This paper was prepared for the annual meetings of the Eastern Economics
Association in Boston, MA, March 2002.
Prior to the introduction of the euro, the capital market within what is now
the Eurozone  was considerably
more heterogeneous than it is today. Each nation primarily issued debt
denominated in its own sovereign currency, meaning that bonds were denominated
in francs, deutsche marks, lira, etc. Differences in market liquidity, primary
dealer systems and issuance techniques, combined with differences in technical,
legal, regulatory and supervisory practices, further amplified the heterogeneity
of pre-EMU bond markets. As a result, it was not uncommon for bonds that were
quite similar in most respects – coupon size, maturity date, redemption value
and denomination – to exhibit sizable bond yield spreads.
These spreads narrowed in the period leading up to the phasing in of the
euro, as the EUR-11 successfully orchestrated the convergence of long term
interest rates.  Then, on January
4, 1999, when financial markets switched over to the euro – new debt was
issued in euros, and nearly all outstanding debt was redenominated in the new
currency – it was widely expected that government bond yield spreads would
narrow even further. This expectation rested on the notion that currency risk
premiums – premiums that reflect the risk of inflation or devaluation –
would disappear, since all member debt would be euro-denominated. Additionally,
the creation of a single, massive euro-denominated bond market
 was supposed to contribute to the narrowing of spreads by reducing the
liquidity premium attached to the debts of smaller member governments. Without
any country-specific risk of inflation or devaluation and a large
euro-denominated bond market, many economists believed that “government debts
issued by different countries of the same maturity [would] become almost perfect
substitutes” (Mundell, 1998: 2).
But, as the Association for the Monetary Union of Europe (AMUE) has
recognized, “the opposite has happened” (2000: 1). That is, the process of
convergence that took place going into EMU has begun to reverse itself. This
reversal has been recognized by William Emmons, who points out that “despite
initial ‘euphoria’ at the outset of European monetary union, true
bond-market convergence has failed to occur,” noting that “after six months
[under EMU], yield spreads on non-German euro-zone benchmark bonds were slightly
higher than they were six months before monetary union took place” (1999: 1).
The purpose of this paper is threefold: (1) to explore the pattern of bond
yield spreads on post-EMU member debt; (2) to relate the implications of these
movements in long-term interest rates to the government’s fiscal stance; and
(3) to consider the extent to which the pricing of risk by financial markets
might limit the potential for stabilizing other macro variables, such as output
Member Debt and the Convergence-Divergence Conundrum
As noted above, Mundell suggested that government bonds issued in the
post-EMU era would become “almost” perfect substitutes. But financial
markets clearly view the obligations of different member governments as
different instruments, as evidenced by the persistent (and widening) bond yield
spreads. Two things account for these yield differentials – liquidity premia
and default risk premia.  Let us
examine these in turn, beginning with liquidity premia.
Despite the fact that all member governments issue euro-denominated debt, “the
size and liquidity of the national bond markets in the euro-zone have differed
widely from one country to another” (Ascoli 1999: 5). Figure 1 shows the share
of outstanding bonds, broken down by issuing country.
As Figure 1 reveals, Italy is the largest issuer, followed by Germany and
France. Indeed, between them, Italy and Germany issue more than half the
government bonds in the Eurozone. This means that bonds issued by Portugal,
Ireland and Finland may be perceived as less liquid instruments than those
issued by Germany, France or Italy. Thus, even though all member government debt
is homogenous in terms of its denomination, bonds issued by smaller countries
“will not have the same liquidity as those of larger countries” (ibid).
 As a result, investors may penalize smaller member states by attaching a
liquidity premium to their debts, thereby causing bond yield spreads to diverge.
Any additional widening of yield differentials must be attributable to
perceived differences in country-specific default risk, since this is the only
remaining characteristic that can be used to distinguish securities issued by
different EMU members. As Benjamin Friedman notes, the default risk premium
arises as a consequence of the fact that “government obligations, [are] no
longer guaranteed by the ability of individual borrowing countries to print the
money in which their bonds are denominated” (2001: 2).
