Recent fiscal policy measures that aim to reduce the macroeconomic impact of the financial crisis have boosted public deficits in almost all industrialized countries. According to the International Monetary Fund (IMF, 2009) gross public debt in the G20 countries will surge to 106% of GDP by 2010. As a consequence, concerns about future government default on debt obligations have become a topic widely discussed in the financial press, as well as the possibility of interest rates on government bonds rising as a reflection of default risk. Indeed, sizeable yield spreads between government bonds of member countries of the European Monetary Union have been observed over the course of recent years, even before the current crisis.

For example, in mid 2007 the interest rates on one year government obligations in the highly indebted countries Belgium and Greece (who had debt to gdp ratios of 88.7 and 96.5 percent) were 23.7 and 113.9 basis points, respectively, above the interest rates on comparable German government bonds. For longer term government securities of Eurozone members, there is a well documented empirical pattern showing that interest rate spreads exist and are increasing in the level of a countryjs indebtedness (see e.g. Manganelli and Wolswijk, 2009). Since, within a currency union, government bonds of all member countries are subject to the same amount of inflation risk and there is no differential exchange rate risk, this divergence in interest rates could be interpreted as reflecting the risk of governments defaulting on their debt obligations. One obvious policy concern would be that higher interest rates on sovereign debt instruments due to default risk premia additionally worsen the fiscal position of indebted governments.