Surviving Black Monday

I’d scrutinized the economy every working day for decades and had visited the Fed scores of times. Nevertheless, when I was appointed chairman in August 1987, I knew I’d have a lot to learn. That was reinforced the minute I walked in the door. The first person to greet me was Dennis Buckley, a security agent who would stay with me throughout my tenure. He addressed me as “Mr. Chairman.”

Without thinking, I said, “Don’t be silly. Everybody calls me Alan.”

He gently explained that calling the chairman by his first name was just not the way things were done at the Fed.

So, Alan became Mr. Chairman.

Though I’d been a corporate director, the Board of Governors of the Federal Reserve System, as it is formally known, was an order of magnitude larger than anything I’d ever run—today the Federal Reserve Board staff includes some two thousand employees and has an annual budget of nearly $300 million. The Fed chairman has less unilateral power than the title might suggest. By statute I controlled only the agenda for the Board of Governors meetings—the Board decided all other matters by majority rule, and the chairman was just one vote among seven. Also, I was not automatically the chairman of the Federal Open Market Committee [FOMC], the powerful group that controls the federal funds rate, the primary lever of U.S. monetary policy. The FOMC is made up of the seven Board governors and the presidents of the twelve regional Federal Reserve banks. While the Board chairman is traditionally the chair of the FOMC, he or she must be elected each year by the members, and they are free to choose someone else. I expected precedent to prevail. But I was always aware that a revolt of the six other governors could remove all of my authority, except writing the Board agendas.

I was scheduled to run one of those meetings the following week, on August 18. 

The Reagan-era expansion was well into its fourth year, and while the economy was thriving, it was also showing clear signs of instability. Since the beginning of the year, when the Dow Jones Industrial Average had risen through 2000 for the first time, the stock market had run up more than 40 percent—now it stood at more than 2700 and Wall Street was in a speculative froth. Something similar was happening in commercial real estate.

The economic indicators, meanwhile, were far from encouraging. Huge government deficits under Reagan had caused the national debt to the public to almost triple, from just over $700 billion at the start of his presidency to more than $2 trillion at the end of fiscal year 1988. The dollar was falling, and people were worried about America losing its competitive edge—the media were full of alarmist talk about the growing “Japanese threat.” Consumer prices, which had gone up just 1.9 percent in 1986, were rising at nearly double that rate in my first days in office. Though 3.6 percent inflation was far milder than the double-digit nightmare people remembered from the 1970s, once inflation begins, it usually grows. 

These were vast economic issues, of course, far beyond the power of the Fed alone to resolve. Yet the worst course would be to sit idly by. I thought a rate increase would be prudent, but the Fed hadn’t raised interest rates for three years. Hiking them now would be a big deal. Any time the Fed changes direction, it can rattle the markets. The risk in clamping down during a stock-market surge is especially acute—it can pop the bubble of investor confidence, and if that scares people enough, can trigger a severe economic contraction.

Though I was friendly with many of the committee members, I knew better than to think that a chairman who had been around for a week could walk into a meeting and shape a consensus on such a risky decision. So I did not propose a rate increase; I simply listened to what the others had to say. The eighteen committee members were all seasoned central bankers and economists, and as we went around the table comparing assessments of the economy, it was apparent that they, too, were concerned. Gerry Corrigan, the gruff president of the New York Fed, said we ought to raise rates; Bob Parry, the Fed president from San Francisco, reported that his district was seeing good growth, high optimism, and full employment—all reasons to be leery of inflation; Si Keehn from Chicago agreed, reporting that the Midwest’s factories were running near full capacity and that even the farm outlook had improved; Tom Melzer of the St. Louis Fed told of how even the shoe factories in that district were operating at 100 percent.

The next opportunity to do so was two weeks later, on September 4, at a meeting of the Board of Governors. The Board controls the other main lever of monetary policy, the “discount rate” at which the Federal Reserve lends to depository institutions. This rate generally moves in lockstep with the rate on fed funds. Prior to the scheduled Board meeting, I spent a few days working my way up and down the corridor seeking out the governors in their offices, building consensus. The meeting, when it came, moved quickly to a vote—the rate increase, from 5.5 percent to 6 percent, was approved by the governors unanimously.