 Thus, the fact that debts have to be repaid in a currency that member
governments cannot create at will (i.e. euros) implies that “the previously
remote possibility of default becomes a significant risk” (Copeland and Jones,
Initially, Copeland and Jones (1999) found that markets were calculating the
probability of default at a much lower level than might have been expected,
suggesting that investors were not terribly worried about credit risk.
 They offered two possible explanations for this. First, it was possible
that market participants, subscribing to the media’s prognosis of “unhampered
yield convergence among EMU members,” failed to realize that the potential for
default had actually changed (ibid.: 5). Second, it was possible that traders
were “well aware of the credit risks of Euro-denominated repayments” but
decided not attach significant premiums to compensate for these risks, since it
was unlikely that the EU would allow a member government to default (ibid.).
 Whatever the reason, it appeared to Copeland and Jones that default risk
premia would remain low so that bond yield spreads would mainly reflect
differences in liquidity premia.
Following this line of reasoning, one is forced to conclude that the recent
widening of yield spreads has primarily been due to perceived liquidity
differences, since markets have not priced significant default risk. Before we
turn to the question of liquidity versus credit risk as a determinant of bond
yields, let us examine Figure 2, which shows the pattern of sovereign yield
differentials on 10-year bonds issued by EUR-12 governments.
Figure 2: Sovereign Yield Differentials on Member Debt
The graphs depict the difference between yields on non-German-issued 10-year
government bonds relative to the yields on 10-year benchmark German issues. A
trend line has been fitted to each time series, indicating the general movement
in the spread – upward, declining or flat. Although we are primarily
interested in the behavior of government bond yield spreads in the post-EMU era,
we have included data from the pre-EMU period so that each trend line reflects
the evolution of a country’s long-term interest rates relative to their
pre-EMU convergence levels.
As the data in Figure 2 reveal, yields on Italian, Spanish, Austrian, Dutch,
Belgian and Irish bonds have risen relative to those on German issues. Although
most EUR-12 nations have experienced a widening of yield spreads, yields on
Finnish and French issues have declined (modestly) relative to benchmark German
issues, and yield differentials on Portuguese issues have remained essentially
flat. Only Greek issues show any significant narrowing, but, of course, the
Greek experience cannot be compared to the rest of the Eurozone, since Greece
joined EMU a full two years after the other eleven countries.
It is impossible to determine precisely how much (if any) of each spread is
due to liquidity risk premia and how much (if any) is due to credit risk premia;
we only know that it must be one, the other, or some combination of the two.
Recently, the European Commission, commenting on the widening of bond yield
spreads during the second quarter of 2000, opined that at least part of the
divergence was due to “the renewed focus on liquidity by major investors to
the detriment of smaller bond issues from Member States with limited financing
needs” (EC, 2000: 10). 
The perceived liquidity of any particular issuer’s debt reflects the
expected ease with which that issuer’s bond can be converted into euros at a
reasonably certain price. Liquidity is related to both the quantity of
outstanding bonds (i.e. the stock) and the issuing volume of new debt (i.e. the
flow). Figure 1 depicted each member’s share of the total (stock) of
outstanding euro-denominated government debt in October 1999. Below, Figure 3
shows the (flow) volume of new debt issued by each member government in 2000.
Source: Merrill Lynch
Note: Data on Luxembourg is not available.
Compared to Germany, Italy, and France, Figure 3 shows that Austria, the
Netherlands, Ireland, Portugal, Finland, Spain and Belgium all have limited
issuing volume. As a result, it is reasonable to expect investors to demand a
premium to compensate for the reduced liquidity of these issues.
In order to test the hypothesis that liquidity premia have contributed to the
widening of bond yield spreads, we examine the yields on AAA-rated member debt
in countries with limited issuing volume and compare them with the yield on
benchmark (i.e. German) issues.  Since
there is no reason to suppose that investors would expect one AAA-rated
government to be more likely to default than another, any difference in yields
should be entirely due to investors’ perceptions about the relative liquidity
of the issuing governments’ debt.
