The recent weakness and volatility of financial markets here and abroad have been perplexing. Since the US economy has been growing fairly steadily, the markets, which had fallen in value by as much as 10 percent since February, evidently do not reflect the state of the economy. The recent increases in interest rates imposed by the Federal Reserve to prevent inflation have been criticized for threatening the economic recovery, especially since inflation has barely increased. In any case while the costs of some loans, particularly mortgages,have risen, they cannot possibly just by themselves have a large economic effect, even though sharp turns in the market are attributed to them. The explanation for the shaky condition of the financial markets has to be found elsewhere.
Some clues to the recent weakness of the markets can be found in the international controversies of the last seven years or so. In October 1987, the US government publicly criticized Germany for maintaining what the US considered artificially high interest rates. Some investors feared that the longstanding German-American relationship was about to come apart and that this would have unfortunate consequences for financial stability generally. Two days later the Dow-Jones Industrial averages fell by over 500 points and the financial system itself seemed in danger. While other factors were undoubtedly involved in this collapse, the quarrel between the US and Germany appears to have been critical. What also soon became clear as well is that technical innovations such as “computerized program trading” and “portfolio insurance” could result in sudden sales of enormous numbers of shares and turn downward market pressures into panic.
In February 1994, the talks between the US and Japan, which were intended to resolve differences on trade issues, broke down acrimoniously. The international managers of the “hedge funds” that control the investment of hundreds of billions of dollars evidently feared that the US, in carrying out a policy of retaliation against Japan, might depress the value of the dollar to make US exports more attractive. The result was that speculative holdings of investments in foreign bonds and foreign currencies-particularly investments of traders who had bet against the yen-were sold, disrupting financial markets throughout the world. The abrupt decline in the bond markets caused a general rise in interest rates. While US markets were relatively unscathed, markets in East Asia and Latin America were harshly affected, and European bond markets were so weakened that some dealings in French government bonds were temporarily suspended. In Spain, Italy, and Scandinavia, sellers were unable to find buyers for relatively routine bond transactions for a few days. As in October 1987, there were more factors in play than just the breakdown of the US-Japanese talks-the recent tightening of interest rates by the Federal Reserve being perhaps the most important among them. But there seems to me no doubt that the event that set off tremors in financial markets was the quarrel between Japan and the US.
It is worth remembering these events as we assess …