Final Project

CIRSES 1987 ANITA NIKAM On Monday, October 19, 1987, stock markets around the world crashed, shedding a huge value in a very short period. The crash began in Hong Kong, spread west through international time zones to Europe, hitting the United States after other markets had already declined by a significant margin. The Dow Jones Industrial Average (DJIA) dropped by 508 points to 1739 (22.6%).By the end of October, stock markets in Hong Kong had fallen 45.8%, Australia 41.8%, Spain 31%, the United Kingdom 26.4%, the United States 22.68%, and Canada 22.5%. New Zealand's market was hit especially hard, falling about 60% from its 1987 peak, and taking several years to recover. (The terms Black Monday and Black Tuesday are also applied to October 28 and 29, 1929, which occurred after Black Thursday on October 24, which started the Stock Market Crash of 1929. In Australia and New Zealand the 1987 crash is also referred to as Black Tuesday because of the time zone difference.) The Black Monday decline was the largest one-day percentage decline in stock market history. Other large declines have occurred after periods of market closure, such as on Monday, September 17, 2001, the first day that the market was open following the September 11, 2001 attacks. (Saturday, December 12, 1914, is sometimes erroneously cited as the largest one-day percentage decline of the DJIA. In reality, the ostensible decline of 24.39% was created retroactively by a redefinition of the DJIA in 1916.) Interestingly, the DJIA was positive for the 1987 calendar year. It opened on January 2, 1987, at 1,897 points and would close on December 31, 1987, at 1,939 points. The DJIA would not regain its August 25, 1987 closing high of 2,722 points until almost two years later. A degree of mystery is associated with the 1987 crash, and it has been labeled as a black swan event. Important assumptions concerning human rationality, the efficient market hypothesis, and economic equilibrium were brought into question by the event. Debate as to the cause of the crash still continues many years after the event, with no firm conclusions reached.

In the wake of the crash, markets around the world were put on restricted trading primarily because sorting out the orders that had come in was beyond the computer technology of the time. This also gave the Federal Reserve and other central banks time to pump liquidity into the system to prevent a further downdraft. While pessimism reigned, the DJIA bottomed on October 20. Following the stock market crash, a group of 33 eminent economists from various nations met in Washington, D.C. in December 1987, and collectively predicted that “the next few years could be the most troubled since the 1930s.” On Monday, October 19, 1987, the Dow Jones Industrial Average fell to 1738 points from 2246 points, triggering a reduction in the value of all U.S. outstanding stocks and earning that fateful day the unenviable title of Black Monday.But while much attention is paid to October 19 because of the harrowing situation, October 1987 in general was a trying period, as key stock indexes lost over 30 percent of their value in the U.S. The response was quick and decisive as the U.S. central bank and the Fed stepped forward to help during this event. Experts believe that it was the quick thinking on the part of the two aforementioned entities that enabled both the Dow and the S & P which had fallen to 225.06 points from 282.7 points on Black Monday to regain their lost value within 24 months. The relatively quick recovery eliminated the very serious possibility of a recession. The stock market crash of 1987, according to some reports, signaled the end of a five-year bull market. But the market proved to be more resilient following the crash of 1987 than it had been following the crash of 1929. The day after the crash of 1987, for instance, the market posted a record single-day gain of 102.27. Many explanations have been given to account for why the stock market crash of 1987 occurred, but none of them provide a full explanation for the happenings on that blackest of Mondays. Also confounding to some experts is how soon the markets rallied following a serious setback. A number of changes were introduced after the 1987 debacle. For instance, more stipulations were applied to program trading. which involves computers programmed to automatically order stock trades whenever certain marketplace conditions are present. Currently, if the Dow drops more than 250 points in a day,

program trading is prohibited to provide enough time for dealers and brokers to touch base with their clients. At the end of the day, however, many believe that if the 1987 crash had one positive impact it was that it warned the powers that be, yet again, that market discipline is necessary. CRASH There is no numerically-specific definition of a crash but the term commonly applies to steep double-digit percentage losses in a stock market index over a period of several days or A precipitous drop in market prices or economic conditions also called crash. "A stock market crash is a sudden dramatic decline of stock prices across a significant cross-section of a stock market. " "What goes up must come" down are the simple lines but when it applies to stock market,this old saying carry a lot of weight.because when a stock market comes down after having went up over a long period, the devastation it sometimes leave behind is horrible.Crashes usually occur under the following conditions:  A prolonged period of rising stock prices and economic optisim,  A market where P/E ratios exceed long-term averages, and  Extensive use of margin debt and leverage by market participants The Stock Market Crash of 1987 The stock market crash of 1987 was the largest one day stock market crash in history. The Dow lost 22.6% of its value or $500 billion dollars on October 19 th 1987! In order to understand the crash, we must first study the cause. 1986 and 1987 were banner years for the stock market. These years were an extension of an extremely powerful bull market that started in the summer of 1982. This bull market had been fueled by hostile takeovers, leveraged buyouts and

merger mania. Companies were scrambling to raise capital to buy each other out, in essence. The philosophy of the time was that companies would grow exponentially simply by constantly purchasing other companies. In leveraged buyouts, a company would raise massive amounts of capital by selling junk bonds to the public. Junk bonds are simply bonds that have a high risk of loss, so they pay a high interest rate. The money raised by selling junk bonds, would go towards the purchase of the desired company. IPOs were also becoming a commonplace driver of the markets. An IPO is when a company issues stock for the first time. “Microcomputers” were also a top growth industry. People started to view the personal computer as a revolutionary tool that will change our way of life, and create wonderful profit opportunities. The investing public was caught up in a contagious euphoria, similar to that of any other bubble and market crash in history. This euphoria made people, once again, believe that the market would always go up. THE CRASH OF 1987 In the days between October 14 and October 19, 1987, major indexes of market valuation in the United States dropped 30 percent or more. On October 19, 1987, a date that subsequently became known as "Black Monday,".The Dow lost 22.6% of its value or $500 billion dollars on October 19 th 1987.The Black Monday decline was the second largest one-day percentage decline in stock market history. Initial blame for the 1987 crash centered on the interplay between stock markets and index options and futures markets and many blamed program trading strategies for blindly selling stocks as markets fell, exacerbating the decline. Some economists theorized the speculative boom leading up to October was caused by program trading, while others argued that the crash was a return to normalcy. Market crashes are random, unpredictable events,certain warning signs exist, which characterize the end of a bull market and the start of a bear market. By learning these common warning signs, you can liquidate your investments and prosper by shorting the market. New York - On October 19, 1987, the Dow Jones Industrial average declined 22.6% in the largest single-day drop in history. Black Monday, as it has become known, was almost twice as bad as the stock market crash of of October 29, 1929 . The 1929

