International Financial Crisis Essay Research Paper Financial

International Financial Crisis Essay, Research Paper

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 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 or unattainable.INSTABILITY IN FINANCIAL MARKETS In 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 country’s 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 acountry’s 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 hegemon’s 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 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 thatwhen 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 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