18. A Monetary Explanation of the October Stock Market Crash: An Essay in Applied Austrian Economics

CHAPTER 18

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A Monetary Explanation of the October Stock Market Crash: An Essay In Applied Austrian Economics

This article will attempt to place the events of “Black Monday,” October 19, 1987, in perspective by explaining how they fit into the broader boom-bust cycle, as this sequence of phenomena is conceived by the Austrian theory of the business cycle. The monetary aggregate known as TMS, initially outlined in the works of Murray Rothbard, plays a central role in my explanation.¹ In particular, I will argue that the October stock market crash was the inevitable consequence, not of newfangled computer trading programs, but of an old-fashioned inflationary boom. Like all inflations, the Great Inflation of 1982-87 was fundamentally a monetary phenomenon. It was orchestrated by the Federal Reserve System and financed by a massive and prolonged increase in the money supply.

Setting the Stage: The Inflationary Boom of 1982-1987

In analyzing the development of the inflationary boom, I focus in turn on developments in the supply of money, the market for consumer goods, capital markets, and foreign exchange markets.

The Supply of Money

The Penn Square bank failure and the threat of default by Mexico and then other LDCs (less developed countries) on their international loans in the summer of 1982 underscored the precarious stability of the world financial system, including and especially U.S. money-center banks. These events in conjunction with the continuing recession in the U.S. economy—whose persistence had repeatedly defied official forecasts—prompted the Federal Reserve System, in July of that year, to initiate a policy of vigorous monetary expansion.

The dimensions of this inflation of money, which propelled the U.S. economy on a rapid recovery from the recession of 1981-1982, can be seen in the sharp acceleration of the growth of adjusted bank reserves.² From 3Q-82 (third quarter, 1982) to 4Q-83, adjusted reserves increased from $49.3 to $54.2 billion, or at an annual rate of 9.94 percent, which represents a tripling of the 3.31percent annualized rate of reserve growth occurring over the seven quarters from 4Q-80 to 3Q-82.³ To supplement its reserve-creating open market operations and to emphatically signal the markets of its resolve to reinflate the economy, the Fed cut the discount rate seven times just in the last two quarters of 1982. Fueled by this rapid increase in bank reserves and by the introduction of MMDA’s, TMS shot up from an average of $929.8 billion in 3Q-82 to an average of $1,355.2 billion in 3Q-83, equivalent to a 45.76 percent (uncompounded) annual rate of growth. It is true that much of the enormous increase in TMS coincided with an anomalous one-shot increase in the overall demand to hold money by a public eager to add high interest-earning and federally-insured dollars in checkable MMDAs to its cash balances. Since (personal) MMDAs require no legal reserve backing, their expansion did not absorb the existing bank reserves, and it was therefore possible for the banking system to meet this demand without a net contraction of other components of TMS. Nonetheless, TMS net of MMDAs and saving deposits still expanded over the period under consideration at the dramatically inflationary rate of 14.17 percent per year. During the same period, the reserve absorbing aggregate of demand deposits plus other checkable deposits grew at an average annual rate of 14.45 percent.⁴

By the fourth quarter of 1983 the Fed had switched to a more restrictive monetary policy, signaled by a freezing of adjusted reserves at a level of $54.2 billion from 3Q-83 to 4Q-83. The restriction of reserve growth constricted TMS growth over the same quarter to a per annum rate of 2.7 percent. The Fed’s less expansionary policy remained in force through the fourth quarter of 1984. Over the five quarters from 3Q-83 through 4Q-84, adjusted reserves expanded at an annual rate of 6.05 percent, from $54.2 to $58.3 billion, a reduction of more than 3.5 percentage points in its annual growth rate when compared to the previous four quarters. In the same period, TMS was inflated at an annual rate of 4.27 percent or from $1,355.2 to $1,427.6 billion.

