In theory, the market should respond to a breakdown in monetary or fiscal discipline by demanding higher risk premium for the sovereign debt issued by those countries that are not behaving in a prudent manner. However, market discipline also seems to have broken down in many instances. For example, right after Greece joined the Euro Zone, the market was somehow attracted by the so called convergence play and for 8 years from 2001–2008 it ignored the fundamentals of Greece and its Single A rating and traded Greek sovereign debts as a Triple A credit, with a spread of as low as 8 basis points above German Bunds in February 2005. Looking back, the rationale for this kind of convergence play defies common sense and any analysis of fundamentals. However, the breakdown of the market discipline had played a key role in encouraging and facilitating continued erosion of fiscal discipline of the national authorities by conveying the wrong signals about the market tolerance, and appetite for their sovereign debts. As an illustration, the sharp fall of interest cost (10-year government bond yield) from over 10% in the mid 1990s to a low of 3% in the mid-2000s had also helped lower the cost of Greek Government borrowings and created the illusion of the affordability and sustainability of the rising pile of government debts. There are many reasons why market forces are failing to impose discipline when national authorities or firms fail to behave prudently.
BIS central bankers’ speeches  3  In conclusion, I wish to leave with you the following message: the breakdown of monetary, fiscal and market disciplines has contributed to the deepness and severity of the latest crisis in the advanced economies. In my view, there is unfortunately no easy way out or clever solution that could avoid the need and thus the pain of structural adjustments that would redress the imbalances built up in the last decade or two. Going forward, we must realise that we have to restore the 3Ds or three Disciplines, without which the conditions for sustainable economic recovery would not exist. Are we now in an era of awakening? I am not totally sure but I think, or at least I hope, we are. If not, then market forces would eventually push all of us into that position, except that the later the awakening occurs the heavier the price we will have to pay. 4  BIS central bankers’ speeches