The incentives for governments to stay current on what they owe are hard to measure, but financial market indicators provide a way to gauge investors’ perceptions of the willingness to repay debt. International investors became reluctant to lend to the troubled European governments, especially Greece, as indicated by interest rates on government borrowing. In particular, interest rate spreads for these countries’ debt relative to safer German issuance rose dramatically. Chart 3 shows 10-year bond spreads—the difference between the interest rate on each country’s 10-year bond minus the rate on Germany’s relatively safe 10-year obligations. Movements in these spreads in recent months show that international investors required a much higher rate of return to buy each country’s debt.
Suppose investors can buy a German bond at an annual interest rate of 4 percent with practically no risk, or a Greek bond that has a 3 percent chance of default. Investors will go with the German bond unless the Greek government offers an interest rate around 7 percent—a spread of about 3 percent—to cover the probability of default. Such a relationship can’t be expected to hold exactly in the data, but interest rate spreads can still be used to learn about the likelihood of default. Chart 3 shows that in May 2010, investors’ perceived risk of default increased drastically for Greece and rose by a lesser degree for the other four countries