In a question in his post-1987 survey, Robert Shiller asked: "Which of the following best describes your theory about the decline: a theory about investor psychology, or a theory about fundamentals such as profits or interest rates?" 67.5% of individual investors and 64% of institutional investors said the crash was about market psychology. It seems there is an unspoken consensus that the market decline was driven by psychology, though this is overshadowed by an accepted theory that events and program trading drove the decline. When Shiller asked what major events people in his survey were reacting to during the day of the crash, the most popular response was the price decline and the behaviour of others during the decline, not fundamental economic changes. Shiller concludes that there were two channels by which price declines fed back into further declines. "First, a price-to-price channel: investors on October 19 were reacting to price changes. Second, a social psychological channel: investors were directly reacting to each other." No events from the physical world are part of Shiller's conclusion. The price-to-price explanation explains why markets may have fallen as far and fast as they did, while the social psychological channel explains the international scope of the decline. These two explanations fail to account for why the crash occurred on October 19 and not any other day. Like the program trading argument, Shiller's psychological explanation is circular, requiring an initial price change to encourage further price changes. This origins of the initial price change are left unexplained. Still, Shiller's perspective explains more than most have been able to.
Let me now focus on some of the specific events that have been credited with sparking the crash. An ongoing spat between Iran and the U.S. had been playing itself out in 1987. The weekend of the crash, the U.S. attacked an Iranian offshore platform, reacting to an earlier Iran attack on American registered vessels in the Persian Gulf. Just because the attack was conveniently situated immediately prior to the crash in time does not mean it is a legitimate explanation. On January 16, 1979, the day the Shah fled Iran, the Dow decline only 1.5%. The arrival of Khomeini in Iran on February 1 of that year went ignored by markets - they rose .2% that day. These were both much greater events in US Iran relations, yet had little effect on markets. Though the Iran US tiff provides an explanation for the timing of the crash, my intuition tells me that because historical U.S.-Iran issues did not significantly affect markets, it was unlikely that an event of such small magnitude as the weekend clash could have caused trillions of dollars in market losses in a single day, and have influenced markets such as South Africa or Sweden, for instance, two countries unlikely to be affected by US-Iranian tensions.
The U.S. dollar had been declining against other currencies since early 1985. On the weekend of the crash, Treasury Secretary Baker made a statement in a television interview that the dollar should slip further, publicly criticizing the German government. This was taken as a sign that recent currency accords were crumbling. A volatile dollar discourages foreign investors, such as the Germans and the Japanese, because it does not allow them to make reasonable assumptions about the return on their investments in American securities. This theory has it that the threat of these investors pulling out caused the crash. The argument is attractive since it provides a good explanation for the timing of the crash, but is weak for two reasons. If Baker's words carried such causal power behind them, why did the U.S Major Currency Index only decline .69% the day of the crash? Why should the equity markets bear the brunt of statements that were really about currency markets? The small change in the U.S. dollar proves that Baker's statements did not carry much power, only marginally influenced equity markets, and that some other cause must have created the decline. The second weakness of the argument is that volatility in the U.S. currency implies repatriation of assets and strength somewhere else, Japan or Germany for instance. Yet both these markets, indeed all international markets declined that day. If Baker's statements had any power, then only the U.S market would have fallen with those in Germany and Japan rising.
Mark Mitchell and Jeffry Netter presented evidence in 1989 that the large decline in the U.S. market from October 14 through 16 was largely a rational reaction to an unanticipated tax proposal by the House Ways and Means Committee limiting the deductibility of interest expense on corporate debt, especially in takeovers. Between Tuesday, October 13, when the legislation was first introduced, and Friday, October 16, when the market closed for the weekend, stock prices fell more than 10 percent -- the largest 3-day drop in almost 50 years. In addition, those stocks that led the market downward were precisely those most affected by the legislation. This explanation certainly explains the temporal problem; why markets started to decline in mid-October. But why would a proposal concerning American markets affect prices in Australia and Hong Kong to a greater degree than in New York? Though a negative American reaction to proposed U.S. tax change might be rational to Mitchell and Netter, expecting us to believe that the remarkably negative response of non-U.S. markets to the same news event seems a stretch.
A collection of general economic conditions have been blamed for the crash. Interest rates in the U.S. had been rising since early 1987 as bond markets steadily deteriorated. Going into October 1987, some commentators believed high interest rates convinced investors to sell stocks, precipitating the crash. The U.S. twin deficits - the budget and trade deficits - had been steadily growing through the 1980's. On October 14, 1987, a large U.S trade deficit of 3.4% of GDP was announced. These two factors may have bred the decline in confidence necessary to knock markets down 23%. Shiller explains why these explanations come short: "Something must have been different On October 19, 1987 that caused the behaviour of the market to be very different from other days. What was different on that day? To answer that question, one must look for something that happened on exactly that day, not general considerations that characterize many days. Thus, for example, it is not enough to say that "portfolio insurance did it," since portfolio insurance has been around for years." Rising interest rates had been around for months, and excessive deficits had been around for years. These reasons cannot explain why markets would not have declined on August 5, or September 30. In other words, they fail to find what was different on October 19, 1987.