was effectively bailed out by the us taxpayer on the basis that it was too interconnected to be allowed to fail. but the shock bankruptcy of lehman brothers in september 2008 saw investors panic, as perceptions about the safety of financial institutions in general took a sudden turn for the worse. each of these events saw funding spreads in interbank markets worldwide spike ( figure 1 ). firms, investors and regulators generally failed to anticipate quite how financial system fragilities could interact. prior to the crisis, they had viewed hedging markets and financial engineering as powerful means of detaching credit and liquidity risk from a wide range and large volume of circulating private - sector securities. the rapid growth and use of apparently low risk private - sector securities in funding markets was itself due to a number of interacting factors. these included a strong global demand for low - risk assets ( mis - sold or mis - used on the basis of inaccurately high credit ratings ), loose monetary policy, and credit - fuelled bis central bankers ’ speeches housing booms in a number of advanced economies, which encouraged financial innovation to meet the demand for low - risk assets. figure 1 libor - ois spreads source : bloomberg. in many large advanced countries, an overall result leading up to the crisis was increased leverage and funding fragility in both the financial system and the “ real ” economy. many could see that these growing imbalances were unsustainable and would need to correct, and that the correction might be very disruptive. but to anticipate fully the magnitude of the subsequent event would have required connecting many apparently disparate pressures and signals. among the most important of these were two factors : first, the funding fragilities created by the shadow banking system ; and second, the catastrophic collapse of liquidity caused by investors ’ sudden doubts about the credit risk and marketability of previously “ safe ” assets, and about the standing of counterparties. the dumping of risky financial assets and indiscriminate cutting of funding caused asset return correlations to jump. the shock rapidly spread between global banks, partly reflecting high - frequency marking - to - market. the cost of credit default insurance for the large financials shot up ( figure 2 ). bottlenecks in market or institutional hubs impeded or prevented risk shedding. the fire sales and chain reactions proved very difficult to halt. faced with disappearing private - sector funding markets, central banks stepped in to supply funds in large quantity

a a weber ( 2010 ), der iwf spielt mit dem feuer ( the imf is playing with fire ), financial times deutschland, 25 february, 2010 ( available in german only ). see c walsh ( 2010 ), the future of inflation targeting, university of california, santa cruz, mimeo. see deutsche bundesbank, price - level targeting as a monetary policy strategy, monthly report, january 2010, pp 31 – 45 ; c gerberding, r gerke and f hammermann ( 2010 ), price - level targeting when there is pricelevel drift, deutsche bundesbank research centre, discussion paper, series 1, no 23 / 2010. bis central bankers ’ speeches of unconventional measures during the crisis give no cause for viewing the lower bound of the interest rate as a binding restriction on the effectiveness of monetary policy. 3. particular lessons for monetary policy in the euro area all the issues i have been talking about up to now concern more or less all central banks and every monetary policymaker. for the remainder of my speech, i would like to focus on the particular challenges for monetary policy in the euro area. these arise from the sovereign debt crisis, which is the major challenge for economic and monetary union. the circumstances surrounding the debt crisis are aggravating the conduct of the eurosystem ’ s common monetary policy, which is geared towards maintaining price stability in the euro area as a whole. 3. 1 heterogeneity as a challenge for monetary policy one of the aggravating factors is heterogeneity in terms of growth, inflation and competitiveness. with regard to the euro - area countries ’ economic performance, we are currently observing a widening divergence. broadly speaking, there is a considerable growth gap between the core and the periphery, or to put it more precisely, some peripheral countries of the euro area. in my view, the economic heterogeneity of the euro area is a non - issue. why should heterogeneity be a problem for the single monetary policy? after all, the dispersion of growth rates, as measured by the weighted standard deviations of quarterly growth rates, is not significantly greater than in the first years of emu. with regard to inflation variance, we see even lower values than then. furthermore, the us economy is characterised by considerable heterogeneity, too, and that does not impede the federal reserve ’ s monetary policy, either. and