Toward a Lender of First Resort

26 Pages Posted: 26 Apr 2006

See all articles by Richard Portes

Richard Portes

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

Daniel Cohen

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

Date Written: March 2006

Abstract

If interest rates (country spreads) rise, debt can rapidly be subject to a snowball effect, which 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' over the 'bad' equilibrium. 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 breaks down the origin of crises into three components: confidence (spreads and currency crisis), fundamentals (real growth rate), and 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 in reducing the risk of self-fulfilling debt crises.

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

JEL Classification: F33, F34

Suggested Citation

Portes, Richard and Cohen, Daniel, Toward a Lender of First Resort (March 2006). IMF Working Paper No. 06/66, Available at SSRN: https://ssrn.com/abstract=898727

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

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

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