- May 6, 2014
- Posted by: essay
- Category: Term paper writing
Theorists, for example, Arestis and Baddeley (2001) focus their research on the efficiency of the international financial markets and they research the question why so many financial crises have happened since 1970s? Authors conclude that before that time the financial system was formed in accordance to Keynes’s thesis that “international capital mobility and rapid economic growth are incompatible”. The capital was better controlled and financial market was more strictly regulated. But since that time, since the liberalization of the financial market, theÂ financialÂ system has become much more instable and suffers from international debt and currency liquidity crises threatening the stability of the global economy. (Arestis and Baddeley, 2001)
Before considering ways of dealing with internationalÂ financialÂ crises, it is first necessary to understand why they arise, what role they play in international capital markets, and whether they can be detected.Â There may be a range of fundamentals over which an economy is susceptible toÂ crisis. TheÂ crisisÂ mechanism lies in the self-fulfilling beliefs of international lenders and results in multiple equilibrium.
Diamond and Dybvig highlightÂ theÂ role of maturity mismatches in generating multiple equilibrium. (Chui and Gai, 2005) Banks have liquid liabilities (deposits), illiquid assets (loans), and are often in a position of having insufficient resources to meet all their commitments. If depositors reachÂ theÂ bank’s teller on a first-come, first-served basis, those who withdraw initially will receive more than those who wait. If no one believesÂ theÂ bank will fail, only those with immediate need for liquidity will withdraw their funds. Assuming that banks have sufficient liquid assets to meet these demands, there is no run. But onÂ theÂ other hand, if everyone believes that a banking collapse is about to occur, all depositors have an incentive to withdraw immediately. A second view ofÂ crisisÂ emphasizesÂ theÂ importance of a secular deterioration in fundamentals, such as a declining level of foreign reserves or a downturn inÂ theÂ business cycle, asÂ theÂ key trigger. Runs need not be ascribed toÂ theÂ beliefs of market participants but can be explained, instead, byÂ theÂ very rationality of their expectations. Crises are never panic-based since, whenever investors run, they would do so even if others did not.Â TheÂ actual and expected deterioration of fundamentals (often inÂ theÂ form of uncontrolled credit expansion byÂ theÂ central bank) pushesÂ theÂ economy intoÂ crisis. When rational investors observe these leading indicators,Â theÂ crisis is anticipated and brought forward to a point in time where speculators are unable to take advantage of arbitrage possibilities.
Summers (2000) indicates real-life crises contain elements of belief-driven and fundamentals-based attacks. In addition, Chui and Gai (2005) note the likelihood ofÂ crisisÂ is often determined byÂ theÂ extent of fundamental weaknesses that call into questionÂ theÂ sustainability of domestic policies.
Morris and Shin (1998) suggest that it is possible to resolveÂ theÂ problem of indeterminacy in beliefs, and captureÂ theÂ key elements ofÂ theÂ two views ofÂ crisis. They highlight two shortcomings of multiple equilibrium models. (Chui and Gai, 2005) First, economic fundamentals are assumed to be common knowledge; and second, creditors are assumed to be certain about others’ behavior in equilibrium. Once disparities inÂ the information sets of market participants are allowed, a creditor’s decision to withdraw depends on his private signal about fundamentals and his assessment ofÂ theÂ probability that other creditors have received a better signal. IfÂ theÂ signal is below a certain trigger value (determined in equilibrium), then it is optimal to run. And if a sufficient number of creditors have signals belowÂ theÂ trigger value, a critical mass of withdrawals is reached starting aÂ crisis.
TheÂ weakerÂ theÂ fundamentals,Â theÂ more fragileÂ theÂ situation becomes inÂ theÂ sense that fewer participants are required to trigger aÂ crisis.
Chui and Gai (2005) specifically indicate that theÂ global games approach to the financial crises perfectly applicable to sovereign liquidity crises. TheÂ advantage ofÂ theÂ global games approach is that it permits a unique mapping betweenÂ the realization of economic fundamentals andÂ theÂ beliefs of creditors. This means that signals about fundamentals serve as a device that coordinates beliefs on a particular outcome.Â TheÂ coordination device is not some random sunspot, but a payoff-dependent variable that matters to investors. Since private signals cannot be directly observed, an abrupt shift from one equilibrium to another can still occur without any change inÂ observableÂ fundamentals.