Policy Shifts and Financial Instability in Emerging Markets

• Published date: 01 August 2015
• Author: Björn Urbansky,Andreas Hoffmann
• Date: 01 August 2015
• DOI: http://doi.org/10.1111/rode.12170

Policy Shifts and Financial Instability in

Emerging Markets

Andreas Hoffmann and Björn Urbansky*

Abstract

We explain periods of financial instability following drastic policy shifts within a Hayekian framework.

Hayek emphasized that prices, established via the market process, help market participants to form coher-

ent expectations about the future and coordinate plans with one another. In this paper, we elaborate on

how policy shifts may undermine planning based on price signals and exacerbate uncertainty about the

future, which can contribute to financial instability. Based on our postulated framework, we clarify how

financial liberalization in the 1980s/1990s and the recent discretionary monetary policies in the advanced

economies may have contributed to recurring episodes of financial instability in emerging markets. In

particular, this paper provides an explanation for (1) why we observe financial instability mainly shortly

following financial liberalization, and (2) why financial developments in the emerging markets are

sensitive to unexpected monetary policy changes in the advanced countries in the current zero-interest rate

environment.

1. Introduction

This paper explains periods of financial instability in emerging markets as an outcome

of knowledge problems and resulting coordination failures that can be attributed to

drastic policy shifts within a Hayekian framework.

Hayek’s work stressed that prices established via the market process may help

market participants to form coherent expectations about the future and to coordinate

plans with one another. In this paper, we elaborate on how drastic unexpected

changes, e.g. coming from policy shifts, may undermine the ability of market partici-

pants to plan based on past price signals. Rising uncertainty can contribute to incoher-

ent expectations, discoordination and instability.

In particular, we outline how (1) the move towards financial liberalization in the

emerging markets during the 1980s/1990s and (2) the discretionary monetary policies

in advanced economies since the 2000s may have contributed to recurring episodes of

financial instability in emerging markets.

(1) We argue that in the 1980s and 1990s financial liberalization disrupted the plans

of market participants in emerging markets because in an environment of rapid insti-

tutional change price signals were not able to guide the formation of coherent expec-

tations in the short run. This ignorance led to a rise in uncertainty about the future

* Hoffmann: Institute for Economic Policy, Leipzig University, Grimmaische Strasse 12, 04109 Leipzig,

Germany. Tel: +49-(0)341-9733566; Fax: +49-(0)341-9733569; E-mail: ahoffmann@wifa.uni-leipzig.de.

Urbansky: Institute for Economic Policy, Leipzig University, Grimmaische Strasse 12, 04109 Leipzig,

Germany. The authors thank two anonymous referees for useful comments and suggestions that substan-

tially improved the paper. Furthermore, they thank Alexander Fink, Israel Kirzner, Mario J. Rizzo, David

Harper, Gene Callahan, Sanford Ikeda, the participants of NYU’s Colloquium on Market Institutions and

Economic Processes, Andreas Schäfer, Gunther Schnabl, as well as the participants of the International

Conference on “Exchange Rates, Monetary Policy and Financial Stability in Emerging Markets and Devel-

oping Countries” at Leipzig University for helpful comments and suggestions.

Review of Development Economics, 19(3), 455–469, 2015

DOI:10.1111/rode.12170

© 2015 John Wiley & Sons Ltd