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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



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 currency to remarkably higher or lower


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

of 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

recognition. 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,


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

the 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

country. 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

contraction 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

view 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

expansionary 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 37.3 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.


Three main policies have been introduced to curb international

financial instability. A global transaction tax, which is a tax on short term

financial investments, a target zone approach, where nations exchange rates

would be allowed to fluctuate within a specific band and a supranational or

regional institution aimed at coordinating global financial reform.

Proposed by economists and Nobel Laureate James Tobin in 1978, a global

transaction tax (STT) would act to "throw some sand in the well greased wheels

of the global financial markets." The STT is predicted to slow the short term

financial excursions into other currencies, yet at the same time it would have a

lighter impact on trade and long-term investments with higher percentage yields.

Speculators, now carrying the burden of a tax woul therefore have less "

leverage" with which to exploit exchange volatility while long-term investment

would be encouraged. Another benefit of the tax is that it would reduce

wasted financial resources and increase government revenues.

While proponents of the STT say the policy will reduce wasted financial

resources, others argue that there would be an adjustment problem because of the

fact that "goods and the price of labor moved in response to international price

signals much more sluggishly than fluid funds, and prices in goods and labor

markets moved more sluggishly than prices of financial assets."(McCallum,

1995:16) Others attack the view that excess volatility would be eliminated

because "deciding whether volatility is excessive is complicated by difficulty

of determining the fundamental value of a security" (Hakkio, 1994:22).

Opponents of the tax argue that it could be avoided by product substitution and

regulatory arbitrage and that the government revenue created would be

overestimated because "the tax base would decline as security prices and the

volume of trading decline" (Hakkio 1994: 26).

Advocates of the "efficient market hypothesis" argue that if financial

markets are allowed to freely operate, there will be a revaluation of asset

values that will produce the most accurate price signals on which to base long-

term resource allocations. They say that a STT would be detrimental to less

developed countries so reliant on short term investment.

Another highly noted policy aimed at curbing international financial

instability is the adoption of a targeted exchange rate system. A sort of "

hybrid" regime, target zones allows currencies to fluctuate within predetermined

and set bands, thus allowing a "float" but at the same time keeping a "fix."

Since "the main sources of conflict have been the unpredictability of exchange

rates" (Frenkel, 1990:318) a target zone approach would in theory alleviate this

unpredictability, while keeping the appealing attributes of a floating system.

Seen to be the optimal answer for coordinated exchange rate stabilization, "

target zones would involve the determination of an international consensus

regarding an appropriate and globally feasible range around which currency

values could fluctuate" (Grabel, 1993:77).

The adoption of a target zone system would not be universally

beneficial. Naturally, the size, status and sector of the economy play an

important role in its desirability. Government officials and central bankers

will likely oppose the adoption of a targeted exchange rate due to the fact that

it would hurt their ability to change the value of their currency in the face of

high capital mobility. With a targeted exchange rate, it is argued that there is

limited room for fluctuation which infringes on the effectiveness of domestic

policies. On the other hand, the fixity of the target zone would in theory

stabilize purchasing power of wage earners in both developed and less developed.

The overriding problem of the adoption of a target zone regime is that

there is no clear way in which target zones could be calculated. If they were

to be calculated what would be the ramifications if a country was to fluctuate

out of the specific bands? Would the target zones be global or regional? If

global, how could the less developed countries be able to stay in the same bands

as the developed countries? If a target zone was adopted, what is to say the

maldistribution of wealth would not remain idle? There seems to be little, if

any, evidence that a fixed, stabilized exchange rate leads to higher or lower

interest rates. If the value of a currency is not able to adapt to high

tendencies of capital mobility, then it is only rational to say that the

developed countries would continue to sap the wealth of less developed countries.

The last major policy aimed at quelling financial instability is the

creation of a supranational institution aimed at coordinating financial reform

and adopting a system of "regulatory supervision." Processing along the lines of

a Bretton Woods architecture, this would in a sense institutionalize the role of

a hegemon with "a creation of a common currency for all of the industrial

democracies" and "a joint Bank of Issue to determine monetary [and financial]

policies" (Cooper, 1984:166). This policy proposal endorses the adoption of an

global financial institution managing the operation of coordinated supervision.

Experience shows us that coordinated supervision is not possible in

international financial markets. For instance, the Basel Concordant was never

able to reach organizational level to properly respond to a crisis.

Additionally, "the BCCI affair demonstrated the limitations of international

bank supervision when confronted by unscrupulous operators intent on exploiting

the gaps in national bank supervisory systems" (Herring and Litan, 1995:105).

