The sovereign debt crisis and monetary policy

Since Lehman Brothers’ filing for Chapter 11 bankruptcy on September 2008, and as a result of the ensuing financial crisis and worldwide recession, policymakers all across the globe responded with a policy mix to better withstand the potential nefarious effects expected by experts and financial markets alike. The series of unprecedented phenomena since World War II1 resulted in a combination of automatic stabilisers and swift discretionary measures on the fiscal side, and accommodative policy on the monetary front. Yet, over three years later, Europe does not seem more “off the hook” than any major advanced areas; and another crisis has emerged: the sovereign debt crisis. Because most euro area governments failed to abide by the Stability and Growth Pact rules prior to 2008, public indebtedness in the euro area countries has reached such a high level that sustainability and even solvency concerns have emerged, triggering a severe confidence crisis for the euro area periphery. At the same time, monetary policy is now close to its zero lower bound, so that there is little room for maneuver on this front. These are exceptionally dangerous times because the euro area monetary policy now stands at a cross road. On the one hand, the legacy of the Lehman Brothers recession entails inflation risks due to fi scal dominance, central bank losses and the ensuing loss of credibility. On the other hand, it generates severe defl ationary risks. Indeed, financial turmoil triggered by increased sovereign default risks has been conducive to a risk of credit crunch and might have impaired the monetary policy transmission mechanism.