This implies that, in a crisis, distressed government debt tends to become a common liability for all governments, at least through the interdependence of banking system vulnerabilities across jurisdictions. The current sovereign debt crisis in Europe is proving to us that fiscal policy should be more grounded – in a similar way to monetary policy – within a rules-based framework with clear medium-term objectives.
These dynamics have implications for how firms and ultimately the real economy in general respond to economic shocks.