Thursday, October 19, 2017

Remembering Black Monday

The largest single one day decline in percentage terms of the Dow-Jones average (22.6%) happened 30 years ago today, on October 19, 1987.  It was a Monday, hence "Black Monday."  Although unlike after the second largest such one day decline in percentage terms (12.8%) on October 28, 1929, the US economy did not go into a decline, much less anything remotely resembling the Great Depression.  Indeed, the very next day, after starting to decline further in the morning, the market turned around and starting rising, led by the futures and options markets in Chicago.  Although the market would decline far more between August, 2007 and March, 2009 at the front end of the Great Recession, there was no single day during all that when the market fell nearly as much as on either of these two days listed above.

Robert Shiller has written an interesting column in the New York Times about Black Monday (linked to by Mark Thoma on Economists View).  He did a survey after it happened of participants and found that they were driven basically by pure panic.  The Brady Commission report said that it was about the trade deficit and a possible tax change, and also program trading via portfiolio insurance.  Yes, Shiller says that latter was some of it, but in fact he determined that fear of it was probably more important than the actual program trading.  There was very little going on with fundamentals, but vague rumors and reports set off a huge crash, the biggest one day one ever, even if in the end it did not really amount to much.  But Shiller says it can happen again (and, if he were alive, the late Hyman P. Minsky would probably agree).

Let me add a few observations of my own, based on things I was working on back then and have since, if with less attention than Shiller.  In particular I was worrying about how one could model such financial market crashes by considering financial markets as complex nonlinear dynamical systems.  The big candidates for helping to understand such phenomena coming out of that field were catastrophe theory and chaos theory.  As it happened, October 1987 was around the time that chaos theory was at its height as the intellectual fad du jour.  Indeed, it sort of looked like maybe chaos theory might be useful.  It is famous for the "butterfly effect," where supposedly a butterfly flapping its wings in a rain forest in Brazil can cause a hurricane in Texas. So, this apparent lack of anything really major happening in the economy or the markets prior to Black Monday brought forth a lot of commentary along the lines of "Wow, this looks like the butterfly effect and chaos theory!"

Well, the heyday of chaos theory has passed.  For better or worse, the econometrics of identifying whether or not a time series is actually chaotic or not is pretty hairy.  There are no significance tests.  Lots of time series, including plenty of financial ones, that exhibit the basic characteristics of having a butterfly effect (sensitive dependence on initial conditions, a positive Lyapunov exponent, to be more technically precise).  But estimated models based on these do not do well forecasting, not much better than random walks.  Actually, the nature of such butterfly effects is that if they exist, one should not expect to be able to make good forecasts. In any case, even though many such time series look like they might chaotic, we have all lost interest.  But, as it is, quite aside from all that, I do not think chaos theory is(was) really the best explainer of what happened on Black Monday.

Rather, of the family of complex dynamics, I think the relevant one was and is catastrophe theory, which was very much out of fashion at that time.  Let me note that as a sub-part of bifurcation theory, catastrophe theory is back in various parts of economics and ecology and other related disciplines. Pretty much any nonlinear system that shows multiple equilibria will be subject to bifurcations and dynamic discontinuities as they move from one basin of attraction to another.  While the economy did not collapse after Black Monday, and the stock market did not continue to decline, it remained well below where it had been prior to Black Monday for quite a long time.

I note that the very first paper in economics that used catastrophe theory was the second paper ever published in the Journal of Mathematical Economics back in 1974.  Without getting into the technical details, I note that it drew on a much older setup long discussed in the financial markets literature, one where two sets of agents were identified.  One was fundamentalists whose behavior is stabilizing and tends to push the market back toward its fundamental (assuming there really is such a thing), while the other set are the chartists or trend chasers, whose pursuit of bubbles as they rise and their dumping of assets when they fall tend to destabilize the market.  The paper, "The Unstable Behavior of the Stock Exchanges," was written by E. Christopher Zeeman, a major figure in the mathematics of catastrophe theory.  His story was one of a shifting balance of dominance in the market between these two sets of agents, with stability and instability oscillating back and forth within a cusp catastrophe setup, which included the possibility of a market crash.