Looking at the AAA-rated bonds of Austria, the Netherlands, Ireland and
Germany, Figure 2 shows that the spreads on Austrian, Dutch and Irish bonds
widened following the introduction of the euro. Since all four governments enjoy
the same AAA rating, it would appear that markets are demanding a higher yield
in order to compensate for the reduced ease of selling Austrian, Dutch and Irish
bonds. However, as the spreads on Finnish bonds reveal, this is not a hard and
fast rule. Finland is a small, AAA-rated issuer, but the yields on Finnish bonds
have actually declined relative to those on German-issued obligations.
So what are financial markets doing? According to Goldberg and Honikman, “the
existence of these spreads indicates the market’s perception of the
credit-worthiness of the issuing sovereign” (1999: 4). In their view, “credit
quality is the overriding means by which market participants differentiate
between sovereign issuers within EMU” (ibid.). But this implies that liquidity
premia are relatively unimportant. Is there any way to figure out what is
causing spreads on Austrian, Belgian, Dutch, Italian, Irish and Spanish bonds to
widen, while Finnish, French and Greek spreads continue to narrow?
These are difficult questions, since it is currently impossible to
disentangle credit and liquidity risk premia. If, in the future, public debt
issuance becomes a more cooperative activity, then the market fragmentation and
associated liquidity premia attached to the bonds of smaller issuers may
decline, making it easier to conclude that differences in bond yield spreads
mainly reflect credit risk. Until then, we can try to infer the extent of the
credit-risk premium by looking at the difference between government bond yields
and the yields on corporate AAA-rated bonds. This method of inference was
proposed by Mundell, who argued that “[g]overnment default risk appears when
the yield on government bonds rises relative to corporate bonds” (1998: 2).
Figure 4 shows the yields on 10-year, AAA-rated, euro-denominated corporate
bonds relative to the yields on member debt. Here, a narrowing of yield
spreads indicates that interest rates on sovereign debts are rising relative to
rates on AAA-rated corporate bonds. Each data series has been fitted with a
trend line to reflect the general movement of the spread over time. As before,
an upward-sloping trend line represents a divergence of yields (i.e. declining
default risk premia) while a downward-sloping trend line reflects a narrowing of
yields (i.e. rising default risk premia).
Prior to the introduction of the euro, Mundell noted that “Belgium and
Italy, the two countries with the highest default risk as measured by the ratio
of debt to gross domestic product, had higher yields on government bonds,
relative to top-grade corporate bonds, than most of the other EU members”
(1998: 2). As the data in Figure 4 indicate, Belgium and Italy are no longer
alone. Yields on sovereign debt issued by every one of the original EUR-11 have
risen relative to the yields on AAA-rated corporate bonds. Indeed, for several
countries, corporate bond yields exceed government bond yields by fewer than 10
basis points. This suggests that markets have begun to attach fairly sizable
default-risk premiums to all member debt since the introduction of the
In sum, the recent divergence of bond yields on member debt has surprised
most analysts. Instead of continuing to narrow, Figure 2 shows that the yields
on bonds issued by most member governments have tended to increase relative to
the yields on benchmark German issues, indicating that markets may require
sizable premiums to compensate for the perceived risk of certain holdings. In
attaching risk premia, financial markets appear to be more concerned with the
sustainability of member government debt than with the liquidity of the debt
instruments themselves. Thus, default-risk premia appear to have emerged as the
most important determinant of bond yield spreads.
Fiscal Competition and the Rationing of Credit
As long as investors perceive differences in credit and liquidity risk, they
will continue to penalize (or reward) the various EMU governments by raising (or
lowering) the premiums attached to their obligations. The purpose of this
section is to examine the manner in which the pricing of risk by financial
markets can impact the budgetary stance of member governments.
Two scenarios seem most plausible. First, policymakers might choose to pursue
tight fiscal policy in the hope that rating agencies, such as Moody’s or
Standard and Poor’s, will upgrade (or avoid downgrading) their issues.
 Second, it is possible that some member governments will wish to
implement expansionary policy (i.e. to increase their liabilities) but will be
prevented from doing so by financial markets. To the extent that this occurs,
financial markets, through their pricing of risk, will largely determine the
country’s budgetary stance. Under either scenario, the public finances of the
EUR-12 are likely to be influenced by financial markets and their pricing of
risk. Let us examine them in turn.
