The soaring volume of international finance and increased interdependence in
recent decades has increased concerns about volatility and threats of a financial crisis.
This has led many to investigate and analyze the origins, transmission, effects and policies
aimed to impede financial instability. This paper argues that financial liberalization and
speculation are the most reflective explanations for instability in financial markets and that
financial instability is likely to be transmitted globally with far reaching implications on real
sector performance. I conclude the paper with the argument that a global transaction tax
would be the most effective policy to curb financial instability and that other proposed
policies, such as target zones and the creation of a supranational institution, are either
unfeasible or unattainable.
INSTABILITY IN FINANCIAL MARKETS
In this section I examine four interpretations of how financial instability arises.
The first interpretation deals with speculation and the subsequent “bandwagoning” in
financial markets. The second is a political interpretation dealing with the declining status
of a hegemonic anchor of the financial system. The question of whether regulation causes
or mitigates financial instability is raised by the third interpretation; while the fourth view
deals with the “trigger point” phenomena.
To fully comprehend these interpretations we must first understand and
differentiate between a “currency” and “contagion” crisis. A currency crisis refers to a
situation is which a loss of confidence in a country”s currency provokes capital flight.
Conversely, a contagion crisis refers to a loss of confidence in the assets denominated in a
particular currency and...
the subsequent global transmission of this shock.
One of the more paramount readings of financial instability pertains to speculation.
Speculation is exhibited in a situation where a government monetary or fiscal policy (or
action) leads investors to believe that the currency of that particular nation will either
appreciate or depreciate in terms relative to those of other countries. Closely associated
with these speculative attacks is what is coined the “bandwagon” effect. Say for
example, that a country”s central bank decides to undertake an expansionary monetary
policy. A neoclassical interpretation tells us that this will lower the domestic interest
rates, thus lowering the rate of return in the foreign exchange market and bringing about a
currency depreciation. As investors foresee this happening they will likely pull out before
the perceived depreciation. “Efforts to get out would accelerate the loss of reserves,
provoking an earlier collapse, speculators would therefore try to get out still earlier, and
so on” (Krugman, 1991:93). This “herding” or “bandwagon” effect naturally cause wild
swings in exchange rates and volatility in markets.
Another argument for the evolution of financial market instability is closely related
to hegemonic stability theory. This political explanation predicts a circumstance (i.e. a
decline of a hegemon”s status) in which a loss of confidence in a particular countries
currency may lead to capital flight away from that currency. This flight in turn not only
depreciates the currency of the former hegemon but more importantly undermines its role
as the international financial anchor and is said to ultimately lead to instability.
The trigger point phenomena may also be used
as an instrument to explain financial
instability. Similar to the speculative cycles described above, this refers to a situation
where a group of investors commits to buy or sell a currency when that currency reaches a
certain price level. If that particular currency were to rise or fall to that specified level,
whether by real or speculative reasons, the precommited investors buy or sell that
currency or assets. This results in a cascade effect that, like speculative cycles, increases
or decreases the value of the currency to remarkably higher or lower levels.
Country after country has deregulated its financial markets and institutions. The
neoclassical interpretation asserts that regulation is thought to create incentives for risk
taking and hence instability. It is said to bring about what are called “moral hazards.”
Proponents of deregulation argue that when people are insured, they are more apt to take
greater risks with their investments in financial markets. The riskier the investment
activity, the more volatile the markets tend to be.
A closer look suggests that perhaps only two of these explanations are valid when
thinking about the origins of financial instability. The trigger point explanation seems to
be a misreading of the origins of instability. It is unlikely that a large number of investors
would have the incentive or operational ability in order to simultaneously coordinate the
buying or selling of a currency or assets denominated in that currency. If even there is
such unlikely coordination, the “existence of even a very large group of investors with
trigger points need not create a crisis if other investors know they are there” (Krugman,
The theory of hegemonic stability also overlooks a number of factors that can
provide useful insights in explaining the emergence of financial instability. Historical
precedence supports this assertion. For instance, Britains role as international economic
manager was very minor in the stability experienced under the gold standard. The success
of the standard can be attributed to endogenous factors such as the self adjusting market
mechanism and the informal discipline maintained by its rules. The destabilization of the
gold standard can be attributed to the extreme domestic economic and financial pressures
brought on nation states by World War I, and not solely on the industrial and economic
demise of Britain.
A valid explanation for the origins of financial instability are the speculative attacks
brought on by investors. Although similar in function to trigger points, these speculative
cycles cannot be mitigated simply by pure recognition. Rather than acting on the value of
the currency itself, speculators act on occurrences or policies that will alter the value of
the currency. Instability arises from the fact that these speculative cycles induce capital
flight and therefore a change in the value of that particular currency, whether or not the
decisions of these investors are based on market “fundamentals.” Futures, options, swaps
and other financial instruments “have given investors and speculators an unheard of
capacity to leverage financial markets. The greater the leverage, the greater the
instability” (McCallum, 1995:12).
If we examine the deregulatory process closely, it becomes clear that there is
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