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
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 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.
THE TRANSMISSION AND EFFECTS OF FINANCIAL INSTABILITY
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
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
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.
CONTENDING VIEWS AND POLICY PROPOSALS
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.
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Barry Eichengreen and Richard Portes, "The Anatomy of Financial Crisis," in
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Jacob Frenkel, "The International Monetary System: Should It Be Reformed" in
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Ilene Grabel, "Crossing Borders: A Case for Cooperation in International
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Charles Hakkio, "Should we Throw Sand in the Gears of Financial Markets?"
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Richard Herring and Robert Litan, Financial Regulation in the Global Economy
(Brookings Institution, 1995).
Ethan Kapstein, "Shockproof: The End of Financial Crisis" Foreign Affairs,
Charles P. Kindleberger, The World in Depression (London: Penguin 1973).
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