days of introspective agonizing at Camp David, Carter emerged in early summer to make his speech of "crisis of the soul and confidence" to a restless nation. In response, the market dropped like a rock in free fall. Miller was a fallback choice for the Treasury, after numerous other potential appointees, including David Rockefeller, declined personal telephone offers by Carter to join a demoralized administration.

Carter felt that he needed someone like Volcker, an intelligent if not intellectual Republican, a term many liberal Democrats considered an oxymoron, who was highly respected on Wall Street if not in academe, to be at the Fed to regenerate needed bipartisan support in his time of presidential leadership crisis. Bert Lance, Carter's chief of staff, was reported to have told Carter that by appointing Volcker, the president was mortgaging his own reelection to a less than sympathetic Fed chairman.

Volcker won a Pyrrhic victory against inflation by letting financial blood run all over the country and most of the world. It was a toss-up whether the cure was worse than the disease. What was worse was that the temporary deregulation that had made limited sense under conditions of near hyper-inflation was kept permanent under conditions of restored normal inflation. Deregulation, particularly of interest-rate ceilings and credit market restrictions, put an end to market diversity by killing off small independent firms in the financial sector since they could not compete with the larger institutions without the protection of regulated financial markets. Small operations had to offer increasingly higher interest rates to attract funds while their localized lending could not compete with the big volume, narrow rate spreads of the big institutions. Big banks could take advantage of their access to lower-cost funds to assume higher risk and therefore play in higher-interest-rate loan markets nationally and internationally, quite the opposite of what Keynes predicted, that the abundant supply of capital would lower interest rates to bring about the "euthanasia of the rentier".

In the longer term, Keynes may still turn out to be prescient, as the finance sector, not unlike the transportation sectors such as railroads, trucking and airlines in earlier waves, or the communication sector such as telecom companies, has been plagued by predatory mergers of the big fish eating the smaller fish, after which the big fish, having grown accustomed to a unsustainably rich diet that has damaged their financial livers, begin to die from self-generated starvation from a collapse of the food chain.

High real interest rates ahead of inflation rate moved wealth from borrowers to lenders in the economy and from bottom to top in the wealth pyramid. Moreover, the impact of high interest rates modifies economic behavior differently in different income groups and even on different activities within the same individual. When the prime rate for some banks exceeded 20 percent in 1980, credit continued to expand explosively in sectors where price appreciation occurred at a much higher rate, such as in real estate. High rates only work to slow credit expansion if the rates are ahead of inflation.

The Fed has traditionally never been prepared to raise interest rates too abruptly, trying always to prevent inflation without stalling the economy excessively, thus resulting in interest rates often trailing rampant inflation. The market demand for new loans, or the pace for new lending, obviously would not be moderated by raising the price of money, as long as the inflation/interest gap remain profitable. Yet bank deregulation diluted the Fed's control of the supply of credit, leaving price as the only lever. Price is not always an effective lever against runaway demand, as Fed chairman Alan Greenspan was also to find out in the 1990s. Raising the price of money to fight inflation is by definition self-neutralizing because high interest cost is itself inflationary. Deregulation also allows the price of money to allocate credit, often directing credit to where the economy needs it least, namely the speculative arena.

The Fed might have had in its employ a staff of very sophisticated economists who understood the complex multi-dimensional forces of the market, but the tools available to the Fed for dealing with market instability was by ideology and design single-dimensional. Interest-rate policy was the only weapon available to the Fed to tame an aggressively unruly market that increasingly viewed the Fed as a paper tiger.

In the early weeks of 1980, the Consumer Price Index (CPI) was 17 percent, prime rate was 16 percent and rising, and gold hit as high as $875 an ounce. Having told the House Banking Committee on February 19 that credit controls do not deal with the "basic causes of inflation", the Fed chairman Volcker announced on March 14 a program of emergency credit controls not only on commercial banks, but also on money-market mutual funds and retail companies that issue credit cards. Banks would be limited to 9 percent credit growth instead of the 17 percent in February. Only a week earlier, the FOMC, trailing inflation data, was forced to raised the Federal Funds Rate (FFR) target to 18 percent.

The economy crash-landed abruptly in response. The gross domestic product (GDP) shrank 30 percent within three months. Consumer credit, instead of growing by $2 billion a month, shrank by $2 billion a month. Money dried up suddenly, leaving many otherwise healthy projects hanging in midstream. Construction loans could not roll over into permanent mortgages. Asset prices fell below their collateralized value, causing loans to be "underwater" overnight, giving otherwise conscientious borrowers an incentive to walk away from their debt obligations. Insolvency became widespread, with financial dead bodies strewn on the sidewalks of every city. For the first time in recent history, a Democrat in the White House pushed the country into recession, and in an election year.

Senate Democrat minority floor leader Robert Byrd of West Virginia expressed concern but was rebuked by senator William Proxmire, Senate Banking Committee ranking Democrat from Wisconsin, who gave a technical lecture on the iron law governing inflation and interest rates, a TINA (there is no alternative) argument. More unemployment and bankruptcies, while painful, had to be accepted as needed medicine.

Then the Hunt brothers' speculative silver bubble burst, punctuated by the silver price dropping from $50 an ounce to $10. The banks had lent the Hunts $800 million to corner speculatively a silver cartel, 10 percent of all bank lending in the past two months, at rising interest rates that inched toward 20 percent. By March 31, the Hunts defaulted on their future contracts because they were unable to roll over the short-term loans, partly due to credit control. To prevent systemic panic, Volcker engineered a private bailout from the 11 banks with a new $1.1 billion loan, similar to the Fed-engineered Long Term Capital Management (LTCM) bailout in 1998. The Hunt brothers were wiped out of their billion-dollar equity and had to file for bankruptcy, but their banks were saved from the fate of having to raise more capital to cover non-performing loans that magically became performing with the wave of the Fed's unseen hand. The Fed waived credit-control rules imposed only two weeks earlier. "Moral hazard" became a loud murmur heard from shaking heads everywhere. The Fed had in the past refused requests for bailouts for Chrysler, New York City, Midwestern grain farmers, Lockheed, Pan Am Airways, etc, in the real economy, but it seldom refuses to bail out the financial markets. TINA, together with the "too big to fail syndrome", was after all a selective doctrine applicable only to the Fed's political constituents.

Volcker, as chairman of the Fed, adopted a "new operating method" for the Fed in 1980 as a therapeutic shock treatment for Wall Street, which seemed to have been conditioned by Burns' brazen political opportunism to lose faith in the Fed's political will to control inflation. The new operating method, by concentrating on monetary aggregates, and letting it dictate FFR swings within a range from 13-19 percent, to be authorized by the FOMC, was an exercise in "creative uncertainty" to shock the financial market out of its complacency about interest-rate stability and gradualism. There had been a traditional expectation that even if the Fed were to raise rates, it would not permit the market to be volatile. The banks could continue to lend as long as they could profitably manage the gradual rise in rates. Under the new operating method, the banks were exposed to risks that interest rates might suddenly and drastically go against even their short-term credit positions. Also, banks had been expanding new loans beyond the growth of deposits, by borrowing shorter term funds at lower interest rates. This practice was given the benign name of "managed liability", allowing banks to profit from interest-rate spreads over the yield curve, which had seldom if ever been allowed by the Fed to get inverted, that is with short-term rates rising higher than longer-term rates. This practice, known as "carry trade" in bank parlance, when internationalized, eventually led to the Asian financial crisis of 1997 when interest-rate and exchange-rate volatility became the new paradigm.

The Fed's new operating method would greatly increase the banks' risk exposure. On top of it all, Volcker also set an additional 8 percent reserve on borrowed funds for lending. The new operating method worked against the traditional mandate of the Fed, which, as a central bank, was supposed to be responsible for maintaining orderly markets, which meant smooth, gradual changes in interest rates. The new operating method was a policy to induce the threat of short-term pain to stabilize long-term inflation expectations.