The third quarter of 1984 saw the reduction of the rate of money creation begin to “bite” in the real economy, causing a “growth slowdown” and precipitating fears of an imminent recession. By 4Q-84, real GNP growth had slowed to an annual rate of 1.7 percent, compared to 10.7 percent and 5.5 percent in 1Q-84 and 2Q-84, respectively.⁵ In addition to the looming specter of an economy-wide recession, the Fed also confronted localized depression in particular U.S. export and import-competing industries, attributable to ongoing international shifts in comparative advantage and the relentless strengthening of the dollar on foreign exchange markets. Thus, as early as August 1984, some members of the policy-setting Fed Open Market Committee (FOMC) were advocating a return to vigorous monetary stimulation, referred todescribed as “a lessening in the degree of reserve restraint.”⁶ Between the FOMC’s November and December meetings, open market operations were “… directed at achieving some reduction in pressures on bank reserves against the background of lagging growth in the narrow money supply, generally sluggish expansion in the economy, subdued inflation, and continued strength of the dollar in the foreign exchange markets.”⁷ Finally, at the December 1984 meeting, an imminent renewal of the inflationary boom was declared in euphemistic terms, as “… most of the members expressed a preference for directing open market operations toward some further easing of reserve conditions to encourage satisfactory growth in M1 and to improve the prospects for economic expansion in 1985.”⁸

Thus the third and final phase of the boom was ushered in at the beginning of 1985 when the Fed unleashed a new and sustained burst of monetary inflation on the U.S. economy with the aim of forestalling the impending recession and driving down the value of the dollar on world currency markets. From December l984 to the end of the boom in May 1987, adjusted reserves grew by over 24 percent (from $58.4 to $73 billion) or at an uncompounded rate of slightly more than 10 percent per annum. The result was an explosion in TMS, which increased by almost 34 percent in this period (from $1,452 to $1,942.2 billion) or at an annualized rate of about 14 percent.

Prices of Consumer Goods

What enabled the Fed to stoke the fires of monetary inflation as vigorously and as long as it did was the fact that the effects of this inflation were obscured in U.S. consumer-goods markets, especially in 1985 and 1986. For example, in the years 1983-1986, consumer prices, as represented by the CPI, increased at annual rates of 3.8 percent, 4.0 percent, 3.8 percent, and 1.1 percent, respectively. In the same four years, the fourth quarter-to-fourth quarter rates of increase for TMS were: 38.8 percent; 4.62 percent; 13.44 percent; and 12.7 percent

The large discrepancy between money inflation and price inflation is attributable to the simultaneous operation of a number of adventitious factors. These include the prolonged appreciation of the dollar on foreign exchange markets, which began in 1980 and propelled the dollar to postwar peaks against the German mark and a trade-weighted basket of foreign currencies in February 1985. The downward pressure that this exerted on the dollar prices of internationally traded goods, and thus on the overall U.S. price level, was reinforced by concurrent developments affecting supplies on various world commodity markets.

For example, the spread of technological advances in food-grain production to developing countries resulted in increased supplies and reduced prices of food products on the U.S. market. The collapse of OPEC and ITA cartel agreements led to supply gluts and sharply lower prices for oil and tin, as well as for substitute fuels and metals. Moreover, the belated and sluggish recovery of Western Europe from recession dampened the world demand for imports of primary commodities at the same time that the supply of these products to world markets was being stepped up by producing nations desperate for foreign exchange, especially dollars, to finance debt repayments.

These exchange-rate and supply factors heavily influenced domestic input prices, as exemplified in annual rates of change of the U.S. producer price index for crude materials for the four years 1983-1986. After a 4.7 percent increase in 1983, changes in the index for the next three years were: -1.6 percent; -5.6 percent; and -9 percent.⁹ To use Mises’s terminology, the tendency to higher consumer prices emanating from the “money-side” of the economy was partially offset by temporary price-reducing factors operating concurrently on the “goods-side” of the economy. We may gain some perspective on the moderating effect of goods-side factors on the overall rate of U.S. price inflation by comparing the GNP deflator for service-producing industries with the GNP deflator for manufacturing industries, whose product costs and prices tend to be directly affected by developments on world currency and commodity markets. In 1982-85, the former index rose at an average annual rate of 5.4 percent, while the latter was rising at a 1.9 percent average annual rate. Alternatively, we note that, for the years 1983-1986, the average annual rate of increase of the CPI computed for all items except food and energy exceeded that of the CPI for all items by 1.3 points (4.5 percent vs. 3.2 percent).¹⁰

