FINANCIAL MARKET TURMOIL: BROADER IMPLICATIONS

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP90T00114R000500830001-2
• Release Decision: RIPPUB
• Original Classification: T
• Document Page Count: 18
• Document Creation Date: December 23, 2016
• Document Release Date: March 13, 2012
• Sequence Number: 1
• Publication Date: November 23, 1987
• Content Type: MEMO

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Central Intelligence Agency
Washington. D.C. 20505
DIRECTORATE OF INTELLIGENCE
23 November 1987
Financial Market Turmoil: Broader Implications
Summary
The continuing turmoil in world financial markets is creating, in
our view, important implications for a number of key global
economic and
li
i
po
t
cal trends.
Economic growth in the industrial countries seems almost
certain to slow, although the degree of the slowdown remains
a major question. CIA econometric estimates indicate
industrial country growth next year will.. be of-f~ only 0.1 to
0.5 percent, while a major forecasting firm estimates a drop
in growth of more than 1 percent in its most likely
scenario. Econometric models, however, often underestimate
the m
i
agn
tude of economic turning points.
Although Tokyo and Bonn moved quickly to loosen monetary
policy in the wake of the crisis, we doubt either government
will consider expansionary fiscal policies unless they
expect growth to plunge to politically unacceptable levels,
which we believe to be less than 2 percent in Japan and less
than 1 percent in West Germany. Moreover, Tokyo and Bonn
probably would ease monetary policy further only if the
dc) 1 1 ar weak
n
....t^
- -, ,
e
s
stant
This memorandum was prepared for The Honorable George Shultz,
Secretary of State, by analysts in the Offices of Global Issues,
European Analysis, and East Asian Analysis. Information as of 23
November 1987 was used in its preparation. Comments and queries
are welcome and may be directed he Director, Office of Global
Issues
G1 M 07-2-0185C
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I I -
Many LDCs probably will face reduced investment inflows and
renewed capital flight as investor uncertainty causes a
shift to higher quality assets in the industrial countries.
Gains for the LDCs from current lower interest rates and the
lower dollar will be dampened by the slackening industrial
Broader political and economic issues are also likely to be
affected b
fall
f
y
out
rom the financial market turmoil.
The current financial difficulties have exacerbated foreign
concern that US domestic problems will override long term US
commitments abroad. Recipients of US foreign aid, for
example -- particularly Israel -- fear that the financial
r. V.;
h
.13 a g
t result in even deeper cuts in US support.
International cooperation has increased i
th
i
n
e
mmediate
wake of the crisis, but if economic growth turns down in the
future, cooperation on economic issues might be tougher to
achieve as other actors in Asia and Europe assert their
increased economic power relative to the United States.
Foreign leaders are likely to take advantage of this growing
strength to make proposals that may be contrary to US
interests
A severe downturn would also increase both the political and
economic pressure on existing multilateral institutions.
Economic organizations could face stiff foreign criticism
for failing to cope with any protracted crisis. As in
previous international economic crises, a wide range of
proposals might emerge to modify these institutions or
Some structural changes in the industrial countries will be
examined more carefully now. For example, some foreign
privatization programs and financial liberalization measures
now mi
h+ b
-1-----3 1
g
e
Because of their economic isolation, the economies of the Soviet
Union and the other East Bloc countries will be much less
affected by economic problems in the West. Should Western
economies enter a prolonged downturn, however, efforts within
these
overn
t
g
men
s to liberalize may face greater obstacles.
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ECONOMIC IMPACTS
It is too soon to accurately gauge the effect of the stock market
crash on the underlying global economy. Prior to the recent
stock declines, most major studies--including those of the OECD,
IMF, World Bank and leading US forecasters--were predicting
moderate world growth in the 2- to 3-percent range through the
next several years. These reports all emphasized, however, that
the unprecedented trade and capital imbalances pose a serious
threat to this foreca
t
s
.
The IMF report states, "A number of uncertainties cloud the
economic outlook. One such uncertainty concerns how quickly
financial imbalances in industrial countries... can be
reduced, and whether their persistance increases the risk of
disruptive mark-
In the wake of the recent fall in stock values, growth forecasts
have been lowered. The direct impact of the crash has been the
loss of shareholder wealth -
- estimated to be well over a
trillion US dollars worldwide -- and a reduction of confidence in
future economic growth amo
ng consumers and businesses.
Indirectly, the crash has affected i
nterest rates and exchange
rates which also changes the outl
k
oo
for the global economy.