Every economist agrees that when money growth slows, market interest rates go up. The trouble with the use of the FFR target to control money supply was that it had to be set by fiat, which exposed the Fed to political pressure. A case could be made, and was frequently made, that the Fed's FFR target tended to be self-fulfilling prophecy rather than a device to manage future trends. High FFR targets deflate while low targets inflate, and there is little argument about that relationship. But there is plenty of argument about the Fed's projection ability on the economy. History has shown that the Fed, more often than not, has made wrong decisions based on faulty projection. The new operating method would let the monetary aggregates set the FFR targets scientifically and provide political cover for the FOMC members if the FFR target needed to go to double digits. This was monetarism through the back door, not by intellectual commitment, but by political cowardice.

The FOMC, as formed by the Banking Act of 1933, did not include voting rights for the Fed Board of Governors. This was changed in the Banking Act of 1935 to include the Board of Governors and amended again in 1942 to the current voting structure, which consists of the seven members of the Board of Governors, the president of the New York Fed and four other district Fed presidents who serve on a rotating basis. These legislative changes were an attempt to centralize the Fed's policy-making while preserving input from Federal Reserve bank presidents. While Federal Reserve bank presidents vote on a rotating basis, they all attend each FOMC meeting and contribute to the debate on monetary policy. The early FOMC at first met quarterly to consider its business; today, the FOMC meets eight times a year, but decisions regarding monetary policy are not limited to formal meeting dates, as the chairman can call a teleconference of the FOMC at any time.

This system for making monetary policy - incorporating regional viewpoints in the making of national policy - is one of the hallmarks of Fed structure. From the beginning of the Fed, opinions differed on the need for, and the location of, geographic representation on the Board, and the debate continued with the formation of the FOMC. In 1964, congressional hearings were held that considered abolition of the FOMC. The importance and dominance of national policy over regional considerations are now generally accepted. The FOMC would not alter monetary policy to address an economic concern pertinent to just one district. Regional input plays an increasingly peripheral role in the formulation of that policy. By extension, as the Fed began to support the Treasury's strong-dollar policy as a matter of national security under Robert Rubin in the 1990s, dominance of US internationalist policy over district concerns became institutionalized. The rust belt and the agricultural exporting states would have to restructure the local economy to survive.

Prior to 1970 and the arrival of Arthur Burns as the chairman of the Federal Reserve Board, the FOMC made comments in a set pattern, known as a "go-around". Burns was not in sympathy with this formalized process, as he was not a consensus builder when it came to making monetary policy, as was his long-serving predecessor, William McChesney Martin, who listened to everyone's input before making his decision. To save himself the unpleasant prospect of having to ignore district views face to face, Burns decided it would be a more efficient use of the FOMC's time to have the reports on district conditions prepared in advance and compiled for the Committee's edification. Burns' directive formalized and broadened the information-gathering process, and thus was born the Red Book, which was the predecessor to the Beige Book.

Aside from the color of their covers, the Red and Beige books differed in one important way: the Red Book was prepared for policy makers only, and was not intended for public consumption. The Red Book became public in 1983 after a request by the longtime representative from the District of Columbia, Walter Fauntroy, for public release of the Green Book, which contains the Fed's closely held national models and economic forecasts. The Board deemed this unwise and the Red Book was offered in its place. To mark the change, the color red was dropped in favor of beige (it was for a time also called the Tan Book). To detract from the implied importance of the document in FOMC policy-making, the public release of the Beige Book was timed for two weeks prior to an FOMC meeting, so that the media and others would recognize that the information was not timely and, therefore, did not have a major influence on policy. So much for policy transparency in a democratic society.

The Fed protects itself from criticism of ideological bias in its decision-making by depriving the public and its critics of timely information paid for by tax money. The Fed remains above criticism because its decisions are always based on more recent information on the economy than that available to the market, decisions that the market would understand only if it had the same information, although the rationale for depriving the market of the latest information in the age of instant communication has never been made clear.

The Federal Advisory Council (FAC) of the Fed is unique in that it is a big bank lobby that officially advises the Fed, a government institution owned by the banks. It meets in secrecy four times a year with Fed officials to give the banking industry an inside track on influencing Fed deliberation, if not decisions. The since-declassified minutes of the FAC show that four weeks before the Fed announced its new operating method, the FAC had recommended to the Fed a "review" of its traditional operating method, before the president was even alerted of the Fed's deliberation and final decision to adopt a new operating method. Carter was totally in the dark about the impending high-interest-rate policy with which the Fed was going to hit his administration in an election year.

The Fed program of Emergency Credit Controls announce on March 14, 1980, affected not only commercial banks, but also money-market mutual funds and retail companies that issue credit cards. Banks would be limited to 9 percent credit growth instead of the 17 percent in February. By April, the Fed was shocked by data that money was disappearing from the financial system at an alarmingly rapid rate. The last two weeks in March saw more than $17 billion vanish, representing an annualized shrinkage of 17 percent. Money was evaporating from the banking system as credit dried up and borrowers paying off their debts at Carter's urging: to save the nation from hyper-inflation through personal restraint on consumption. Another cause was the shift of bank deposits to three-month T-bills that were paying 15 percent.

Volcker's new operating method adopted six months earlier now faced a critical test. According to monetarist theory, the Fed now must pump up bank reserves to stimulate money growth. But in practice, Volcker and the FOMC were to apply monetarism, which by definition must be a long-term proposition, to short-term turbulence, and in the process undermined their own earlier efforts to fight hyper-inflation and, worse, destabilized the economy unnecessarily. When mortals play god, other mortals die unnecessarily.

On May 6, 1980, with the New York Fed's Open Market Desk furiously trying to brake the money-supply shrinkage now in raging progress, pumping more bank reserves by buying government securities and creating new "high power" money by increasing bank reserves, interest rates fell abruptly. The FFR dropped 500 basis points in two weeks, from 18 to 13 percent, the bottom of the FOMC range, and was actually trading below the FOMC target.

The Fed was in danger of losing control of its FFR target and jeopardizing its credibility. The New York Fed notified the FOMC that it could continued to follow the new operating method by injecting more reserves or to tighten up the supply of bank reserves to get the FFR back up to 13 percent, but it could not do both, any more than a train could go in opposite directions simultaneously. Volcker opted for continuing the new operating method and staged an emergency telephone conference of the FOMC to authorize a new low FFR target of 10.5 percent, down from 13 percent.

Market conditions were such that the interest rate falling below 10 percent would mean negative interest adjusted for inflation, which would start another borrowing binge. The fundamental fault of monetarism was being exposed by real life. The claim that stabilizing the money supply would also stabilize interest rates was inoperative. In reality, stabilizing one destabilized the other in a fast-reacting dynamic market.

Desperate, the Fed, with concurrence from an even more panic-stricken Carter White House, started to dismantle Emergency Credit Controls as fast as administratively possible, so that demand for credit would not be artificially hampered, in hope of making market interest rates rise from more borrowing. Still it took until July 1980 before the last of the controls were lifted. In April, the New York Fed injected additional reserves into the banking system at an annualized rate of 14 percent, and in May at 48 percent annualized rate in non-borrowed reserves.

It was obvious Volcker panicked, spooked by the sudden economic collapse touched off by his own credit-control program. By the last week of July, the FFR fell below the discount rate and hit 8.5 percent. For one trading day, it dipped to 7.5 percent and for a time the Fed lost control. The short-term rate that monetary policy regulates most directly was free-floating on its own. With the FFR below the discount rate, the FFR could fall to zero by banks responding to market forces. So the pressure to lower the discount rate was overwhelming. The financial markets had never seen anything like it. The FFR dropped from 20 percent in April to 8.5 percent in 10 weeks. In the autumn of 1979, the Fed had seized the initiative to push the price of money up 100 percent to fight inflation. Now, barely seven months later, the Fed allowed the price of money to fall even more rapidly to reverse a money-supply shrinkage. The recession abruptly ended by the Fed's overreaction and Volcker was facing a worse inflation problem than when he first became chairman in July 1979. Many businesses went under during this brief period of illiquidity, but the banks were dancing in the streets with windfall profits.

