Market Discipline and Exuberant Foreign Borrowing
Recent crises in emerging markets call into question the effectiveness of market discipline for ensuring efficient foreign borrowing. We review arguments that indicate that market discipline is limited by lack of information and may be dangerously distorted by moral hazard induced by official guarantees. Aside from these well-known concerns, we show that the market fails to internalize country risk and panic risk, which leads to inefficient borrowing even in the absence of traditional distortions. We also discuss optimal tax and trade policy as well as the role of liquidity facilities to address these externalities.
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