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Example research essay topic: Stock Market Crash Third World Countries - 3,623 words

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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?

bandwagon ing? 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 pre commited 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 levels. 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, 1995: 12). 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 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 perceived 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. 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 would 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? (Gravel, 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 mal distribution 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 fault lines and management problems experienced by the United States under the Bretton Woods regime. 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 and? 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, 1995: 16). 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.

BIBLIOGRAPHY Richard N. Cooper, ? A Monetary System for the Future? Foreign Affairs Fall, 1984. Barry Eichengreen and Richard Portes, ?

The Anatomy of Financial Crisis, ? in Richard Portes and Alexander Swoboda, Threats to International Financial Stability, (Cambridge University Press, 1987). Barry Eichengreen, James Tobin and Charles Wyplosz, ? Two Cases for Sand in the Well of International Finance?

Economic Journal, 1995. Jacob Frenkel, ? The International Monetary System: Should It Be Reformed? in Philip King, editor, International Economics and International Economic Policy (McGraw-Hill, 1990). Ilene Gravel, ? Crossing Borders: A Case for Cooperation in International Financial Markets, ?

in Gerald Epstein, Julie Graham, Jessica Nembard (eds. ), Creating a New World Economy: Forces of Change and Plans of Action (Temple University Press, 1993). Charles Hakkio, ? Should we Throw Sand in the Gears of Financial Markets? ? Federal 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 January 1, 1995. James Tobin, ? A proposal for international monetary reform? Eastern Economic Journal 1978, volum John Williamson, The Failure of World Monetary Reform 1971 - 1974) (NY: NYU Press, 1977) L. B. Yeager, International Monetary Relations: Theory, History, and Policy 1976.


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