The experience put the Fed back on its old path: focusing on interest rates and not money-supply numbers and vowing again to focus only on the long term. Yet for the long term, money supply was the correct barometer, while for the short term, interest rate was the appropriate tool. The Fed did not seem to have learned anything, despite having made the nation pay a very costly tuition.

In 2000, when the Humphrey-Hawkins legislation requiring the Fed to set target ranges for money-supply growth expired, the Fed announced that it was no longer setting such targets, because money-supply growth did not provide a useful benchmark for the conduct of monetary policy. However, the Fed said, too, that "... the FOMC believes that the behavior of money and credit will continue to have value for gauging economic and financial conditions". Moreover, M2, adjusted for changes in the price level, remains a component of the Index of Leading Indicators, which many private-sector market analysts use to forecast economic recessions and recoveries.

To make the case that money supply, rather than interest rates, moves the economy, one would have to assert that the money supply affects the economy with zero lag. Such a claim can only be validated from the long-term perspective. For the long term, six months may appear as near zero, just as macro-economists may consider the bankruptcy of a few hundred companies mere creative destruction, until they find out some of their own relatives own now worthless shares in some of the bankrupt companies. Targeting the money supply produces large sudden swings in interest rates that produce unintended shifts in the real economy that then feed back into demand for money. The process has been described as the Fed acting as a monetarist dog chasing its own tail.

By September 1980, data on August money supply revealed that it had grown by 23 percent. Monetarists, backed by the banks, clamored for interest-rate hikes dictated by money-supply data. Having been burned a few months earlier, the Fed was not again going to abandon its traditional interest-rate gradualism focus and again let the money-supply tail wag the interest-rate dog. Nevertheless, the Fed raised the discount rate from 10 to 11 percent on September 25, still way behind both monetary aggregate needs and the inflation rate.

Carter, falling behind in the polls, attacked the Fed for its high-interest-rate policy in the final weeks of his reelection campaign in October. Reagan opportunistically and disingenuously defended the Fed's unfair scapegoating by Carter. After the election, the Fed continued its high-interest-rate policy while Reaganites were preoccupied with transition matters. By Christmas, prime rate for some banks reached 21.5 percent.

The monetary disorder that elected Reagan followed him into office. Carter blamed inflation on prodigal popular demand and promised government action to halt hyper-inflation. Reagan reversed the blame for inflation and put it on the government. Yet Reagan's economic agenda of tax cuts, defense spending and supply-side economic growth was in conflict with the Fed's anti-inflation tight-money policy. The monetarists in the Reagan administration were all longtime right-wing critics of the Fed, which they condemned as being infected with a Keynesian virus. Yet the self-contradicting fiscal policies of the Reagan administration (balanced budget despite massive tax cuts and increased defense spending) overshadowed its fundamental monetary-policy inconsistency. Economic growth with shrinking money supply is simply not internally consistent, monetarism or no monetarism.

The Reagan presidency marked the rehabilitation of classical economic doctrines that had been in eclipse for half a century. Economics students since World War II had been taught classical economics as a historical relic, like creationism in biology. They viewed its theories as negative examples of intellectual underdevelopment attendant with a lower stage of civilization. Three strands of classical economics theory were evident in the Reagan program: monetarism, supply-side theory, and phobia against deficit financing (but not deficit itself). Yet these three strands are mutually contradictory if pursued equally with vigor, what Volcker gently warned about in his esoteric speeches as a "collision of purposes". Supply-side tax cuts and investment-led economic growth conflict with monetarist money-supply deceleration, while massive military spending with tax cuts means budgetary deficits. Voodoo economics was in full swing, with the politician who coined the term during the primary, George Bush, now serving as the administration's vice president. Reagan, the shining white knight of small-government conservatism, left the US economy with the biggest national debt in history.

Volcker was a man of far superior intellect to most at the Reagan White House except Martin Feldstein, chairman of the Council of Economic Advisors, whose incisive warnings against budget deficits were ignored by the White House. Volcker began to gain control over the administration on monetary policy through his rationality and adherence to reality, which allowed him to dominate events over the White House's doctrinaire "rational expectation": the theory that rational market participants always anticipate government policy and adjust their actions accordingly.

By March 1981, the FFR, which reached a historic high of 20 percent in January, had been pushed below 16 percent by the FOMC. The bond market refused to go along. Long-term rates went up. Henry Kaufman, a highly respected Wall Street guru, blamed it squarely on Reagan's expansionary tax cuts. The money-supply component M1 started to expand rapidly in April. Bond traders feared a Fed tightening with interest rate hikes, thus depressing the price of outstanding bonds with lower rates. Traders, many of whom have been exposed to simplified summaries of Milton Friedman's monetary theory in the trade press, began bidding up rates in anticipation. "Rational expectation" was working against the Reagan economic plan instead of with it. The Fed pleaded with market specialists not to jump to extreme conclusions based on a two-week change in the supply of money, that the Fed was no longer using the new operating method. But the bond market, having simplistically embraced Friedman's monetarist views to the point of conditional reflex, reacted nervously to M1 data and the Fed reacted nervously to the bond market. Monetarism was made real not by theoretical logic but by market herd instinct.

The daily column "Credit Markets" in the Wall Street Journal is a gossip page on the private world of bond traders that lets the reader eavesdrop on a no-nonsense summary of Fed-watcher analysis. Fed economists also read the column religiously just as Broadway stars read opening-night reviews or socialites read society pages. It is the trade's main source of information on market sentiment and it legitimizes an arcane abstraction as reality to the participants. To participate in this esoteric media dialogue, one must subscribe to certain basic assumptions, lest the material sound incomprehensible. The assumptions are that the Fed's first priority is to maintain interest-rate stability, orderly markets and "hard money", above economic growth or full employment or any such socialist claptrap.

When bond prices fell in April 1981, the Fed discreetly yielded to the judgment of the bond market, instead of guiding it. Though economic recovery was nowhere in sight, the Fed again changed direction in its interest-rate policy and moved rates upward. The Fed was once more forced to follow the market instead of leading it, thus merely reinforcing market trends instead of preventing market excesses, as it has always done throughout its history and continues to do today. As the Reagan program moved through Congress, gathering popular enthusiasm and legislative momentum, the bond market went into seizure. The Fed was faced with the option of losing control of the FFR or cutting more drastically the money supply and push up interest rates.

A tightening of money supply alongside a budget deficit is a sure recipe for a recession. Long-term high-grade corporate and government bonds were seeing their market rates jump 100 basis points in one month. New issues had difficulty selling at any price. The possibility of a "double dip" recession was bandied about by commentators, as it is now. The Fed was attacked from all sides, including the commercial banks, which held substantial bond portfolios, and White House supply-siders, despite the fact that everyone knew the trouble originated with the Reagan economic agenda. The Democrats were attacking the Fed for raising interest rates, which was at least conceptually consistent.

The White House accused the Fed of targeting interest rates again instead of focusing on controlling monetary aggregates, and Volcker himself was accused of undermining the president. Reagan publicly discussed "abolishing" the Fed, notwithstanding his disingenuous defense of the Fed from attacks by Carter during the election campaign. Earlier, back in mid-April, Volcker had publicly committed himself to gradualism in reining in the money supply and avoiding shock therapy, to give the economy time to adjust. But he changed his promise by May, and decided to tighten on an economy already weakened by high rates imposed six months earlier, yielding to the White House and the bond market. Gradualism was permanently discarded. Volcker's justification was amazing, in fact farcical. He told a group of Wall Street finance experts in a two-day invited seminar that since policy mistakes in the past had been on the side of excessive ease, in the future it made sense to err on the side of restraint. Feast and famine was now not only a policy effect but a policy rationale as well. Compound errors, like compound interest, were selected as the magical cure for the nation's sick economy.

