Dealing with Destabilizing 'Market Discipline'
Ecole Normale Superieure (ENS) - Department and Laboratory of Applied and Theoretical Economics (DELTA); Centre for Economic Policy Research (CEPR)
London Business School - Department of Economics; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)
CEPR Discussion Paper No. 4280
If interest rates (country spreads) rise, debt can rapidly be subject to a snowball effect, which then becomes self-fulfilling with regard to the fundamentals themselves. This is a market imperfection, because we cannot be confident that the unaided market will choose the 'good equilibrium' over the 'bad equilibrium'. We see here a fundamental flaw in the process of market discipline. We propose a policy intervention to deal with this structural weakness in the mechanisms of international capital flows. This is based on a simple taxonomy that enables us to break down the origin of crises into three components: a crisis of confidence (spreads and currency crisis), a crisis of fundamentals (real growth rate), and a crisis of economic policy (primary deficit). The policy would seek to short-circuit confidence crises, partly by using IMF support to improve ex ante incentives.
Number of Pages in PDF File: 28
Keywords: Market discipline, sovereign debt, country spreads, financial crises
JEL Classification: F33, F34working papers series
Date posted: April 5, 2004
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