Global Financial Crisis 2008 – Article No 11
by Humphrey McQueen
19 October 1987
The attention being lavished on bank failures and failing bailouts deflect attention from another fault line. The US economy remains dependent on the in-flow of funds to pay for its imports and to fund its three tiers of government. Here, the parallel is not with October 1929 but with October 1987.
That plunge had its source in the redemption of the US economy through driving the less productive firms to the wall through an appreciation of the US currency. That policy made imports cheaper and exports harder to sell. Devastation created the rust-belt.
By the start of Reagan’s second term in 1985, the purge had done its work. US capital and its competitors both needed to wind back the value of the dollar. On 22 September 1985, at the New York Plaza Hotel, the “Plaza Accord” was signed. The plan was to ease the dollar down by 10-12%. Instead, it fell by around 50% against the Yen and the Deutschmark.
A thought experiment helps us to understand what happened next. You are the Sumitomo Bank with investments in the US stocks and bonds. The dollar loses a quarter of its value against the Yen. Instead of owning 100 units, Sumitomo now owns 75 units. All indications are that the dollar will continue to slide. Do you leave money in New York and Washington in the hope that the exchange rate will eventually move in your favour? Or do you pull your investments out and taking the 25% drop rather than risking a 50% loss?
While Sumitomo is pondering what to do, so are all the other investment houses. They are watching the exchange rate and each other. If you are going to exit, you need to get out first to minimise the dangers from a run on the dollar driving down the value of your investments even more.
The flight from the dollar precipitated the plunge on Wall Street on “Black Monday”, 19 October 1987. Catastrophe was averted when the Bank of Japan and the Ministry of Finance instructed Japanese institutions to bear the unbearable by carrying the losses to preserve the global system.
One medium-term consequence of being burned was to encourage smaller investors to look closer to home, thereby feeding the real-estate and stock-market bubbles which went wild until the early 1990. Thereafter, Japanese capital entered into a deflationary cycle from which it still has not escaped, with an interest rate of 0.5%, an effective minus.
A longer-term outcome is that the Japanese were no longer in any position to rescue global capital. Moreover, they were no longer the ones pouring most savings into the USA. That place has been taken by the Mainland Chinese. And that should make us very afraid. China’s financial sector itself conceals an Everest of bad debt and has no guardians comparable to Japan’s in 1987 to marshal financial resources.
Against the tide the declines, the Greenback has been appreciating. So far, so good. The worst case will be a falling US dollar with a collapse of US stocks. That combination will encourage overseas investors to cut and run. One impediment to that solution will be finding a better hole in which to hide. Buy gold!
Next: If she blows