Financial markets are not the real economy. They are shadows of the real economy. The shape and fidelity of the shadows are affected by the position and intensity of the light source that comes from market sentiments on the future performance of the economy. The institutional character of the Fed over the decades has since developed more allegiance to the soundness of the financial market system than to the health of the real economy, let alone the welfare of all the people. Granted, conservative economists argue that a sound financial market system ultimately serves the interest of all. But the economy is not homogenous throughout. In reality, some sectors of the economy and segments of the population, through no fault of their own, may not, and often do not, survive the down cycles to enjoy the long-term benefits, and even if they survive are permanently put in the bottom heap of perpetual depression. Periodically, the Fed has failed to distinguish a healthy growth in the financial markets from a speculative debt bubble.

The Reagan administration by its second term discovered an escape valve from Volcker's independent domestic policy of stable-valued money. In an era of growing international trade among Western allies, with the mini-globalization to include the developing countries before the final collapse of the Soviet Bloc, a booming market for foreign exchange had been developing since Nixon's abandonment of the gold standard and the Bretton Woods regime of fixed exchange rates in 1971. The exchange value of the dollar thus became a matter of national security and as such fell within the authority of the president that required the Fed's patriotic support.

Council of Economic Advisors chairman Martin Feldstein, a highly respected conservative economist from Harvard with a reputation for intellectual honesty, had advocated a strong dollar in Reagan's first term, arguing that the loss suffered by US manufacturing was a fair cost for national financial strength. But such views were not music to the Reagan White House's ears and the Treasury under Donald Regan, former head of Merrill Lynch, whose roster of clients included all major manufacturing giants. Feldstein, given the brushoff by the White House, went back to Harvard to continue his quest for truth in economics after serving two years in the Reagan White House, where voodoo economics reigned. Feldstein went on to train many influential economists who later would hold key positions in government, including Lawrence Summers, Treasury secretary under president Bill Clinton and now president of Harvard University, and Lawrence Lindsey, presidential economic assistant to George W Bush (just dismissed along with Treasury secretary Paul O'Neill in a Bush shake-up of his economic team).

By Reagan's second term, it became undeniable that the United States' policy of a strong dollar was doing much damage to the manufacturing sector of the US economy and threatening the Republicans with the loss of political support from key industrial states, not to mention the unions, which the Republican party was trying to woo with a theme of Cold War patriotism. Treasury secretary James Baker and his deputy Richard Darman, with the support of manufacturing corporate interest, then adopted an interventionist exchange-rate policy to push the overvalued dollar down. A truce was called between the Fed and the Treasury, though each quietly worked toward opposite policy aims, much like the situation in 2000 on interest rates, with the Fed raising short-term FFR while the Treasury pushed down long-term rates by buying back 30-year bonds, resulting in an inverted rate curve, a classical signal for recession down the road.

Thus a deal was struck to allow Volcker to continue his battle against domestic inflation with high interest rates while the overvalued dollar would be pushed down by the Treasury through the Plaza Accord of 1985 with a global backing-off of high interest rates. Not withstanding the Louvre Accord of 1987 to halt the continued decline of the dollar started by the Plaza Accord two years earlier, the cheap-dollar trend did not reverse until 1997, when the Asian financial crisis brought about a rise of the dollar by default, through the panic devaluation of Asian currencies. The paradox is that in order to have a stable-valued dollar domestically, the Fed had to permit a destabilizing appreciation of the foreign-exchange value of the dollar internationally. For the first time since end of World War II, foreign-exchange consideration dominated the Fed's monetary-policy deliberations, as the Fed did under Benjamin Strong after World War I. The net result was the dilution of the Fed's power to dictate to the globalized domestic economy and a blurring of monetary and fiscal policy distinctions. The high foreign-exchange value of the dollar had to be maintained because too many dollar-denominated assets were held by foreigners. A fall in the dollar would trigger a selloff as it did after the Plaza Accord of 1985, which contributed to the 1987 crash.

It was not until Robert Rubin became special economic assistant to president Clinton that the United States would figure out its strategy of dollar hegemony through the promotion of unregulated globalization of financial markets. Rubin, a consummate international bond trader at Goldman Sachs who earned $60 million the year he left to join the White House, figured out how the US was able to have its cake and eat it too, by controlling domestic inflation with cheap imports bought with a strong dollar, and having its trade deficit financed by a capital account surplus made possible by the same strong dollar. Thus dollar hegemony was born.

The US economy grew at an unprecedented rate with the wholesale and permanent export of US manufacturing jobs from the rust belt, with the added bonus of reining in the unruly domestic labor unions. The Japanese and the German manufacturers, later joined by their counterparts in the Asian tigers and Mexico, were delirious about the United States' willingness to open its domestic market for invasion by foreign products, not realizing until too late that their national wealth was in fact being steadily transferred to the US through their exports, for which they got only dollars that the US could print at will but that foreigners could not spend in their own countries. By then, the entire structure of their economies was enslaved to export, condemning them to permanent economic servitude to the dollar. The central banks of these countries competed to keep the exchange values of their currencies low in relation to the dollar and to each other so that they can transfer more wealth to the United States, while the dollars they earned from export had no choice but to go back to the US to finance the restructuring of the US economy toward new modes of finance capitalism and new generations of high-tech research and development through US defense spending.

Constrained by residual limitation on rearmament resulting from their defeat in World War II, both Germany and Japan were unable to absorb significant high-tech research funds in their own defense sectors and had to buy weapon systems from the US. By continuing to provide a defense umbrella over Japan and Germany after the Cold War, the US preserved its leadership in science and technology, with financing coming mostly from the exporting nations' trade surpluses. The more the export economies earned in their trade surpluses, the poorer these exporting nations became. Neo-liberal market fundamentalism is not the same as 19th-century mercantilism in that trade surpluses in the form of gold would flow back to the exporting economy - trade surpluses denominated in dollars merely expand the US economy globally. The sucking sound that Ross Perot warned of regarding the North American Free Trade Agreement (NAFTA) during his 1992 presidential campaign turned out not to be the sound of US jobs migrating to Mexico, but the sound of foreign-held dollars rushing into US equity and debt markets.

The Plaza Accord of 1985 produced an agreement among the Group of Five (United States, Britain, France, Germany, and Japan) calling for coordinated and concerted effort to lower the value of the dollar. In September 1985, the G-5 met at the Plaza Hotel in New York City to ratify an initiative to use exchange rates and other macro policy adjustments as the preferred and necessary means to bring about an orderly decline in the value of the dollar. The agreement, intended to curb increasing US trade imbalances and protectionist sentiment and action, supported orderly appreciation of the main non-dollar currencies against the dollar.

Two years after the Plaza Accord, the Louvre Accord of 1987 reached by the G-7 (G-5 plus Canada and Italy) called for a halt in the dollar's decline, re-establishment of balanced trade, and non-inflationary growth by introducing reference ranges among the G-7 currencies. In February 1987, the G-7 met at the Louvre in France and announced that the dollar had reached a level consistent with the underlying economic conditions, and that they would intervene only as needed to insure stability. Under the Louvre Accord, nations would intervene on behalf of their currencies as needed, unannounced.

These two elaborate arrangements set up by the major industrial countries to stabilize their exchange rates had a mixed record. Developments since then have shown that it would be futile for governments to waste scarce financial resources intervening in unregulated foreign exchange markets, as the Bank of England discovered in 1992. Another reason exchange-rate instability will continue to increase in the near term is that the euro-dollar exchange rate will be of less concern to the European Central Bank (ECB) than it was to the national central banks of Europe because the economy of the euro zone as a whole will be more closed and inward looking than the individual members' economies. The euro zone's openness rate (measured by the ratio of trade in goods and services to GDP) is about 14 percent, compared with 25 percent for France and Germany individually. Euroland has discovered the indispensability of domestic development and the disadvantage of excessive reliance on exports.

International commitment to the Louvre Accord eventually waned. Germany raised interest rates in 1990 to combat inflation after reunification, while the United States eased monetary policy to counteract a decline in economic activity after the 1987 crash. Although the interest-rate differentials between the US and Europe caused several European currencies to appreciate, the G-7 did not react. Nor did it try to halt depreciation of the yen in 1990. By 1993, the Louvre Accord was virtually dead, as domestic policy objectives took priority over internationally agreed targets. Political shocks (such as German reunification and the invasion of Kuwait) and economic facts (such as the persistence of Japan's current account surplus in spite of a strong yen) also weakened commitment to the accord. The G-7's approach changed from "high-frequency" to "low-frequency" activism, with ad hoc interventions only in cases of extreme misalignment, and the focus shifted from exchange rate levels to exchange rate volatility.