In order to see why policymakers might be motivated to adopt policies
designed to protect or improve their credit rating, we must make clear the
significance of a country’s rating. Lonning (1998) studied the yield
differences on Deutsche Mark-denominated bonds issued by various EU governments.
He recognized that even though all nations were issuing bonds denominated in the
same currency (DM), markets demanded a premium on non-German-issued paper, in
order to compensate for the possibility of default. In his study, Lonning
regressed bond yield spreads against a number of macro variables, including
outstanding (net) government debt, the budget surplus/deficit, the structural
surplus, the current account and the country’s credit rating. What he found
was interesting: the only variable that yielded a statistically significant
coefficient, regardless of the model being tested, was the country’s credit
A country’s credit rating reflects the market’s assessment of the
likelihood of a debt-default, which, among other things, depends on the country’s
debt service burden. Thus, a high debt service burden may cause investors to
calculate a higher probability of default and, hence, to demand a premium over
benchmark rates.  These
premiums generate differentials that might, at first blush, seem fairly
insignificant. However, as John Winter, head of debt markets for Deutsche Bank
in London, recognizes, “even a few basis points can be significant,”
especially when we are talking about hundreds of billions in outstanding debt
(quoted in Capell, 1999). In order to reduce the default-risk premia that
financial markets may attach to bonds issued by member states with relatively
high debt-to-GDP ratios (e.g. Belgium, Greece and Italy), many EUR-12
governments may strive to balance their budgets (or run large surpluses) so that
they can retire debt and improve their credit rating.
 If they are successful, markets may reward them by reducing the rates
required on new offerings. 
The second scenario is different. It suggests that policymakers actually want
to increase their liabilities – i.e. to stimulate the economy through
fiscal policy – but that financial markets might effectively prevent them from
doing so. Here, the idea is that there is a demand for additional credit, but
lenders are unwilling to supply additional finance without compensation for the
(perceived) added risk. Thus, fiscal prudence may be assured through access to
Suppose, for example, that Italy or Belgium – with debt-to-GDP ratios of
110.5 and 110.3, respectively, at the close of 2001 – decided to pursue
expansionary fiscal policy in order to stimulate GDP and combat high domestic
unemployment.  If capital
markets demand high rates of interest in order to hold Italian or Belgian
government debt, then it is easy to see how these governments could be forced to
abandon expansionary policy. As Kregel (1999) notes, an attempt by Italy to
expand domestic demand would lead to a deterioration of the Italian fiscal
deficit and, hence, “credit risks rising on Italian securities” (40). Jordan
states the implications succinctly:
The risk for the fiscal authorities of any member country is
that the ‘dismal arithmetic’ of the budget constraint leaves few palatable
alternatives. If the yield on government securities demanded by markets exceeds
a country’s nominal income growth, then interest expense on the outstanding
debt must become a relatively larger burden (Jordan, 1997: 3).
In a country like the United States, this should never cause financial
stress; the U.S. government can always meet any dollar-denominated commitment as
it comes due. But markets clearly recognize that things work differently in the
Eurozone, where governments are no longer able to “print money.” As a
result, the bonds issued by member governments now resemble those issued by
state and local governments in the United States (or bonds issued by provinces
in Canada or Australia), where yields often differ by a sizable amount.
Several studies of state bond markets have shown that yields on state-issued
bonds mainly reflect the market’s assessment of default risk. For example,
Goldstein and Woglom (1992) and Bayoumi, Goldstein and Woglom (1995) concluded
that bond yield differences were correlated with the quantity of outstanding
state debt and the state’s fiscal balance. Specifically, it was found that
when debt levels were relatively large lenders were likely to calculate the
probability of default at a relatively high rate, thereby increasing premiums on
bond issued by these states. Bayoumi, Goldstein and Woglom believe that if
individual U.S. states interpret rising yields as a signal of market resistance,
then default premia can play a “positive role in disciplining irresponsible,
sovereign borrowers” (1995: 1).
