The market convulsions of the last few weeks have shaken the world. We are still far from understanding exactly what happened and why; but we know that without the intervention of governments a serious financial crisis would have gone out of control. For the moment they have succeeded in stabilizing the situation and we may have bought the time, and created the political climate, to deal with some of the causes of these convulsions. We are still facing, however, an extremely volatile and dangerous situation.
Before looking for “solutions” to “problems” we must get some perspective about what the facts are and how they are related to one another. Most of the time the facts themselves will point, if not to the solution, at least to a direction that, over time, can improve the situation.
In the case of financial market crises the difficulty in getting facts is compounded by the psychological factors connected with the market. Trying to outguess the markets may be interesting but it is highly uncertain. We really know very little about why the markets collapsed at this particular time. The federal budget and trade deficits were not new; nor was pressure on the dollar, which, only recently, was supposed to be a positive development. Relatively modest increases in interest rates earlier this year were thought to be troublesome but far from disastrous. The underlying economic statistics were unchanged for some time.
Was there anything really new? The answer may be that what was new was that the Dow Jones average reached 2700 and that the market was being driven upward by the most aggressive level of speculation seen in decades. Continued irresponsible fiscal behavior on the part of government combined with continued irresponsible behavior on the part of the financial community, throughout the world. The crash occurred, ricocheting around the world.
What happened subsequently is also worth noting:
1) The day after Black Monday the markets threatened to go into free fall and we came within an eyelash of shutting down our markets in the face of an uncontrollable panic. What saved the situation, at that time, was not only the self-correction of a free market but vigorous, direct intervention by government and business. The Federal Reserve injected billions of dollars into the system and drove down interest rates; a number of blue-chip companies announced huge programs to repurchase their shares. The result was to drive the market averages back up. The Japanese government urged its securities industries to support the Tokyo market.
2) In addition to the effects of this swift and direct intervention, confidence was maintained by the existence of safety nets and regulatory bodies created by the New Deal during the 1930s—the Federal Deposit Insurance Corporation, Social Security and unemployment compensation funds, the SEC, federally guaranteed pensions, etc. There was not a murmur of concern about the soundness of the banking system, since the public assumed, correctly, that the government was the lender of last resort.
3) The market may or may not recover; only time will tell. But the market collapse revealed important fundamental weaknesses. For some days after Black Monday, the securities market as we knew it ceased to exist. It became a commodities market, with no relation to real values. For many stocks the process of making a market just disappeared; and liquidity to purchase falling stocks was at times mainly provided by corporations buying back their own shares. Large losses created by speculation on paperthin margins are just beginning to be recognized. Volatility created by computerized stock trading programs, which very few complained about when the market was going up, was recognized as unstabilizing and it was temporarily suspended. The interaction of US markets with foreign markets and with the foreign exchange markets, continuously carried on television, created chain reactions that were almost impossible to control.
If these observations are factually correct, they suggest that even though some stability may return to the markets at lower levels than this summer, we will still be faced with the need to reform the markets and reduce the level of speculation, together with a need to change government policy. It is not realistic, either politically or economically, for the financial community to insist on difficult changes in government policy without recognizing the need for change in private financial behavior. We in the financial community are part of the problem. We have to be part of the solution.
The changes required in government behavior are conceptually simple but they require delicate and sophisticated execution. As practically all observers have said, the US needs to reduce its borrowing; and to do so it must reduce its budget deficit. At the same time the European nations and Japan should stimulate their economies, helping the US to reduce its trade deficit. All this is easier said than done. We have waited very late for deficit reduction. Whereas two years ago the economy was strong enough to withstand both a tax increase and spending cuts with very little risk, this is no longer the case. No one can tell whether the decline in the stock market has set off a recession or whether harsh deficit reduction, at this delicate time, would do so.
I believe that we have now no other choice than to go ahead with a serious deficit reduction program. How we do it—and what other actions are taken by us and by our foreign partners—is more important than whether the budget is cut by $23 billion, $27 billion, or some other amount. The risk of a recession is very real and our weapons to fight recession very limited. In addition to the existing deficit, the billions of dollars the government has recently printed to support the financial markets have probably strained the capacity of foreign central banks to support the dollar indefinitely. Financing a $250 to $300 billion deficit in a recession would pose a serious challenge to the financial system. The least burdensome, and most credible, deficit reduction package would probably include a twenty to twenty-five cent per gallon gasoline tax, phased in over two to three years, coupled with an across-the-board freeze on all spending for one year. During the one-year freeze a fairer allocation of burdens could be determined by Congress to be put in place for the rest of the program. The objective should be a three-year program aimed at reducing the deficit steadily but not brutally through 1990. Trying to do more than this now would, in my view, be dangerous.
At the same time, the Federal Reserve, together with the central banks in Europe and Japan, would have to reduce interest rates aggressively, say by at least 2 percentage points. Interest costs are such a large part of the federal budget that a saving of $10 to $15 billion a year could easily result from such action.