Reagan replaced Volcker with Alan Greenspan as Fed chairman in the summer of 1987, over the objection of supply-side partisans, most vocally represented by Wall Street Journal assistant editor Jude Wanniski, a close associate of former football star and presidential potential Jack Kemp of New York. Wanniski derived many of his economics ideas from Robert Mundell, who was to be the recipient of the Nobel Prize for economics in 1999 on his theory on exchange rates. Wanniski accused Greenspan of having caused the 1987 crash, with Greenspan, in his new role as Fed chairman, telling Fortune magazine in the summer of 1987 that the dollar was overvalued. Wanniski also maintained that there was no liquidity problem in the banking system in the 1987 crash, and "all the liquidity Greenspan provided after the crash simply piled up on the bank ledgers and sat there for a few days until the Fed called it back". Wanniski blamed the 1986 Tax Act, which while sharply lowering marginal tax rates nevertheless raised the capital gains tax to 28 percent from 20 percent and left capital gains without the protection against inflated gains that indexing would have provided. This caused investors to sell equities to avoid negative net after-tax returns, according to Winniski.

On Monday, October 19, 1987, the value of stocks plummeted on markets around the world, with the Dow Jones Industrial Average (DJIA, the main index measuring market activity in the United States) falling 508.32 points to close at 1738.42, a 22.6 percent fall, the largest one-day decline since 1914. The magnitude of the 1987 stock-market crash was much more severe than the 1929 crash of 12.8 percent. The loss to investors amounted to $500 billion. Over the four-day period leading up to the October 19 crash the market fell by over 30 percent. By peak value in January 2000, this would translate into the equivalent of an almost 4,000-point drop in the Dow. However, while the 1929 crash is commonly believed to have led to the Great Depression, the 1987 crash only caused pain to the real economy but not its collapse. It is widely accepted that Greenspan's timely and massive injection of liquidity into the banking system saved the day. The events launched the super-central banker cult of Greenspan, notwithstanding Winniski's criticism.

The 1987 market crested on August 25 with the DJIA at 2,747. It is hard to relate to the fact that the same DJIA peaked in January 2000 near 12,000 without thinking of bubble inflation. The United States' 1987 GDP was $4.7 trillion and 2000 GDP was $9.8 trillion. The GDP doubled in this period while the DJIA quadrupled. After reaching the top in 1987, the market fell off to 2,500, rallied back to 2,640 then fell back to a slightly lower level around 2,465. Another longer rally started that took the Dow to around 2,660. Technical analysis shows that in 55-day declines, the market's rallies tend to end around the 40th day. It was almost as if investors gave up hoping things would turn back to the upside and decided to take some money off the table. Some 50 percent or more of the total market decline was in the last three or four days. In 1987, the market fell from 2,747 to 1,600, a total of 1,147 points. The last three days ranged from 2,400 to 1,600, a total of 800 points or 69.7 percent of the total range of 1,147 points. Yet the 1988 GDP grew to $5.1 trillion, up $360 billion over 1987, while it took until 1941 and a war economy for the GDP to recover to the level before the 1929 crash.

Panic-driven trading on the New York Stock Exchange on October 19, 1987, reached 604.3 million shares, nearly double the prior record volume of 338.5 million shares set the previous Friday, when the Dow lunged a then-record 108.35 points. Nowadays, a routine daily volume would be 1.6 billion shares and the system is supposed to handle 3 billion shares with ease. But the ability to handle increased volume itself created a demand for high-volume trading. It is not unlike the opening of new lanes of traffic in a crowded expressway: the new lanes themselves attract more traffic until overload occurs again.

The DJIA was down 36.7 percent on October 19, 1987, from its closing high less than two months earlier. The selling started right from the opening on the day of the crash. Some 11 of the 30 stocks in the DJIA did not open for the first hour because of order imbalances - there were so many sell orders they could not be matched to buy orders. With many stocks on the NYSE not trading, traders turned to the futures markets to cover their positions. An eerie quiet settled over the normally teeming stock-index futures pit at the Chicago Mercantile Exchange early on October 19 as traders watched the beginning of the worst washout in stock-market history. The Wall Street Journal reported the following day, October 20, 1987: "With trading delayed in many major New York Stock Exchange issues because of order imbalances, Chicago's controversial 'shadow markets' - the highly leveraged, liquid futures on the Standard & Poor's 500 stock index - were, for just a few minutes, the leading indicator for the world's equity markets. And the stock-index markets were leading the way down - fast. In a nightmarish fulfillment of some traders' and academicians' worst fears, the five-year-old index futures for the first time plunged into a panicky unlimited free fall, fostering a sense of crisis throughout the US capital markets."

The Fed supplied liquidity through the open-market purchase of US government securities, adding $2.2 billion in non-borrowed reserves between the reserve periods ended on November 4, 1987. In addition, the Federal Reserve provided help to commercial banks by making the discount window available when they encountered heavy reserve needs. Chairman Greenspan also reassured the public that the Federal Reserve would serve as a source of liquidity to support the economic and financial system. Interest rates on short- and long-term instruments fell in order to provide liquidity. For example, the rate on three-month Treasury bills dropped from 6.74 percent on October 13 to 5.27 percent on October 30, while the FFR declined by 179 basis points over this interval, and the rate on 30-year Treasury bonds fell from 9.92 percent to 9.03. Further, banks' increasing lending to securities firms during October 19-23 enabled firms to finance the inventories of securities accumulated by their customers' sell orders. Partially because of the Federal Reserve's and banks' assistance, the stock price recovery period was much shorter than after the 1929 crash.

Initial blame for the 1987 crash centered on the interplay between stock markets and index options and futures markets. In the former, people buy actual shares of stock; in the latter they are only purchasing rights to buy or sell stocks at particular prices. Thus options and futures are known as derivatives, because their value derives from changes in stock prices even though no actual shares are owned. The Brady Commission, officially named the Presidential Task Force on Market Mechanisms, concluded that the failure of stock markets and derivatives markets to operate in sync was the major factor behind the crash. In part, investors' concern about the US federal budget and international trade deficits were found to be responsible. Comments made by the US Treasury secretary, who criticized foreign economic policies and hinted that the Reagan administration would let the US dollar's value decline further, also contributed. The key factor was program trading, a recent development on Wall Street in which computers were programmed to order the buying or selling automatically of a large volume of shares when certain circumstances occurred. The commission also criticized "specialists" on the floor of the New York Stock Exchange who neglected their duty by not becoming buyers of last resort and by treating small investors "capriciously". The Securities and Exchange Commission (SEC) joined in, faulting computerized trading and exchange specialists as well as citing a negative turn in investor psychology. Both the Brady Commission and the SEC called for greater regulation to prevent a similar occurrence in the future.

On February 4, 1988, the New York Stock Exchange established safeguards forbidding the use of its electronic order system for program trading whenever the DJIA increases or drops 50 points in a single day. The NYSE implemented on Tuesday, February 16, 1999, new trigger levels at which restrictions on index arbitrage trading, or trading "collars", would track the movement of the DJIA. The revisions to NYSE Rule 80A were approved by the SEC. The NYSE implemented new circuit-breaker and trading-collar trigger levels that changed with the level of the DJIA. Circuit-breaker points represent the thresholds at which trading is halted marketwide for single-day declines in the DJIA. The 10, 20 and 30 percent decline levels, respectively, in the DJIA at its peak around the first quarter of 2000 were as follows: A 1,050-point drop in the DJIA before 2pm would halt trading for one hour; would halt trading for 30 minutes if between 2pm and 2:30pm; and would have no effect if at 2:30pm or later. A 2,100-point drop in the DJIA before 1pm would halt trading for two hours; for one hour if between 1 and 2pm; and for the remainder of the day if at 2pm or later. A 3,150-point drop would halt trading for the remainder of the day regardless of when the decline occurred. Trading collars, which restrict index-arbitrage trading, would be triggered when the DJIA moved 180 points or more above or below its closing value on the previous trading day and removed when the DJIA was above or below the prior day's close by 90 points.

