1992 and Capital Market Liberalization
Unhealthy interest

In 1990 EC countries are obliged to remove all their remaining capital controls. In Discussion Paper No. 318, Programme Director Francesco Giavazzi and Research Fellow Marco Pagano argue that the attempt to create an area of quasi-fixed exchange rates without capital controls may prove very difficult.
Giavazzi and Pagano show how, under free capital mobility, confidence crises can lead to devaluations of the currencies of countries with high public debt, even when exchange rates are fixed at levels consistent with economic fundamentals. During a confidence crisis domestic interest rates rise, reflecting the market's expectation of devaluation. If this coincides with the expiry of a large amount of public debt, then rather than selling reissued debt at punitive rates, fiscal authorities will turn to money financing. Even if this injection of liquidity is only temporary, until interest rates fall to normal levels, it will fuel currency speculation and make devaluation more likely.
This can only be avoided, the authors argue, by policies to reduce the stock of public debt, lengthen its average maturity and smooth the time distribution of maturing issues. Pagano discussed these problems at a lunchtime meeting reported in Bulletin No. 30/31

Confidence Crises and Public Debt Management
Francesco Giavazzi and Marco Pagano

Discussion Paper No. 318, May 1989 (IM/AM)