In Issue 2, it was suggested that these problems are to a large extent related to the strength of the dollar and to the growing financial asset bubble in the United States, both of which are causing a massive flow of international capital into the USA.

Japan has never recovered from the effects of the domestic financial and real estate bubble which collapsed in early 1990. The rest of the region however did not appear to be having problems until first Thailand then, at staggered intervals, other nations also began to experience declining stock markets. By the middle of June of this year the worst effects were still only apparent in Thailand which, in addition to a massive collapse in stock market valuations, was by then also seeing problems with a number of its financial institutions. Elsewhere, as in South Korea and Singapore, all that was visible on the surface were falling stock markets, and meanwhile, Hong Kong stocks were still following the USA up to stratospheric new heights.

But, with increasing momentum, South Korea started following Thailand into the abyss. With hindsight, Korea's crisis began back in January when Hanbro steel group collapsed. Now a stream of other companies has sought bankruptcy protection, including the huge Kia Group. As the number of bad loans multiplied, the commercial banks moved into overall loss, and some may be facing serious problems.

Planning is in the hands of the President's Working Group on Financial Markets, which is chaired by Robert Rubin, and includes Gene Sperling, head of the White House's National Economic Council, Federal Reserve Chairman Alan Greenspan, Securities and Exchange Commission Chairman Arthur Levitt, and Commodity Futures Trading Commission chairwoman Brooksley Born. This group was formed after the October 1987 market crash, and its primary purpose is to coordinate the response to such events in the future. Its stated position is that its purpose is not to attempt to prevent or arrest a market crash as such, but to maintain orderly markets throughout the crisis. The ultimate aim of this is to prevent the effects of such an event from spreading and causing major problems in the rest of the American economy (and internationally).

In particular, great care has been taken not to publicly imply that there is any particular "target" or "right" level of equity valuations. As Rubin said "Those are the kind of judgments each investor has to make for himself." To do otherwise might be taken by the markets as implying a floor below which the authorities will intervene: a sort of Federal insurance policy for your stocks.

But, in reality, the practical distinction between maintaining orderly markets and intervening to shore up a collapsing market can be very fine. In fact, given some very possible scenarios, it becomes invisible. Though never admitted, it is widely believed that the Federal Reserve Board (via surrogates) intervened directly in 1987 through the purchase of S&P Index Options. His attempt to draw such a fine distinction is what explains Alan Greenspan's verbal contortions over the past 18 months. He has said everything he can, short of "The damn stock market is too high!" to get the message across. Have a look at the Greenspan quotations that I have gathered in the Appendix. I also give some official quotes from the Bank of International Settlements. Central bankers around the world apparently have few doubts that US stocks are very overbought.

What actions will be taken in the event of a severe downturn in the US equity markets?

There have been recent media reports that the Federal Reserve has a valuation model that puts the S&P 500 Index currently at something like twenty percent above fair value. We can deduce from this that there would be little concern about a decline of 20% to 30% provided that it is orderly and not sudden.

The concern is that if the market becomes illiquid and can't function then this itself can exacerbate the crisis, perhaps turning a correction into a rout*, or spreading throughout the financial system as cash flow and credit dry up. This actually almost happened during the 1987 Wall Street crash. The authorities were ill prepared and we came perilously close to a total financial meltdown.

(* when any market ceases to function, the vital pricing information upon which buy and sell decisions are made is no longer available. There is a natural tendency in such circumstances for potential sellers to sell out of fear, but for potential buyers to hold off. The latter effect is potentially the worst problem: because prices are established at the margin, crashes involve a lack of buyers more than an increase in the number of sellers.)

The primary line of defence is really nothing more than systems design. It is about ensuring that investors can contact their brokers or mutual fund companies to get advice or give instructions; that trades can be executed promptly and smoothly; and that the associated cash flows will not be interrupted. For example the capacities of the electronic trading systems at the big American exchanges have been increased to ensure that they are capable of handling huge surges in traffic. The big financial firms have installed additional telephone lines and have arranged for trained staff to be available to man them.

