The Recessionary Period After the Black Monday

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Table of Contents

Black Monday
The effects
The Federal Reserve
Works Cited

Black Monday

Black Monday was on October 19, 1987, when stock markets around the world crashed unexpectedly leading to a period of recession in its aftermath. In the United States (US), the Dow fell by a wide margin, and other crashes were witnessed in the options and futures markets. Panic selling led to widespread declining prices throughout the day, which peaked during the last hour of trading. The increased trading activities of the day overwhelmed the systems in place due to the large total trading volume, and at the close of the trading that day, many orders were unfulfilled. This paper discusses the events that led to the stock market crash of Black Monday in the US, how Doe responded, and the impact of the economy with a focus on the major macroeconomic variables – GDP, employment, and economic growth. The paper also highlights how the federal government responded to the crash through fiscal stimulation plan to assess whether such efforts were appropriate and effective.

By the time investors in the US resumed work on Monday, October 19, 1987, global markets were already collapsing and when the markets opened on withered liquidity, players, especially in risk arbitrage, started and continued selling as much as they could. According to Maley, this crash was mainly a trading event, as opposed to an economic or fundamental one. Portfolio insurance was popularized in 1987, and investment companies were worried that their profits would not be sustained throughout the year. Therefore, institutions who had bought the portfolio insurance product “engaged in an agreement to sell short S&P 500 futures if the stock market fell by a certain amount; this would allow them to offset any losses that a meaningful decline would inflict on a portfolio” (Maley). This approach departed from the stock market traditions where investors only sold aggressively into a falling market. The problem with portfolio insurance was that investors did not have to sell, but they had to, especially into a falling market, as part of a contractual agreement. The decision to sell was based on a mathematical formula, and thus triggers to sell would be raised if the market fell to a certain level. The problem occurred when other investors in different areas were prompted to sell at the same time. Therefore, when the market fell on Friday, October 16, 1987, when Washington failed to promise to withhold the Rostenkowski committee’s takeover bill (Maley). Many takeover stocks dropped sharply on that Friday and investors started to sell as much as possible based on the mathematical formula noted earlier. Therefore, by the time the US markets opened on Monday, overseas markets were in a panic, and everyone went into panic selling, ultimately compounding the crash. According to Rosenbaum, the Dow dropped by 508 points to close at 1,738.74, which was more than 20% of the entire US stock market at the time. The Dow fall was 22.6%, which was a historic drop since December 1914. However, the federal government intervened to prevent further drop, and the down recovered on Tuesday and Thursday as discussed elsewhere in this paper.

The effects

Despite the momentum and the unprecedented magnitude of the Black Monday stock market crash, the effects were primarily felt in the financial markets only. The US economy did not experience significant changes. Similarly, the GDP and employment rates were not affected in any meaningful ways. By Tuesday, October 20, 1987, the Dow rebounded unprecedentedly, and within three trading days, it had gained 288 points, and by September the same year, it has recovered all losses that were incurred due to the crash (Rosenbaum). Therefore, in terms of macroeconomic variables of unemployment, GDP, and economic growth, the Black Monday market crash did not have significant negative impacts. However, the impact of this crash was contained within the financial market due to a raft of measures that the federal government initiated on that Monday when this incident occurred. The quick response to intervention by the Federal Reserve (Fed) Chairman, Alan Greenspan, saved the spillover effect of this crisis on the economy, as discussed in the next section.

The Federal Reserve

After the US investors woke to a falling stock market on Black Monday, the Federal Reserve acted swiftly. That day, the Fed chairman released a statement saying, “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” (Berry). The crisis management was precise using different tools at the disposal of the Fed, such as direct intervention, requesting lending institutions to loan money to securities businesses, liquidity supply through open markets, and public announcements. First, the stock market was in desperate need of liquidity, and thus the Fed acted by pumping its reserves into the market through widespread purchases in the open markets (Berry). The Fed continued with this trend for weeks, ultimately providing the needed liquidity and preventing the crisis from permeating other economic sectors. In addition, the Fed chairman employed an ingenious tactic to prevent continued panic selling, which could have affected the market liquidity adversely. Every evening, he would announce how the Fed planned to inject more money into the financial system through the open markets, thus creating confidence among investors. Consequently, investors were not worried about selling their stocks because they were assured of liquidity. Second, on the one hand, the Fed applied the moral suasion strategy to persuade lending institutions to loan money to securities firms. On the other hand, the Fed promised banks that it would support their liquidity by actively supplying them with the needed money (Berry). This strategy worked as Dow rebounded and the markets recovered within a short time to recoup all the losses made during the crisis within one month.

The policies that the Fed used were effective because the market recovered fully within a month without the effects of the rash spreading to other areas in the economy. As discussed earlier, the crisis was largely caused by panic selling due to a combination of factors. During such time when investors are selling risky assets, liquidity becomes a major problem. Therefore, the Fed acted swiftly and precisely to address this issue by releasing a statement on the day of the crash. The fiscal strategy targeted the correct sector by coming up with measures to ensure liquidity in the financial sector. The Fed used a two-sided strategy to achieve this goal by injecting money directly into the system through the open markets and supporting banks to lend to securities firms. As such, the Dow rebounded instantly to gain 288 points within three trading days and recover fully within a month. Therefore, it suffices to conclude that the Fed’s fiscal intervention was effective and enough to address the problem.