Another deflationary influence on prices of consumer goods was the increase in the total demand to hold U.S. dollars, which, ceteris paribus, tends to increase the purchasing power of the dollar in goods markets. One component of this increased demand can be traced to the enormous expansion of the volume of transactions in U.S. financial markets, which, for a variety of reasons, has been under way in the 1980s. To finance this growth in transactions, both domestic and foreign investors were required to acquire and hold larger dollar balances. In addition, capital fleeing from hyperinflationary and collapsing currencies abroad, e.g., Mexico and Argentina, found a “safe haven” in U.S. bank deposits and currency. Indeed, as Murray Rothbard has pointed out, there has occurred a substantial but un-measurable leakage of dollar currency out of the U.S. into foreign hoards and to finance transactions in the subterranean economies of foreign nations, especially in Latin America and Asia. There is also evidence that the ever-growing, worldwide drug trade, now estimated at $100 billion per year, absorbed substantial quantities of U.S. currency and thereby contributed to a rise in the global demand for dollars.

Capital Markets

Austrian business-cycle theory leads us to expect that monetary inflation will have an earlier and more intense impact on capital markets than on markets for consumer goods for two reasons. First, in the modern economy, most newly-created money initially enters the economy via increased commercial bank lending to business firms, which directly tends to lower interest rates. The additional loan funds are used by borrowing firms to increase investment in productive assets, especially fixed investment in long-lived capital goods such as producers’ durable equipment and business structures. The increased investment spending, in turn, leads to higher prices for capital goods (relative to consumer goods), and higher earnings and capital values for firms producing these goods. Furthermore, the lowering of interest rates produced by the inflow of new money through the credit markets tends to increase the capital values and market prices of existing capital goods and of productive land factors, and this is reflected in increased market values for the firms which own these productive assets. Stock, credit (bond, commercial paper, commercial bank loan), and real estate markets, therefore, react most sensitively to monetary expansion, because these are the markets in which ownership titles to capital goods are exchanged.

The second reason why price inflation in consumer goods markets is generally presaged by boom conditions in capital markets involves the nature and formation of inflationary expectations. As Mises points out, during a progressing monetary inflation, inflationary expectations do not abruptly take hold of all market participants at once, but spread gradually through the ranks of those who are most keenly attuned to developments affecting the future state of market prices, and subsequently to the public-at-large. In particular, the premium on interest rates which reflects generally prevailing expectations of inflation in credit markets “… comes into existence step by step as soon as first a few and then successively more and more actors become aware of the fact that the market is faced with cash-induced changes in the money relation [i.e., the supply of and demand for money] and consequently with a trend oriented in a definite direction.”¹¹

Empirically, those who are first to anticipate a decline in the purchasing power of the monetary unit and to adjust their buying and selling decisions accordingly tend to be the “entrepreneur-promoters,” who regularly and successfully operate on capital markets and whose livelihood depends on rapidly and correctly adjusting their current activities to anticipated changes in future market conditions.

Thus the “promoter” concept is central to the theory of inflationary expectations,

for it refers to a datum that is a general characteristic of human nature, that is present in all market transactions and marks them profoundly. This is the fact that various individuals do not react to a change in conditions with the same quickness and in the same way. The inequality of men, which is due to differences both in their inborn qualities, and in the vicissitudes of their lives, manifests itself in this way too. There are in the market pacemakers and others who only imitate the procedures of their more agile fellow citizens.… The driving force of the market, the element tending toward unceasing innovation and improvement, is provided by the restlessness of the promoter and his eagerness to make profits as large as possible.…¹²

Moreover, in the modern economy, the main locus of entrepreneurial activities tends to transcend the narrow confines of the organization of the business firm and to center in markets in titles to capital goods, that is, in capital markets. As Mises explains:

The entrepreneurs and capitalists … perform all those acts the totality of which is called the capital and money market. It is these financial transactions of promoters and speculators that direct production.… These transactions constitute the market as such. If one eliminates them, one does not preserve any part of the market.… The speculators, promoters, investors and moneylenders [determine] the structure of the stock and commodity exchanges and of the money market.…¹³

These theoretical considerations account for the accelerated price inflation evidenced in capital markets during the inflationary boom of 1982–1987.

