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Dealing with Destabilizing 'Market Discipline'

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  • Daniel Cohen
  • Richard Portes

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.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10533.

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Date of creation: May 2004
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Handle: RePEc:nbr:nberwo:10533

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  1. Harold L. Cole & Timothy J. Kehoe, 1998. "Self-fulfilling debt crises," Staff Report 211, Federal Reserve Bank of Minneapolis.
  2. Antonio Afonso, 2003. "Understanding the determinants of sovereign debt ratings: Evidence for the two leading agencies," Journal of Economics and Finance, Springer, vol. 27(1), pages 56-74, March.
  3. Calvo, Guillermo A, 1988. "Servicing the Public Debt: The Role of Expectations," American Economic Review, American Economic Association, vol. 78(4), pages 647-61, September.
  4. Martin Uribe & Vivian Yue, 2004. "Country spreads and emerging countries: who drives whom?," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  5. Daniel Cohen, 2000. "The HIPC Initiative: True and False Promises," OECD Development Centre Working Papers 166, OECD Publishing.
  6. John Williamson, 2000. "The Role of the IMF: A Guide to the Reports," Policy Briefs PB00-5, Peterson Institute for International Economics.
  7. Peter H. Lindert & Peter J. Morton, 1989. "How Sovereign Debt Has Worked," NBER Chapters, in: Developing Country Debt and Economic Performance, Volume 1: The International Financial System, pages 39-106 National Bureau of Economic Research, Inc.
  8. Richard Cantor & Frank Packer, 1995. "Sovereign credit ratings," Current Issues in Economics and Finance, Federal Reserve Bank of New York, vol. 1(Jun).
  9. Fischer, Stanley, 1999. "Reforming the International Financial System," Economic Journal, Royal Economic Society, vol. 109(459), pages F557-76, November.
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Cited by:
  1. Montiel, Peter & Serven, Luis, 2004. "Macroeconomic stability in developing countries - How much is enough?," Policy Research Working Paper Series 3456, The World Bank.
  2. Hefeker, Carsten, 2006. "Vermeidung und Bewältigung von Verschuldungskrisen: Die Rolle privater und öffentlicher Institutionen," HWWA Discussion Papers 340, Hamburg Institute of International Economics (HWWA).
  3. Philipp Paulus, 2004. "The fiscal stability impact of monetary unions - looking beneath the Stability Pact debate," Otto-Wolff-Institut Discussion Paper Series 05/2004, Otto-Wolff-Institut für Wirtschaftsordnung, Köln, Deutschland.

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