Economic backdrop eerily similar to 1987 crash

NEW YORK Fri Oct 19, 2007 8:08pm EDT

NEW YORK (Reuters) - Economists who believe history tends to repeat itself can be forgiven for approaching the 20th anniversary of the 1987 stock market crash with a sense of trepidation.

Leading up to the "Black Monday" rout on Wall Street, a massive budget shortfall, falling dollar and burgeoning trade deficit clouded the horizon for the U.S. economy, even as the Dow hit a string of record highs.

Sound familiar?

Since the start of this decade, the U.S. budget has swung from surplus to deficit, the dollar has slid to record lows and a huge hole remains in the trade balance -- only now it's nearly twice as big compared to the overall economy.

Transcripts from the Federal Reserve's meeting a month before the 1987 crash show similar issues were on the minds of policy makers.

Investors were also concerned, particularly after a bond market rout in the wake of a precipitous drop in the dollar during the two years leading up to the October 19, 1987, crash.

"Eventually the dollar broke and that crushed the bond market," said William O'Donnell, head of U.S. interest rate strategy and research with UBS in Stamford, Connecticut.

"Part of that was weakness in the dollar caused a flight of foreign investors and eventually what that did, the combination of higher rates, just eventually crushed the stock market."

FOREIGN CURES

Then, as now, the U.S. looked abroad for cures to the economy's maladies. Officials pressed West Germany and Japan, which had large trade surpluses, to stimulate their domestic economies so their imports of U.S. goods would rise.

Today, they decry a global "savings glut" as the culprit behind the huge U.S. trade deficit, a shortfall that also weighs on the withering dollar.

The greenback has tanked against a host of other currencies, raising concerns it may spark U.S. inflation, scare off foreign investors and undermine Europe's economy.

In recent years the U.S. has also embarked on a campaign of jawboning and cajoling the Chinese into allowing their currency to rise against the greenback to close the trade gap.

Which brings us back to 1987, when aggressive U.S. efforts to get Germany to help support the dollar were blamed for contributing to the stock market tailspin

In a survey of overseas officials and economists after the 1987 crash, Reuters reported: "Most of those interviewed said a basic reason for the selloff was the imbalances in the world financial system created by the failure of the Reagan Administration to reduce its budget and trade deficits."

CORRELATION, NOT CAUSATION

Though some conditions are the same 20 years on, there are also very big differences, analysts argue.

"The main dissimilarity, which I think is the most important story these days, is that the market in '87 was dramatically overpriced before all that happened," said Bill Tedford, director of fixed income strategy at Little Rock, Arkansas-based Stephens Capital Management.

By a common method of measuring stocks' value, Tedford said, Wall Street was 35 percent overvalued in October 1987.

"Fast forward to today and by the same measure the market is 35 percent undervalued," Tedford added.

The budget deficit is also smaller now as a percentage of gross domestic product than it was back then. And while the dollar is sickly and the trade deficit huge, some argue the effect on interest rates has diminished.

"There doesn't seem to be the same toxic link between external deficits and interest rates that people have so long feared," said O'Donnell at UBS.

Meanwhile, if there is a bubble, it's more likely to be in housing, not stocks, and that has already popped.

In fact, this may be a better comparison to 1987. Some saw that crisis as a prelude to the housing slump at the end of that decade, which proved a more serious drag on the economy.

This may be the most daunting imbalance facing the United States, as markets struggle to come to grips with the persistent fall in house prices and new home building.

"Housing is terrifying," said Princeton economist and New York Times columnist Paul Krugman. "The dollar much less so."