For example, the bond market rallied and short-term interest rates fell steadily from the inception of the inflationary boom in mid-1982 and reached a plateau in 1983. After trendless fluctuations through the period of slower monetary growth ending in early 1985, rates trended sharply downward during the renewed burst of monetary expansion of the next two years. The three-month commercial paper rate fell almost three percentage points, from 8.77 percent to 5.87 percent, from March 15, 1985 to January 23, 1987. Over approximately the same period, the yield on Corporate Triple A bonds declined from 12.64 percent to 8.31 percent and the prime rate fell from 10.5 percent to 7.5 percent. One bond price index, the Dow Jones Index for 10 Industrials, rose from an intrayear low of 57.36 for 1982 to a yearly high of 93.10 for 1987, an increase of about 62 percent.

In the case of the stock market, the great bull market(s) of the 1980s coincided almost exactly with the accelerated monetary inflations of 1982-83 and 1985-1986. In the fifteen months from the end of August 1982 through October 1983, the broad-based Standard & Poor’s Index of 400 Industrial stocks increased by about 54 percent, from 122.49 to 189.00. After a period, of stagnation, decline, and recovery, which lingered through 1984, the bull market resumed in 1985, propelling the index upward to 334.65 by March 1987. Over the entire period, the index rose by 173 percent. Concomitantly, the annual yield on stocks (the inverse of the P/E ratio), averaged over the same 400 stocks, was driven down from 5.91 percent in July 1982 to 2.51 percent in March 1987.

Foreign Exchange Markets

The latest approach to foreign exchange markets, which was clearly formulated by Mises as early as 1912, treats them as efficient asset markets, wherein current prices or exchange rates quickly adjust to take account of changes in expectations regarding the future development of the relative purchasing powers of the various currencies. Mises’s statement of the approach, however, is more realistic than the modern approach. Whereas the latter assumes “rational expectations,” Mises bases his statement of the approach on a realistic theory of expectations formation and revision which that focuses on the entrepreneur-promoter described above. An important implication of this asset market approach to exchange rates, in both its Misesian and rational-expectations variants, is that exchange rates adjust to monetary inflation very rapidly and certainly before consumer prices and the internal purchasing power of the currency fully adjust. As Mises explained in 1919:

Price increases, which are called into existence by an increase in the quantity of money, do not appear overnight. A certain amount of time passes before they appear. The additional quantity of money enters the economy at a certain point. It is only from there, step by step, that it is dispersed. It goes first to certain individuals in the economy only and to certain branches of production. As a result, in the beginning it raises the demand for certain goods and services only, not for all of them. Only later do the prices of other goods and services also rise. Foreign exchange quotations, however, are speculative rates of exchange—that is they arise out of the transactions of business people, who, in their operations, consider not only the present but also potential future developments. Thus, the depreciation of the money becomes apparent relatively soon in the foreign exchange quotations on the Bourse—long before the prices of other goods and services are affected.…¹⁴

In the first part of the boom, the dollar continued to appreciate against foreign currencies generally, including the Japanese yen and the German mark, reaching its peak in February 1985. The dollar appreciation was due to the fact that the price inflation rate in the U.S. before 1985 was not significantly higher than in Germany and Japan, while relatively high U.S. interest rates resulting from heavy government borrowing to finance federal budget deficits attracted a substantial influx of foreign capital. In early 1985, however, symptoms of the ongoing dollar inflation finally began to appear in world currency markets as inflationary expectations were kindled by the ballyhoo and publicity surrounding the decision of the Fed to cure the yawning U.S. trade gap by deliberately driving down the foreign-exchange value of the dollar.

As a consequence, the dollar price of a German mark was bid steadily upward from approximately $.31 at its all time low in February 1985 to around $.55 at the end of the boom in April-May 1987, representing a price increase of 7.42 percent. Over the same period, the dollar exchange rate for the yen rose from just under $.004 to just over $.007 per yen, a price inflation of 75 percent.¹⁵ Against a trade-weighted basket of foreign currencies, the dollar lost about 40 percent of its market value during the period.