decline approximated 11.7% and started the Great Depression.The Securities Exchange Commission, academic professors, financial writers and every financial security firm has analyzed the stock market crash of 1987 in about every way possible. Some believe the market crash was caused by an irrational behavior on the part of investors. Some analysts believe that excessive stock prices and computerized trading were the cause. The key finding is that no single news event occurred that could account for the crash. The stock market was doing quite well for the first nine months of 1987. It was up more than 30%, reaching unprecedented heights. That was after two consecutive years of gains exceeding 20%. By 1997, interest rates began to climb. Three days before Black Monday, the stock market gains for the year dropped by 11.6%, including the effects of a 9.5% drop on October 16, 1987. The three day drop was caused be several macroeconomic factors. Long-term bond yields that has started 1987 at 7.6% climbed to approximately 10%. This offered a lucrative alternative to stocks for investors looking for yield. The merchandise trade deficit soared and the value of the U.S. dollar began to decline. After a speech by Treasury Secretary Jim Baker, investors began to fear that the weak US dollar would cause further inflation. On Monday, the Dow dropped about 200 points or 9% in the first hour and half. During the day, most institutional investors implemented various computer-based portfolio insurance programs. Portfolio insurance was destabilizing because it required selling stock as prices declined. The more stocks fell, the more stocks were sold. As the market did not have the liquidity to support the sales, the stock market fell even further. Buyers waited, knowing the more the market dropped, the more selling would have to take place. By the end of the day, the Dow had lost 508 points. One important lesson came out of the stock market crash - is that investors who sold, took a bath. Those who held and continued a disciplined and systemic approach received rewards. In fact, by the end of 1997, total return for the year, including dividends, approximated 5%. TIMELINE Timeline compiled by the Federal Reserve. SIn 1986, the United States economy began shifting from a rapidly growing recovery to a slower growing expansion,

which resulted in a "soft landing" as the economy slowed and inflation dropped. The stock market advanced significantly, with the Dow peaking in August 1987 at 2722 points, or 44% over the previous year's closing of 1895 points. On October 14, the DJIA dropped 95.46 points (a then record) to 2412.70, and fell another 58 points the next day, down over 12% from the August 25 all-time high. On Friday, October 16, the DJIA closed down another 108.35 points to close at 2246.74 on record volume. Treasury Secretary James Baker stated concerns about the falling prices. That weekend many investors worried over their stock investments. The crash began in Far Eastern markets the morning of October 19. Later that morning, two U.S. warships shelled an Iranian oil platform in the Persian Gulf in response to Iran's Silkworm missile attack on the U.S. flagged ship MV Sea Isle City. TIME BEFORE CRISES Now it is turn to talk about the period before the crises of 1929 and 1987. What a kind of period was it? What were the conditions? Well, almost each person in the United States of America was a participant in the process of buying, selling different shares. Everyone thought about money. It was the period of speculators. For shareholders the best way to save money, to their mind, was stock. But it turned to be wrong. It was just a hypothesis. Was it really safe?During the researching the situation in 1987, the situation was the same. People were so stupidly involved in the process of buying stocks that they forgot that terrible crisis. It was true endless process: big companied wanted to be larger with the help of small one by buying the shares. After that they sold unnecessary bonds to others with elevated interest rate. But that process was under the risk as well. Also for that period the preposition that microcomputer would be a great investment was wrong. But people could foresee so far and that is why bought the stocks of those corporations which were connected with such kind of field. One reason for significant supply-side outcomes was grounded on the fact that employees waited that they could get large compensation from their investments. And they believed that Internet or work salary would be smaller compensation: they trusted only in their stock.

It is important to speak on the point concerning the place of the biggest stock exchange market in the world - New York Stock Exchange, during those crises. Well, this market is the head of dollar amount. Nowadays the amounts are remarkable and shocking: the capitalization is more than 23 trillion dollars. COMMODITY PRICE EFFECT In 1987 the situation for commodity prices was very different. The CRB index had made its all time high of 338 in 1980, a year of surging metals prices, and a 20% prime rate. But the price action since then was not in a consistent decline, but erratic with large rallies and declines, and from August 1986 it had been rising strongly. Furthermore after two wild days in the CRB pit caused by the stock exchange crash, the CRB index resumed its erratic rise. Commodity prices both before and after the 1987 crash were therefore a strong indication that the crash problem was specific to the mechanics of the stock market, and not a general monetary or economic phenomena. In particular it was related to derivatives trading. The money managers had not fully understood the lack of liquidity in the futures pits. Their rush to sell created 10, 15, and 20 and even 40 handle discounts in the futures pits, compared to cash prices (a “handle” represents 100 points in the index). Those who bought futures from them at these discounts, then rushed to offset their positions by selling the underlying stocks, “at the market.” This process was repeated all day for two days, and that’s what caused the meltdown of the New York Stock Exchange in October 1987. Also attached are chart #5 - the US Dollar Index, 1987 crash; and chart #6 - the % year Treasury bond, 1987 crash, for your information on their behavior during this crisis.The daily trading limits established by the Stock Exchange and the Chicago Mercantile Exchange (the S& P pit) as a means of breaking panics gave participants a moment to think about what they were doing.

One last unfortunate 87 crash incident from the NYFE floor should be mentioned to Europeans, to show the mentality of much of the exchange trading community. On Friday afternoon the week of the crash, one of the NYFE clerks hired a professional stripper, to perform in the NYFE Lounge. I watched most of the traders and clerks again abandon the exchange floor to mob the lounge entrance to ogle the stripper. They considered this a “cool” event. Their mentality was as shallow as the exchange’s liquidity.

