Financial Instability Essay Example For Students

Financial Instability Essay The soaring volume of international finance and increasedinterdependence in recent decades has increased concerns about volatility andthreats of a financial crisis. This has led many to investigate and analyze theorigins, transmission, effects and policies aimed to impede financialinstability. This paper argues that financial liberalization and speculationare the most reflective explanations for instability in financial markets andthat financial instability is likely to be transmitted globally with farreaching implications on real sector performance. I conclude the paper with theargument that a global transaction tax would be the most effective policy tocurb financial instability and that other proposed policies, such as targetzones and the creation of a supranational institution, are either unfeasible orunattainable. INSTABILITY IN FINANCIAL MARKETSIn this section I examine four interpretations of how financialinstability arises. The first interpretation deals with speculation and thesubsequent bandwagoning in financial markets. The second is a politicalinterpretation dealing with the declining status of a hegemonic anchor of thefinancial system.The question of whether regulation causes or mitigatesfinancial instability is raised by the third interpretation; while the fourthview deals with the trigger point phenomena. To fully comprehend these interpretations we must first understand anddifferentiate between a currency and contagion crisis. A currency crisisrefers to a situation is which a loss of confidence in a countrys currencyprovokes capital flight. Conversely, a contagion crisis refers to a loss ofconfidence in the assets denominated in a particular currency and the subsequentglobal transmission of this shock. One of the more paramount readings of financial instability pertains tospeculation. Speculation is exhibited in a situation where a governmentmonetary or fiscal policy (or action) leads investors to believe that thecurrency of that particular nation will either appreciate or depreciate in termsrelative to those of other countries. Closely associated with these speculativeattacks is what is coined the bandwagon effect.Say for example, that acountrys central bank decides to undertake an expansionary monetary policy.Aneoclassical interpretation tells us that this will lower the domestic interestrates, thus lowering the rate of return in the foreign exchange market andbringing about a currency depreciation. As investors foresee this happeningthey will likely pull out before the perceived depreciation. Efforts to getout 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 inexchange rates and volatility in markets. Another argument for the evolution of financial market instability isclosely related to hegemonic stability theory. This political explanationpredicts a circumstance (i.e. a decline of a hegemons status) in which a lossof confidence in a particular countries currency may lead to capital flightaway from that currency. This flight in turn not only depreciates the currencyof the former hegemon but more importantly undermines its role as theinternational financial anchor and is said to ultimately lead to instability. The trigger point phenomena may also be used as an instrument to explainfinancial instability. Similar to the speculative cycles described above, thisrefers to a situation where a group of investors commits to buy or sell acurrency when that currency reaches a certain price level. If that particularcurrency were to rise or fall to that specified level, whether by real orspeculative reasons, the precommited investors buy or sell that currency orassets. This results in a cascade effect that, like speculative cycles,increases or decreases the value of the currency to remarkably higher or lowerlevels. Country after country has deregulated its financial markets andinstitutions. The neoclassical interpretation asserts that regulation is thoughtto create incentives for risk taking and hence instability. It is said to bringabout what are called moral hazards. Proponents of deregulation argue thatwhen people are insured, they are more apt to take greater risks with theirinvestments in financial markets. The riskier the investment activity, the morevolatile the markets tend to be. A closer look suggests that perhaps only two of these explanations arevalid when thinking about the origins of financial instability. The triggerpoint explanation seems to be a misreading of the origins of instability. It isunlikely that a large number of investors would have the incentive oroperational ability in order to simultaneously coordinate the buying or sellingof a currency or assets denominated in that currency. If even there is suchunlikely coordination, the existence of even a very large group of investorswith trigger points need not create a crisis if other investors know they arethere (Krugman, 1991:96). The theory of hegemonic stability also overlooks a number of factorsthat can provide useful insights in explaining the emergence of financialinstability. Historical precedence supports this assertion. For instance,Britains role as international economic manager was very minor in the stabilityexperienced under the gold standard. The success of the standard can beattributed to endogenous factors such as the self adjusting market mechanism andthe informal discipline maintained by its rules. The destabilization of thegold standard can be attributed to the extreme domestic economic and financialpressures brought on nation states by World War I, and not solely on theindustrial and economic demise of Britain. A valid explanation for the origins of financial instability are thespeculative attacks brought on by investors. Although similar in function totrigger points, these speculative cycles cannot be mitigated simply by purerecognition. Rather than acting on the value of the currency itself,speculators act on occurrences or policies that will alter the value of thecurrency. Instability arises from the fact that these speculative cycles inducecapital 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 havegiven investors and speculators an unheard of capacity to leverage financialmarkets. The greater the leverage, the greater the instability (McCallum,1995:12). If we examine the deregulatory process closely, it becomes clear thatthere is a perverse relationship between deregulation and financial stability. Say for example, investors suffer from a profit squeeze. This causes theinvestors to lobby politicians for deregulation. The resulting wave ofderegulation fosters instability and wide swings in exchange rates which in turncause loan defaults and subsequent banking crisis. The resulting financialinstability thus begs calls regulation, likely placing the investors in theoriginal position with an unsolved problem. We can see that the dialectic ofthe regulatory process undermines anticipated stability and will eventually leadto financial instability and collapse. In this environment, there arises callsfor new forms of financial regulation. These policies and proposals are ofcritical importance and will