Proponents of re-creating a Bretton Woods-type system are unaware of the

lessons to be learned from that period. The theoretical brethren of hegemonic

stability advocates, proponents of this policy seek too place "the direction of

world monetary policy in the hands of a single country" or institution that

would have "great influence over the economic destiny of others" (Williamson,

1977:37). As seen under the Bretton Woods system the "destiny" of others was in

the hands of a country that was unable to maintain stability. It is yet to be

demonstrated how an institutional framework would sidestep the same faultlines

and management problems experienced by the United States under the Bretton Woods


The organizational barriers to creating such cooperation and

coordination would be insurmountable. Secondly, whose view would most likely be

presented in the supranational forum? Experience in international organizations

shows us that it will probably be the powerful, industrialized nations. The

voice and needs of the less developed countries is likely to be marginalized and

situations such as the Latin American debt crisis would continue to occur.

When looking at the progress of the European Monetary Union we see that

the completion of a single market is far too radical for today's international

financial climate. Just as "the costs of qualifying for the EMU has become too

high" it becomes "unrealistic to hope that the major industrial countries can

make comparable strides toward political [much less financial] unification in

our lifetime" (Eichengreen and Tobin, 1995:170).

Ideally, the best policy for stemming financial instability and

spillover effects would be one that extinguishes the problem at its roots. If

deregulation in itself causes instability in financial markets, then regulation

would be appealing. "Even when the benefits of financial deregulation are

apparent, there is a role for regulatory policy" that would "leave the world

economy less vulnerable to financial collapse" (Eichengreen and Portes, 1987:51).

. If we also hold true the conclusion that the best explanation for financial

instability is speculation, then a global securities transaction tax such as the

one proposed by Tobin would be optimal. The discouragement of short term

speculative excursions and the endorsement of long-term investment will

eliminate the problem of volatility based on speculative attacks that so often

stray from market "fundamentals." Critics are quite correct when they argue

that the tax could induce financial arbitrage and substitution. However this

problem would be solved as long as the tax was globally adopted. Secondly, the

tax would be applied to goods, services, and financial instruments that had few

or no substitutes. The view that the creation of new government revenues is

overestimated and that Third World countries would carry the financial burden is

nullified when we see that "a .5 percent tax on exchange transaction would

augment government revenues globally by as much as $300 to $400 billion per anum"

and "devoting merely 10-20 percent of that revenue to a revolving fund for

long-term lending to Third World countries would be a healthy substitute for

the hot money on which some have become disastrously overdependent" (McCallum,


The recognition and ceasing of financial instability and its global

transmission is becoming more and more universally endorsed. To decide on a

prudent and practical policy will prove to be a major hurdle of international

financial leaders around the world. However, if we look closely, we will find

the locus of instability in financial markets to be deregulation and speculative

attacks. Government and central bankers can no longer adopt an attitude of "

benign neglect" toward international financial instability as it becomes

increasingly apparent that there are far reaching consequences on real sectors.

We can see that there is one policy that supersedes the rest. If the world

financial system hopes to curb these real sector ramifications of speculative

attacks and financial liberalization, then it becomes indisputable that the STT

is an idea whose time has come.


Richard N. Cooper, "A Monetary System for the Future" Foreign Affairs Fall,


Barry Eichengreen and Richard Portes, "The Anatomy of Financial Crisis," in


Portes and Alexander Swoboda, Threats to International Financial


(Cambridege University Press, 1987).

Barry Eichengreen, James Tobin and Charles Wyplosz, "Two Cases for Sand in the


of International Finance" Economic Journal, 1995.

Jacob Frenkel, "The International Monetary System: Should It Be Reformed" in


King, editor, International Economics and International Economic Policy


Ilene Grabel, "Crossing Borders: A Case for Cooperation in International


Markets," in Gerald Epstein, Julie Graham, Jessica Nembard (eds.),

Creating a

New World Economy: Forces of Change and Plans of Action (Temple


Press, 1993).

Charles Hakkio, "Should we Throw Sand in the Gears of Financial Markets?"


Reserve 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., The

Risk of Economic Crisis (Chicago: University of Chicago Press, 1991).

John McCallum, "Managers and Unstable Financial Markets" Business Quarterly


1, 1995.

James Tobin, "A proposal for international monetary reform" Eastern Economic


1978, volume 4.

John Williamson, The Failure of World Monetary Reform 1971-1974) (NY:NYU Press,


L.B. Yeager, International Monetary Relations: Theory, History, and Policy 1976.


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