Financial Instability

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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...
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