And if there is any correlation between credit risk perceptions acrossgovernment borrowers, this process in one country can create contagion to others. Indeed, while eight euro area governments entered the crisis with AAA-rated sovereign issues, today only three have that status.14 Market discipline has destroyed safe assets more than it has created them.
One response to this, which is now being fiercely discussed in the euro area, is to apply regulatory constraints and/or risk weights to sovereign bonds, thus encouraging systemic sectors – banks, pension funds, insurers – to appropriately consider their risk of default. This would in principle make market discipline more linear and effective ex ante.