Financial Instability

Financial Instability


     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 c
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