Within the Eurozone, fiscal discipline is supposed to be ensured by the Stability
and Growth Pact. The Pact, which was ratified at the June 1997 Amsterdamn
Summit, strengthens the surveillance of member states by forbidding countries
from running deficits in excess of 3 percent of GDP or carrying debts in excess
of 60 percent of GDP. In the event that a country does not fulfill these fiscal
criteria, the excessive deficit procedure pursuant to Article 104(c) will apply.
Under the Excessive Deficit Procedure, deficits exceeding 3 percent of
GDP are subject to a fine as declared by the European Council upon a report by
the European Commission and a judgement by the Monetary Committee.
Some groups (e.g. the European Council) adamantly believe in the necessity of
these limits, arguing that they “mark an essential condition for sustainable
and non-inflationary growth and a high level of employment” (quoted in
Spiegel, 1997: 1). Others (Eichengreen and von Hagen, 1995; DeGrawe, 1996;
Pasinetti, 1997; Arestis and Sawyer, 1998; Arestis, Khan and Luintel, 2002.)
have suggested that the limits are too restrictive and that member states should
be free to pursue independent fiscal policy without arbitrary limits or
penalties. But there is a third group (Wray 1998; Mosler 1999; Bell 2002), which
believes that the Stability and Growth Pact and the Excessive
Deficit Procedure probably don’t do much to constrain government spending
so that increasing (or dispensing with) the arbitrary limits would do little to
increase fiscal freedom. The argument is based on the notion that financial
markets, through their pricing of risk, are likely to discipline member
governments even before the Maastricht limits are reached.
The Market Discipline Hypothesis
The reason that some have argued that specific deficit-to-GDP and debt-to-GDP
limits probably do little to constrain government spending is that default
premia and credit constraints may be powerful enough to limit these ratios. The
argument is captured by the market discipline hypothesis, which maintains that
there is a nonlinear relationship between yields and debt variables. Using data
on U.S. municipal bond yields, Bayoumi, Goldstein and Woglom (1995) test the
market discipline hypothesis by estimating the supply curve faced by sovereign
borrowers. They found that when a state runs large and persistent deficits, the
default premium may increase at an increasing rate (i.e. the relationship
between debt variables and yields in nonlinear). Beyond some point, they
conclude, credit may become rationed, leaving the borrowing state unable to
increase its liabilities. 
This seems intuitive. Financial institutions must decide which households to
lend to; which small business loans to underwrite; whether to rollover debt or
increase the overdraft accounts of corporate customers; how much state, local
and federal government debt to hold; etc. In making these decisions, they
project whom, among their would-be borrowers, is the most likely to meet
interest and principal payments as scheduled. When the perceived risk of default
increases, lenders will raise the premium added to certain obligations, which
might discourage additional borrowing. Thus, we should not be surprised if,
beyond some point, lenders within the Eurozone, like lenders within the United
States, refuse to accommodate the demand for additional loans. When this occurs,
capital markets will, in effect, dictate a nation’s fiscal stance.
The Prospects for Stabilization
Currently, it appears that few countries, despite their high unemployment
rates, have attempted to stabilize their economies through expansionary fiscal
policy. Figure 5 shows seasonally adjusted unemployment rates for the EUR-12.
Figure 5: EUR-12 Seasonally Adjusted Unemployment Rates
|Seasonally Adjusted Unemployment Rates (%), Third
Source: OECD (Data not available for Greece)
One might expect that in countries like Belgium, Finland, France, Germany,
Italy and Spain, where unemployment rates range from nearly 7% to 13%, member
governments would at least have taken advantage of their legal right to run
deficits of up to 3 percent of GDP. But as Figure 6 shows, only half of these
countries – France, Germany and Italy – were actually predicted to run
deficits, and only Germany’s, at 2.5% of GDP, at 2.5% of GDP would even come
close to the running up against the Maastricht limit.
Source: OECD Economic Outlook, December 2001
It is impossible to know whether each member’s budgetary position reflects
its preferred stance or whether market discipline prevented larger deficits from
being run. It may well be that Spain, Finland and Belgium, with unemployment
rates of 13.0%, 9.1% and 6.8%, respectively, all chose to run balanced budgets
or surpluses in 2001. But it is also possible that some them were dissuaded from
taking a more expansionary stance.
