Dealing with Destabilizing 'Market Discipline'
AbstractIf 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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Date of creation: May 2004
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Other versions of this item:
- F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions
- F34 - International Economics - - International Finance - - - International Lending and Debt Problems
This paper has been announced in the following NEP Reports:
- NEP-ALL-2004-06-07 (All new papers)
- NEP-IFN-2004-06-07 (International Finance)
- NEP-REG-2004-06-07 (Regulation)
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