Narrow Results

This paper explores how behavioral finance and complexity economics, along with imperfect information, faulty mental models and perverse incentive structures can cast light on the factors that generate the international capital flow surges and sudden stops that McKinnon described as the over-borrowing syndrome. While there has been a great deal of empirical research on this topic in recent years, there has been much less theoretical analysis of why these flows too often behave in such a volatile manner. Developing a better understanding of the forces driving capital flows should help us identify situations where capital flow surges are particularly likely to end in costly sudden stops and help policy makers decide how best to respond to such flows.

The current paper investigates the impact of sovereign ratings on sudden stops of capital in the context of the Eurozone. Our analysis focuses on the qualitative aspect of ratings on the hypothesis that such aspect has a concrete impact on capital movements. A panel probit model is utilized for our purposes. We distinguish between net and gross capital inflows, while we also draw a distinction between long-term and short-term oriented capital. Our results confirm the influence of sovereign ratings for the majority of our model specifications. They also appear to be most significant in the case of short-term flows.

There has been controversy about the appropriate responses of monetary and fiscal policies to sudden stops of capital inflows. There have been concerns that expansionary policies could undermine confidence leading to currency depreciation and a worsening of the crisis. Previous literature has generally found favorable effects from fiscal expansion and mixed results for monetary policy. We revisit this issue using more recent data and alternative measures of monetary policy. We find considerable support for the view that expansionary monetary policy reduces output costs of sudden stops and no significant evidence that the costs are increased. We find that fiscal expansion by countries with low levels of debt is expansionary, but that these effects can become negative at high levels of debt.