Betting Against The State: Socially Costly Financial Engineering

Abstract

The central question raised in the paper is the desirability of state-contingent contracts under imperfect policy credibility. The paper shows a benchmark case in which imperfect credibility of a trade liberalization program is distorting, and the distortion is magnified by statecontingent markets. In addition, it examines the welfare implications of gaining credibility concluding that, in general, more credibility is better than less, and examines the moral hazard faced by policymakers in carrying out reform in case the private sector is able to obtain insurance against its discontinuation.