Financial Markets
Crash course

The stock market crash of October 1987 highlighted the widespread concern at the rapid pace of innovation in financial markets during the 1980s. Increased competition as a result of deregulation, the creation of new financial instruments, and increasing global interdependence of capital markets may, it is argued, have made markets more susceptible to instability. On 25 November, CEPR and the Séminaire d'Economie Monétaire Internationale (SEMI) held the first of a series of Paris workshops on the international monetary and financial system. The November workshop, on `Recent Turbulence in the International Financial Environment', was organized by Daniel Cohen (CEPREMAP and CEPR). CEPR funding came from grants by the Ford Foundation and the Alfred P Sloan Foundation.
Elisabetta Bertero (City University Business School and CEPR) presented the first paper to the workshop, on `Global Interdependence of Stock Markets Around the Crash of October 1987' (now available as Discussion Paper No. 307), written jointly with CEPR Programme Director Colin Mayer. Their analysis was based on a new cross-sectional dataset of equity price movements in 23 stock markets in North America, Europe and the Pacific Basin. It revealed little evidence that the size of the fall in share prices in different markets varied according to the structural characteristics of markets, such as the existence of index futures, portfolio trading strategies or capital controls on foreign-owned investments. This contrasts with many interpretations of the US stock market crash. Bertero also examined the degree of interdependence of stock markets before, during and after the week of 19 October 1987, focusing on the listing and trading of foreign shares on domestic markets. She found that returns in a given market were more closely correlated with returns in those markets whose shares were traded on the given market. Correlations of equity price movements across stock markets were much more pronounced after the crash than prior to it, even though the high volatility of equity prices experienced during the crash rapidly died away.
On a similar theme, Mervyn King (LSE and CEPR) presented a paper entitled `Transmission of Volatility Between Stock Markets', which reported joint research with Sushil Wadhwani (LSE and CEPR). King challenged the ability of `full information' models to provide a reasonable explanation of the crash. How could `news' on `fundamentals' have produced a 23% fall of the stock market in one day? How could it be that so many other stock markets followed suit with falls of similar magnitudes? King argued that a theory based on the notion of `imperfect information' could go further towards answering these questions. One implication of such a theory is that investors on one market may try to infer information from the behaviour of other markets, so that a mistake in any one market may well be transmitted to other markets. High volatility thus becomes self-reinforcing, and the theory predicts that it should be positively correlated with the contagion effects. King found empirical evidence which confirmed the existence of such a positive correlation as well as other implications of the theory.
In `Endettement et Défaillance des Entreprises en France', Christian Bordes (Université de Limoges and Banque de France) and Jacques Melitz (Institut National de la Statistique et des Etudes Economiques, Paris, and CEPR), analysed the influence of financial factors on the probability that a firm will default on its debt. The ratio of business debt to GDP is higher in France, of the order of 70%, than it is in the United States and the United Kingdom, where it has been around 40%. Indices of default have risen rapidly in all three countries since 1975, though more rapidly in the United States. Bordes and Melitz undertook an econometric analysis of the relationship between levels of corporate debt and firms' financial fragility in France. They regressed the probability of default on a number of real and financial variables designed to capture aspects both of long-term solvency and of short-term illiquidity. The analysis revealed that the probability of default was influenced by debt, interest rates and the business cycle, as well as by unit labour costs, external competitiveness and the age of the firm.

The workshop ended with a roundtable discussion introduced by Gilles Oudiz (Banque Stern and CEPR) and Mervyn King. Oudiz highlighted the risk of instability which has been created by the deregulation of financial markets. Many of the participants at the workshop agreed with Oudiz's arguments and emphasized the need for government regulation in a period of financial instability. As Richard Portes (CEPR and Birkbeck College, London) pointed out, however, the debate on how to rescue the `thrift' institutions in the United States has always assumed that a rescue will be forthcoming: there seems little risk of repeating the mistakes of the 1930s.
Mervyn King stressed how far we were from fully understanding the behaviour of the international financial system. He wondered whether `chaos' theories might provide some insight, and whether econometric tests could help settle the issues. He strongly opposed the suggestion that the role of banks as providers of liquidity should necessarily be defended by government intervention. Liquidity in the next millennium, King argued, is bound to be provided in a very different way (i.e. through computers) than in the past. We should not, therefore, be too worried by the vicissitudes of the banking system.