PRASHANT KADAM CAUSES Potential causes for the decline include program trading, overvaluation, illiquidity, and market psychology. The most popular explanation for the 1987 crash was selling by program traders. U.S. Congressman Edward J. Markey, who had been warning about the possibility of a crash, stated that "Program trading was the principal cause. "In program trading, computers perform rapid stock executions based on external inputs, such as the price of related securities. Common strategies implemented by program trading involve an attempt to engage in arbitrage and portfolio insurance strategies. The trader Paul Tudor Jones predicted and profited from the crash, attributing it to portfolio insurance derivatives which were "an accident waiting to happen" and that the "crash was something that was imminently forecastable". Once the market started going down, the writers of the derivatives were "forced to sell on every down-tick" so the "selling would actually cascade instead of dry up." As computer technology became more available, the use of program trading grew dramatically within Wall Street firms. After the crash, many blamed program trading strategies for blindly selling stocks as markets fell, exacerbating the decline. Some economists theorized the speculative boom leading up to October was caused by program trading, while others argued that the crash was a return to normalcy. Either way,

program trading ended up taking the majority of the blame in the public eye for the 1987 stock market crash. New York University's Richard Sylla divides the causes into macroeconomic and internal reasons. Macroeconomic causes included international disputes about foreign exchange and interest rates, and fears about inflation. The internal reasons included innovations with index futures and portfolio insurance. I've seen accounts that maybe roughly half the trading on that day was a small number of institutions with portfolio insurance. Big guys were dumping their stock. Also, the futures market in Chicago was even lower than the stock market, and people tried to arbitrage that. The proper strategy was to buy futures in Chicago and sell in the New York cash market. It made it hard -- the portfolio insurance people were also trying to sell their stock at the same time. Economist Richard Roll believes the international nature of the stock market decline contradicts the argument that program trading was to blame. Program trading strategies were used primarily in the United States, Roll writes. Markets where program trading was not prevalent, such as Australia and Hong Kong, would not have declined as well, if program trading was the cause. These markets might have been reacting to excessive program trading in the United States, but Roll indicates otherwise. The crash began on October 19 in Hong Kong, spread west to Europe, and hit the United States only after Hong Kong and other markets had already declined by a significant margin. Another common theory states that the crash was a result of a dispute in monetary policy between the G7 industrialized nations, in which the United States, wanting to prop up the dollar and restrict inflation, tightened policy faster than the Europeans. The crash, in this view, was caused when the dollar-backed Hong Kong stock exchange collapsed, and this caused a crisis in confidence. 1. DERIVATIVE SECURITIES :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 [also known as the Presidential Task Force on Market Mechanisms, which was appointed to investigate the causes of the crash], concluded that the failure of stock markets and derivatives markets to operate in sync was the major factor behind the crash. 2. COMPUTER TRADING :In searching for the cause of the crash, many analysts blame the use of computer trading (also known as program trading) by large institutional investing companies. In program trading, computers were programmed to automatically order large stock trades when certain market trends prevailed. However, studies show that during the 1987 U.S. Crash, other stock markets which did not use program trading also crashed, some with losses even more severe than the U.S. market. 3. ILLIQUIDITY :During the Crash, trading mechanisms in financial markets were not able to deal with such a large flow of sell orders. Many common stocks in the New York Stock Exchange were not traded until late in the morning of October 19 because the specialists could not find enough buyers to purchase the amount of stocks that sellers wanted to get rid of at certain prices. As a result, trading was terminated in many listed stocks. This insufficient liquidity may have had a significant effect on the size of the price drop, since investors had overestimated the amount of liquidity. However, negative news to investors about the liquidity of stock, option and futures markets cannot explain why so many people decided to sell stock at the same time. While structural 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 to dramatically lower their estimates of stock market values. The main culprit here seems to have been legislation that passed the House Ways & Means Committee on October 15 eliminating the deductibility of interest

on debt used for corporate takeovers. Two economists from the Securities and Exchange Commission, 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, 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 3-day drop in almost 50 years. In addition, those stocks that led the market downward were precisely those most affected by the legislation. [Ultimately, the legislation was stripped of the provisions that concerned the stock market before being enacted into law. 4. U.S. TRADE AND BUDGET DEFICITS :Another important trigger in the market crash was the announcement of a large U.S. trade deficit on October 14, 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. One belief is that the large trade and budget deficits during the third quarter of 1987 might have led investors into thinking that these deficits would cause a fall of the U.S. stocks compared with foreign securities (this was the largest U.S. trade deficit since 1960). However, if the large U.S. budget deficit was the cause, why did stock markets in other countries crash as well? Presumably if unexpected changes in the trade deficit were bad news for one country, it would be good news for its trading partner. 5. INVESTING IN BONDS AS AN ATTRACTIVE ALTERNATIVE :Long-term bond yields that had started 1987 at 7.6% climbed to approximately 10% [the summer before the crash]. This offered a lucrative alternative to stocks for investors looking for yield. 6. OVERVALUATION:-

Many analysts agree that stock prices were overvalued in September, 1987. Price/Earning ratio and Price/Dividend ratios were too high [Historically, the P/E ratio is about 15 to 1; in October 1987 the P/E for the S&P 500 had risen to about 20 to 1]. Does that imply that overvaluation caused the 1987 Crash? While these ratios were at historically high levels, similar Price/Earning and Price/Dividends values had been seen for most of the 1960-72 period. Since no crash happened during that period, we can assume that overvaluation did not trigger crashes every time. 7. GENERAL FACTORS :Talking about general factors concerning the appearance of two crises it is very essential not to forget one of the major factors that play one of the important roles – human one, or to be more concrete – psychological. Its impact on economical system is very strong, and that fact was introduced through many newspapers. They underlined that very psychological factor was not probably noticeable, the economists didn’t pay attention to it, but the prices were managed by that very human factor. In order to get something new and to have the possibility to compare we should research the views of different representatives from that epoch. As for the year of 1929, well, John Kenneth Galbraith said that in the stocks there was an extreme speculation and Federal Reserve had to control the usage of the credits. From another point of view, the specialists told that the process of price-investing selling was activated by the markets. But that action promoted the aggressive institutions to vend in anticipation of price changes. In order to make a conclusion concerning the same lines of the crises in 1929 and the one of 1987 we should underline the next point: a number of same reasons, the major and more important was of course the changes in prices; but the changes also were present; they were connected with the consequences and the character of the governmental actions. And the most invisible but very powerful factor presented and in 1929 and in 1987 was of course the psychological, or in other words, human factor, which made a great sign in the history of two greatest stock crises.