Monetary Deflation and Crash

The monetary deflation of 1987 was motivated by the Fed’s desire to arrest the two-year decline in the external value of the dollar. In late January, the U.S. and Japan undertook “coordinated intervention” into the foreign exchange markets to support the dollar. Under the terms of the Louvre accord, concluded in late February, monetary authorities of six industrial countries including the U.S. agreed “…to cooperate closely to foster stability of exchange rates around current levels.”¹⁶

The decision to prevent further depreciation of the dollar on foreign exchange markets and to stabilize its exchange rates with the mark and yen within “narrow bands” established by the Louvre accord brought monetary inflation to a screeching, if only temporary, halt in February 1987. During the six months prior to this date, the annualized growth rates of adjusted reserves and TMS were 18.27 percent and 19.59 percent, respectively. Suddenly, monetary policy was thrown into reverse as the Fed sold $8.4 billion of government securities, disgorging almost 4 percent of its entire stock in one month. This produced a virtual halt in the growth of bank reserves and a collapse of TMS, which fell from $1,920.4 to $1,873.3 to yield an annual growth rate of -29.4 percent for February. The result was that from late January to early March, dollar exchange rates held firm.

Despite the fact that the Fed’s actions continued to lean toward a policy of monetary tightness in March (open-market operations were slightly expansionary and adjusted reserves grew negligibly), TMS continued to spiral upward at an annual rate of 13.8 percent, fueled by a mammoth 9 percent expansion of the nonreservable savings deposit component that swamped a net decline in other elements of TMS. With the onset of the bond market collapse in April, however, the Fed turned expansionary with a vengeance, swelling its stock of government securities by 4 percent and driving up adjusted reserves and TMS at annual rates of 24.6 percent and 27.7 percent, respectively. Predictably, the dollar once again depreciated sharply on foreign exchange markets from mid-March through April despite active and strong intervention by the U.S. and foreign central banks. From its levels in mid-March, the dollar had depreciated 8.38 percent against the yen and 4.38 percent against the mark by the end of April.¹⁷

Alarmed at the accelerating free fall of the dollar, Paul Volcker announced in late April that the Fed had “snugged up” monetary policy to counteract exchange rate pressure.¹⁸ Thus in May, reserve growth virtually ceased and TMS increased at an annual rate of 2.2 percent, with the dollar falling to nearly a 40-year low against the yen and to a seven-year low against the mark before beginning to sharply appreciate in late May. The Fed continued efforts to bolster the external value of the dollar through the next three months by contractionary open market operations, which saw it shrink its government securities portfolio by 4.2 percent. The result was a three-month monetary deflation, with TMS contracting by a total of about $21 billion or at annual rates of -4.6 percent, -1.0 percent, and -7.0 percent for June, July, and August, respectively. The deflationary policy came to an end in September when the Fed reinstituted expansionary open market operations (although adjusted reserves declined for the month) and TMS increased at a 6.3 percent annual rate, fueled mainly by a large increase in U.S. Government Deposits.

As noted above, the bond market began a steep fall in early April that persisted through May. The interest rate on Triple A corporate bonds rose more than one percentage point, from 8.36 percent to 9.49 percent, between March 27 and May 22. Other credit markets followed, as the commercial paper and prime rates increased, respectively, from 6.29 percent to 6.96 percent and from 7.5 percent to over 8 percent. After relative stability through June, July, and most of August, credit markets became firmly convinced that the monetary inflation was at an end and interest rates resumed their steep ascent, which continued until the October crash. By October 16, the AAA corporate bond rate had reached 10.73 percent, over one percentage point higher than its rate on August 28. Likewise, short-term interest rates rose rapidly between these two dates, with the commercial paper rate jumping from 6.64 percent to 7.86 percent and the prime rising from 8.25 percent to 9.25 percent.

Equities markets followed a different pattern than credit markets in 1987. During the steep run-up in interest rates that occurred during March-May, the stock market experienced only a temporary pause, with the S & P 400 Industrials averaging 334.65 in March and 336.10 in May. While conditions stabilized in credit markets during the summer months, the stock market resumed its boom, the S & P index averaging 14.53 percent higher in August than in May. The deflationary monetary policy of the summer months finally brought the stock market boom to an end in August. However, it took another month and one-half and a series of further events to fully break the back of inflationary expectations in the stock market. The renewed depreciation of the dollar on the foreign exchange markets, which had begun in early August, provoked a discount rate hike in early September, which failed to more than momentarily strengthen the dollar. Against the background of further weakening of the dollar in early October, Treasury Secretary James Baker’s desperate bashing of and threats against West Germany for raising the discount rate in the week before the crash at long last galvanized investors into the realization that tight monetary policy was here to stay and that the Fed was not about to reignite boom conditions.