Interest rates were driven lower following the stock market
panic 19 October as investors poured money into the more
secure bond market and as central banks provided additional
liquidity during the crisis. Continued lower interest rates
could provide some stimulus to the world economy and ease
concerns over the global debt overhang -- particularly for
the 60 percent of Third World debt based on floating
interest rates.
Although the US dollar strengthened in the first few days
following the crash, continuing investor concerns over the
US trade and fiscal deficits -- along with the rising
possibility of a US recession -- has weakened the dollar 5
to 7 percent against other major currencies. A lower dollar
is likely to slow growth in the export-oriented economies of
Japan and Western Europe, and could lead these governments
to reexamine their austere economic policies. Moreover, a
weaker dollar puts additional pressure on the EC budget,
which is already projected to post a record $7 billion
deficit in 1988. The Third World would likely benefit from
a weaker dollar, however, because many of their currencies
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are linked to the US dollar and because most LDC debt is
On balance, growth rates in the industrial economies are almost
certain to slow, although the degree of the slowdown remains a
major question. Econometric estimates indicate US growth will be
1.7-2.0 percent in 1988, down from an expected 2.5 percent due to
the recent t
il
urmo
.
Growth in Europe and Japan will probably lag that of the United
States, but the direct impact of the crash is estimated to be far
less. At current exchange rates, CIA estimates put 1988 Japanese
growth at 2.7 percent--off 0.3 percentage point because of the
stock declines--and growth in Europe to be 2.2--an impact of a
mere tenth of a percentage point. Econmetric models, however,
often underestimate the magnitude of economic turning points--if
consumers and businesses respond more strongly-than suggested by
historical trends in our model, the negative impact would be
greater
A worst-case scenario foresees a cut in global economic
growth to about 1 percent in both 1988 and 1989, according
to a leading forecasting firm. This scenario could occur if
the US dollar falls below 110 yen next year, consumer
savings increases sharply while business investment
stagnates, and if the governments of the industrial
countries exacerbate the slowdown by cutting spending rather
than pursuing stimulative policies. The United States would
fare somewhat better under these conditions than would Japan
and West Germany, which would face a loss of exports because
of the weaker dollar. LDCs would be severely hurt by a halt
in the growth of -
a L__ ,_
r
Regardless of whether the outcome is better or worse, it is
likely that over the next five years the world economy will not
be as strong as it has been since the 1980-82 global recession.
Moreover, the downside risks of recession have clearly increased.
If international economic problems become serious, the United
States would confront a wider range of foreign policy challenges.
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BROADER POLICY IMPLICATIONS
Broader political and economic issues -- such as global economic
leadership, foreign macroeconomic and asset management policies,
and the LDCs -- will also be affected by the financial market
turmoil
ECONOMIC LEADERSHIP
Recent financial events have galvanized concerns about a falling
dollar and the prospects for sustained growth, and have shaken
foreign confidence in the global economy. Economic officials and
policymakers in Europe and Japan are concerned that Washington
ma not make the hard choices necessary to cut its deficits. ~~ 25X1
The US budget deficit reduction negotiations were portrayed
abroad and were seen as a litmus test for US economic
leadership--foreign leaders hoped for reductions beyond the
$23 billion mandated by Gramm-Rudman, and lobbied Washington
both publicly and privately for further cuts. E=
US trading partners are worried the forces that led to the
current financial crisis could eventually lead the United
States to adopt protectionist trade policies. While foreign
observers are hopeful the US Congress will not pass a highly
protectionist bill this year, most remain concerned that
domestic pressure may in. the end produce a restrictive trade
bill-F__ I
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FOREIGN MACROECONOMIC POLICIES
Although Tokyo and Bonn moved quickly to loosen monetary policy
in the wake of the stock market crisis, policymakers in both
countries are still movin slowly in considering expansionary
fiscal policies
.
The crisis rekindled debates within the Japanese and West
German Governments over the need for fiscal stimulus, but
the pro-austerit
f
y
orces in each country remain strong.
West German Finance Minister Stoltenberg, widely regarded as
Bonn's most powerful decisionmaker, publicly insists larger
federal budget deficits
l
wou
d be inflationary.
We believe neither government will make fundamental shifts in
fiscal policies unless growth drops to politically unacceptable
levels, which we believe to be less than 1 percent in West
Germany and less th
an 2 percent in Japan.