PRAJAKTA AUTI

Financial System in Collapse, Credit Crisis Worst Yet to Come :Fundamental Causes of the Crisis Beginning in 1971, for the first time in the history of global finance, no currency in the world has been backed by anything. This monetary experience should be properly called an experiment, which is now reaching its logical conclusion. This includes some curious facts, such as the Estonian kroon, which is backed by a reserve currency, primarily the Euro, while at the same time the Euro itself is backed by nothing. And the Estonian Kroon is not backed by euro banknotes, but instead, in all likelihood, is backed by a mixture of German, US, and Japanese treasury bills. These are only government promises to pay that will, at the end of the crisis, make Estonia's entire foreign reserves, gathered for bad times, almost worthless. If money is backed by nothing more than government seals, decorated paper, and strongly voiced promises, greed enters into play. No army in history has hindered central bankers and governments from creating money out of thin air and then spending it according to their own vision. The modern term for this is credit money, the loaning of credit by the central bank that becomes money itself. In normal and stable systems, bankers have only been able to loan out money that they have in their own vaults, and they were also always ready to exchange issued paper money and obligations for the gold bars stored in the vault of the bank. However, there has come a moment when bankers realised that people were not coming back to request gold, the result of which was that worthless pieces of paper (read: banknotes and electronic impulses) were placed into circulation and if they

issued supplementary paper currency, which lacked any coverage, nothing happened, at least initially. In the old days, the mess would eventually surface and the matter ended with either the bankruptcy of the bank or the destruction of the state's monetary system through hyperinflation. Currently, the entire monetary system is global, and therefore has lasted longer than usual. The process, which took place in Germany in the 1920's over a period of 3-4 years, will last for 3-4 decades on the global market. Throughout history there has been no monetary system that was not backed by a precious metal or some other equivalent accepted by all, ever, without exception, that has remained standing. The current experiment cannot remain standing either. We have created financial “capital” in a heretofore unseen extent. This “capital” is incorrectly believed to be wealth, because it could be exchanged for actual wealth during certain historical stages. Unfortunately, all this financial “capital” and all of this financial “wealth” have little backing in real goods or productive assets. This is an inherent property of our modern-day fractional-reserve banking system. Te result is that, whether we want it or not, the entire global financial system will fall into chaos and will destroyed, and hopefully a new and better system will be created. What will happen is another important question, and impulse psychology comes into play here. People have a tendency to view things, above all, with a short-term time horizon. This “short-termism” can be seen on the stock markets and by the developments in the financial world. Even though the crisis had already been predicted at the end of the 1990's, financial analysts were guided by “mystical” numbers and assessed the condition of the current situation as good. This type of analysis reminds of the anecdote where a man falls out of a skyscraper; when asked by someone from the fifth floor window how things are going, he answers “so far so good, I'm simply moving quickly”. The Initial Phase – Financial Crisis Unfortunately, the depth and length of the crisis are currently being discounted. At the moment, the crisis is in its initial phases. What is taking place only has affected mostly

the financial sector; there has been only a minimal effect on the real economy. However, at the latest by next year, the second phase of the crisis will begin, with spillover effects into the economy. In 2009, the weakness of the global economy will become central. The current economic system is built on providing loans in ever increasing amounts, not on saving and the repayment of debt over time. If a private person builds his life on a series of new loans, where he repays old debt with new debt, then he would be considered crazy and would inevitably end up either in debtor's prison or bankruptcy. If the same thing were to take place at the corporate and state level, then nobody would dare say anything. It would be considered perfectly normal. Where is the child from the fairytale who wasn't afraid to cry out that the king was naked! Companies have become accustomed to taking new loans, although the financial system is attempting to correct. A contraction of bank credit to the private sector is in place, and inevitably the economy will not receive the money (read: credit) that it was planning on receiving. In addition, financial companies are unable to sell financial securities to finance themselves, since even the currently successful companies that kept free funds in shares and securities in order to earn a higher return, have lost over half of their value. This first initial phase is well familiar to us. We have lived with it for almost two years. The media has called it by various names: “The Subprime Crisis”, “The Credit Crunch”, and “The Credit Crisis”. The Second Phase – Economic Crisis The lack of money becomes evident in the second phase of the crisis – the financial crisis is replaced by an economic crisis, triggering massive bankruptcies that would spread globally in a chain reaction. After the series of initial difficulties encountered by home borrowers and the construction companies, there have been no bankruptcies so far in manufacturing, shipping, media, food processing, not to mention luxury goods like luxury cars, yachts and watches, or exotic businesses like space tourism. But their time will come. During the second phase of the crisis, another large sum of capital will “evaporate” from the market, because a company which is going bankrupt will leave

nothing for shareholders and very little for its bondholders. In the second stage of the crisis, unemployment will begin to grow along with the wave of bankruptcies. The final quarter of 2008 is only the beginning. Remember that in 1931-1932, the unemployment rate in the USA was 20%, with one in five people unemployed. The Third Phase – Hyperinflation Throughout the series of crises, politicians will attempt to interfere in the game, but the third stage of the crisis will nevertheless begin. Since banks were “saved” with large bailouts, politicians will also begin to lavish corporations with various aid packages. The recent charade of automakers begging for money is only the beginning. Thus, measures will be undertaken that, in the opinion of politicians, will help the economy and save jobs, something that will likely become known as Obama's “ New New Deal”. This will include a multitude of spending programs and, above all, the loaning of credit with astronomical increases in the money supply, together with the classifying of the corresponding numbers into the trillions. Just like now nobody talks any more in terms of millions, so in the not so distant future no one will be talking any more in terms of billions. Trillions will be the order of the day. Perhaps bank lending standards will be relaxed. Perhaps the government will lavish the banks with a lot more money than it does today, just to keep them lending. Perhaps the central bank will directly monetize private debt. Perhaps the government will guarantee many more corporate loans, just like it recently guaranteed the securities/loans of the GSEs. Perhaps GSEs will proliferate throughout the economy, transforming the U.S economy into the “GSE Economy”, transforming a former great capitalist economy into a modern-day nationalsozialistische economy. Perhaps the government will implement all of the above. It will seem for awhile that peace has arrived, that the crisis has been overcome, as if the bankrupt companies have been “saved”, although this will only be the calm before the storm. If there is already more money in the financial system than actual goods, then after the subsequent injections of money, more like dropping money from helicopters or showering corporations with money, the economic ship will begin to heel.

