Economic Thought and the 1987 Crash
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One of the reasons the 1987 stock market crash has proven so controversial is its ability to contradict the primary body of economic and financial theory that has dominated Western thought through most of the last century. I'll make an effort to describe in a very general way the basic models economists have used to understand people and markets, and why the crash contradicts these models.

Economists in the 1800's created a concept called 'rational man,' an archetype for how humans are, or were, believed to function. In the tradition of Adam Smith, who helped to perpetuate the idea that man is primarily driven by self interest, rational man seeks to maximize his own interests. He does so in a rational manner; given a list of preferences from which he might choose, rational man determines that which will serve him best. Because he is able to sort out all his preferences, in other words, because his rationality bequeaths him with perfect knowledge of that which affects him, as well as calculator-like computational ability, he always chooses optimal solutions. Taking this to an economy-wide perspective, many rational men interacting amongst each other in a way such that each maximizes their self interests was believed to result in an efficient market. The combined rational choices of the many actors who made it up, was impervious to mistakes. Given these sort of conditions, markets were given the almost religious designation of perfect, always at an equilibrium due to the actions of its many intelligent participants.

In the mid 20th century, these sorts of ideas were migrated by economists from labour and good markets to stock and commodity markets. In the setting of the stock market, man's rationality was believed to give him the ability to instantaneously react to new events, determining whether the information contained in events might be positive or negative with respect to whichever stock was being analyzed. If the news was beneficial, the stock price was immediately bid up, and vice versa if it was detrimental. The infallibility of man's rational thought process meant that stock prices always corresponded to economic reality, and automatically adjusted when this underlying reality changed.

When an event occurs, economists tell us, it's implications are immediately reflected in a stocks price. After appraisal by the perfectly rational mind from all angles, prices quickly adjust, and the event ceases to have any influence on price. From this, economists concluded that past events and prices had no relevance to present stock prices. For if everything of importance available from glances to the past could be assumed to already have been evaluated by rational market actors, why bother looking at old events for hints? Instead, the market waits for new events to occur, quickly adjusting to each as they occur. Say IBM issued a press release on Monday. Profit maximizing investors would immediately analyze the press release, determine its merits and demerits, and subsequently bid IBM prices up or down, arriving at an optimal market price. By Tuesday, Monday's press release and price change would both be irrelevant to the rational investor, all information long since reflected in IBM's share price.

The famous random-walk hypothesis states that because markets are created by rational investors, all past information is already factored into prices, only future events affecting shares. Any attempt to analyze previous price charts or news releases is pointless, since only future news will affect prices. Because future events are unpredictable and occur randomly as time passes, stock prices follow a random walk. The theory holds that any effort to predict future stock prices is folly, akin to guessing the result of a coin toss.

Random number series such as coin tosses have certain characteristics. There is no memory in a random series, correlations between past returns and future returns non-existent. If heads came up last toss, for instance, this information will by no means effect the results of the next toss. All random series have a recognizable statistical distribution - a zone in which one can expect future changes to lie. This distribution - the normal distribution - states that day-to-day stock price changes can be expected to be located somewhere under a bell shaped curve, the greatest probability being small negative or positive changes, the smallest probability being a large change somewhere on the edge of the bell, near the tails. By assuming that markets took this random distribution, a whole battery of statistical applications were opened to economists.

Then the 1987 crash occurred.

The crash completely contradicted this entire body of work. If markets were believed to be normally distributed with daily changes lying somewhere under the safety of a the bell shaped curve, then 1987 completely turned this assumption on its head. I enclose a quote from economist Mark Rubinstein.
"Adherents of geometric Brownian motion or log normally distributed stock returns (one of the foundation blocks of modern finance) must ever after face a disturbing fact: assuming the hypothesis that stock index returns are log normally distributed with about a 20% annualized volatility, the probability that the stock market could fall 29% (the decline in S&P futures on October 19th, 1987) in a single day is 10-160. So improbable is such an event that it would not be anticipated to occur even if the stock market were to last for 20 billion years, the upper end of the currently estimated duration of the universe. Indeed, such an event should not occur even if the stock market were to enjoy a rebirth for 20 billion years in each of 20 billion big bangs."

In other words, the 1987 crash lies so far to the extreme of the bell shaped curve that the normal distribution is unable to account for it. It is an anomaly, an outlier, a paradox. If the normal distribution fails to explain real market conditions, the assumptions underpinning the application of the normal distribution to markets - investor rationality, efficient markets, and a random walk - find themselves being threatened. Perhaps market returns are not random rolls of the dice, but instead are characterized by memory effects that link changes in one period to those in another. If assumptions of normality are in fact right, say their critics, the crash should never have occurred. That it did occur seems to contradict them, and begs the question: what distribution does the stock market take?

The lack of major events prior to the 1987 crash also defies economic logic. If, as theory would have it, rational man observes shifts in economic reality and immediately makes self motivated choices that result in optimal changes in market prices, then what sudden shift in economic reality caused him to make the choices leading to a 23% decline? Economists tell us a drastic 23% fall can only have been precipitated by an extreme change in economic reality, not defects in rational man's thought processes, nor memory effects or psychology. Yet looking back at the event, no extreme change in economic reality occurred. One might try characterizing the US-Iran conflict or the Baker-Germany dialogue as potential crash-makers, but these were really only small events with strong counter-arguments (see the events link), not the sort of events that lead to 23% changes. Thus, using the economic tools available to us, we are left holding an empty bag. We know the crash occurred, we are told man is rational, yet, we can find no cause. When we acknowledge 1987, economic theory fizzles out.

Economic historians teach us that the concept of rational man started out only as a helpful guide by which to understand humanity. Like any generalization of the world, it was never expected to accurately portray us in every way and form, only provide a model of how things might be. Over the years, as the body of work built upon the rational foundation grew, academics turned from rational man-as-assumption to rational man-as-corner-stone of economic thought. To remove the rational assumption from the economic body would destroy years of theorizing and statistical achievement. Better to accept rational man as an axiom than question him, seems to be the academic response, most forgetting that rationality was never but an assumption in the first place. And the theory is not without its successes. It cannot be ignored that rationality has been a very helpful assumption to adopt when approaching markets conceptually. If everyone was indeed rational, able to perfectly order their preferences, and make optimal choices based on given information, then markets would indeed be efficient. Share prices would approach randomness, and very few mistakes would be made in the valuation of security prices.

Because mainstream economics cannot explain the 1987 crash, we are brought back to the days when rationality in markets was accepted as only an assumption, not an inherent truth. The failure of theory gives us room to pause and question: are people purely rational, or are they driven by other complex drives? Are markets always correct, or are they riddled through with the complexity of psychology, un-optimal decision making, and unexplainable phenomena like crashes? Did rational man ever exist?

  JPK and Lope