To subdue inflationary pressures, we were trying to slow the economy by making money more expensive to borrow. There’s no way to predict how severely the markets will respond to such a move, especially when investors are gripped with speculative fervor. I couldn’t help but remember accounts I’d read of the physicists at Alamogordo the first time they detonated an atom bomb: Would the bomb fizzle? Would it work the way they hoped? Or would the chain reaction somehow go out of control and set the earth’s atmosphere on fire? After the meeting ended, I had to fly to New York; from there I was scheduled to leave that weekend for Switzerland, where I was attending my first meeting of the central bankers of the ten leading industrialized nations. The Fed’s hope was that the key markets—stocks, futures, currency, bonds—would take the change in stride, maybe with stocks cooling off slightly and the dollar strengthening. I kept calling back to the office to check how the markets were responding.

The sky did not catch fire that day. Stocks dipped, banks upped their prime lending rates in line with our move, and the financial world, as we’d hoped, noted that the Fed had begun acting to quell inflation. I was finally allowing myself to breathe a sigh of relief when a message reached me from Paul Volcker, the former Chairman of the Federal Reserve. He knew exactly what I’d been going through. “Congratulations,” it read. “You are now a central banker.”

I did not for a minute think we were out of the woods. Signs of trouble in the economy continued to mount. Slowing growth and a further weakening of the dollar put Wall Street on edge, as investors and institutions began confronting the likelihood that billions of dollars in speculative bets would never pay off. In early October, that fear turned to near panic. The stock market skidded, by 6 percent the first week, then another 12 percent the second week. The worst loss was on Friday, October 16, when the Dow Jones average dropped by 108 points. Since the end of September nearly half a trillion dollars of paper wealth had evaporated in the stock market alone—not to mention the losses in currency and other markets. The decline was so stunning that Time magazine devoted two full pages to the stock market that week under the headline “Wall Street’s October Massacre.”

I knew that, from a historical perspective, this “correction” was not nearly the most severe. The market slump in 1970 had been proportionally twice as large, and the Great Depression had wiped out fully 80 percent of the market’s value. But given how poorly the week had ended, everyone was worried about what might happen when the markets opened again on Monday.

I was supposed to fly on Monday afternoon to Dallas, where, on Tuesday, I was to speak at the American Bankers’ Association convention—my first major speech as chairman. On Monday morning, I conferred with the Board of Governors, and we agreed that I should make the trip, lest it seem that the Fed was in a panic. The market that morning opened weakly, and by the time I had to leave it looked awful—down by more than 200 points. There was no telephone on the airplane. So the first thing I did when I arrived was to ask one of the people who greeted me from the Federal Reserve Bank of Dallas, “How did the stock market finally go?”

He said, “It was down five oh eight.”

Usually, when someone says “five oh eight,” he means 5.08. So, the market had dropped only 5 points. “Great,” I said, “what a terrific rally.” But, as I said it, I saw that the expression on his face was not shared relief. In fact, the market had crashed by 508 points—a 22.5 percent drop, the biggest one-day loss in history, bigger even than the one on the day that started the Great Depression, Black Friday 1929.  

I went straight to the hotel, where I stayed on the phone into the night. Manley Johnson, the vice chairman of the Fed’s Board, had set up a crisis desk in my office in Washington, and we held a series of calls and teleconferences to map out plans. Gerry Corrigan filled me in on conversations he’d had in New York with Wall Street executives and officials at the stock exchange; Si Keehn had talked to the heads of the Chicago commodities futures exchanges and trading firms; Bob Parry in San Francisco reported what he was hearing from the chiefs of the savings and loan industry, who were mainly based on the West Coast.

The Fed’s job during a stock-market panic is to ward off financial paralysis—a chaotic state in which businesses and banks stop making the payments they owe each other and the economy grinds to a halt. To the senior people on the phone with me that night, the urgency and gravity of the situation was apparent—even if the markets got no worse, the system would be reeling for weeks. We started exploring ways we might have to supply liquidity if major institutions ran short of cash. Not all of our younger people understood the seriousness of the crisis, however. As we discussed what public statement the Fed should make, one of them suggested, “Maybe we’re overreacting. Why not wait a few days and see what happens?”

