Thumbs down common bond: countries like France and Germany would pay higher interest rates.

• Author: Issing, Otmar

With the deepening of the global financial crisis, spreads between the government bonds of different European Monetary Union (EMU) countries for a while widened dramatically. Relative to German bonds, the spreads in February of secondary-market yields of government bonds with maturities of close to ten years were 141 basis points for Italy, 257 for Greece, and 252 for Ireland, compared to just 32, 84, and 25 basis points, respectively, in 2000.

In EMU's early years, long-term interest rates in eurozone countries more or less converged to the low levels seen in countries like France, Germany, and the Netherlands before the euro's introduction. Italy and Greece enjoyed huge declines in the cost of servicing their public debt in comparison to pre-EMU days. For many people, the introduction of the euro meant not only that currency risk--that is, the risk of devaluation had disappeared, but also that all eurozone members now belonged to an economic area of monetary stability and, thanks to the discipline of the Stability and Growth Pact, of fiscal stability.

Moreover, before the crisis, differences in long-term interest rates among EMU members were around 25 basis points, despite unfavorable fiscal developments in some EMU countries. But today, countries with rising budget deficits, like Ireland, along with countries with high levels of public debt, like Greece and Italy, are at risk to pay substantially higher rates on their government bonds. Risk-averse investors may now demand higher risk premia for buying bonds from countries seen as weak debtors. On the other hand long-term interest rates in countries with stronger fiscal positions--France, Germany, and Finland--have enjoyed low rates as a consequence of a "flight to quality."

This rise in long-term interest rates has hit the countries with sharply deteriorating fiscal positions hardest. It is even suggested that some countries might abandon EMU if this process continues--a threat that, if carried out, would amount to economic suicide.

It comes as no surprise, then, that the idea of a common European bond is becoming popular as a way to counter the risk of rising EMU interest-rate spreads. The main idea is to reduce the risk premia paid by debtors with lower fiscal credibility. But this can be achieved only by implicit or explicit guarantees from EMU countries with sound public finances. A "true" pan-European bond would have to entail a joint guarantee by all countries of the full bond...