Trading collars were first implemented in July 1990 in response to concerns that index arbitrage may have aggravated large market swings. When implemented, the collars represented an approximate 2 percent move in the DJIA. The amendment took into account the dramatic advances in the DJIA over the previous few years. Widely credited with helping reduce market volatility, trading collars were triggered 23 times on 22 days in 1990; 16 times in 1992; nine times in 1993; 30 times in 28 days in 1994; 29 times in 28 days in 1995; 119 times in 101 days in 1996; 303 times in 219 days in 1997; and 366 times in 227 days in 1998.

The stock market recovered from the 1987 crash and began another upward climb, with the DJIA topping 3,000 in the early 1990s. While technical problems within markets may have played a role in the magnitude of the market crash, they could not have caused it. That would require some action outside the market that caused traders dramatically to lower their estimates of stock-market values. The main culprit had been legislation that passed the House Ways and Means Committee on October 15, 1987, eliminating the deductibility of interest on debt used for corporate takeovers.

Two SEC economists, Mark Mitchell and Jeffry Netter, published a study in 1989 concluding that the anti-takeover legislation did trigger the crash. They note that as the legislation began to move through Congress, the market reacted almost instantaneously to news of its progress. Between Tuesday, October 13, 1987, when the legislation was first introduced, and Friday, October 16, when the market closed for the weekend, stock prices fell more than 10 percent - the largest three-day drop in almost 50 years. In addition, those stocks that led the market downward were precisely those most affected by the legislation. Many pending merger and acquisition (M&A) deals were abruptly aborted. The entire industry that grew to support M&A activities - investment banks, lenders, law firms, arbitrageurs, corporate raiders and greenmailers - was faced with imminent idleness.

Another important trigger for the market crash was the announcement of a large US trade deficit (3.4 percent of GDP) on October 14, 1987, which led Treasury secretary James Baker to suggest the need for a fall in the dollar on foreign-exchange markets. Fears of a lower dollar led foreigners to pull out of dollar-denominated assets, causing a sharp rise in interest rates. The front page of the New York Times Business Day section (June 10, 2000) ran an article headlined "Economy may have a soft spot - swelling trade gap worries some experts and policy makers". The US current account deficit reached $338.9 billion in 1999, up 53.6 percent from 1998. It amounted to 3.7 percent of GDP in 1999 and 4.2 percent of Q4. The DJIA peaked in January 2000 at close to 12,000, and has since lost more than 40 percent of its peak value.

What the 1987 crash ultimately accomplished was to teach politicians that markets heed their words and actions, reacting immediately when threatened. Thus the crash initiated a new era of market discipline not so much on bad economic policy, but on policy honesty.

Greenspan issued a statement at 8:41am on Tuesday, October 20, 1987, before the markets opened: "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 statement was widely credited as limited the systemic damage of the 1987 crash by restoring market confidence.

The forces behind the 1987 crash actually began two years earlier. In January 1985, the value of the dollar peaked and began to weaken. But its decline was nominal and nine months later there was no discernible improvement in the trade deficit. In fact, by September 1985, the US trade deficit had worsened substantially, just as the J-curve theory predicts. The J-curve is the illustration of the performance of a country's balance of payments after its currency has been devalued. The immediate effect of a devaluation is to raise the cost of imports and reduce the value of exports, so that the current account deteriorates. Gradually, however, the volume of exports increases because their price is down and the volume of imports declines because they have become more expensive. This should rectify the current account balance, turning deficit to surplus. Like much in economics, this is a persuasive theory that appears to straddle the line between natural law and wishful thinking. The adjustment period, which was expected to be six to 12 months (nine-month average), should have been over. But in 1985, the dollar fell for nine months with no discernible improvement in the trade deficit.

The Brady Commission concluded that the failure of stock markets and derivatives markets to operate in sync was the major factor behind the crash. The crash is now part of a pantheon of financial market "problems" that included Barings, Daiwa, Metallgesellschaft, Orange County, Sumitomo, LTCM, Quantum Funds, Tiger Funds, Enron, Global Crossing, WorldCom, etc. It was also a forerunner of the 1997 financial crises that started in Thailand.

The investing public has been assured that the lessons of the 1987 crash have been learned and that changes have been installed to prevent a recurrence. Among the key changes in the US financial market after the 1987 crash are "circuit breakers" restricting program trading. Some believe that the halts they cause will provide time for brokers and dealers to contact their clients when there are large price movements and to get new instructions or additional margin. Others argue that trading halts can increase risk by inducing trading in anticipation of a trading halt.

Circuit breakers were triggered for the first and only time on October 27, 1997, when the second wave of the Asian financial crisis that had begun on July 2 in Thailand hit New York markets, and the DJIA fell 350 points at 2:35pm and 550 points at 3:30. That reflected an approximate 7 percent overall decline and shut the market for the remainder of the day.

The circuit breakers were installed primarily to prevent extreme changes in the stock market. Their usefulness is often in doubt because in order to prevent extreme shifts in the market the causes of values change must be revealed. There are several suggestions as to what can cause these changes. A primary cause is fundamental changes in the economy, including the availability of money or changes in interest rates. Here restrictions on trading are detrimental because they can decrease the effectiveness of the pricing in the stock market. The advocates of circuit breakers insist that periods of suspension of the market will allow time for the investors to consider what their next move will be and how to overcome this large price move. Yet it is unlikely that investors will sit and contemplate the reasoning behind the drop in points. Most are apt to become nervous and anxious as they consider what the market will do when it resumes, at which time they will be poised to sell.

Circuit breakers are widely cited today as one of the successes of the crash post-mortems. Yet circuit breakers have only been triggered once, in contrast to some of the so-called "speed bumps" that affect particular trading strategies and are now tripped routinely. (In contrast to circuit breakers, which are coordinated across the equity and derivative markets, speed bumps are trading restrictions that have been put in place by individual marketplaces.) If circuit breakers have been used to halt trading only once, it follows that we have never had sufficient experience of trying to restart trading either. The scariest times during the market crash were those in which trading was not occurring. The tendency to worry more about stopping trading than restarting it is mystifying. Recent reassessments of circuit breakers have focused on increasing the magnitude of price declines necessary to trigger coordinated trading halts. It is not clear that circuit breakers continue to be the best public-policy response to market volatility.

Many features of financial markets have changed over the past decade and are still changing rapidly, not least of which is the continuing growth in international activity. Circuit breakers are much more difficult to impose when trading activity can move to markets that do not participate in the trading halt. The main concerns is the restarting of trading following a halt. If liquidity has moved to over-the-counter markets or foreign venues, that liquidity may not return to the domestic, exchange-traded market when the trading halt ends. Domestic specialists and market makers may have problem in restarting if the market has moved away from them during the halt. Recent changes to shorten the duration of the circuit breakers may ameliorate these concerns somewhat, but these changes also reduces the effectiveness of the circuit breakers in achieving their intended goals.

After the crash of 1987, federal regulators were pressured to prevent any sort of crash again from market manipulation. But no one knows the best way to prevent a crash from occurring. In order to design "preventive measures" that would "protect" the market from dangerous speculative declines, the regulators imposed the circuit breakers that would act as weak restraints and would probably do no harm. Circuit breakers have little to do with the stock market but demonstrate more about the use of regulation. Because of the very weak restraints provided by these circuit breakers, it does seem that their purpose is to cover the backs of the stock-market regulators. Despite the empirical evidence on the futility of throwing sand in the gears of the market, mechanisms like circuit breakers are attractive to policy makers because they offer a relatively low-cost way for regulators to say to the public that they are doing something to try and prevent another crash. If they did nothing to try to prevent another crash, the public would not question the necessity. If nothing was done after the crash, the public would distrust the market and its high volatility. Because of this distrust, investors would be reluctant to put their money in the market and might instead deposit it in banks and the market would decline.