I note that this basic sort of setup had been modeled in the 1950s by people like William Baumol in long forgotten papers without any fancy nonlinear dynamics.  More recently complexity economists have developed models that follow this Baumol-Zeeman approach, such as the Santa Fe stock market model using agent based modeling in the 1990s, by people like Blake LeBaron and William (Buz) Brock, along with others.  Models with multiple agents who shift their strategies according to recent performance and move back and forth between stabilizing behavior and destabilizing behavior are all over the place and continue to be studied, if not necessarily getting published in the top journals. But these models look pretty good as ways of analyzing these sorts of dynamics.

Addendum:  One other outcome of Black Monday also was that it was the beginning of the end for the dominance in economic theory of the rational expectations axiom.  Yes, it is still around and strong in the whole DSGE modeling world.  But increasingly people take more behavioral assumptions seriously, and Black Monday was a body blow to ratex big time.

Barkley Rosser

13 comments:

dilbert dogbert said...

The election of the current occupier of the White House certainly demolished Rational Expectations in politics. As the study of econ and politics are both social sciences there should be some slop over effects on econ.

AXEC / E.K-H said...

How the representative economist gets it wrong big time
Comment on Barkley Rosser on ‘Remembering Black Monday’

Barkley Rosser summarizes: “One other outcome of Black Monday also was that it was the beginning of the end for the dominance in economic theory of the rational expectations axiom. Yes, it is still around and strong in the whole DSGE modeling world. But increasingly people take more behavioral assumptions seriously, and Black Monday was a body blow to ratex big time.”

Economics is a failed science since 200+ years. How does this cargo cult science survive nonetheless? An important ingredient of the time-tested survival strategy of incompetent scientists is to readily admit and superficially fix striking defects in the so-called protective belt in order to save the methodological core. Let us call this the epicycle stratagem because it was by adding epicycle after epicycle how the Geo-centrists tried to postpone the final admission of empirical and logical refutation.

Economists have always been incompetent scientists but managed to cover it vis-a-vis the general public with some skill in the application of what Popper called immunizing stratagems.

The inevitable failure of economics started with Jevons/Walras/Menger but was officially institutionalized much later by Arrow with this methodological specification: “It is a touchstone of accepted economics that all explanations must run in terms of the actions and reactions of individuals. Our behavior in judging economic research, in peer review of papers and research, and in promotions, includes the criterion that in principle the behavior we explain and the policies we propose are explicable in terms of individuals, not of other social categories.”

The neoclassical concretization of methodological individualism translates into the following hard core propositions a.k.a. axioms: “HC1 economic agents have preferences over outcomes; HC2 agents individually optimize subject to constraints; HC3 agent choice is manifest in interrelated markets; HC4 agents have full relevant knowledge; HC5 observable outcomes are coordinated, and must be discussed with reference to equilibrium states.” (Weintraub)

Obviously, this axiom set contains THREE NONENTITIES: (i) constrained optimization (HC2), (ii) rational expectations (HC4), (iii) equilibrium (HC5). Every theory/model that contains a nonentity is A PRIORI false. By consequence, economics of the Arrow-Debreu type and its offspring until DSGE/RBC/New Keynesianism is scientifically worthless.

The economist’s immunizing stratagem consists of admitting the most blatant defect but adhering to the paradigm of methodological individualism. One example is the replacement of the obviously idiotic behavioral axioms of constrained optimization and rational expectations by something more commonsensical which is readily provided by Behavioral Economics. It should be obvious that Behavioral Economics is not a new paradigm but just another version of methodological individualism as defined by Arrow.#1

One of the loudest proponents of the proto-scientific approach of Behavioral Economics is Barkley Rosser and his buddies in the econoblogoshpere.#2 What these folks do not understand is that economics is NOT a science of behavior and that if it isn’t macro-axiomatized, it isn’t economics at all.#3

Egmont Kakarot-Handtke

#1 See also ‘Joan Robinson and the early death of Behavioral Economics’
https://axecorg.blogspot.de/2017/10/joan-robinson-and-early-death-of.html

#2 Rather weird examples of Behavioral Economics are ‘The Case of the Spitting Legionnaire’ and ‘Why I Lack Sympathy For The Catalan/Catalunyan Independence Movement’ and many others at EconoSpeak
http://econospeak.blogspot.de

#3 For details of the big picture see cross-references Failed/Fake scientists
http://axecorg.blogspot.de/2015/11/failedfake-scientists-cross-references.html

Anonymous said...

AXEC / E.K-H:

What is the point of reading such mean-spirited writing? The mean tone alone immediately tells me there is no substance to the writing. Trying to be decent could make the writing substantive, even if critical. Try to help yourself think rationally.

Don Coffin said...