The result of the divergent movements in credit and equities markets during April-September 1987 was to create a growing differential between bond and stock yields. Thus, between 1981 and Spring 1987 stock and bond prices and yields tracked one another quite closely.¹⁹ However, from April to September 1987, the average yield for S & P’s 400 Industrial stocks fell from 2.52 percent to 2.33 percent, while the yield on Triple A bonds rose from 8.85 percent to 10.18 percent. With inflationary expectations no longer operative in the stock market, this unprecedented yield differential became unsustainable. During the boom—but especially from early 1985 onward—stock P/E ratios were driven to dizzying heights by investors’ expectations of a continuation of low interest rates and of the imminent arrival of price inflation and inflated corporate earnings. The Fed’s volte-face on monetary policy eventually compelled a wrenching revision of expectations among bull-market investors, who now were convinced that interest rates would remain high for the foreseeable future and began to use these higher rates to discount their lowered estimates of future corporate earnings.

The precipitous fall of stock prices on Meltdown Monday thus represented a fundamentally rational, if belated, adjustment of the market to the termination of the Fed-induced inflationary boom. The remedy for stock-market volatility therefore does not lie in the proposals offered by the new Luddites on the Brady commission, who seek to seriously impede, if not destroy, the new productive machinery of stock index trading, portfolio insurance, and computer program trading. No, the aim of preventing stock-market crashes can be attained only by successfully preventing monetary inflation. And this can be achieved only by restoring the ultra-hard money of a genuine gold standard and putting a definitive end to political manipulation of the supply of dollars.

Epilogue: After the Crash²⁰

Since the October stock market crash and especially since the beginning of 1988 the Federal Reserve System has pursued a vigorously inflationary monetary policy and this has succeeded in rekindling the boom and postponing the recession-readjustment which had just begun to take hold in 4Q-88. The fact that interest rates have risen steadily since March has misled financial writers and some economists into proclaiming that the Fed has been progressively tightening monetary policy during this period. But let us examine the money supply figures.

From December 1987 to March 1988 adjusted reserves increased at an annual rate of 7.36 percent, while M1 expanded at a 6.5 percent annual rate and TMS by a 2.78 percent annual rate. The period March 1988 to June 1988 witnessed a speed-up of monetary inflation, as the annual growth rates of adjusted reserves, M1, and TMS accelerated to 10.56 percent, 7.05 percent, and 7.36 percent, respectively. In response to the inflationary monetary policy, the U.S. economy experienced a significant increase in the rate of price inflation in 2Q-88, as the CPI rose at a 4.8 percent annual rate in this period after increasing at a 3.4 percent annual rate in 1Q-88. Credit markets responded to the expansionary monetary policy with steadily declining interest rates from the beginning of 1988 through early March. The sharp reversal of this downward trend during March, especially with respect to short-term rates, was due not to any alleged tightening of monetary policy by the Fed but to the growing realization and conviction among market participants that inflation rather than recession was the most likely prospect for the near future. While the trauma of the October crash kept a jittery stock market on a roller coaster during the first five months of 1988, inflationary expectations finally took hold at the end of May and drove the market (as measured by the Dow Jones Average for 30 Industrial Stocks) to post-crash highs by late June. The real sector of the economy, particularly in the area of investment, also regained substantial momentum in the first half of 1988 under the stimulus of inflationary credit creation by the commercial banking system. From December 1987 to June 1988, commercial bank loans to business expanded at a 10.22 percent annual rate, with the rate exceeding 17 percent over the final three months of the period. The explosive growth of new bank deposits in the hands of business firms succeeded in rekindling the investment boom that had all but died out in 4Q-87. Business fixed investment, which had grown at a paltry 1.7 percent per annum year during 4Q-87, increased by annual rates of 7.6 percent in 1Q-88 and 15.65 percent in 2Q-88. The investment boom also manifested itself during 2Q-88 in a dramatic surge in the after-tax “profits” (net incomes) of corporations operating in basic or “higher-stage” industries such as autos and equipment, forest products, industrial and farm gear, nonferrous metals, petroleum, pipelines, railroads, and steelmaking. Throughout the third quarter, evidence has continued to mount that the American economy is in the midst of a renewed inflationary boom. For example, price inflation, as measured by the CPI, exceeded 5 percent per annum for July and August. Inflationary expectations have driven short term interest rates up between 100 and 150 basis points since March. Whether and for how long this boom can be prolonged and the inevitable recession delayed depends crucially on the actions of U.S. policymakers, particularly the Federal Reserve System.