Uniform margin requirements are another change introduced after the 1987 crash. They aim to reduce volatility for stocks, index futures, and stock options. An April 1997 study by Paul H Kupiec, senior economist, Trading Risk Analysis Section, Division of Research and Statistics, Board of Governors of the Federal Reserve System, assesses the state of the policy debate that surrounds the federal regulation of margin requirements. It found no undisputed evidence that supports the hypothesis that margin requirements can be used to control stock return volatility and correspondingly little evidence that suggests that margin-related leverage is an important underlying source of "excess" volatility. The evidence does not support the hypothesis that there is a stable inverse relationship between the level of Regulation T margin requirements and stock returns volatility, nor does it support the hypothesis that the leverage advantage in equity derivative products is a source of additional returns volatility in the stock market. So the question of margins appears to be a red herring.

After the crash, some stock exchanges upgraded their computer systems to improve data-management effectiveness and increase speed, accuracy, efficiency, and productivity. Many stock-market analysts believe that the crash was set off by a number of events that include the poor choices of portfolio insurance professionals and program trading, which made portfolio insurance operational. A portfolio is a collection of stocks. Portfolio insurance, a form of investment, is the guarding of other stock investments against losses. This is regarded as a highly risky way of investing in the stock market because these portfolio insurance professionals rely on their intuition instead of reliable information. These risky investors sell their stocks at a high price when they think the market is declining and their stocks are losing value. But when they feel that the market will increase again, they buy back their stocks at a lower value and use the profit made by the purchase to make up for the monetary losses within the portfolio. This type of massive selling caused the value of the stocks used to decrease below their true value and because of the low value the process would be repeated.

In the summer of 1987 the yield of a 30-year US bond increased to almost 10 percent. Because of this, investors began to shift from investing in stocks to putting their money into bonds, which yielded more money. Program trading was itself also a cause of the crash of 1987. This is when the prices of a stock fall below a preset price, and a programmed computer automatically sells that stock. Within one second, a computer would finalize 60 transactions in 1987. Now it can handle 2,000. These computers were handling trillions of dollars of transactions per second. The market was being controlled more by computers and set prices than by investors who made considered deals. The rises and falls of the stock market echoed the sounds of the computers programmed buying and selling stocks, rather than a dependence on sound judgments made by investors.

The changes brought by the 1987 crash to clearing systems have received far less attention than those to trading systems, but their long-term consequences likely are more profound. Such critical parts of the "plumbing" as the agreements between the futures clearing houses and the settlement banks have been clarified and put on sounder footing. In addition, many clearing organizations have established backup liquidity facilities that will enable them to make payments to clearing members in a timely fashion even if a clearing member has defaulted.

There is now supposedly a better understanding of the way these systems work, but the understanding tended to be through the rearview mirror. During ordinary trading days, market participants rarely if ever question counterparties' ability and willingness to perform on obligations. In the months following the crash, policy makers and market participants began to examine those payment conventions more closely. The bulk of the changes to risk management systems that flowed from the 1987 crash related to efforts to clarify or make more rigorous the responsibilities and obligations of market participants that previously had been left ambiguous or were part of the lore of "normal" market practice.

The options clearing house has strengthened its liquidity reserve and taken other steps to avoid a collapse. Just as significantly, so has the Clearing House Inter-Payments System (CHIPS), the large-dollar clearing and settlement system for the largest US banks and many of their foreign counterparts. CHIPS in 1998 could withstand the simultaneous failure of the two largest banks on the system, a level of safety far greater than that of a decade ago. But banks are merging faster than the divorce rate in Hollywood. It is unknown what a failure of a giant like JP Morgan/Chase or Citibank would mean to the banking system.

Another intangible legacy of the crash is the acceptance of the need for cooperation and coordination among commodity, securities, and banking market authorities. The 1987 crash vividly illustrated the extent to which markets are intertwined and the extent to which large financial firms have lines of business that cut across many markets. The forums for coordination are numerous, the most high-power being the President's Working Group on Financial Markets, which the market has dubbed the Plunge Prevent Team. The Working Group comprises the heads of the Treasury, SEC, Commodity Futures Trading Commission (CFTC), and Federal Reserve and, in addition, other banking supervisory agencies, the National Economic Council, and the Council of Economic Advisors participate. Yet every new crisis resulted in yet another Presidential Working Group, such as after the LTCM episode. None has ben able to prevent new unanticipated crises.

An important change in the financial landscape in the years since the crash has been a greater focus on risk management by both market participants and supervisors. Developments of new instruments, both on and off exchanges, and of new methods for evaluating risk, have given market participants powerful new tools to allow them to absorb market shocks. Similarly, risk management tools have been enhanced at clearing organizations. Yet these new tools do not enhance systemic safety, they merely raise the level of "acceptable" risk for individual participants and transfer them to increase systemic risk. The phenomenal growth of day trading since 1978 also thrived on volatility and systemic stress.

Regulators have been slow to respond to these new tools. Seduced by their benefits, regulators merely approach regulation and supervision in traditional, permissive ways. Greenspan's official approach has been timid on that front. In essence he thinks the benefits outweigh the risks, and that regulation will threaten US financial hegemony. Like Winston Churchill, whose narrow vision failed to transform the British Empire into a lasting sphere of influence for Britain after World War II, Greenspan is also not about to give the empire away voluntarily. Whereas Churchill plunged the British Empire into a sea of revolutionary wars of independence, Greenspan, by insisting on structural advantages for US interests in US-led finance globalization, is plunging the world into a battlefield of economic nationalism and protectionism.

The approach by banking supervisors to developing a universal capital requirement for market risk has been less than adequate. The one-size-fits-all approach has been too lenient for big banks in the advanced economies and too strict for those in developing economies. After initial fits and starts, the Basel Supervisor's Committee halfheartedly embraced the concept of using banks' internal models as a basis for a capital requirement for market risk. Internal models are meaningless when the bulk of the risk facing banks lies in counterparty credit risk. The Federal Reserve has favored an incentive-compatible approach to regulation. Self-regulatory organizations (SROs) obviously find such an approach beneficial, particularly in this era in which SROs are being asked to assume more and more regulatory responsibilities. Incentive-compatible regulation in essence tries to harness the self-interest of market participants to achieve broader public-policy goals, but often only modify those goals to fit private special group self-interest. This approach smells of policy abdication.

By January 1989, 15 months after the crash, the market had fully recovered, but not the US economy, which remained in recession for several more years. When a recession finally hit in full force, three years after the crash, it was blamed on excessive financial borrowing, not the stock market, notwithstanding the fact that excessive financial borrowing itself was made possible by the stock market. The Tuesday after the crash on Black Monday, Alan Greenspan issued a one-sentence assurance that the Federal Reserve would provide the system with necessary credit. John D Rockefeller had made a somewhat similar declaration in 1929 - but failed to buoy the market. Rockefeller was rich, but his funds were finite. Greenspan succeeded because he controlled unlimited funds with the full faith and credit of the nation. The 1987 crash marked the hour of his arrival as central banker par excellence, the beginning of his status as a near-deity on Wall Street. All the world now hums the mantra: In Alan We Trust (an update of the slogan "In God We Trust" printed on every Federal Reserve note, known as the dollar bill). It was the main reason for his third-term reappointment by president Clinton. He is the man who will show up with more liquor when the partying hits a low point.

At a macroeconomic level, public policies are supposed to ensure that markets and the economy itself can withstand shocks. While the 1987 crash escaped significant, real economic effects in the years immediately following, this is not always the case with stock-market crashes. Such episodes are generally accompanied by dramatic increases in uncertainty and increased demands for liquidity and safety. Some of these demands for liquidity may, in turn, reflect the fear that the crisis will spread more broadly to the economy. In 1987, a key role played by the Fed was to demonstrate a determination to meet liquidity demands, and thereby to reassure market participants that problems would not spread beyond the financial system. Problems were contained in this instance, not without cost of "exuberant irrationality". The 1987 market bailout has created widespread complacency. Greenspan has become the main source of moral hazard.