therefore be discussed later in the paper. THE TRANSMISSION AND EFFECTS OF FINANCIAL INSTABILITYThere are three contending albeit interrelated views on how financialinstability may be transmitted globally. These include equity markets,multiplier effects and monetary reverberations. Aaron Burr Treason Trial EssayThe last major policy aimed at quelling financial instability is thecreation of a supranational institution aimed at coordinating financial reformand adopting a system of regulatory supervision. Processing along the lines ofa Bretton Woods architecture, this would in a sense institutionalize the role ofa hegemon with a creation of a common currency for all of the industrialdemocracies and a joint Bank of Issue to determine monetary and financialpolicies (Cooper, 1984:166). This policy proposal endorses the adoption of anglobal financial institution managing the operation of coordinated supervision. Experience shows us that coordinated supervision is not possible ininternational financial markets. For instance, the Basel Concordant was neverable to reach organizational level to properly respond to a crisis. Additionally, the BCCI affair demonstrated the limitations of internationalbank supervision when confronted by unscrupulous operators intent on exploitingthe gaps in national bank supervisory systems (Herring and Litan, 1995:105). Proponents of re-creating a Bretton Woods-type system are unaware of thelessons to be learned from that period. The theoretical brethren of hegemonicstability advocates, proponents of this policy seek too place the direction ofworld monetary policy in the hands of a single country or institution thatwould have great influence over the economic destiny of others (Williamson,1977:37). As seen under the Bretton Woods system the destiny of others was inthe hands of a country that was unable to maintain stability. It is yet to bedemonstrated how an institutional framework would sidestep the same faultlinesand management problems experienced by the United States under the Bretton Woodsregime. The organizational barriers to creating such cooperation andcoordination would be insurmountable. Secondly, whose view would most likely bepresented in the supranational forum? Experience in international organizationsshows us that it will probably be the powerful, industrialized nations. Thevoice and needs of the less developed countries is likely to be marginalized andsituations such as the Latin American debt crisis would continue to occur. When looking at the progress of the European Monetary Union we see thatthe completion of a single market is far too radical for todays internationalfinancial climate. Just as the costs of qualifying for the EMU has become toohigh it becomes unrealistic to hope that the major industrial countries canmake comparable strides toward political much less financial unification inour lifetime (Eichengreen and Tobin, 1995:170). Ideally, the best policy for stemming financial instability andspillover effects would be one that extinguishes the problem at its roots. Ifderegulation in itself causes instability in financial markets, then regulationwould be appealing. Even when the benefits of financial deregulation areapparent, there is a role for regulatory policy that would leave the worldeconomy less vulnerable to financial collapse (Eichengreen and Portes, 1987:51). . If we also hold true the conclusion that the best explanation for financialinstability is speculation, then a global securities transaction tax such as theone proposed by Tobin would be optimal. The discouragement of short termspeculative excursions and the endorsement of long-term investment willeliminate the problem of volatility based on speculative attacks that so oftenstray from market fundamentals.Critics are quite correct when they arguethat the tax could induce financial arbitrage and substitution. However thisproblem would be solved as long as the tax was globally adopted. Secondly, thetax would be applied to goods, services, and financial instruments that had fewor no substitutes. The view that the creation of new government revenues isoverestimated and that Third World countries would carry the financial burden isnullified when we see that a .5 percent tax on exchange transaction wouldaugment government revenues globally by as much as $300 to $400 billion per anumand dev oting merely 10-20 percent of that revenue to a revolving fund forlong-term lending to Third World countries would be a healthy substitute forthe hot money on which some have become disastrously overdependent (McCallum,1995:16). The recognition and ceasing of financial instability and its globaltransmission is becoming more and more universally endorsed. To decide on aprudent and practical policy will prove to be a major hurdle of internationalfinancial leaders around the world. However, if we look closely, we will findthe locus of instability in financial markets to be deregulation and speculativeattacks. Government and central bankers can no longer adopt an attitude of benign neglect toward international financial instability as it becomesincreasingly apparent that there are far reaching consequences on real sectors. We can see that there is one policy that supersedes the rest. If the worldfinancial system hopes to curb these real sector ramifications of speculativeattacks and financial liberalization, then it becomes indisputable that the STTis an idea whose time has come. BIBLIOGRAPHYRichard N. Cooper, A Monetary System for the Future Foreign Affairs Fall,1984. Barry Eichengreen and Richard Portes, The Anatomy of Financial Crisis, inRichardPortes and Alexander Swoboda, Threats to International FinancialStability,(Cambridege University Press, 1987). Barry Eichengreen, James Tobin and Charles Wyplosz, Two Cases for Sand in theWhellsof International Finance Economic Journal, 1995. Jacob Frenkel, The International Monetary System: Should It Be Reformed inPhilipKing, editor, International Economics and International Economic Policy(McGraw-Hill,1990). Ilene Grabel, Crossing Borders: A Case for Cooperation in InternationalFinancialMarkets, in Gerald Epstein, Julie Graham, Jessica Nembard (eds.),Creating aNew World Economy: Forces of Change and Plans of Action (TempleUniversityPress, 1993). Charles Hakkio, Should we Throw Sand in the Gears of Financial Markets?FederalReserve Bank of Kansas City Economic Review, 1994. Richard Herring and Robert Litan, Financial Regulation in the Global Economy(Brookings Institution, 1995). Ethan Kapstein, Shockproof: The End of Financial Crisis Foreign Affairs,January/February 1996. Charles P. Kindleberger, The World in Depression (London: Penguin 1973). Paul Krugman, International Aspects of Financial Crises in Martin Feldstein,ed., TheRisk of Economic Crisis (Chicago: University of Chicago Press, 1991). John McCallum, Managers and Unstable Financial Markets Business QuarterlyJanuary1, 1995. James Tobin, A proposal for international monetary reform Eastern EconomicJournal1978, volume 4. John Williamson, The Failure of World Monetary Reform 1971-1974) (NY:NYU Press,1977)L.B. Yeager, International Monetary Relations: Theory, History, and Policy 1976. . Category: Business