In this stage, the third stage, the hyperinflation scenario will begin when people realize that the money in banks will buy them next month half as much as it did this month. Then panic will ensue. People will begin to buy essential and non-essential items, just as long as there is something of value that can be obtained in exchange for their colourful pieces of worthless paper. Manufacturing enterprises would no longer want to sell goods, because the money received in exchange for the sale of their goods is not sufficient to purchase the new raw materials. Everyone who sells an actual object or good for paper money is a loser, since the same money is no longer enough to purchase again the same goods. Money created out of thin air electronically has brought tremendous benefits to the initial users and issuers, but at the expense of the wider masses through the collapse in their standards of living in this stage. The third phase will be chaotic and difficult. The details are difficult to predict, but if history is any judge, the politicians won't be asleep. They will likely pass a number of important laws, prices will be fixed, wages will be standardized, foreign currency accounts will be frozen; in general, everything that could be done, will be done, and this will only serve to extend the agony. Social upheaval and riots will be suppressed by brute force; many democratic freedoms and values will likely be lost. As of today, the hyperinflation spiral and Zimbabwe Syndrome have reached the point of no return. Final Phase – Monetary Collapse In the event that democracy survives, then the fourth and final phase will begin, a phase which can be called The Darkness before Dawn, the final agony before the rising of the sun. This is the ultimate destruction of the monetary and financial system, the loss of all electronic and financial values that is accompanied by monetary reform throughout most of the world. In the worst case scenario, this will result in the creation of a Global Government; in the best case scenario, the process will take place separately in each country. For example, at the end of the Tulip Mania of the 17th century, all futures transactions with which tulips were bought and sold for millions of florins were declared void. Similarly, all electronic

assets, contracts, securities, and futures contracts will be declared void, because the world doesn't have a court or executive power which is capable of enforcing bankruptcies and debt collection resulting from millions of non-performing contracts. Only the actual collateral for loans will be demanded - land, houses, apartments. The losers will be private persons, while legal entities, along with their debts and non-existent collateral, will be lost in the virtual world, the place from whence they came. Things will begin again with a clean slate. We will once again all be on an equal level. Railroads and planes, bridges and houses won't disappear. All real wealth will remain, lost is only the paper wealth, those things that people believed they had and that they believed someone else (read: government, banks, pension funds, etc) will preserve for them. At that moment, faith will truly have been lost, as the fruits of a person's life will have, through several metamorphoses, been transformed into banking sector profits and executive bonuses that had been spent by the suits long before the crisis even began. The new economic system will be different than the current one. Its type, shape, or form is impossible to predict at the moment. Similarly to the end of the slave-holding system, it was not possible to see the creation of the feudal system. It was also impossible to foresee the blossoming of capitalism before the industrial revolution in England in 1785. So, it now is impossible to predict all the changes, although those changes are inevitable. Each process must go through its historical development and must reach its natural conclusion. History shows that every changeover from one organisation of society to another has been very painful. Nevertheless, each following step, no matter how painful, has moved humanity forward and offered a better life to more people. Hopefully it will also go forward this time. All we have to do is hang on.

BINOD PRASAD & SACHIN KADAM (Please divide this part in between you tow) GRAFICAL PRESENTAION

For a few short days in October 1987 the U.S. financial system came perilously close to completely collapsing. Dramatic shifts in the flow of capital between interrelated markets occurred as a sudden swing in expectations from optimism to pessimism among market participants overwhelmed the worlds financial systems. Panic selling led to a complete loss of liquidity and a breakdown in the clearing and settlement process that hindered capital flows between markets (Eichenwald, 1). On Monday, October 19, 1987, the Dow Jones Industrial Average fell 22.6%, its greatest one day loss ever. On the following Tuesday, it was up to the Federal Reserve Bank to pick up the pieces and prevent financial gridlock.

There is not much debate today as to what caused the crash, as there were fundamental reasons that did not justify the level of valuation given to the stock market. One of the

main factors that pushed stock prices so high throughout 1987 and created the speculative bubble was the large influx of foreign capital, especially from Japan (Solomon, 48). Also, a large amount of highly leveraged corporate takeovers reduced U.S. corporate equity while at the same time raising corporate debt levels to record levels. Going into the fall of 1987, large U.S. trade and budget deficits combined with rising interest rates throughout the world put pressure on the dollar to depreciate and led market players to lose confidence in the G-7’s ability to maintain target rates for currency exchange set by the Louvre accord (Soros, 346). There was a series of bad news beginning on Wednesday, Oct 14, beginning with the raising of interest rates in Germany by the Bundesbank, followed by a larger than expected U.S. trade deficit (Solomon, 49). The rise in interest rates leading up to the crash was creating a large and untenable spread between returns on bonds and stocks. This can be shown by the large rise in the spread between the 30yr U.S. T-Bond yield and the dividend yield on the Dow Industrials Average throughout 1987 leading up to the crash as indicated in the following graph.

Over the weekend immediately prior to Oct 19 1987, a massive, sudden reversal of sentiment occurred from the optimism that current difficulties would be resolved to a sudden pessimism (Toporowski, 3). This change in market psychology dramatically increased the demand for safety and liquidity.

Ominously, prior to the U.S. opening on Monday, Tokyo’s Nikkei Average closed down -2.5% and London’s FT 30-share index fell -10.1%. On Monday morning in the U.S., the market makers were the first firms to suffer from the onslaught of selling pressure (Hertzberg, 1). Volume on the NYSE was three times normal on 10/19 and buyers all but disappeared which left the market makers by themselves in the market, forced to buy stock when there were no other buyers (Hertzberg, 1). This left them with huge inventories that they would have to pay for at settlement, which for stocks was five days hence (Solomon, 66). Many market makers simply stopped buying from sellers despite their obligation to do so (Solomon, 67). As a result, on Tuesday, many stocks stopped trading and this in turn had a domino effect on the futures and options markets (Hertzberg, 23). The S & P 500, which is a popular hedging instrument for owners of stock who sell futures to protect their stock portfolios against losses, ceased trading from 12:15pm to 1:00pm (Hertzberg, 23). Rumors that the NYSE was going to close put the stock indexes in a further freefall but Fed officials strongly encouraged NYSE Chairman John Phelan to keep the NYSE open despite desperate pleas from brokerages and market makers (Hertzberg, 23). With sellers outnumbering buyers 40 to 1, arbitrage became impossible as intermarket linkages broke when liquidity dried up in the stock market (Antoniou, 1459). The result of this was a vicious downward spiral in both the stock and stock index futures markets (Antoniou, 1460). The record volume overwhelmed the clearing and settlement systems, creating confusion and significant delays with one system suffering a complete overload, losing both orders and trade reports (Lindsey, 285). Following the NYSE close on Monday, as foreign markets opened, the result was similar. In Tokyo, 95% of the stocks could not open for trading due to extreme selling pressure and the Nikkei Average closed down -14.9% (Solomon, 82). Australia had no formal pauses in trading but the All Ordinaries Index closed down -24.9%. In Germany on the Frankfurt exchange, Indexes fell -5.08% and in England the FT-30 Index fell -11.7%. In European markets, there was generally no breakdown in trading as there was in the U.S. This can be attributed to more heavily regulated markets and capital controls that made it