Germany, which was projected to run deficits equal to just 2.5% of GDP, has
recently come under fire for its expansionary stance. In a series of articles
run by the Financial Times, financial experts have announced that markets
may be preparing to downgrade German issues (Stephens 2002; Barber and Major
2002). If this occurs, Germany will lose its benchmark status and will face
penalties in the form of increased risk premiums.
While some (e.g. Eichengreen and von Hagen, 1995) have argued that member
states can still service higher debt levels because they retain the power to
alter tax rates, others recognize that EUR-12 governments are seriously
constrained in this regard. Jordan, for example, argues that “the prospect of
higher taxes would cause the factors of production to migrate . . . [so that] .
. . higher tax rates could, eventually, shrink the tax base” (1997, p. 3).
 Taylor also disagrees with Eichengreen and von Hagen, suggesting that,
despite “their substantial revenue-raising powers,” member states will “be
increasingly constrained by the pressure of ‘fiscal competition’” (1999,
This “fiscal competition” is the direct result of Article 104. Because
member states can no longer create spendable deposits internally (i.e. “print”
money), they must compete for euros by selling bonds to private investors
(including private banks), who clearly do not view the various obligations as
perfect substitutes. Thus, governments must float bonds on the capital market,
where they must compete with debt instruments offered by other government (and
non-government) entities. Some nations will compete for benchmark status (e.g.
Germany and France), while others will compete for relative advantages in the
pricing of risk. To the extent that policymakers pursue these objectives
vigilantly, they may assign other goals, such as the stabilization of output and
employment, a less important role.
Following the switch over to the euro, most economists expected yields on
sovereign bonds issued by EUR-12 governments to continue to converge. With a
massive, euro-denominated market for sovereign debt, no country-specific
exchange rate risk and no currency risk, dealers were expected to view the
issues of different EUR-12 governments as more-or-less homogeneous. But things
did not unfold as expected.
As explained above, markets continue to differentiate among issues on the
basis of liquidity risk. Evidence of this follows from the fact that AAA-rated
bonds issued by small governments with limited issuing volume “are still
obliged to offer investors a spread over bonds from benchmark issuers”
(European Commission, 2000: 3). While this probably accounts for some of the persistence
in yield differentials, it seems clear that credit risk has emerged as the
primary cause of the divergence of bond yield spreads. And, since ratings
agencies such as Moody’s have made it clear that possible future increases in
fiscal deficits are to be taken into account when assigning credit ratings to
member governments, the intensification of fiscal competition seems assured.
Countries that wish to compete for benchmark status, or to improve the terms
on which they borrow, will have an incentive to reduce fiscal deficits or strive
for budget surpluses. In countries where this becomes the overriding policy
objective, we should not be surprised to find relatively little attention paid
to the stabilization of output and employment. In contrast, countries that
attempt to eschew the principles of “sound” finance may find that they are
unable to run large, counter-cyclical deficits, as lenders refuse to provide
sufficient credit on desirable terms. Until something is done to enable member
states to avert these financial constraints (e.g. political union and the
establishment of a federal (EU) budget or the establishment of a new lending
institution, designed to aid member states in pursuing a broad set of policy
objectives), the prospects for stabilization in the Eurozone appear grim.
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 The Eurozone refers to the
12 countries that have adopted the euro. On January 1, 2001, Greece became
the twelfth member of the Eurozone.
 For example, in 1995, the
gap between Italian and German sovereign debt was more than 600 basis points
 By the February 24, 1999,
interest rates on Italy’s 10-year bond had fallen to 4.11% compared to
Germany’s 3.9%, thereby reducing the Italian-German yield spread to 21 bp.
 The market in
euro-denominated bonds became the second largest bond market in the world.
The U.S. dollar bond market is the largest.
 Emmons (1999) adds the
possibility that a member government might abandon the euro and devalue its
new currency. Since this is specifically prohibited under the rules of the
Maastricht Treaty, this form of risk is not explored here. Neil Record
(1999) attempts to price “break-up” or “opting-out” risk premia.
