Dealing with Destabilizing 'Market Discipline'

26 Pages Posted: 11 Jun 2004

See all articles by Daniel Cohen

Daniel Cohen

Ecole Normale Superieure (ENS) - Department and Laboratory of Applied and Theoretical Economics (DELTA); Centre for Economic Policy Research (CEPR)

Richard Portes

London Business School - Department of Economics; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

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Date Written: May 2004

Abstract

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.

Suggested Citation

Cohen, Daniel and Portes, Richard, Dealing with Destabilizing 'Market Discipline' (May 2004). NBER Working Paper No. w10533, Available at SSRN: https://ssrn.com/abstract=552896

Daniel Cohen

Ecole Normale Superieure (ENS) - Department and Laboratory of Applied and Theoretical Economics (DELTA) ( email )

48 boulevard Jourdan
75014 Paris
France
+33 1 4313 6208 (Phone)
+33 1 4424 3857 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Richard Portes (Contact Author)

London Business School - Department of Economics ( email )

Regent's Park
London, NW1 4SA
United Kingdom
+44 20 7000 8424 (Phone)
+44 20 7000 8401 (Fax)

HOME PAGE: http://faculty.london.edu/rportes/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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