I am reminded that I changed jobs in 1987 (moving from Illinois State University to Indiana University Northwest), and that shortly before the October 19 crash I had received a transfer of funds from the Illinois Teacher Retirement Fund, which I re-invested as a rollover IRA. On October 12. As always, my timing was exquisite...

rosserjb@jmu.edu said...

Um, Egmont, obviously neither the post by Sandwichman on The Spitting Legionnaire, nor mine on the Catalan independence movement have much to do with economics directly, much less behavioral economics specifically. But you have been repeatedly informed that posters here do post about broader political and social topics when they feel like it, and that went on at Maxspeak as well, the predecessor to this blog, where both Sandwichman and I did our things.

Regarding the crash of 1987, the behavioral economists, with people like Robert Shiller very prominent among them, were far more on top of what was going on and why than others. There is certainly no evidence that anybody who believed your wacko theory about profits had anything useful or intelligent or insightful to say about Black Monday, and you offer a big fat zero yourself here, and your theory has nothing to say about it, nothing whatsoever. You are just completely useless.

And that is all I shall have to say to you on this thread, unless you actually show you can say something remotely relevant or intelligent about stock market crashes. But I know you cannot and will not. You have nothing to offer on this, nothing.

AXEC / E.K-H said...

Barkley Rosser

Most people/economists have no proper understanding of what economics is all about. Therefore it is, first of all, of utmost importance to distinguish between political and theoretical economics. The main differences are: (i) The goal of political economics is to successfully push an agenda, the goal of theoretical economics is to successfully explain how the actual economy works. (ii) In political economics anything goes; in theoretical economics the scientific standards of material and formal consistency are observed.

Theoretical economics has to be judged according to the criteria true/false with truth well-defined as material and formal consistency. Political economics has produced NOTHING of scientific value in the last 200+ years. The four major approaches — Walrasianism, Keynesianism, Marxianism, Austrianism — are mutually contradictory, axiomatically false, and materially/formally inconsistent. Economics is a failed science but economists award themselves the “Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel” (note the brain-dead plural).

The political agenda pushing of orthodox and heterodox economists normally comes in the form of a verbal/formal model/theory that pretends to satisfy scientific criteria. This, of course, is what Feynman called cargo cult science.#1 However, soapbox economist like you and Sandwichman do not even care about pretending to do science but vomit their political agenda directly into the econoblogosphere.

To argue that you have done this already at the predecessor of this blog does not make things better but worse. It proves only that the scientific self-governance never worked in economics.#2

You are right in assuming that I do not discuss the crash of 1987 with you.#3 For cargo cult scientists who have until this day not realized that constrained optimization, rational expectations, supply-demand-equilibrium, Arrow-Debreu economics up to DSGE, Behavioral Economics, Keynesian I=S, Post Keynesianism up to MMT is proto-scientific garbage and who after 200+ years still do not understand what profit is there is only one message: get out of the way.

Egmont Kakarot-Handtke

# 1 See ‘Mr. Keynes, Prof. Krugman, IS-LM, and the End of Economics as We Know It’
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2392856

#2 For the perversion of peer-review see Heckman ‘Publishing and Promotion in Economics: The Curse of the Top Five’
https://hceconomics.uchicago.edu/sites/default/files/file_uploads/AEA-Curse-Five-HO-SMALL-STATIC_2017-01-06d_jbb.pdf

#3 For the correct crash theory see ‘Mathematical Proof of the Breakdown of Capitalism’
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2375578

Anonymous said...

"Most people/economists have no proper understanding of what economics is all about...."

No reason to read further. Being polite might lead you to think properly, but I suppose there is little to no chance of being polite...

Flow5 said...

"So, this apparent lack of anything really major happening in the economy or the markets prior to Black Monday"

Dead wrong. 1987 was the litmus test for Central Bank stupidity (no black swan). Even Robert Prechter’s Elliott Wave International got it exactly right.

