DP4280 Dealing with Destabilizing 'Market Discipline'
Authors: Daniel Cohen (Ecole Normale Supérieure, Cepremap and CEPR) and Richard Portes (London Business School, Columbia Business School, EHESS and CEPR
February 2004
The widespread debt crisis of the 1980s became 'the lost decade' for Latin America, and the banks ultimately had to accept substantial write offs. The Asian crisis of 1997-98 was devastating at the time and is still not over for Indonesia. The Russian default of August 1998 was settled relatively quickly, but even quicker were the shock waves it sent out to the financial markets - with some role in the failure of Long Term Capital Management, a sharp rise of all emerging market bond spreads, and the subsequent Brazilian exchange-rate crisis. Dealing with country debt crises is always very messy, often protracted and very costly to both debtor and creditors.
However, there are alternatives. In CEPR Discussion Paper No.4280, Daniel Cohen and Richard Portes review the existing literature and different proposals for dealing with international financial crises. They propose a policy intervention to deal with what they argue is a structural weakness in the mechanisms of international capital flows: 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 it is uncertain that the unaided market will choose the right outcome. Cohen and Portes argue that this is an example of a fundamental flaw in the process of market discipline.
The authors 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). Their policy proposal would seek to short-circuit confidence crises, partly by using IMF support to improve ex ante incentives.
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