It was 31 years ago, on Monday October 19th 1987 that the world discovered a new problem. It started as an anticipated stock market crash in Hong Kong, the result of a fairly obvious bubble. But it did not stop there. Within hours, exchanges opened up in the morning already down and panic pushing them lower, all around the world.

It was eventually blamed on “program trading” or automatic sell-offs directed by computers. Circuit breakers were put in place to stop it, and that was that. But it was the first sign that equity markets had become truly global and had much less to do with global conditions than everyone thought.

The lessons from this are much deeper than program trading, but they are much harder to learn.

Locked together. Note all the arms are rather pale.

This morning, a rally in China was expected to prop up US stocks after a week of simmering panic. While the market opened very weak, it did eventually come back to even and everything is calm for the moment. The enthusiasm did not spread around the world, but it did help considerably.

That is the state of financial markets today, especially equity markets. As a wise old accountant I knew in my youth loved to say, “Never forget that the stock market is nothing but a market of stocks.” It can, and often does, become detached from the underlying economic conditions that it is supposed to represent for a lot of reasons.

Chief among these today is how incredibly global these markets have become. Capital goes around the world easily, looking for an edge here and there but generally reflecting the supply of capital everywhere, not in any one market.

Bad stock news requires a picture like this. Apparently, these traders still exist.

This may not seem like a cause for concern. After all, stocks rise and fall all the time. Doesn’t globalism introduce some level of stability? Sadly, however, this situation not only makes currencies, and thus the local economy, less stable in the long run it institutionalizes the instability. Trade it goods depends much more on local factors but capital markets are purely a matter of global faith. The net result is that currency translation is far from even.

The difference can be measured by the difference between official exchange rates and the calue of a currency locally based on what it can buy, called Purchasing Power Parity(PPP). As discussed at length before, this difference is minimal between the US and Europe, given that their systems and tastes are essentially the same. There is little difference between the economies, and the only real difference is in the value of the US Dollar as the global reserve currency.

You like your tea green or fermented?

Elsewhere, however, the situation is very different. It is no more so than in China, where the Yuan Renminbi (RMB) is currently about 7 to the US Dollar but PPP is about 4 to the buck. Why is there such a big difference? Local savings is higher, local ability to invest is lower, and overall faith is not high.

This means that good produced in China, with workers paid in RMB, will always be cheaper. It has been this way for a long time, and it is unlikely to cahnge.

The net result is that cash flows, measured as trade deficits, are one thing and capital flows are another. Rather than work together to promote stability, they actually work against each other to create yawning disparities that decrease the overall stability of the global system. They also do so on a secular basis, which is a situation which is so long scope that it appears permanent.

This has to be corrected over the long haul for a truly global system to work properly, which is to say tend toward stability like all open markets. But it is not. Capital markets and cash flow markets are incredibly distinct and trade is not truly global in most of the goods traded, which is to say anything with higher value added outside of commodities.

Retail is always tricky.

As long as this persists, cash will flow to nations with lower consumption rates and higher savings rates. That means that the money supply will only become larger and capital cheaper. Interest rates must tend to zero.

This globalization of finance seems to herald the end of the time value of money as we know it, heavily favoring equity over time-based debt service payments. That may yet be the biggest change to come in the global economy.

That it was signaled by a panic among global equity markets is not ironic. We should not forget that after 1987 the world went on to a boom in equities of historic breadth and depth. Equities now rule the financial world, but they had to stumble a bit the first time that they really ran.