Monetary flows (volume X’s velocity), fell from 16 in AUG, to 4 in NOV (See G.6 release – debit and demand deposit turnover). [ Δ, not Δ Δ ] Note, money flows, bank debits (money actually exchanging counter-parties), turned negative during the S&L crisis.

http://monetaryflows.blogspot.com/2010/07/monetary-flows-mvt-1921-1950.html

Conterminously (3 months prior to the crash), the rate-of-change in RRs (the proxy for R-gDp), was surgically sharp, decelerating faster than in any prior period since the series was first published in January 1918. The proxy declined from 11 in JUL to (-)4 in OCT. [ Δ, not Δ Δ ]

Accompanying this sharp deceleration in the RoC for M*Vt (proxy for all transactions in American Yale Professor Irving Fisher’s truistic: “equation of exchange”, the monetary authority mis-judged macro-economic strength (like the last half of 2008), and on Sept. 4 the FOMC raised (1) the discount rate, which was not yet a penalty rate, 1/2 percent to 6%, & (2) the policy FFR 1/2 percent to 7.25% (up from 5.875% in Jan).

Black Monday began when the target FFR was increased to 6.5% on 9/4/1987. The effective FFR began to trade above the policy rate c. 9/22/1987 (constrained by reserve demand). The effective FFR spiked on Thursday (the very first day of the reserve maintenance period).

On Sept. 30 the effective FFR spiked at 8.38%; fell to 7.30% by Oct. 7; then rose to back to 7.61% Oct 19 (Black Monday). Thus, the effective FFR spiked 36 basis points higher than the FOMC’s official target, it’s policy rate on “Black Monday”.

The shortfall in the quantity of legal reserves supplied by the FRB-NY’s trading desk (which had already dropped at a rate not exceeded at any time since the Great Depression) bottomed with the bi-weekly period ending 10/21/87. This was the trigger. However, the Fed covers: The Nattering Naybob’s “Elephant Tracks”. So you can't run a regression against the historical time series.

At the same time, the 30 year conventional mortgage yielded 11.26%, up from 8.49% in Jan. 87, & Moody’s 30 year AAA corporate bonds yielded 11.06% on 10/19/87, up from 9.37% in Jan. 87.

The preceding tight monetary policy (monetary policy blunder), i.e., the sharp reduction in legal reserves (mirroring the absolute decline in our means-of-payment money), had effectively forced all rates up along the yield curve in the short-run (when inflation and R-gDp were already markedly subsiding). I.e., interest is the price of loan funds, the price of money is the reciprocal of the price level.

Note: interest rates may either rise or fall during the short-run, in response to the FOMC tightening policy, depending upon the “arrow of time”, and the monetary fulcrum (the thrust of inflation).

On 10/19/87 the CBs had to scramble for reserves (too stringently supplied relative to demand) at the end of their maintenance period (bank squaring day), to support their loans-deposits (it is noteworthy that contemporaneous reserve requirements were then in effect exacerbating the shortfall & response time).

A significant number of banks, with large reserve deficiencies, tried to settle their legal reserve maintenance contractual obligations at the last moment. But the FRB-NY’s “trading desk” failed to accommodate the liquidity needs in the money market – until it was already way too late (i.e., ignored their perversely coveted interest rate transmission mechanism).

rosserjb@jmu.edu said...

Flow5,

Sorry, but the Elliott Wave did not get it, certainly not precisely. I consider the EW to be pretty much crackpot economics, sorry.

My discussion of this in writings in 1990 and 1991 put it In the framework both of catastrophe theory and also of the Minsky approach. My post already covers the catastrophe theory part of it, the Minsky part is that like most major bubbles, this one had a period of financial distress prior to the crash. The market had peaked in August, 1987 and had been gradually declining since that point, dropping between the peak and Oct. 19 by about as much as it dropped on Oct. 19 itself. Greenspan had been watching this and had prepared emergency actions to do if there was a crash, which he did, and which made his reputation for many years, later undone.

However, the rest of your argument is pretty much of a joke. Look at the magnitude of the changes you list, essentially miniscule changes in various interest rates and other variables, and there was basically nothing going on in the broader macroeconomy. There had been a pause in GDP growth in mid-1986, but nothing of the sort happened in 1987, with both inflation and GDP growth pretty stable and not out of line in any direction noticeably.

The bottom line remains that basically nothing happened in the broader economy with only very minor wiggles in both primary financial variables as well as some policy discussions (there had been a tiff over currency values between the US Treasury Sec. and the German fin minister at the end of the previous week). But this was the largest single day decline in the US stock market ever, larger than any that preceded the Great Depression or the more recent serious Great Recession, and it had barely any impact on anything.

Regarding the black swan, in fact it was the 1987 crash that my friend Nassim Taleb identified as being a classic black swan: completely unexpected. The 2008 crash was not a black swan according to him as pretty much anybody with any brains could see that it was coming with the massive decline from the housing bubble and the major problems erupting throughout the banking system as a result. I saw it and posted about it, calling the crash about two months before it happened, noting at the time that we were in a clear Minsky period of financial distress. It was a grey swan, merely a fat tail on a not too far out distribution. The 1987 crash was the truly unexpected black swan, coming totally out of the blue.

