7:46 a.m. Friday 7/26/96
After the stock market crash of 1987 the exchanges created a number of “circuit breakers.” These circuit breakers are rules designed to prevent the kind of cascade effect we apparently see in a crash, price declines rapidly generating sell orders and thereby more price declines. For example, the New York Stock Exchange’s Rule 80A restricts the kinds of orders program traders can place if the Dow moves more than 50 points in a day. It is widely believed that the circuit breakers may have some stabilizing effect on markets. At the very least Rule 80A, when it is triggered, prevents people from being influenced by a worry that observed price movements are caused by program traders. Thus, Rule 80A might calm markets. But I wouldn’t expect these circuit breakers to do too much. Recall that both the 1929 crash and the 1987 crash occurred after one of the most powerful circuit breakers of all: a long suspension of trading called the weekend. There is just no reason that any measure to slow down trading can be expected to eliminate speculative pressures on markets. Note that with real estate, it can take months to trade, and speculative price movements seem to be alive and well there. Robert Litan
8:06 a.m. Friday 7/26/96
Dr. Stein asks whether my back-of-the-envelope estimate of a GDP loss of 0.2 percent from a sustained drop in the stock market refers to a short-run (i.e. one/two years) or a long-run effect. The answer is short-run. The so-called “wealth effect” is the amount by which total consumption varies with wealth. Consumption is a component of aggregate demand, and so if wealth falls, then total demand falls. But this drop in consumption will not be permanent, if for no other reason than because the Federal Reserve will allow the economy later to make up the shortfall with faster growth than it would otherwise allow. A reasonable estimate, therefore, is that the fall in consumption would be felt for about a year (at most), and then taper off. Dr. Stein suggests that a stock market decline could have the opposite–growth-enhancing–effect in the long run. The reason is that with less wealth today, individuals will save more tomorrow than they otherwise would, in order to hit the same desired level of wealth when they retire. That may be true for “target” savers, but not everyone thinks this way. I suspect that at the end of the day any effect of the recent stock decline on long-run growth is likely to be too small to detect. Finally, Dr. Stein wonders if we are rid of the evil effects of program trading. I share Prof. Shiller’s views on this and suggest that readers consult page C1 of today’s Wall Street Journal, which talks about “momentum investing,” sounding very much like program trading to me under another guise. Bottom line: When investors want to bolt for the door, circuit breakers designed to limit program trading won’t stop them (although they may slow them down a bit).