The Fed signaled its concern with inflation by raising the discount rate from 6.0 percent to 6.5 percent in early August. The minutes of the mid-August meeting of the FOMC reveal that many of the members “saw substantial risks that inflationary pressures would intensify” and “thought that some further firming was likely to be necessary, perhaps relatively soon.” So far, however, the Fed has refrained from significantly tightening monetary policy. Nor is the Fed likely to tighten and risk panicking financial markets before the Presidential election.

In the months after the election, however, the Fed’s hand will be forced. In response to the rapid increase of the money supply in 1988, consumer price inflation will worsen and will head into the range of 6 percent to 8 percent per year This will intensify inflationary expectations and cause interest rates to rise more steeply. The new president, whoever he turns out to be, will be eager to get the accelerating inflation under control in the first year or two of his administration in order to avoid the prospect of the consequent recession dragging on into the year leading up to the 1992 election.

But the greatest pressure moving the Fed to slow monetary growth will not come from the speed-up of domestic price inflation. As inflationary expectations take hold in the foreign exchange markets, the recent appreciation of the dollar, which has been due to the operation of several temporary factors, will be reversed. As the dollar heads downward to the lower end of its “official” trading ranges with the yen and mark, U.S. policymakers may importune the Germans and Japanese to lend support to the dollar by accelerating the inflation of their own currencies. It is highly unlikely, however, that the U.S. will obtain more than rhetoric and token support from this quarter. Foreign capital will begin to leak and then run out of U.S. financial markets, putting additional upward pressure on interest rates and causing the long-term bond market to begin to crumble.

At this point, there will be enormous pressure brought to bear on the Fed to provide increased “liquidity” to financial markets and to bring down interest rates, in order to avert defaults of LDC debtors and a new rash of failures among still-weak U.S. thrift and banking institutions. Should the Fed succumb to this pressure and increase the rate of monetary growth, it will only succeed in intensifying inflationary expectations, accelerating the depreciation of the dollar, and precipitating a full-fledged capital flight out of the U.S. economy.

If the Fed did not already realize it, then it would quickly discover that the only viable option for restoring confidence in the future purchasing power of the dollar and arresting its decline on currency markets is to significantly restrict or even halt the growth of money and credit. When this occurs, the expansion of the 1980s will come to a definitive end and recession will set in. One optimistic note in this scenario regards the stock market. Since the stock market has already discounted the next recession in its October crash, the downtown in real economic activity should not be accompanied by a large drop of overall stock prices.

Based on Austrian cycle theory, my summary outlook for the U.S. economy for the next year therefore includes accelerating price inflation coinciding with rising interest rates and a declining dollar during the first two or three quarters of 1989. While these trends of interest rates and exchange rates may be temporarily interrupted by well-publicized attempts by the U.S. and foreign governments to coordinate support of the dollar on currency markets, the Fed will be compelled to substantially tighten monetary policy before the end of the year. This will usher in a recession in late 1989 or early 1990, which should strike the U.S. economy with a particularly heavy impact on the thrift and banking industries.

Bibliography

Federal Reserve Bank of Cleveland. 1987a. Economic Trends (February).

Federal Reserve Bank of Cleveland. 1987b. Economic Trends (December).

Federal Reserve Bank of Cleveland. 1988. Economic Trends (January).

Federal Reserve Bank of New York. 1987. “Treasury and Federal Reserve Foreign Exchange Operations: February-April 1987.” Quarterly Review 12 (Spring 1987). Available at http://www.newyorkfed.org/research/quarterly_ review/1987v12/v12n1article5.pdf.

