Towards a Lender of First Resort

Daniel Cohen and Richard Portes

No 4615, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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 (search for similar items in EconPapers)
JEL-codes: F33 F34 (search for similar items in EconPapers)
Date: 2004-09
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Citations: View citations in EconPapers (2)

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Working Paper: Toward a Lender of First Resort (2006)
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