Discussion paper

DP4280 Dealing with Destabilizing 'Market Discipline'

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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Citation

Cohen, D and R Portes (2004), ‘DP4280 Dealing with Destabilizing 'Market Discipline'‘, CEPR Discussion Paper No. 4280. CEPR Press, Paris & London. https://cepr.org/publications/dp4280