In a speech before the Federation of Bankers Associations of Japan in Tokyo on November 18, 1996, Alan Greenspan said: "This expanded role of governments, central banks, and bank supervisors implies a complex approach to managing and even sharing the risks of failure between governments and privately owned banks. Some of what central banks do might be termed 'shaping' or reducing some kinds of risks, primarily by providing liquidity in certain situations to reduce the odds of extreme market outcomes, in which uncertainty feeds market panics. Traditionally this was accomplished by making discount or Lombard facilities available, so that depositories could turn illiquid assets into liquid resources and not exacerbate unsettled market conditions by forced selling of such assets or calling in loans. Similarly, open market operations, in situations like that which followed the 1987 stock-market crash, satisfy increased needs for liquidity that otherwise could feed cumulative, self-reinforcing, contractions across many financial markets.

"Guarding against systemic problems also has involved, on very rare occasions, an element of more overt risk-sharing, in which the government - or more accurately the taxpayer - is potentially asked to bear some of the cost of failure. Activating such risk-sharing quite appropriately occurs at most maybe two or three times a century. The willingness to do so arises from society's judgment that some bank failures may have serious adverse effects on the entire economy and that requiring banks to carry enough capital to avoid any risk of failure under all circumstances itself would have unacceptable costs in terms of reduced intermediation."

Having said that, the United States would go on to criticize Japan for dragging its feet in cleaning up its banking mess. Since 1987, financial crises have occurred every two to three years around the globe. Greenpsan has already used up his quota of risk-sharing incidents for the century. With the unprecedented polarization of wealth in recent decades, it is amazing that the chairman of the Fed can talk about the socialization of the cost of systemic bank failure without mentioning the need for bank profit sharing with the tax-paying public, and not just among bank shareholders. The risk takers with other people's money, such as top investment bankers and top executives of their bank-holding parents, each routinely take home hundreds of millions of dollars in annual pay. Such winnings remain safely in their private pockets while the loss from their risk-taking is shared by taxpayers. The former chairman of Citibank, John Reed, reportedly earned more than $1 billion during his decade of high-risk lending.

The question is not whether stock markets are overvalued, which can be benignly cured by market corrections. The danger is when market corrections are cumulatively delayed by a dam of financial hedging instruments: the dam will break one day, with overwhelmingly damaging force. The crash of 1987 demonstrated how structural flaws in the financial infrastructure could significantly aggravate a sudden downturn in prices triggered by any one of many possible causes. If trading volume overwhelms the physical ability of the exchanges to handle it, then trade and price information is delayed. The resulting uncertainty can induce many investors to sell before they wait to find out how far their stocks have fallen. Prices can plunge even further if investors fear that the mechanisms for clearing and settling trades will grind to a halt, as they nearly did in the case of the options clearing house in Chicago in October 1987. And contagion can spread if stock prices are falling against a backdrop of weakness elsewhere in the financial system, as was the case in 1987, when many of the United States' leading banks were plagued with problem loans to real-estate developers and less developed countries. In the 2000s, counterparty default in over-the-counter (OTC) derivative trades will no doubt be the weak link in the precarious financial chain.

But that is only the mechanical side of the problem. The demise of LTCM and Tiger Funds showed that even if the trading system can handled the volume, which twice topped 3 billion shares since 2001, the market tends to have difficulty absorbing large liquidation. Large holdings cannot liquidate suddenly and quickly without incurring severe additional harm to themselves. Recent deregulation have directly contributed to bigness in every sector, particularly in the finance sector, thus increasing systemic vulnerability.

The trend toward aggregation, reflected by investors participating through mutual funds, makes the market more susceptible to sudden deep plunges. At the end of 1996, equity funds accounted for 21 percent of the overall market, three times the 7 percent share they had in 1987. Since a good chunk of the new money comes from investors who have never experienced a bear market and who can least afford any loss on their retirement pensions, when a normal market correction occurs, there is widespread concern that these investors will flee from the markets, aggravating any initial selling pressure.

The minutes of the FOMC meeting of March 22, 1994, showed Greenspan saying: "I'd like to take a minute to put the current period in some historical perspective. We have had extraordinary financial turmoil, and it's worthwhile to go back in time and see where it came from and where it's likely to go.

"My impression is that we are looking at the aftermath of the 1987 stock-market crash, which is the first and perhaps the only major stock-market crash in history that actually was beneficial to the economy. In other words, it appeared to me in retrospect that the crash stripped out a high degree of overheating and sort of got right to the edge of where the overheating got into the muscle of the economy and stopped. We came out of it with a very shaken environment but one which recovered relatively quickly. As a consequence of that, from the 1987 stock-market crash on, all the key risk spreads started to narrow. We saw it in, say, this stage of the economic recovery.

"Historically, waiting too long to adjust rates has been a greater risk, and I think it's the one that we need to be especially sensitive to in this current environment. I am sensitive to the financial risks that you point out, but I must say that in one form or another that has been the argument around the table for not moving in the past when we should have moved. It also may be that this point is significantly different from other points historically, but my guess is that if we push on this economy, we will get inflation and we will end the growth. So one can come up with lots of arguments, some subtle, some not.

"I think the important thing is to stick to the basics and go to the heart of the matter. We have an economy that is telling us that we need a less accommodative monetary policy, and in my view we ought to move in that direction decisively. It's surprising, but when people do things decisively, they end up getting better results than if they try to outsmart themselves and consider all the angles in the curve. So, I think we ought to go to the heart of the matter."

By 1994, Greenspan was already riding on the back of the debt tiger from which he could not dismount without being devoured. The DJIA was below 4,000 in 1994 and rose steadily to a bubble of near 12,000 while Greenspan raised the FFR seven times from 3 percent to 6 percent between February 4, 1994, and February 1, 1995, to try to curb "irrational exuberance", and kept it above 5 percent until October 15, 1998. When the DJIA started its current slide downward after peaking in January 2001, the Fed lowered the FFR from 6.5 percent on January 3, 2001, to the current rate of 1.25 percent set on November 6, 2002.

In testimony before the Joint Economic Committee of the US Congress on October 29, 1997, on Turbulence in World Financial Markets, chairman Greenspan stated: "Yet provided the decline in financial markets does not cumulate, it is quite conceivable that a few years hence we will look back at this episode, as we now look back at the 1987 crash, as a salutary event in terms of its implications for the macroeconomy. From the market peak to the October lows the S&P 500 lost 35.9 percent of its value. The S&P 500 regained the lost value about two years later."

The Asian financial crises that began in 1997 did represent temporarily a "salutary" event for US financial markets with flight capital rushing into safe haven in the US, but there was little doubt that it led to the crash of October 1998 when the DJIA fell below 7,000, and the crash of September 2000 when the DJIA fell below 8,000 from its all-time high of near 12,000 nine months earlier in January, and the crash of July 2002 when the DJIA fell to 7,500, and in October 2002 when the DJIA fell to 7,000. The bottom is far from being in sight.

Fed Board member Ben S Bernanke in a speech on November 21 reinforced an earlier Greenspan speech, particularly statements during questions, that the Fed would not be out of bullets even if the FFR fell to zero, as it can move out to longer-term debt instruments to drive interest rates down. Bernanke said: "The US government has a technology, called a printing press, or today, its electronic equivalent, that allows it to produce as many US dollars as it wishes at essentially no cost." It is an amazing statement from a Fed Board governor.

Of course, the last part of the statement is inoperative: the cost is inflation. There is not much wrong with the Fed printing money, as it has been doing since 1971 when Nixon took the dollar off the gold standard. The question is how the money is injected into the system, and toward whom. By bailing out credit-impaired illiquid banks, the money will only go to fuel more speculative excess, or to keep corporate walking deads walking, as Japan has discovered. At least Japan has a rationale for its madness, which is the cultural fix of the role of national banking: to feed the industrial sector of the economy. The Japanese economy does not exist to feed the banks, as the US economy does. This is why bank bailouts in Japan makes some sense while they do not in the United States.

Next: The Lesson of the US experience