  Euro area countries have taken rapid and significant steps to bring their public finances back into balance and going forward to restore the competitiveness of their economies. This is clearly the case for countries whose debt markets have been the most affected over the past months.   Yet, in May, financial markets started to seize up again, admittedly in a slightly different way than that seen in 2008, but with the same potentially disastrous consequences, that is to say a drying up of financing for the economy. In 2008, the financial system was badly impacted by the subprime crisis and the failure of Lehman Brothers that brought transactions to a standstill as market participants realised that any bank, no matter how big, can fail especially since the exact amount of exposure to subprime risk of all institutions were not fully known. In the May 2010 episode, the same dynamics were at work: the different investors started to believe that euro area countries could default on their debt, and therefore stopped lending to these countries or their banks, or to any banks with possible exposure to these countries and, finally, as a precaution, ceased all lending activity. This situation called for rapid and decisive action by the ECB because:   We cannot implement monetary policy in dislocated markets that do not effectively allocate the liquidity that we inject or that radically modify the effects of our monetary policy by offering interest rates that are inconsistent with our key rates.
  If the shape of the yield curve is evolving regardless of monetary policy decisions, if risk premia are uncorrelated with fundamentals, if market liquidity dries up, then the interest rate channel ceases to function.   When this affects banks’ funding, in particular via a freezing of the interbank market, the bank lending channel seizes up. In such circumstances, central banks must turn to non-standard measures such as direct aggressive interventions to ensure that their monetary policy decisions are effectively transmitted and that markets keep ticking over. Needless to say, the recent period has seen many such incidents as well as the implementation of many non-standard measures. Among the measures currently in place, some are based on “quantitative easing”, which involves the purchasing of securities primarily with a view to generating excess liquidity that in turn moves into all market segments and fosters a better refinancing of the economy; others are based on “credit easing” and aim to restore the functioning of certain particularly disrupted market segments. Seen from another angle, certain policies aim to restore the smooth functioning of the interest rate channel by directly impacting the yield curve, others aim to restore the bank lending channel by ensuring that banks can obtain funding beyond the very short-term maturities to which central banks usually confine themselves. In all events, central banks stand in for failing market participants or markets.