Exchange-Rate Policies
The roots of the surge in interest rates that preceded the October 1987
stock market crash are found in the futile attempts by the United States
and other G7 countries (Japan, the United Kingdom, Germany, France,
Italy, and Canada) to prevent the dollar from falling in the international
exchange markets.
The dollar had bounded to unprecedented levels in the middle of
the 1980s on the heels of huge Japanese and European purchases of dol-
lar securities and a strong U.S. economy. Foreign investors were attracted
to high dollar interest rates, in part driven by record U.S. budget deficits
but also by a strengthening of the U.S. economy and the capital-friendly
presidency of Ronald Reagan. By February 1985, the dollar became mas-
sively overvalued and U.S. exports became very uncompetitive, severely
worsening the U.S. trade deficit. The dollar then reversed course and
began a steep decline.
Central bankers initially cheered the fall of the overpriced dollar,
but they grew concerned when the dollar continued to decline and the
U.S. trade deficit, instead of improving, worsened. Finance ministers
met in February 1987 in Paris with the goal of supporting the dollar.
They worried that if the dollar became too cheap, their own exports to
the United States, which had grown substantially when the dollar was
high, would suffer.
The Federal Reserve reluctantly participated in the dollar stabiliza-
tion program, whose success depended on either an improvement in the
U.S. trade position or, absent that, a commitment by the Federal Reserve
to raise interest rates to support the dollar.
But the trade deficit did not improve; in fact, it worsened after the
initiation of the exchange stabilization policies. Traders, nervous about
the deteriorating U.S. trade balance, demanded ever higher interest rates
to hold U.S. assets. Leo Melamed, chairman of the Chicago Mercantile
Exchange, was blunt when asked about the origins of Black Monday:
“What caused the crash was all that f— around with the currencies of the
world.”^3
The stock market initially ignored rising interest rates. The U.S.
market, like most equity markets around the world, was booming. The
Dow Jones Industrials, which started 1987 at 1,933, reached an all-time
high of 2,725 on August 22—250 percent above the August 1982 low
reached five years earlier. All world markets participated. Over the same
274 PART 4 Stock Fluctuations in the Short Run
(^3) Martin Mayer, Markets, New York: Norton, 1988, p. 62.