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 rgument 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. 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 inancial 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 peculation. 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 ringing 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. 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 f 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, 1991:96). 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 ecognition. 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 a perverse relationship between deregulation and financial stability. Say for example, investors suffer from a profit squeeze. This causes the investors to lobby politicians for deregulation. The resulting wave of deregulation fosters instability and wide swings in exchange rates which in turn cause loan defaults and subsequent banking crisis.
The resulting financial instability thus begs calls regulation, likely placing the investors in the original position with an unsolved problem. We can see that the dialectic of he regulatory process undermines anticipated stability and will eventually lead to financial instability and collapse. In this environment, there arises calls for new forms of financial regulation. These policies and proposals are of critical importance and will therefore be discussed later in the paper. There are three contending albeit interrelated views on how financial instability may be transmitted globally.
These include equity markets, multiplier effects and monetary reverberations. Say for example, a movement of stock prices generates a recession in one ountry. This is turn leads to a reduce in imports from abroad. The lower aggregate demand for foreign imports will generate a contraction in other country’s output markets. The resulting contraction in the foreign countries will then induce a contraction in the originating country. As seen, the multiplier effect begins to take place that in turn leads to a global recession. If an asset crash leads to a monetary crises, the money crisis could be transmitted worldwide.
The Mundell-Flemming model assumes that under a fixed exchange rate system, such as that under the gold standard, a worldwide monetary ontraction will result from a contraction in any one particular country because a monetary contraction in one country, which raises interest rates in that country, must be matched by an equal rise in rates elsewhere (Krugman, 1991:103). However, under a flexible exchange rate system, such as the one in operation today, the model predicts that monetary shocks will be transmitted perversely, that is, a monetary contraction in one country will produce expansion elsewhere.
Herring and Litan (1995) advance this argument by concluding that the transmission of crisis creates a systemic risk. This iew states that continuous losses in financial markets has adverse effects on the real economy because significant losses can occur if there is a significant disruption in the payments system or the mechanism through which transactions for goods, services, and assets are cleared (Herring and Litan, 1995:51) . While it may be accepted that financial crises can be transmitted globally, there is debate on its ramifications on the real sector of the economy.
Krugman (1991:97) states that a currency depreciation will produce an improvement in competitiveness that will increase net exports and thus have an xpansionary effect on the domestic economy. He also asserts that policy responses may help to curb real sectors effects. When currencies depreciate, government officials and central bankers raise interest rates to discourage capital flight. The recessionary effects of tight monetary and fiscal policies, it is argued, dilute the inflationary repercussions of the currency crisis.
Citing historical evidence of the US stock market crash, Kapstein (1996:6) goes so far as to say that the real economy is shockproof from transmission of financial instability and even in the face of financial crisis continues to function normally. The assumption that swings in financial markets do not influence real sector performance is inattentive to many factors. Advocates of this view use what is percieved as relatively small repercussions felt worldwide after the US stock market crash in 1929 where in general the slump was mild (Krugman 1991:91).
The empirical data of the slump underscores this argument. Between December 1929 and December 1932, for example, Germany experienced a 30. % percent stock market decline, France 38. 5 percent and Canada 37. 5% (Kindleberger, 1973). If we keep in mind that the percentage swing in the US stock during that same period was 37. percent, we see that the slump was only slightly milder but by no means mild. The real sector ramifications were just as remarkable.
Germany saw a 58 percent decline in industrial production, France 74 percent and Canada 68 percent, all comparably higher declines than in the United States (Yeager, 1976). It is obvious that financial crises do have global spillover effects and consequences on real sector performance. However, recognition of these adverse effects does not solve the problem. In the next section I present contending policies and proposals designed to curb international financial instability and its repugnant ramifications.