All such measures, however, will not deal adequately with the rest of the world. Further reduction of the value of the dollar, advocated by many and probably inevitable as a result of our recent actions, can also be harmful. It is hard to induce foreign capital into our markets if, in addition to normal investment considerations, the investor has to factor in a possible currency loss of 10 to 20 percent as well. Furthermore, economies that are driven by exports, especially Japan’s, can be pushed into recession or worse by a too-abrupt devaluation of the dollar. The overvalued Japanese securities markets can still collapse. They have to be lowered gently.
These realities would argue for a conference to reconsider world financial arrangements comparable to the one at Bretton Woods in 1944. Such a conference should deal with currency stabilization, including a possible dollar devaluation of about 10 percent in relation to the deutsche mark and the yen, and stronger direct linkages between the main currencies, as well as serious efforts to restructure third world debt. Growth in the third world is still a critical factor in any Western economic recovery program; it cannot happen without considerable relief from existing debt service and a supply of new capital, mainly from Japan and West Germany. A new Bretton Woods conference could obtain such commitments for debt relief and new financing as part of a rearrangement of currency markets and a reinforced role for the World Bank and the IMF with respect to third world debt. Our trade negotiations with the Japanese leaders should emphasize the importance of a commitment on their part to assistance with the third world debt problem, as part of our commitment to maintain an open world trading system.
Such new financial policies will be difficult to carry out and will require close coordination with other governments. Coordination without American leadership is unlikely; yet for the US to take the lead now will require steady and clear direction, not simply scaring the rest of the world with the swings of our markets. It means having our financial house under control.
The market collapse, as I indicated earlier, was at least as much caused by excessive speculation and irresponsible private financial behavior as it was by irresponsible financial behavior on the part of government. The principal form of such private behavior has been the creation of excessive debt. The deregulation of the financial markets together with new financial products made possible by market technology—such as futures trading and programmed trading—has produced a stunning amount of business debt and personal debt as well as huge off–balance sheet commitments not sufficiently recognized as liabilities. In a period of steady business expansion, American nonfinancial corporations retired $250 billion of capital in excess of what they have issued over the last three years, largely by substituting debt in the form of bonds. As part of this proliferation of debt, about $150 billion in junk bonds has been issued during the last few years. A substantial number of these bonds were used in connection with takeovers, restructurings, and leveraged buyouts, and their real impact has yet to be measured. How they will fare in a recession is a question for the buyers. Whether the businesses can service the debt they owe to the bondholders, while investing for growth, is a question for management.
It is also fair to say that institutional investors have encouraged and significantly participated in this behavior. Among the chief buyers of this paper have been pension funds, insurance companies, thrift institutions, and banks. They have also encouraged the notion that immediate stock price increases are more important considerations than long-term investment and growth. Often they have driven managements to radical restructurings, whereby future earnings are distributed by borrowing in order to “maximize value” and as a protection against takeovers. It may be that pension funds, insurance companies, and other institutional investors need legislative changes in order to have more flexibility concerning what constitutes their “fiduciary responsibility,” and that what some conceive as an obligation to make shortterm gains should come under review. But the philosophy behind much of the recent short-term institutional activity has been wrong, in my judgment. Much more emphasis should be put on investment geared to long-term growth.
Commercial banks also played a role in this explosion of debt. If investment bankers created junk-bond debt, commercial bankers (urged on by their governments) created third world debt. One trillion dollars of debt is now growing annually by the amount of interest that is lent to the borrowers. It is choking growth in half the world and will never be repaid. The Congress will soon consider repeal of the Glass-Steagall Act in order to permit US banks to enter those parts of the securities business in which they are not already active. I believe a case can be made for the repeal of the Glass-Steagall Act in order to put US banks on an even footing with their foreign competitors.
However, before such a change is made, a review of current banking regulation is in order. According to published reports, the Continental Illinois Bank of Chicago had to inject $650 million into its subsidiary, First Options Corporation, in order to keep it afloat during the market crash. So far, the bank appears to have lost almost $100 million as a result of its options trading activity during the current quarter. It is hard to believe that a bank recently bailed out of bankruptcy with $4.5 billion of FDIC money (ultimately backed by the US taxpayer) was permitted to acquire an options trading house requiring $2.5 billion of operating funds in the first place; and it is harder to understand how it was subsequently allowed to get out of control. The dividing line between a holding company and a bank is not solid enough to permit this kind of risk-taking. A number of questions concerning banks—the adequacy of their capital, the extent of their risk-taking, the lines of business in which they should engage—should all be subject to more careful scrutiny by legislatures and by the financial community itself.
The same goes for the securities industry. We have lived with the illusion that 1929 could not recur because of high margin requirements and less speculation in securities on credit. But such restrictions have only applied to individual investors who are subject to the 50 percent margin rule. In the case of professional market makers dealing in options and futures the ratios of credit to cash can be astronomical. The same is true of speculations in foreign exchange and commodities futures. Margin requirements on options and futures must be sharply increased.
