Dealing with Destabilizing 'Market Discipline' / Daniel Cohen, Richard Portes.

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Cohen, Daniel

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Material type: Text

TextSeries: Working Paper Series (National Bureau of Economic Research) ; no. w10533.Publication details: Cambridge, Mass. National Bureau of Economic Research 2004.Description: 1 online resource: illustrations (black and white)Subject(s):

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Abstract: 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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Previous	nber w10530 Bargaining in Legislatures: An Empirical Investigation /	nber w10531 The Value of Phased Retirement /	nber w10532 Fiscal Policy and Financial Depth /	nber w10533 Dealing with Destabilizing 'Market Discipline' /	nber w10534 International Reserves Management and Capital Mobility in a Volatile World: Policy Considerations and a Case Study of Korea /	nber w10535 Building Relationships Early: Banks in Venture Capital /	nber w10536 Mergers and Acquisitions in the Pharmaceutical and Biotech Industries /	Next

May 2004.

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.