Dealing with Destabilizing 'Market Discipline'

Daniel Cohen and Richard Portes

No 10533, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: F33 F34 (search for similar items in EconPapers)
Date: 2004-05
New Economics Papers: this item is included in nep-ifn and nep-reg
Note: IFM
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Citations: View citations in EconPapers (3)

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