DP4280 Dealing with Destabilizing 'Market Discipline'

Author(s): Daniel Cohen , Richard Portes

Publication Date: February 2004

Keyword(s): market discipline , sovereign debt , country spreads , financial crises

JEL(s): F33 , F34

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP4280.asp

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.