Our econometric analysis suggests that the impact of
stock market losses to date and the fallout from a further
15-percent depreciation of the dollar would cut growth in
these count-r es +-
these
o
Further budget deficit cuts by Washington -- such as meeting
the $50 billion total deficit reduction called for abroad --
would probably not spur a fundamental reassessment by Tokyo
or Bonn. However, we believe both Tokyo and Bonn probably
would consider it politically desirable to offer something
limited in return -- increased public works spending in
Japan, or a promise from West Germany to keep interest rates
low and to reexamine fiscal policy if growth slows. Indeed,
Takeshita is more likely than Nakesone to push the Finance
Ministry to adopt a more expansoinary fiscal policy because
of the political advantages that stem from greater public
works spending.
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Despite their initial loosening of monetary policy, Tokyo and
Bonn probably would further ease monetary policy only if the
dollar weakens
b
t
i
su
s
ant
ally mo
re.
If the dollar does fall substantially, both governments --
as they have in the past -- are-likely to urge their central
banks to lo
i
wer
nterest rat t
eso prevent appreciating
currencies 4= - a_ . .
FOREIGN ASSET MANAGEMENT
The crisis so far has not affected foreign asset management
strategies, but protracted market instability or a continued fall
l .. i.____ ,_ _
of the dollar .?o
u
Japanese investors appear to have sold little of their
dollar-d
enominated at di
ssesurng the crisis.
recognize that a major selloff of dollar-denominated11assetsS
wrni 1 ri r?a110 G
urther fall of the dollar.
STRUCTURAL CHANGE
The effects of the stock market crisis have produced mixed
reactions concerning privatization programs in the developed
countries, and other structural economic issues like financial
liberalization and the role of international financial
instituti
ons might al bff
soe aected.
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The United Kingdom moved ahead on schedule with its $12
billion dollar sale of British Petroleum shares. London was
forced, however, to offer a support plan for the deal's
underwriters -- who collectively stood to lose more than $1
billion.-- which guaranteed that the Bank of England would
buy back shares at a "floor price" of $1.20 per share,
th
b
ere
y capping underwriters' losses.
France postponed its planned sale of shares in the
defense and electronics firm Matra until markets stabilize,
a mo
i
ve v
ewed by some French officials as a politically
embarrassing policy compromise,
West Germany put off announcing a date for sale of its
remaining share in VW, and Belgium will also face tough
decisions. on privatizations planned for coming months
because revenues anticipated from the sales have already
been fi
d i
gure
nto government budgets.
The crisis almost certainly. will reinforce Tokyo's view
that its present gradual, incremental liberalization of
financial markets is the best course.
West European governments are likely to step up efforts to
strengthen financial regulatory cooperation among themselves
and with the United States. Agreement on the pending G-10
accord on commercial bank capital adequacy might be speeded
as a result.
IMPLICATIONS FOR THE LDCS
The stock market crisis probably will reduce the investment
resources available to many LDCs-to finance development and could
slow the progress of Third world economic reform.
Losses in some emerging Latin American stock markets, for
example -- which are on a par with drops in the developed
countries -- are a setback to the development of stable
markets needed to attract foreign capital, mobilize domestic
investment, and facilitate the privatization of state-owned
F_ I
com
i
pan
es.
Some LDCs, such as South Korea, are insulated from the
direct financial impact of the crash because they restrict
~L_ - _
n ten,
forei
g
to
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Some LDC capital flight probably will resume as investors
seek safer assets in the United States or other developed
countries. Capital has already begun flowing out-of Mexico
because of the stock market collapse there, according to the
US Embassy, contributing to the dramatic two-day,-49-percent
fall of the peso against the dollar.
LDC debtors will benefit from the lower dollar and lower
world interest rates, but these gains. will be dampened by
slackening industrial country demand for their exports. In
addition, the crisis has caused their commodity export
IMPACT ON THE SOVIET BLOC
Because of their economic isolation, the economies of the Soviet
Union and the other East Bloc countries will be much less
affected by economic problems in the West. Should Western
economies enter a prolonged downturn, however, efforts within
these governments to liberalize may face greater obstacles.
Conservative factions that oppose economic reform efforts
could point to problems within the market oriented Western
economies in their political battle to maintain strong
central planning domestically. This risk increases if the
Weser een to go through a series of financial crises. F
Weakening Western economies would lead to decreased
opportunities for East Bloc exports. Weapons
sales to the Third World and Soviet energy exports to
Western Europe would slow. A prolonged: recession would
hinder Moscow's long-term efforts to boost sales of
manufactured goods to the West. This would be a setback for
these countries' efforts to increase trade ties with the
For Eastern Europe, a more difficult trade environment could
make regimes more cautious about reform, as it did during
the Hungarian experience of 1972-78. Moreover, difficulties
in exporting would worsen the already severe debt problems
of several East European countries and limit their ability
to acquire needed Western goods. This, in turn, could
weaken Eastern Europe's ability to support the Soviet
modernization goals.