 The liquidity of any
particular issuer’s debt is often evaluated on the basis of the bid-offer
spread, where a narrow spread indicates a relatively high degree of
liquidity. Ascoli (1999) constructs euro yield curves, using 40 bp as the
liquidity benchmark. Thus, a bond with a bid-offer spread in excess of 40 bp
is considered relatively illiquid, while a bond is considered very liquid if
the bid-offer spread does not exceed this mark.
 Article 104 of the
Maastricht Treaty prohibits the ECB and the national central banks (NCBs) of
all member governments from purchasing securities directly from any member
state. This effectively prevents member governments from “printing”
euros to service their euro-denominated debts, making the risk of
debt-default a legitimate possibility.
 The probability of default
is calculated as
, where N gives the number of coupon payments still outstanding and pt
indicates the probability of default at time t. See Copeland and Jones
(1999) for more on this.
 This implies that the
Treaty’s no-bailout clause – the provision that neither the Community
nor any member state shall be “liable for or assume the commitments of
central governments, regional, local or other public authorities, other
bodies governed by public law, or public undertakings of any Member State,
without prejudice to mutual financial guarantees for the joint execution of
a specific project” (The Treaty on Monetary Union: Article 104b) – was
not perceived as credible.
 Ideally, a
default-risk-free instrument would be assigned benchmark status. But, since
such an instrument no longer exists, something else must be used. We have
chosen to calculate spreads using the yield on 10-year German bunds (i.e.
German bonds), since they have become the de facto benchmark in the
10-year-sector euro bond market.
 This is consistent with
the findings of Copeland and Jones, who concluded that markets were not
pricing significant default risk.
 Moody’s rates the
debts of Austria, Germany, the Netherlands, Ireland, Finland and France as
 The idea is to hold
credit risk constant and treat any difference in yields as liquidity risk.
 Lemmen and Goodhart
(1999) infer default risk premia by comparing yields on domestic government
bonds with interest rate swap yields.
 Greece, which is not
shown in Figure 4, is the only exception. But this makes sense, since the
euphoria that caused yield spreads on Greek and German bonds to narrow may
have some lingering effects. Additionally, markets may be rewarding the
Greek government for reducing its deficit from 10.2 percent of GDP in 1995
to 1.1 percent of GDP in 2000.
 Obviously, policymakers
might adopt restrictive policies for purely political reasons as well.
 Charging a premium to
compensate for the risk of default makes sense when “the central bank’s
ability to act as lender of last resort is limited due to a currency board
regime, dollarization, or membership in a monetary union” (Moody’s,
2001: 1). As Wray (2002) explains, it makes little sense to rate government
bonds denominated in a local currency that is not tied to one of these
monetary regimes as anything other than AAA.
 Indeed, Parguez expects
this kind of behavior, arguing that markets will prefer to the debt of a
government that “pledge[s] to balance its budget, to get a zero ex post
deficit, so as to protect the banks against the risk of accumulating public
debt” (1999: 72).
 Ironically, however,
some of this reward may be offset by the emergence of a “scarcity premium,”
which might be demanded in order to compensate for the diminished liquidity
of the market. This was recognized in a study by the Giovannini Group, which
argued that “the liquidity premium … is likely to grow in importance as
budgetary consolidation reduces the supply of public debt across the area as
a whole” (2000:2).
 The seasonally adjusted
unemployment rate was 7.0% in Belgium and 9.3% in Italy in October 2001 (Eurostat).
 Yields on state-issued
bonds differed by as much as 84 basis points in 1989, down from a high of
170 basis points in 1982 (Lonning, 1998).
 The yield on
state-issued bonds was found to rise by about 23 basis points each time debt
increased by one percentage point above the mean level of debt. At one
standard deviation above the mean, yields rose to over 35 basis points, and
credit became rationed at debt levels that exceeded 25 percent above the
highest debt level in the sample (Bayoumi, Goldstein and Woglom, 1995).
 Jordan’s scenario
seems fairly implausible since labor has been extremely immobile within the