Though I was new at this job, I’d been a student of financial history for too long to think that made any sense. It was the one moment I spoke sharply to anybody that night. “We don’t need to wait to see what happens,” I told him. “We know what’s going to happen.” Then I backed up a little and explained. “You know what people say about getting shot? You feel like you’ve been punched, but the trauma is such that you don’t feel the pain right away? In twenty-four or forty-eight hours, we’re going to be feeling a lot of pain.”

As the discussion ended, it was clear that the next day would be full of major decisions. Gerry Corrigan made a point of telling me solemnly, “Alan, you’re it. The whole thing is on your shoulders.” Gerry is a tough character and I couldn’t tell whether he meant this as encouragement or as a challenge for the new chairman. I merely said, “Thank you, Dr. Corrigan.”

I was not inclined to panic, because I understood the nature of the problems we would face. Still, when I hung up the phone around midnight, I wondered if I’d be able to sleep. That would be the real test. “Now we’re going to see what you’re made of” I told myself. I went to bed, and, I’m proud to say, I slept for a good five hours.

Early the next morning, as we were honing the language of the Fed’s public statement, the hotel operator interrupted with a call from the White House. It was Howard Baker, President Reagan’s chief of staff. Having known Howard a long time, I acted as though nothing unusual were going on. “Good morning, Senator,” I said. “What can I do for you?” “Help!” he said in mock plaintiveness. “Where are you?”  

“In Dallas,” I said. “Is something bothering you?” Handling the administration’s response to a Wall Street crisis is normally the job of the treasury secretary. But Jim Baker was in Europe trying to make his way back, and Howard didn’t want to deal with this one on his own. I agreed to cancel my speech and return to Washington—I’d been inclined to do so anyway, because in light of the 508-point market drop, going back seemed the best way to assure the bankers that the Fed was taking matters seriously. Baker sent a military executive jet to pick me up.

The markets that morning gyrated wildly—Manley Johnson sat in our makeshift operations center giving me the play-by-play while I was airborne. After I got in a car at Andrews Air Force Base, he told me the New York Stock Exchange had called to notify us it was planning to shut down in one hour—trading on key stocks had stalled for lack of buyers. “That’ll blow it for everybody,” I said. “If they close, we’ve got a real catastrophe on our hands.” Shutting down a market during a crash only compounds investors’ pain. As scary as their losses on paper may seem, as long as the market stays open investors always know that they can get out. But take away the exit and you exacerbate the fear. To restore trading afterward is extraordinarily hard—because no one knows what prices should be, no one wants to be the first to bid. The resuscitation process can take many days, and the risk is that in the meantime the entire financial system will stall, and the economy will suffer a crippling shock. There wouldn’t have been much we could do to stop the executives at the exchange, but the marketplace saved us by itself. Within those sixty minutes enough buyers materialized that the NYSE decided to shelve its plan.

The next 36 hours were intense. I joked that I felt like a seven-armed paperhanger, going from one phone to another, talking to the stock exchange, the Chicago futures exchanges, and the various Federal Reserve presidents. My most harrowing conversations were with financiers and bankers I’d known for years, major players from very large companies around the country, whose voices were tightened by fear. These were men who had built up wealth and social status over long careers and now found themselves looking into the abyss. Your judgment is less than perfect when you’re scared. “Calm down,” I kept telling them, “it’s containable.” And I would remind them to look beyond the emergency to where their long-term business interest might lie.

The Fed attacked the crisis on two fronts. Our first challenge was Wall Street: we had to persuade giant trading firms and investment banks, many of which were reeling from losses, not to pull back from doing business. Our public statement early that morning had been painstakingly worded to hint that the Fed would provide a safety net for banks, in the expectation that they, in turn, would help support other financial companies. It was as short and concise as the Gettysburg Address, I thought, although possibly not as stirring: “The Federal Reserve, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.” But as long as the markets continued to function, we had no wish to prop up companies with cash.