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The Soviet Union may find opportunities during a western
recession, however. Moscow's efforts to increase economic and
political'ties with the Third World may be enhanced, particularly
during a period of deflation--which would increase LDC debt
burdens while reducing cash earnings from commodity exports. As
in the 1930s, this combination would significantly increase the
use of countertrade.worldwide, which might increase the-number of
Soviet Bloc barter deals in the Third World. Moreover, Moscow may
be able to take advantage of weak demand and glutted markets in
the West to secure better prices for machinery and equipment
needed for its modernization drive, despite import problems that
may arise F
h
_
.
or t
e
ther -
OTHER FOREIGN POLICY CONCERNS
The current financial difficulties have exacerbated foreign
concern that US domestic problems will override long term US
comma tmen+s ai.,
roa
Recipients of US foreign aid fear that the financial crisis
might result in even deeper cuts in US support. Both press
concerned a public and private aid from ~thejUnited States
may decline this year due to the financial crisis, and in
th
f
e
as Washington wrestles with the budget deficit.
NATO allies see the crisis as yet another factor likely to
force r.,,+ rrn ----- -
International cooperation has increased in the immediate wake of
the crisis, but if economic growth turns down in the future,
cooperation on economic issues might be tougher to achieve as
other economic actors in Asia and Europe assert their increased
power. Foreign leaders are likely to take advantage of their
growing strength to make proposals -- perhaps in such areas as
the new GATT round, LDC debt, or monetary reform -- that may be
contrary to US int
.
er--
s
A severe global downturn would also increase both the political
and economic pressure on existing multilateral institutions.
Economic organizations could face stiff foreign criticism for
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failing to cope with any protracted crisis. As in previous
international economic crises, a wide range of proposals might
emer a to modif th
~ y ese institutions or even create new ones.
In particular, the IMF and World Bank might face a reduction
of repayments on their Third World loans as LDC exports
decline and as. interest rates possibly rise, worsening
problems the Fund and Bank already face with LDC arrears.
At the same time,. developed countries would be less
financially able to expand the resources of these
A continued fall of the dollar also would imperil the World
Bank's ability to lend to the LDCs because its capital is
denominated in dollars. According to the Bank's own
estimates, a further 9-percent decline -- in the absence of
a capital increase -- would wipe out its funds available for
lendin
g
.
The Uruguay Round of GATT might also be jeopardized by
heightened global trade tensions accompanying a weaker
dollar and .l - , . .
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APPENDIX I
ROLE OF GLOBALIZATION OF FINANCIAL MARKETS
The recent stock market turmoil-has demonstrated the tight
interdependence that now exists among the wozld's financial
markets and among the economies themselves. This interdependence
can be seen in the uniformity of the decline that occurred on 19
October -- Black Monday. Five of the world's top exchanges lost
record percentage amounts within 24 hours of the New York crash.
By contrast, stock marke ownturns in the late 1920s ranged over
several years.
The globalization of markets has occurred largely as a
result of financial deregulation and has been greatly facilitated
by the rapid growth-in.international capital flows as a result of
the oil shocks and the widespread introduction of computers and
telecommunications systems. Shares of many major multinational
firms are now traded on multiple foreign exchanges, and the top
investment institutions trade on an almost 24-hour basis through
representatives in Tokyo, London, New York, and the smaller-stock
markets. ~ I
The strong linkages between economies also helped transmit
the effects of the crash. For example, Japanese export companies
and stocks of American firms were hardest hit on the Tokyo
exchange, largely over fears that the crash would weaken the US
economy. Despite the rapid integration of global financial
markets, there remains an effective separation between investment
banking and commercial banking in most developed economies. This
regulatory "firewall" between the two activities helped prevent
the recent stock market turmoil from severely damaging the
international hpnlrin" --4-
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THE '29 AND '87 CRASHES: SIMILARITIES AND DIFFERENCES
Comparisons between the recent crash and the 1929 panic are
inevitable. Despite the differences between the two events,
there are two important lessons from the 1929 experience.
First, the October 1929 stock market crash was a symptom of
fundamental economic problems that existed, rather than a
watershed point between good times and bad. Second, the later
slide into the Great Depression was more a result of government
policies and consumer responses that followed the crash rather
than the crash itself. The similarities and differences between
the two eras demonstrate these points in the causes, the crash
it
lf
se
, and the aftermath.
The 1929 crash occurred several months after a recession
began within the United States and amid a generally weakening
economy internationally. By contrast, the global economy at the
moment of last month's crash was muddling through with moderate
th
grow
by historical standards.
