Paul De Grauwe is Professor of Economics at the Faculty of Business Economics at the University of Leuven and Senior Research Fellow at the Centre for European Policy Studies. Wim Moesen is Professor at the Faculty of Business Economics at the University of Leuven. CEPS Commentaries offer concise, policy-oriented insights into topical issues in European affairs. The views expressed are attributable only to the author in a personal capacity and not to any institution with which he is associated. Available for free downloading from the CEPS website (http:/ / www.ceps.eu) y © CEPS 2009 Gains for All: A proposal for a common Eurobond Paul De Grauwe & Wim Moesen 3 April 2009 ntil the eruption of the credit crisis in August 2007, financial markets were gripped by a ‘flight to risk’. The perception was that risks were very low. This perception was fed by the rating agencies that liberally distributed top ratings to dubious assets. Dulled by this low risk perception, investors and financial institutions accumulated vast amounts of risky assets on their balance sheets. Today the markets have moved to the other extreme and perceive risks everywhere. They are now gripped by a ‘flight to safety’. This has profound implications for the workings of the government bond markets in the eurozone. Spreads of sovereign debt within the eurozone have increased dramatically during the last few months. Figure 1 shows the evidence of this. The governments of Greece and Ireland now (in February 2009) pay an interest rate on their debt that exceeds the German government bond rate by more than 250 basis points, while the governments of Portugal, Italy, Spain, Austria and Belgium have to pay more than 100 basis points extra. Thus, sovereign bonds with the same maturity but issued by different national governments are now perceived as imperfect substitutes. Since all these bonds are expressed in the same currency: the euro, these spreads reflect either a pure default risk (assuming that the German bonds are free of default risk) or a liquidity risk. There is empirical evidence that part of the spreads are due to the fact that (with the exception of the German government bond market), the government bond markets in the eurozone have become less liquid (see Schwarz, 2008). This liquidity problem itself is due to the ‘flight to safety’ syndrome that has gripped the financial markets. This can be explained as follows. The panic that followed the banking crises has led investors into a stampede away from private debt into assets that are deemed safe. These are mainly the government bonds of a few countries that are perceived to provide safety. The US, Germany and possibly France are a few of these countries that have been singled out as harbours of safety. Other countries did not profit from the same ‘panic flight to safety’. This is shown in Figure 2, which presents the levels of the government bond rates in the eurozone. We observe a significant decline of the German government bond rate by more than 100 bp since November 2007. Germany was singled out by the market as the country offering safety. France also benefitted from this, but less so. With the exception of Greece and Ireland (and to a lesser degree Portugal), the other countries kept their U