Working Paper: CEPR ID: DP4615
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). Theory then suggests a set of circumstances in which a lender of first resort would be desirable. The policy would seek to short-circuit confidence crises, partly by using IMF support to improve ex ante incentives. Theory also illuminates the potential role of collective action clauses (CACs) in eliminating the risk of self-fulfilling debt crises.
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) | sustainability of sovereign debt (H63) |
| high spreads (F31) | sustainability of sovereign debt (H63) |
| high spreads (F31) | self-fulfilling crisis (H12) |
| self-fulfilling crisis (H12) | sustainability of sovereign debt (H63) |
| IMF support (F33) | sustainability of sovereign debt (H63) |
| confidence crises (G01) | crises of fundamentals (G01) |
| crises of fundamentals (G01) | self-fulfilling crisis (H12) |