In other ways, the economic backdrops were similar. In both
cases there were rising interest rates that raised concerns over
tightening credit causing economic hardship. Related to this,
there were exchange rate difficulties in both cases. Because of
the gold standard that prevailed in 1929, exchange rate
"instability" manifested itself through increased flows of gold
stocks, rather than by changes in rates themselves. Increased
capital outflows to the United States, rather than fears of
inflation, led London and other European governments to boost
their interest rates to maintain their gold reserves. Moreover,
a global debt overhang coupled with a reversal of easy-money
d i_ iz- - _
nn7 ir?iFoC contrib
t
u
e
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The Crash Itself
Both the 1929 and 1987 crashes came several weeks after the
peak in the market, and were characterized by accelerating
declines over a period of days prior to the day of panic. Both
markets crashed to price levels that prevailed late in the
previous year, and observers--as many are now--cited this fact as
a reason for optimism. As often occurs immediately following a
stock panics; there was a large rally the day after each crash.
. Contrary to popular notions, the initial government response
to the 1929 crash was a textbook case of proper policy. As it
did last month, the New York Federal Reserve Bank in 1929
provided substantial liquidity to the financial system during the
days following the crash--more than six times the maximum allowed
by standing regulations. Moreover, key governments moved quickly
to lower interest rates both then and now--and Britain and West
Germany acted to lower rates within a week of both crashes.
Finally, international cooperation tem orarily improved after the
shock of the 1929 stock panic. 25X1
As a result, the world monetary situation eased in the days
after both panics--although the recent pressure on the US dollar
stands in contrast to the November 1929 period. In both cases,
large financial institutions supported the markets to a greater
extent than smaller investors in the weeks after the fall. 25X1
.The key difference between the two crashes lies in the effect
on the banking system. During the late 1920s commercial banks
were heavily involved in stock market financing, whereas tight
restrictions now apply to such activity in the United States and
most major foreign financial centers. This separation between
investment banking and commercial banking has helped contain the
damage done by the recent collapse. 25X1
In addition, the 1987 crash was the first simultaneous global
stock market panic. By contrast, the West German stock market
peaked in 1927, the London market in 1928, the French market in
the spring of 1929, and the then-important Vienna market began to
fall in 1931. Moreover, the cross effects between markets in the
1920s were transmitted via the underlying economies, rather than
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The Aftermath
As an anxious global economy moves into the post-crash
period, it is important to remember that the 1930s depression was
far more the result of government actions taken long after
October 1929 than it.was of the crash itself. Indeed, the New
York market rose strongly between November 1929 and April of
1930. General opinion in the months that followed the crash was
relatively upbeat. Consumer spending stayed strong through
Christmas of that year. By contrast, businesses began to
retrench, which in conjuction with the delayed psychological
impact of 1he stock market fall, began to sour consumer spending. 25X1
Economic historians generally believe that the underlying
weakness of the world economy in the late 1920s and early 1930s
led to both the crash and the economic downturn that began
earlier in 1929. But the emergence of counterproductive
government policies worldwide turned the recession into
depression. Despite widespread acknowledgement among foreign
officials on the need for economic policy cooperation, most
governments raised taxes, erected protectionist barriers, and
devalued their currencies.
Charles Kindleberger, an eminent scholar on the Depression,
argues that the global economic system was fundamentally unsound
throughout the 1920s as Britain could no longer provide economic
leadership while the United States was not yet strong enough to
fill the void. The consequence, Kindelberger argues, was a
s
l
evere g
obal adjustment process that became the depression.
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Performances of Key Stock Indexes:
Tokyo, London, New York
1801
TOKYO LONDON NEW YORK
Legend
31 DEC 86
I1 Peak Value
Low Value
? 19 NOV 87
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SUBJECT: Financial Market Turmoil: Broader Implications
OGI/ECD/IF
23 Nov 87)
Distribution:
1 - The Honorable George P. Shultz, State
1 - The Honorable Morton I. Abramowitz, State
1 - DCI
1 - ExDir
1 - SA/DDCI
1 - ExRegistry
1 - DDI
- C/PES/DDI
- DD/OGI, D/OGI
NIO Econ
- D/OEA
- C/OEA/NA/J
- D/EURA
- C/EURA/WE
- C/EURA/IA/RE
- C/EURA/IA/RP
- D/DDO/EUR
- C/DDO/EA
- C/OGI/ECD
- C/OGI/ECD/ES
- C/OGI/ECD/IF
- OGI /PUI3
- CPAS/ISS/SA/DA
- CPAS/IMC/CB
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