Towards a Lender of First Resort

27 Pages Posted: 4 Nov 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)

Date Written: September 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). Theory then suggests a set of circumstances in which a lender of first resort would be desirable. The policy would seek to short-circuit confidence crises, partly by using IMF support to improve ex ante incentives. Theory also illuminates the potential role of collective action clauses (CACs) in eliminating the risk of self-fulfilling debt crises.

Keywords: Market discipline, sovereign debt, country spreads, financial crises

JEL Classification: F33, F34

Suggested Citation

Cohen, Daniel and Portes, Richard, Towards a Lender of First Resort (September 2004). Available at SSRN: https://ssrn.com/abstract=614842

Daniel Cohen (Contact Author)

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

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

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
27
Abstract Views
847
PlumX Metrics