If the probability of this event concentrates over the short horizon, then the cumulative default probability for longer horizons (bounded overall by 100%) cannot rise much further, and inversion of the spread curve necessarily follows. Redenomination premia share some similarities with exchange rate premia that were driven out of control in the early 1990s by speculative attacks against the legacy currencies. The early symptoms – inverted sovereign yield curves, at least for some contries – were the same. And the potential of such attacks is known to generate self-fulfilling prophecies. In early summer 2012 this situation had two main implications. One was for fiscal policy: it needs to deliver sound fundamentals as the only way to lastingly overcome the crisis; but, at the same time, there can be no viable fiscal adjustment that can ensure sustainability if the interest rate faced by the fiscal authority keeps rising and there are severe distortions in government bond markets. The second implication was for monetary policy: the central bank cannot fulfil its mandate to maintain price stability if its policy intentions are not transmitted correctly to the real economy through the chain which forms the basis for monetary policy transmission; but, at the same time, the central bank cannot fulfil its mandate to maintain price stability if the fiscal authority does not fully honour its obligation to pay back its liabilities under all circumstances.
5  To remove the influence of market expectations about future policy rates, it is useful to focus on the term structure in terms of spreads between sovereign bond yields of a given euro area country and benchmark yields – which can be represented by the OIS curve or the term structure of German Bunds. BIS central bankers’ speeches  5  How to make these apparently conflicting instances compatible? And how to overcome the deadlock? The ECB policy response: Outright Monetary Transactions Guidance to answer these questions can be derived from the Maastricht Treaty and the conceptual apparatus developed in the context of the economic literature on monetary vs. fiscal dominance. These insights have made clear that, from an institutional design perspective, central bank independence and a clear focus on price stability 6 are necessary but not sufficient to ensure that the central bank can provide a regime of low and stable inflation under all circumstances – in the economic jargon, ensuring “monetary dominance”. Maintaining price stability also requires appropriate fiscal policy. To borrow from Leeper’s terminology, 7 this means that an “active” monetary policy – namely a monetary policy that actively engages in the setting of its policy interest rate instrument independently and in the exclusive pursuit of its objective of price stability – must be accompanied by “passive” fiscal policy.