Why Government Meddling is Necessary in Broken Markets

(This original article from January 31st is bumped due to deteriorating financial condition and current legislative action to curb lending practices.)

There has been a lot of discussion here lately about economics. The subprime mess is clearly influencing the stock markets and leading economic indicators negatively, although reasonable people will disagree on the long-term economic outlook.

Some experts expect we will enter a recession over the summer, some say we may see it in the current quarter. A few optimists believe the current crisis is overblown and we will only see slower growth.

Irrational exuberance is what often leads to large stock market corrections. Eventually, investors wake up to the realities of underlying weaknesses in an economy that have been hidden. I’m not saying that the current correction is a crash. It is not as severe as two other drops in our generation, but it is worrisome.

The reason for the sudden downturn this year is the usual. Investors have woken up to the fact that the irrational exuberance of subprime mortgage lenders may have done a lot of damage to the economy.

When the stock market faces a sudden crisis of confidence, we have leaders in positions of power to mitigate the damage. This January, the Federal Reserve Board acted swiftly to ease a credit crunch by lowering interest rates by 75 basis points in an emergency meeting. They followed that action a week later with another 50 basis point reduction.

Their actions are astonishingly unprecedented, creating more inflationary pressures at a time when economic data is already showing rising prices. But something sudden was needed because the Fed and lawmakers were asleep as the subprime problem festered over the last years. And now we have lawmakers scrambling to pass a Keynesian-style giveaway to consumers that will increase the consumption portion of GDP, but further risk inflation.

Regardless, the significant interest rate reductions eased a potential market meltdown, although it may be like putting a band-aid on a gaping wound. The recession will probably still come, but the landing will be softer as a result. That is what the Fed typically tries to do: soften the landings while avoiding actions that cause more long-term harm than good.

Sometimes, we have brilliant market managers who through exceptional leadership can steer us away from recession entirely, which brings me to the purpose of this post.

October 19th, 1987, was one of the worst days in Wall Street history. $500 billion dollars was lost before noon as the market plunged 23%, coming on the heels of a miserable week which preceded it. That was the largest nominal drop in history, which would be equivalent to a 3,000 point drop today. That time, the underlying cause was a sudden realization that the leveraged buyout craze financed by junk bond derivatives was a disaster.

As the market tumbled that day, nervous lending windows closed up tight and nobody could find money to cover their positions. Trades could not be made, and panicked lenders were calling in their rights. A key bank had no cash. The market was poised to fall off a cliff, just like happened after the crash of 1929, when a one day crash precipitated a downward spiral in which the stock market lost 90% of its value and ushered us into the depression.

This is why we have Federal Reserve Boards, Treasury Secretaries and an SEC, but they don’t always rise to the occasion. On Black Monday in 1987, Alan Greenspan and the other market managers rose to the occasion. Their skillful leadership went way beyond the scope of their official duties, and it worked brilliantly.

October 19th, 1987 was Greenspan, Rubin, and others’ Rudi Giuliani moment in history. Not only did they right the market, but their actions avoided a recession entirely. I am still looking for a terrific play-by-play account of what was done that morning, but I cannot find it today so use the URL in the prior paragraph for now.

Incidentally, it is now fashionable to paint Greenspan as a reluctant accomplice or lucky bumbler, such as what Bob Woodward did to sell a book. And a few partisans want to blame him for Bill Clinton’s election. However, presiding over 20-years of unparalleled prosperity as the longest-serving Fed Chairman in history while skillfully navigating through crises, earns him a spot among the giants in our nation’s history.

The market managers learn from these moments in history to make the markets work more efficiently. They learned after 1929 to inject liquidity immediately during a crash (short-term fix) and increase margin requirements (long-term fix).

In 1987, they learned more. The practice of junk bond financing was curtailed and new financial disclosures were required in corporate financial statements. Automatic stop-losses were put in place to stop a downward trading spiral. A permanent working group was formed which meant that the market managers could coordinate a response quickly. That team was used to great effect on a day in 1989 when the market tumbled 500 points.

Now what do they learn from the current crisis? A major stock market crash was avoided for now by dramatically dropping interest rates, loosening credit, and giving away money to consumers. But the underlying danger remains, which is why the practice of variable-rate, subprime mortgage lending should (and will be) severely curtailed.

If only the markets worked efficiently at all times. They do not sometimes, and that is when the government market managers step in to meddle. Hopefully they will get it right this time.