more difficult for international investors to buy and sell at will (Toporowski, 132). The worst damage may of occurred in Hong Kong, whose stock and futures markets closed for a week. This locked many large brokerage firms into positions that they wanted to liquidate (Solomon, 102). These same brokerages were the underwriters of a large rescue fund that the Hong Kong government used to bailout speculators and reopen the Hong Kong Stock Exchange (Toporowski, 131). The biggest problems occurred on Tuesday following the crash when differences in the clearing and settlement obligations of the stock, options and futures markets further increased the demand for loans (Garcia, 154). The transfer of funds, or settlement as it is called, occurred in the stock market on the fifth business day after a trade was made. In the options market, settlement occurs at the market open of the next day and in the futures markets, margin calls to firms were payable within the hour (Garcia, 154). Gerald Corrigan, then president of the Federal Reserve Bank of New York said after the crash, “The greatest threat to the stability of the 1987 market break was the danger of a major default in one of these clearing and settlement systems.” These asymmetries forced further liquidation as traders scrambled to meet margin and settlement requirements (Garcia, 154). The disruptions in the flow of funds threatened not only br kerage firms, but also central clearinghouses that are vital to the operation of the financial markets (Eichenwald, 1). The large volume of trades on Oct 19 and 20 greatly increased the demand for short-term credit that was needed by market players to fulfill their settlement obligations. Alan Greenspan was appointed Chairman of the Federal Reserve Bank in August of 1987 and at this time was standing in the shadow of Paul Volcker, whom Wall Street trusted as a tested leader in moments of crisis (Murray, 26). One of the first things Greenspan did upon assuming his role as Chairman was to set up a task force to make sure the Fed was ready for any financial crisis that might arise (Solomon, 47). The result of this task force was a large notebook that became known as the Pink Book (Solomon, 47). The Pink Book described strategies for responding to certain financial crisis, one of which was a hypothesized stock market crash of 150 points (Solomon, 47). This was nowhere as severe as the 508 point drop on October 19, but Chairman Greenspan and other members

of the Federal Reserve rose to meet the challenge. Fed officials established a crisis center in an office at the Fed’s headquarters where they stayed round the clock and monitored worldwide markets (Murray, 1). There they opened channels to other officials at major exchanges, banks and brokerages to assess the situation. The Fed officials knew that liquidity would be a problem on Tuesday. As losses mounted, banks became reluctant to extend credit to brokerages and market makers. If credit dried up, securities firms would collapse and economic gridlock would ensue and it was the goal of the Federal Reserve Bank not to let that happen. The crash placed a huge demand for credit on the banking system as securities firms and their customers had to meet margin calls that were 10 times precrash levels (Garcia, 153). At the same time, banks became reluctant to lend out of fear of adverse selection and a further market collapse that would expose them to losses. Aside from serving as a source of liquidity, the Federal Reserve Bank also played the role of psychologist, trying to restore confidence by sending the message that the system would not be allowed to fail. Particularly important was the role of New York Federal Reserve President E. Gerald Corrigan. Being in New York and connected to Wall Street, Corrigan played a crucial role as the Fed’s eyes and ears on Wall Street. He personally urged bankers in New York not to seize up and to continue lending to securities firms (Eichenwald, 1). Because of the Fed’s moral suasion and reassurance to bankers that they would not have to worry about running out of funds, the banking system did not turn its back on Wall Street and handled the special needs created by the crash (Quint, 10). On the morning of Oct 20 at 8:15 am the Fed released a statement that said “The Federal Reserve, consistent with its responsibilities as the nations central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.” (Garcia, 1). The Fed then backed up its words with action by supplying liquidity through open market purchases of U.S. government securities which drove down interest rates as displayed in the following chart.

The actions of the Federal Reserve dramatically lowered interest rates. Not only did the yield curve drop lower, but the Federal Funds rate fell from 7.5% on Monday to 6.75% on Tuesday (Murray, 1). The Fed was liquefying banks who would in turn liquefy securities firms (Soloman, 56). In this way, the Fed could avoid the moral hazard of bailing out the securities firms directly. U.S. Federal Reserve officials requested that Japanese and German Central Banks follow suit in easing credit conditions (Solomon, 85). The fear was that if the U.S. Fed strongly eased but Japan and Germany did not, the resulting widening of interest rate differentials would cause capital flight from the U.S. and a similar move in bonds resulting in a rise in interest rates (Solomon, 85). In response to this, Japanese officials at the Ministry of Finance encouraged major brokerage houses not to sell and encouraged investors to focus on the fundamentals of the economy (Solomon, 84). The Bank of Japan modestly eased credit and several large brokerage firms agreed to buy shares in the Japanese bellwether Nippon Telegraph and Telephone (Solomon, 84). Further moves to limit selling pressure included the lowering of margin requirements by Tokyo stock exchange officials. As a result of the above moves, the loss in Japan’s Tokyo’s Nikkei Average was limited to -14.9% on Tuesday. After the close, Bank of Japan Governor Satoshi Sumita issued a

statement: “The Bank of Japan is determined to continue to pursue firmly the cooperative framework of the Louvre Agreement” and followed up with foreign exchange intervention for the next few days to prevent a dollar plunge (Solomon, 88). However, on Tuesday morning, things got worse before they got better. The NYSE opened on time but many sectors were at a standstill. When trading did resume, there was a brief rally during which market makers and major firms unloaded the large inventories they had accumulated. (Hertzberg, 23). This brought a barrage of sell orders which caused the closure of trading in many of the stocks and options as market makers simply stood aside and let them collapse (Hertzberg, 23). All selling and no buying caused the stock index futures to sell at a large discount to the underlying cash value of the stocks.

