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).