Working Paper: NBER ID: w10533
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: No keywords provided
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) | self-fulfilling snowball effect on debt (F65) |
| self-fulfilling snowball effect on debt (F65) | increased debt service burden (F34) |
| increased debt service burden (F34) | debt crisis (F34) |
| Lack of confidence (D83) | unfavorable economic outcomes (F69) |
| IMF intervention (F33) | improved market discipline (G18) |
| IMF intervention (F33) | mitigate confidence crises (H12) |