BTW, for the record, while I do not agree with him on some of his controversies with others, I largely agree with Taleb on probability theory and black swans and what happened in the financial markets. I have him on my editorial board at the Review of Behavioral Economics and have published two papers by him in journals I edit. He has returned the favor and in the second edition of The Black Swan includes me in his list (late in the book) of three economists he "takes seriously," the others being Nouriel Roubini (aka "Dr. Doom") and Michael Spence.

Wallfly said...

My daughter (who is fairly precocious) has been listening to the James Gleick book on Chaos. Any recommendations for updating the story on the fortunes of chaos theory?

AXEC / E.K-H said...

Anonymous

BloombergView writes: “Economists have come to rival even journalists and politicians in lack of public esteem. That might be partly because so many economists seem as interested in journalism and politics as in advancing their science. But there’s also a deeper problem: Far from advancing, the science of economics has been going backwards.”*

The article is titled ‘Why Not Make Economics a Science?’ Hmm, stupid folks at Bloomberg! Have they never heard of the “Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel”? Take notice of the plural, Bloomberg editors: economics is already sciences not merely science.

Obviously, someone is taking the general public for a ride, is it the journalists or the ‘Nobel’ committee?

To make economics a science presupposes the eviction of all failed/fake scientists and political blatherers like you, Sandwichman, and Barkley Rosser. You complain that this is not very polite. That is true but misses the point.

Here is Schumpeter’s good advice for all complainers: “Remember: occasionally, it may be an interesting question to ask why a man says what he says; but whatever the answer, it does not tell us anything about whether what he says is true or false.”

Refute my post above if you can but spare the world the horrors of your ruminations about politeness.

Egmont Kakarot-Handtke

* https://www.bloomberg.com/view/articles/2017-02-06/why-not-make-economics-a-science?utm_content=view&utm_campaign=socialflow-organic&utm_source=twitter&utm_medium=social&cmpid%3D=socialflow-twitter-view

Barkley Rosser said...

Wallfly,

I hate to be sort of esoteric, but the mathematical appendix to my 2011 book, Complex Dynamics in Urban-Regional and Ecologic-Economic Systems: From Catastrophe to Chaos and Beyond, Springer, will do it, although I fear the darned book costs a lot of money, but maybe you can get a copy of it from a library somewhere.

Oh, Egmont, aside from dragging in some journalists, you have said nothing you have not said a thousand times previously in your now two new posts above. I have refuted these arguments many times and am not going to waste peopeles' time by indulging you with more refutations, none of which you seem to recognize have completely obliterated your arguments. I suggest you try getting more than the one publication in a journal than you currently have, as near as I can see. I know you blame your inability to publish all those papers you cite in your posts here on some conspiracy by all the terrible unscientific economists who do not worship at the feet of your empty accounting identity about retained earnings, but in fact is because your arguments are useless garbage.

AXEC / E.K-H said...

Barkley Rosser

You say: “… you have said nothing you have not said a thousand times previously in your now two new posts above.”

Even you in your utter confusion should understand that to repeat a thousand times 2+2=4 does not make it false. Physicist repeat the Law of the Lever since more than 2000 years and it is still true. To repeat a thousand times the statement of fact that Barkley Rosser is a scientifically incompetent political agenda pusher does not alter the fact.

You hallucinate: “I have refuted these arguments many times and am not going to waste peoples’ time by indulging you with more refutations, …”

My argument is that the profit theory is false since Adam Smith.* The axiomatically correct macroeconomic relationships are:
Qm=−Sm in the case of the pure production-consumption economy,
Qm=I−Sm in the case of the investment economy,
Qm=(I−Sm)+Yd+(G−T)+(X−M) in the general case.
Legend: Qm monetary profit, Sm monetary saving, I investment expenditures, Yd distributed profit, G government expenditures, T taxes, X export, M import.

You say “I have refuted these arguments many times”. Fact is (i) that you have NOT refuted it once, and (ii), that you have blathered your lifetime about economics without understanding the pivotal concept of the subject matter.

Egmont Kakarot-Handtke

* For details and sources see cross-references Profit
http://axecorg.blogspot.de/2015/03/profit-cross-references.html