Federal Reserve Bank of St. Louis. 1987. National Economic Trends (December).

____. 1988. International Economic Conditions (January).

Gilbert, R. Alton. 1987. “A Revision in the Monetary Base,” Federal Reserve Bank of St. Louis Review 69 (August/September): pp. 24–29.

Hafer, R. W. “The FOMC in 1983–84: Setting Policy in an Uncertain World.” Federal Reserve Bank of St. Louis Review 68 (April): pp. 15–37. Available at http://research.stlouisfed.org/publications/review/85/04/FOMC_Apr1985.pdf

Mises, Ludwig von. 1966. Human Action: A Treatise on Economics. Chicago: Henry Regnery.

____. 1978. “Balance of Payments and Foreign Exchange Rates.” In idem, On the Manipulation of Money and Credit, Percy L Greaves, ed., Bettina Bien Greaves, trans. Dobbs Ferry, N.Y.: Free Market Books.

Salerno, Joseph T. 1988. “The October Stock Market Crash: Causes and Consequences.” The University of Baltimore Business Review 8, no. 5 (September/October): pp. 1–3, 6–8.

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From: “A Monetary Explanation of the October Stock Market Crash: An Essay in Applied Austrian Economics,” Austrian Economics Newsletter 9 (Spring/Summer 1988): pp. 2–6.

¹ TMS stands for “true money supply”–in the sense of true to the theoretical definition of money as athe general medium of exchange. For a discussion of TMS and its components, see Chapter 3.

² I focus on adjusted reserves to gauge the intended thrust of Fed policy, because variations in adjusted reserves are directly related to variations in the aggregate money stock and because the Fed possesses the means for controlling the rate of growth of total reserves, if not in the short run then certainly in the intermediate run (quarter to quarter). In addition, since 1979 the Fed’s policy-making arm has been using reserve targets to guide its actions toward policy objectives. To ascertain short-run changes in monetary policy, I resort to month-to-month changes in the Fed’s stock of government securities, which are determined solely by Fed open market operations, although changes in Federal Reserve credit or even in the adjusted monetary base could also be used for this purpose.

³ All statistics relating to adjusted reserves and the Fed stock of government securities are drawn from Monetary Trends, published monthly by the Federal Reserve Bank of St. Louis.

⁴ For a discussion of the effects on the money supply of the new structure of reserve requirements for different kinds of bank deposits introduced in 1980 , see R. Alton Gilbert, “A Revision in the Monetary Base,” Federal Reserve Bank of St. Louis Review 69 (August/September): pp. 24–29.

⁵ Federal Reserve Bank of St. Louis, National Economic Trends (December 1987), p. 12.

⁶ Hafer, 1985, p. 27.

⁷ Ibid., p. 28.

⁸ Ibid.

⁹ Federal Reserve Bank of Cleveland 1988.

¹⁰ Federal Reserve Bank of Cleveland, Economic Trends (February 1987).

¹¹ Ludwig von Mises, Human Action: A Treatise on Economics (Chicago: Henry Regnery, 1966), p. 544.

¹² Mises, Human Action, p. 255.

¹³ Ibid., p. 708.

¹⁴ Ludwig von Mises, “Balance of Payments and Foreign Exchange Rates,” in idem, On the Manipulation of Money and Credit, ed. Percy L. Greaves, trans. Bettina Bien Greaves (Dobbs Ferry, N.Y.: Free Market Books, 1978), p. 51.

¹⁵ Federal Reserve Bank of St. Louis, International Economic Conditions (January 1988): pp. 2–3.

¹⁶ Federal Reserve Bank of St. Louis, National Economic Trends (December 1987): p. 58.

¹⁷ Ibid, p. 62.

¹⁸ Ibid.

¹⁹ Federal Reserve Bank of Cleveland, Economic Trends (December 1987).

²⁰ This Epilogue is an excerpt from an article (Joseph T. Salerno, “The October Stock Market Crash: Causes and Consequences,” The University of Baltimore Business Review, 8, no. 5 [September/October 1988]: pp. 1–3, 6–8) published one year after the October stock market crash of 1987.