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The Dangerous Myth of Risk-Free Euro Debt

Most people don’t need to be reminded that, just a few years ago, Europe teetered on the edge of a full-blown sovereign debt crisis that nearly destroyed the common currency. But apparently European financial regulators do. In the recent “stress tests”—the European Central Bank’s assessment of European banks’ ability to withstand another financial crisis—regulators made a curious choice: They assumed all European sovereign debt is risk-free.

That’s right: According to the ECB, there is zero chance that any of the European nations will ever default on their debt. Not Germany, not Spain, not Sweden, not Portugal. Markets quite clearly disagree with this assessment. The credit default swap rate—the price of debt default insurance—suggests that there are stark differences in the stability of sovereign debt. The higher the rate, the riskier the market thinks the debt is.