This is an example of how extreme the selling pressure was, there were not even any arbitragers willing to buy the futures at such a large discount and as a result, trading in the Standard and Poors 500 futures contract ceased from 12:15 pm until 1:00 pm. The turning point came early Tuesday afternoon when the Major Market Index futures contract on the Chicago Board of Trade, a little known stock index similar in content to

the Dow Jones Average index, staged a powerful rally, apparently due to manipulation, driving the futures to a premium to the cash index (Hertzberg, 23). This triggered buying of the underlying stocks included in the Major Market Index as arbitragers attempt to profit by buying the underlying stocks when they are undervalued relative to the futures. Because many of the stocks that comprise the MMI are also included in the Dow Jones Average, the buying carried over to that average as well (Hertzberg, 23). Also important in reversing the downtrend that Tuesday afternoon were the announcements of stock buybacks by several large corporations, apparantly under the encouragement of major investment banks (Hertzberg, 23). These developments combined with the Fed’s actions caused market sentiment to swing to optimism just as rapidly as it switched to pessimism the prior day and at the close on Tuesday the DJIA was up 5.88% and followed through with record gains of 10.1% on Wednesday, October 21. The dollar held up reasonably well in the days following the crash, due in large part to a capital flight to safety into the most liquid asset available, U.S. Government Bonds. The crash signaled the arrival of high-speed global financial markets that overwhelmed the credit and settlement processes. Market players wanted more liquidity and when they feared they couldn’t get it, panic ensued. The structure of the financial markets in 1987 simply could not handle the volatility during the crash. Prone to excess, the systems structure was outdated. This led the Brady Commission Study of the crash to suggest that a simpler, single mechanism should be developed for settlement in the Stock, Futures and Options Markets (Lindsey, 103). Since that time, there have been many innovations and improvements to the clearing and settlement process that make a repeat of the events of October 1987 very unlikely. Because of the Fed’s quick action in using its lender of last resort power, its quickness in increasing the money supply and their calming effect on the banking sector, a disaster was averted and the crash of 1987 turned into an economic non-event. At the time, there was some fear that the crash would cause a decline in consumption and thus result in a

decline in Gross Domestic Product due to the loss in wealth, but it was essentially a financial crash and not an economic crash and did not reflect the real economy (Toporowski, 142). The 87′ crash did provide a wakeup call to the world and especially the U.S to modernize its financial systems to be able to handle the coming advances in technology and the speed of information flows. By John Bardacino, originally written in the fall of 1999 BINOD PRASAD & SACHIN KADAM

. _______________________________________________________________________ _ PRASHANT GAWADE THE STEPS FOR OVERCOMING THE CRISES In order to have the possibilities to get through the crisis it is important to create some useful steps just for being ready for any problems, unforeseen disasters and troubles. Probably for the first stock crisis in 1929 the population wasn’t ready, but the presence of that crashed pushed the government to create some helpful steps. In 1933 Franklin Roosevelt came to the United States of America in the role of the president. And he was obliged to make or just to create new perfect and conscientious achievements in order to manage with the crises in stock markets, also to help to restart the work of banks in the USA. But all those action shouldn’t be harmful for the world because the USA with its New York Stock Exchange turned to be the largest investors. Well, here are the first steps of Franklin Roosevelt: 3 rest days for banks for regenerating with severer limitations. In some days the banks whish were able to exist showed their

capacity to work and to carry out all necessary functions in economy. And without any surprises it helped. One more step for avoiding similar troubles was establishing by the government the Federal Deposit Insurance Corporation –the safest place of the investors’ deposits. And in the case if the bank stopped working, the deposits would be in safe with the help of acting government. The market crisis showed that the reason for economic mess is capitalism brutal search with the help of any ways. The only way out is the reconstruction of economic system by means of revolution. Well, in near future it could be noticeable that all procedures made by the society and the government turned to be right, positive and successful.

NEW CREATIONS OF THE GOVERNMENT As for the measures in 1987, they were done at high right level and in very good way. At the beginning, the circuit breakers were created for avoiding panics and problems in stock markets in 1988. As for their usage it calls a lot of argues even now. Many experts say that the prices rest the same and sometimes even get soaring. Well, it is an open question. The next point was enlarging the communication between the investors and the stock market itself. Here is an example: the meeting between the heads of the Federal Reserve Board and Security and Exchange Commission; and the aim of such conferences is forecast the next problem and chaos. Also, one more invention – is “squawk box”. It helps people to be aware about the changes and progress of the company. Such boxes are supplied positively to the whole situation. In 1987 portfolio insurance became a forceful investment theory which was based on the Black-Scholes alternative pricing rule. This theory tried to copy a put decision in stocks. This very information was given in the articles of 90ies.

It goes without saying that Federal Reserve that was the helpful point for stocks in 1987. It wasn’t so harmful because Federal Reserve shifted rapidly to ease monetary policy. Those were the first actions of the government in order to prevent the crash in 1987. And how it was predicted Federal Reserve played very important role in the creation of new ways from the difficult situation and the actions of government are improved in quit positive way.

NYSE AND THE FORMATION OF HELPFUL STEPS

New York Stock Exchange, the famous stock market in the world had survived and was able to exist and to work until the crisis. Being 112 years old in the period of crash in 1929 it continued operating. The consequences of 1929 seemed to be useful and good enough. But in 1932, the stock point was low, 86% from pre-cash level. New York Stock Exchange had all possibilities to survive after the world crash, to establish its reputation and to recover the organization and to be ready for work in much more short time than other stock markets. Also, it is important to say about one more point during the process of crashes – this phenomenon was called as “bubble” effect. But probably someone doesn’t know the essence of it, or could make some wrong deductions. In order not to confuse here is example. The reason for it was, of course, price speculation. The sudden far above the ground position of price could turn to be in sudden near to the ground position. After a great leap a great depression follows. And between the difficulties absorbed in assessing the bases for depression none is more difficult then the responsibility to be charged to the stock crisis. Experts and now can’t decide this very problem. But they just say something just in order to say something. Well, that is the bubble principle which should be trounced. Also it is useful to underline the sets of actions made during the crises. Of course, the steps were not the same, may be thanks to the experience given for world. And if in 1929

the government was not ready for some quick reaction, in 1987 they were more concrete in its actions and more experienced.

