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Dealing with Destabilizing 'Market Discipline'

  • Cohen, Daniel
  • Portes, Richard

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 C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 4280.

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Date of creation: Feb 2004
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Handle: RePEc:cpr:ceprdp:4280
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  1. 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.
  2. 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.
  3. Martin Uribe & Vivian Z. Yue, 2003. "Country Spreads and Emerging Countries: Who Drives Whom?," NBER Working Papers 10018, National Bureau of Economic Research, Inc.
  4. Cole, Harold L & Kehoe, Timothy J, 2000. "Self-Fulfilling Debt Crises," Review of Economic Studies, Wiley Blackwell, vol. 67(1), pages 91-116, January.
  5. Fischer, Stanley, 1999. "Reforming the International Financial System," Economic Journal, Royal Economic Society, vol. 109(459), pages F557-76, November.
  6. Cohen, Daniel, 2000. "The HIPC Initiative: True and False Promises," CEPR Discussion Papers 2632, C.E.P.R. Discussion Papers.
  7. Richard Cantor & Frank Packer, 1995. "Sovereign credit ratings," Current Issues in Economics and Finance, Federal Reserve Bank of New York, vol. 1(Jun).
  8. John Williamson, 2000. "The Role of the IMF: A Guide to the Reports," Policy Briefs PB00-5, Peterson Institute for International Economics.
  9. 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.
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