The next line of defence is to supply liquidity to the markets, if and when it is needed. Developments will be monitored minute by minute by telephone hot line to major firms in all sectors of the financial services industry, including the mutual funds industry which is of special concern today due to its huge holdings and the inexperience of many mutual fund investors. (Equity mutual funds are extremely vulnerable to market shocks because they can be forced into selling stocks simply to meet redemptions. They have a cushion in that they may borrow on lines of bank credit secured by their holdings of stocks, but as it is absolutely impossible for anyone to predict how the many novice investors will react, the level of redemptions that will be experienced cannot be even estimated.) If it appears that problems are developing, the Federal Reserve will pump money into the system by supplying funding to the banks who will make it available to brokerages and the funds industry. They are also likely to sharply reduce the Fed funds interest rate to ease credit: another way to add "liquidity" to the system.

Finally, probably as a last resort, there is the possibility of direct intervention in the equity markets themselves. The rumoured purchases of S&P Index Options in 1987 have already been mentioned.

International arrangements are likely to at least include coordinated efforts to prop up the dollar to reduce capital outflows from USD assets.

In 1987, the crisis was contained and did not spread to the wider economy. The stock markets recovered after a few months, and the only price paid was a subsequent surge in inflation: a direct result of the reflationary actions taken by the Federal Reserve in managing the crash. Today, a decline of 20% or even 30% can likely be weathered, but the American equity markets have become so huge that should they fall further than that, the potential economic consequences are severe.More about this in the next Issue.

From remarks by Alan Greenspan at the Annual Dinner and Francis Boyer Lecture of The American Enterprise Institute for Public Policy Research, Washington, D.C.December 5, 1996:-

"Inflation can destabilise an economy even if faulty price indexes fail to reveal it. But where do we draw the line on what prices matter? Certainly prices of goods and services now being produced--our basic measure of inflation--matter. But what about futures prices or more importantly prices of claims on future goods and services, like equities, real estate, or other earning assets? Are stability of these prices essential to the stability of the economy?

Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?" And "how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs,and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy."

From Humphrey-Hawkins Testimony of Alan Greenspan, July 22, 1997:-

"With the economy performing so well for so long, financial markets have been buoyant, as memories of past business and financial cycles fade with time. Soaring prices in the stock market have been fuelled by moderate long-term interest rates and expectations of investors that profit margins and earnings growth will hold steady, or even increase further, in a relatively stable, low-inflation environment. Credit spreads at depository institutions and in the open market have remained extremely narrow by historical standards, suggesting a high degree of confidence among lenders regarding the prospects for credit repayment."

Excerpts from the speech delivered by W.F. Duisenberg,Chairman of the Board of Directors and President of the Bank for International Settlements, to the sixty-seventh Annual General Meeting of the Bank held in Basle on 9th June 1997:-

"Nevertheless, this benign outlook is not free from risks. Some of these risks relate primarily to the shorter-term prospects.It cannot be ruled out that in the United States the incipient signs of inflationary pressures might prove more stubborn than anticipated, potentially posing a threat to further rapid expansion.In Japan, headwinds arise from continuing weakness in segments of the financial sector and from the need for fiscal restraint.In parts of continental Europe, prospects remain vulnerable to a sudden reversal of market sentiment or to policy shortcomings.In those non-industrial countries where progress in reducing inflation has resulted in a marked real appreciation of the currency, and particularly where financial systems contain elements of fragility,the erosion of competitiveness could make it harder to reconcile strong growth with control over inflation. And linking several of these concerns is the remarkable buoyancy of financial markets,generally driven by a relentless search for higher yields. The question is whether the macroeconomic risks have been correctly evaluated and factored into asset prices or whether the materialisation of any of them could trigger some broader form of retrenchment.

The roots of . . . instability often lie in excessive credit creation. This can either generate inflation in product markets or facilitate excessive increases in asset prices, whose subsequent reversal can lead to financial strains and undermine the quality of loan portfolios. Finally, and for much the same reasons, instability in one sphere can complicate the task of preserving stability in the other. To mention just two examples,how should central banks respond when the adjustments in interest rates needed to contain inflation are deemed inconsistent with financial stability, or when those required to restrain excessive buoyancy in asset prices may risk undue contraction in product markets?"

From a news report by Wolfgang Minchau covering the 1996/97 Report of the BIS:- "Just as it would be premature to declare inflation dead, it would also be unwise to assume that sound fundamentals guarantee good performance in the near term. Perhaps the most pressing concern is that inflationary pressure in the US may soon prove more difficult to tame than expected and the expansion may end abruptly. Even a"soft landing" which demanded a series of tightening measures might have significant implications for equity prices and other more risky investments", the BIS said in its report. Mr Andrew Crockett,general manager of the BIS, said: "The fact that asset prices are on the increase, when inflation is low, is something to reflect on."