Holding out for a haircut: Financial crisis, moral hazard, and interest rate policy

The International Monetary Fund (IMF)-prescribed introduction of higher int erest rates in crisis-hit economies has been criticized as being unnecessar ily contractionary. This criticism ignores the effects of interest rate pol icy on the incentives to restructure corporate debt once it has become stra tegically optimal for domestic firms to declare a state of over-indebtednes s. A widespread state of debt moratoria constitutes a 'bad' equilibrium, wh ereas the widespread adoption of a quick debt workout strategy is a potenti ally 'good' equilibrium. The latter can be encouraged through various polic ies, most controversially a short-term policy of high interest rates. Other potential policies include: (i) widespread debt forgiveness; (ii) enhanced implementation of the bankruptcy court; and (iii) the enforcement of free market competition. Copyright (C) 2000 John Wiley & Sons, Ltd.