Working Paper: CEPR ID: DP4280
Authors: Daniel Cohen; Richard Portes
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.
Keywords: country spreads; financial crises; market discipline; sovereign debt
JEL Codes: F33; F34
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| rising interest rates (E43) | country spreads (R12) |
| country spreads (R12) | self-fulfilling debt crisis (F34) |
| self-fulfilling debt crisis (F34) | perception of high risk (D81) |
| perception of high risk (D81) | higher costs of borrowing (G21) |
| diminished confidence (D80) | rapid increase in spreads (F65) |
| rapid increase in spreads (F65) | exacerbated debt situation (F65) |
| IMF intervention (F33) | improved ex ante incentives (D82) |
| improved ex ante incentives (D82) | mitigated risk of confidence crises (H12) |