The securities business used to consist of relatively small firms that provided financial advice to individuals and corporations and distributed securities. It was a service business and did not require large amounts of capital; nor did it involve the assumption of large risks. It has evolved into a business in which very large firms make large capital commitments, often involving very high risks. Again, the proportional risk has become enormous. A firm that in 1980 may have had seven hundred employees, capital of $200 million, and total commitments of $2 billion may now find itself with five thousand employees, $1 billion of capital, and $30 billion or more of commitments. The creation of holding companies has enabled securities firms to carry even more outstanding obligations. Several of our securities firms are today larger than most banks.
The language used by our business tends to play down the element of risk, but the reality is different. “Risk arbitrage” is a very important activity for many firms; it is, however, mostly risk and not very much arbitrage. In reality, risk arbitrage is mostly speculation in takeover stocks. The so-called bridge loan is the latest innovation in “creative financing” of corporate takeovers. It is a bridge only as long as bond refinancing, mostly of the junk-bond type, is available to repay the loan; under present market conditions, it may be a very long and shaky bridge indeed.
Similar semantic problems obscure the arguments about takeovers. What makes a takeover unsound and damaging is not whether it si friendly or hostile but whether it is fair to the shareholders, whether it is soundly financed, and whether it makes industrial sense. Our failure in the financial community has been consistently to underestimate risk and to tolerate financial structures that are undercapitalized and whose assets are overvalued.
The financial community is not alone, however, in underestimating risk. Academics and intellectuals have done so as well. The virtues of deficit finance have been sung by the most conservative publications and economists, under the name of supply-side economics. Our leading business papers and magazines have lionized raiders and junk-bond kings, and the op-ed pages have been filled with academic writings claiming that high levels of debt are sound because they concentrate the mind of management. This is the environment in which we still function, notwithstanding recent events.
I have been involved twice in financial crisis management, first between 1968 and 1970, as chairman of the New York Stock Exchange’s surveillance committee dealing with the market crisis of the 1960s, and later as chairman of New York’s Municipal Assistance Corporation, dealing with the New York City fiscal crisis of 1975. The recent market crisis and the economic problems facing the world obviously pose difficulties of a vastly different order, but some of the problems are similar and some of the same remedies seem applicable. The problems include unreliable data, unstable and volatile markets, shrill and conflicting expert advice, high levels of attention from television—probably the worst medium for explaining complicated, abstract issues. The remedies we should be looking for would include finding calm, stable political leadership, which means bipartisanship; not running after markets but, on the contrary, trying to get ahead of them through credible, long-range plans; making stability and a sense of security the first priority; making those who were part of the problem part of the solution. I believe that Alan Greenspan, chairman of the Fed, and John Phelan, chairman of the New York Stock Exchange, have performed superbly in controlling the crisis, a fact that deserves much greater public recognition than it has received.
A broad study of our financial markets should now be undertaken as soon as possible. The presidential commission headed by Nicholas Brady of Dillon Read is charged with a review of market volatility, but its work, I suggest, should be more broadly conceived and should more closely reflect the structural concerns of the Cohen Commission appointed by the Congress in 1961. I believe that such a study would find that a number of reforms are urgent: greater capital adequacy; less risk-taking; elimination of computer-driven trading and portfolio insurance programs; significantly greater margin requirements on futures and options trading; more stringent, and possibly multinational, regulation for commercial banks, thrifts, and securities houses. Furthermore, if commercial banks and securities houses are going to compete across the board, the role of the Federal Reserve as a lender of last resort must be reexamined to apply not only to commercial banks but to securities firms as well. The recent and very successful action of the Bank of England in stabilizing the £12 billion issue of British Petroleum shares could serve as an example. By committing itself to acquire shares at a given price, notwithstanding the fall in the market, the Bank of England reassured investors and helped avoid a disaster.
The list of problems requiring urgent attention is a very long and complicated one. The level of sophistication and cooperation that will be required among government officials not only in this country but around the world will have to be very high. We will also have to be very lucky. It has taken us many years to get to where we are today. It will take many years, at best, to get back to real stability.
In the meantime, government must go on, and the questions it must face will not be dealt with just by budget cutting. This country has huge unmet needs—for investment in public facilities ranging from schools to water works; for an improved public education system; for protection of the environment; for insurance against catastrophic illness. Hard choices will have to be made since adequate new funds will not be available. Taxes will have to be raised and entitlements may have to be subjected to means tests. Military spending will have to be managed carefully and reduced wherever possible. Fortunately for us, the Soviet Union has even more serious problems than we do and seems open to arms negotiation.
The President and the Congress might well consider the appointment of a prestigious, bipartisan commission, somewhat along the lines of FDR’s Temporary National Economic Commission in the late 1930s, to advise the Congress and the Executive about the challenges facing the economy in the long term. Governor Cuomo and others have suggested this approach, and legislation has been introduced in Congress that could bring it about.
We have no way of predicting the nearterm action of the securities markets. If they stabilize, the current crisis may appear to be behind us. But the fundamental problems will not have changed. On the contrary, throughout the world tens of billions of dollars have been spent by central banks to stabilize the markets, confidence has been eroded, and huge values in paper assets have been eliminated. We have had a very severe warning; another warning may come too late.
—November 4, 1987