Gerry Corrigan was the hero in this effort. It was his job as head of the New York Fed to convince the players on Wall Street to keep lending and trading—to stay in the game. A Jesuit-educated protégé of Volcker’s, he’d been a central banker for his entire career; there was no one more streetwise or better suited to be the Fed’s chief enforcer. Gerry had the dominant personality necessary to jawbone financiers, yet he understood that even in a crisis, the Fed must exercise restraint. Simply ordering a bank to make a loan, say, would be an abuse of government power and would damage the functioning of the market. Instead, the gist of Gerry’s message to the banker had to be: “We’re not telling you to lend; all we ask is that you consider the overall interests of your business. Just remember that people have long memories, and if you shut off credit to a customer just because you’re a little nervous about him, but with no concrete reason, he’s going to remember that.” That week Corrigan had dozens of conversations along these lines, and though I never knew the details, some of those phone calls must have been very tough. I’m sure he bit off a few earlobes.

As this was going on, we were careful to keep supplying liquidity to the system. The FOMC ordered the traders at the New York Fed to buy billions of dollars of treasury securities on the open market. This had the effect of putting more money into circulation and lowering short-term rates. Though we’d been tightening interest rates before the crash, we were now easing them to keep the economy moving.

Despite our best efforts, there were a half dozen near disasters, mostly involving the payment system. A lot of transactions during the business day on Wall Street aren’t made simultaneously: companies will do business with each another’s customers, for instance, and then settle up at day’s end. On Wednesday morning Goldman Sachs was scheduled to make a $700 million payment to Continental Illinois Bank in Chicago, but initially withheld payment pending receipt of expected funds from other sources. Then Goldman thought better of it, and made the payment. Had Goldman withheld such a large sum, it would have set off a cascade of defaults across the market. Subsequently, a senior Goldman official confided to me that had the firm anticipated the difficulties of the ensuing weeks, it would not have paid. And in future such crises, he suspected, Goldman would have second thoughts about making such unrequited payments.

We also went to work on the political front. I spent an hour on Tuesday at the Treasury Department as soon as Jim Baker returned (he’d been able to catch the Concorde). We huddled in his office with Howard Baker and other officials. President Reagan’s initial reaction to Wall Street’s calamity on Monday had been to speak optimistically about the economy. “Steady as she goes,” he’d said, later adding, “I don’t think anyone should panic, because all the economic indicators are solid.” This was meant to be reassuring, but in the light of events sounded disturbingly like Herbert Hoover declaring after Black Friday that the economy was “sound and prosperous.” Tuesday afternoon we met with Reagan at the White House to suggest he try a different tack. The most constructive response, Jim Baker and I argued, would be to offer to cooperate with Congress on cutting the deficit, since that was one of the long-term economic risks upsetting Wall Street. Even though Reagan had been at loggerheads with the Democratic majority, he agreed that this made sense. That afternoon he told reporters that he would consider any budget proposal Congress put forward, short of cutting Social Security. Though this overture never led to anything, it did help calm the markets.

We manned the operations center around the clock. We tracked markets in Japan and Europe; early each morning we’d collect stock quotes on U.S. companies trading on European bourses and synthesize our own Dow Jones Industrial Average to get a preview of what the New York markets were likely to do when they opened. It took well over a week for all the crises to play out, though most of them were hidden from public view. Days after the crash, for example, the Chicago options market nearly collapsed when its biggest trading firm ran short of cash. The Chicago Fed helped engineer a solution. Gradually, prices in the various markets stabilized, and by the start of November the members of the crisis management team returned to their regular work.

Contrary to everyone’s fears, the economy held firm, actually growing at a 2 percent annual rate in the first quarter of 1988 and at an accelerated 5 percent rate in the second quarter. By early 1988, the Dow had stabilized at around 2000, back where it had been at the beginning of 1987, and stocks resumed a much more modest, and more sustainable, upward path. Economic growth entered its fifth consecutive year. This was no consolation to the speculators who had lost their shirts, or to the scores of small brokerage houses that failed, but ordinary people hadn’t been hurt.

In retrospect, it was an early manifestation of the economic resilience that would figure so prominently in the coming years.