The Fed's role in financial crises A stock market crash raises a couple of interrelated policy issues for a central bank: one has to do with our role as monetary policymaker, and the other with our role in ensuring the safety and soundness of financial markets and the payments system--that is, as "lender of last resort." From the monetary policy point of view, we were concerned that the loss of wealth due to the crash might cut consumer spending and lead to an economic contraction. When the market bottomed out, the loss of wealth owned by individuals amounted to nearly eight hundred billion dollars, and in theory, this could have reduced people's spending on consumer goods. It's true that the response of consumption to a given change in wealth has always been estimated to be relatively small. But the size of this crash meant that the wealth effect might have had an important impact on overall economic activity. As it turned out, the "wealth effect" wasn't a key threat. Looking back, it appears to have had nearly imperceptible effects on spending. One reason may have been that stock prices right after the crash were actually above the levels of the previous year. Fortunately, we didn't need to wait for the published data--which come in with a substantial lag--to know that we weren't dealing with an overall slowdown in economic activity. Through the District Banks and their branches, the Fed has a nationwide network of contacts that includes current and former Directors on our Boards as well as a number

of Advisory Council members. And the message from virtually all of them was that the crash wasn't having a big effect on regional economic activity. Indeed, in the year after the crash, GDP growth was quite strong. Instead, the greater threat was to the viability of the exchanges and brokerage firms, and, by extension, to the perfectly sound businesses that might have failed if the exchanges had collapsed. Addressing this threat has a lot in common with the Fed's historic role as lender of last resort in preventing banking panics. Like banks, the various intermediaries in the stock and bond markets held relatively small amounts of capital. This made them vulnerable to sudden withdrawals by lenders. When firms have problems because of their own business decisions, it's clearly not the Fed's role to step in and help out. In fact, doing so would only create a moral hazard, inducing firms to take excessive risks and leading to instability in the financial system as a whole. But when the effects of a bank run or a break in the stock market spread to fundamentally sound firms and threaten the stability of the financial system--that is, when there's systemic risk--then the Fed has a clear and important role to play. How systemic risk arose in 1987 We usually think of stock exchanges as highly liquid markets, largely because of the financial intermediaries in these markets who stand between buyers and sellers by guaranteeing the execution of transactions. For example, stock exchange specialists must buy into falling markets in order to serve as a shock absorber. The system works very well to maintain liquidity when buy and sell orders aren't too far out of balance. Ordinarily, a small stock of inventories relative to gross trade flows is enough to bridge the gap between buy and sell orders. Furthermore, clearinghouses can guarantee the execution of trades in the face of any individual's default risk. But on October 19, order flows were grossly out of balance--there were virtually no other buyers. That left the specialists at the end of the day with much larger inventories than

usual. They had to pay for those purchases within five business days and needed credit to do so. In addition, investors had to meet margin calls as prices fell, and brokerage firms extended credit to many of their customers to enable them to do so. Finally, the solvency of the clearinghouses was in doubt, because the default risk they were insuring was systemic. Although the clearinghouses were well capitalized, they weren't able to bear this kind of risk, and on the morning of October 20 there was a real possibility that they might fail. At this point, then, all these players needed additional credit to continue their functions. But banks were growing nervous and reluctant to lend. And who can blame them? The drop in asset prices cast doubt on the creditworthiness of all parties: investors, specialists, brokerages, and clearinghouses. Furthermore, the reluctance of banks and other creditors to issue further loans itself increased the risk of default. So there was a genuine risk that expectations of a market meltdown would become self-fulfilling. How the Fed intervened Before the market opened on October 20, the Fed issued the following announcement: "The Federal Reserve System, consistent with its responsibilities as the nation's central bank, affirmed today its readiness to serve as a source of liquidity to support the financial and economic system." This affirmation of the Fed's responsibilities to serve as lender of last resort was intended to reverse the crisis psychology and to guarantee the safety and soundness of the banking system. The Fed backed up this announcement with a number of critical actions, and I'll highlight four of the most important. First, we added substantially to reserves through open market operations. The funds rate fell from 7-1/2 percent just before the crash to 6-1/2 percent in early November. This added liquidity helped prevent the crash from spreading to bond prices.

Second, we liberalized the rules governing the lending of securities from our own portfolio to make more collateral available. Third, we used all of our contacts in the financial system to keep the lines of communication clear and open. In talking with banks, for example, we stressed the importance of ensuring adequate liquidity to their customers, especially securities dealers, and at the same time affirmed that they were responsible for making their own independent credit judgments. We also were in close touch with participants and regulators in the government securities market, officials at the various exchanges and their regulators, and our colleagues at central banks in other countries. Finally, as a means of gathering real-time information, we placed examiners in major banking institutions to monitor developments--such as currency shipments--to identify the potential for bank runs. To sum up, performing the lender-of-last-resort activity, and backing it up with close monitoring and close communication, did what it was supposed to do: it transferred the systemic risk from the market to the banks and ultimately to the Fed, which is the only financial institution with pockets deep enough to bear this risk. This allowed market intermediaries to perform their usual functions and helped keep the market open. What did we learn? As our mothers sometimes tell us, we learn more from our mistakes than from our successes, and the policy lesson here really comes from the Great Depression, rather than from the October 1987 crash. During the Depression, the Fed failed to avert the collapse of the banking system, and the loss of intermediary services was one reason why the Depression was so deep and so prolonged. So the crash of 1987 and the Fed's swift and decisive response serves to reaffirm our understanding of what we need to do. While this should give confidence to the markets, I think it's worth repeating that it should be used sparingly. Such Fed actions must be limited to crises marked by systemic risk. Bailing out individual firms is not the job of the Fed, nor is it in the public interest since it would induce excessive risk-taking in the private sector.

Let me conclude with one last caveat that brings me back to monetary policy concerns: once the critical stages have passed, the Fed needs to be especially careful not to generate another set of problems--that is, we must be careful not to overplay an easier policy stance. That could create inflationary pressures that would menace the process of healing in the financial system and possibly create future economic crises. I think it's fair to say that the Fed did not make this mistake following the '87 crash. In the face of a strong economy, tight labor markets, and an upward creep in inflation, monetary policy was tightened noticeably between early 1988 and early 1989. The funds rate rose from a low of around 6-1/2 percent in late 1987 to just under 10 percent in early 1989. While some people have debated about whether this action contributed to the 1990-1991 recession, I think it is clear that it helped set the stage for the decline in inflation that has occurred in the 1990s.