The risk premia on the sovereign debt of Greece, Ireland, and others have not diminished.

Risk premia in Russia have skyrocketed.

The risk premia that financially distressed countries must pay remain high and signal continuing risk.

Yet another theory is that changes in our ways of handling risk have reduced risk premia.

These observers proved right the crisis was marked by soaring risk premia.

Sovereign Environmental Risk

Lenders (the bankers) are suspicious, worried about creditworthiness, and demand high risk premia.

Before the crisis, some thought risk premia for developing countries were irrationally low.

As a result, sovereign risk is now becoming banking risk.

Growth has resumed, financial risk premia have fallen sharply, foreign investment is picking up, and exports are booming.

Today, the global surfeit of liquidity has once again resulted in comparably low risk premia and a resurgence of capital flows, despite a broad consensus that the world faces enormous risks (including the risks posed by a return of risk premia to more normal levels.)

As real interest rates and risk premia begin to rise, the level of global trade and investment will decline.

US municipal bonds are already trading at huge risk premia, and the first big government default hasn t even hit yet.

But higher risk premia elsewhere force the rest of the eurozone to cut spending, thus reducing their demand for these funds.

Traditionally, sovereign risk has been concentrated in emerging market economies.

The European debt crisis, however, remains, and markets do not fully trust the current calm. The risk premia that financially distressed countries must pay remain high and signal continuing risk.

Investors were not worried about default risk on Spanish or Irish sovereign debt, or about Italy s chronically large sovereign debt.

But it is clear that in an environment of slow growth, low interest rates, and high risk premia, many banks must struggle to survive.

The premia paid by Portugal have actually soared since major ratings agencies, explicitly citing the agreement reached at the EU summit in late March, lowered the country s sovereign debt rating.

Sharp rises in sovereign, corporate, and interbank liquidity spreads will increase the cost of capital, and increases in risk aversion, volatility, and sovereign risk will undermine business, investor, and consumer confidence further.

Doubts in financial markets lead to higher risk premia, which make it even more difficult to finance a government that is already facing financial problems.

Doubts about the sustainability of government debt produce sudden surges in interest rates, as risk premia rise dramatically with perceptions of the likelihood of default.

The European Commission s claim that this slowdown reflects high sovereign default risk, rather than fiscal consolidation, is belied by the UK, where the sovereign risk is deemed by markets to be virtually nonexistent.

In fact, lowering the benchmark rates for risk free assets changes the distribution of the risk premia on risky assets, making it too low when asset bubbles are forming and too high when they burst.

The logic and the mechanism that the government uses to set benchmark prices are very different from those that the market uses to set risk premia.

The eurozone s sovereign risk problems could worsen, leading to another round of asset price corrections, global risk aversion, volatility, and financial contagion.

We must then break the perverse feedback loop between banking risk and sovereign risk that is at the heart of the euro crisis.

The government (the visible hand) sets the benchmark price for risk free financial assets through monetary policy and control over fiscal deficits, while the market (the invisible hand) sets the risk premia of risky assets above the benchmark rate.

It didn t work. Eurozone sovereign debt turned out not to be homogenous with respect to risk.

Until recently, advanced country markets predominated in setting risk premia, owing to their mature and well functioning PRIs, which include clear rules and a high level of transparency in price formation.

This is why the current spiral of ever lower interest rates in Germany (and northern Europe) and higher risk premia for most of the rest of the eurozone is so destructive.

But the risk that the world s investors currently are trying to avoid by rushing into US, Japanese, and German sovereign debt is not a fundamental risk.

Even if this sounds unfair, it is logical to expect rating agencies, which had been lax in evaluating credit risk, now to be rigorous in assessing all forms of risk, including sovereign risk.

These steps, it is argued, have taken both sovereign default risk and a banking crisis off the table.

But low interest rates are entirely compatible with stagnation or depression if risk premia remain large as the world learned in the 1930 s, and as Japan relearned in the 1990 s.

The collapse of Lehman Brothers in 2008 drove up risk premia and triggered panic in financial markets, weakening assets in the United States and elsewhere, and threatening to provoke a credit crunch.

National risk premia would then disappear, and German savers would have no problem investing their savings in the eurozone s periphery, knowing that the German government would ultimately underwrite these countries government bonds.

As government deficits and public debt increase in many developed and emerging economies, financial markets will most likely demand higher risk premia, owing to heightened fears of default and inflation down the road.

A sovereign default in Europe will never be a mere value to be plugged into some statistical risk model.

NEW YORK Today s swollen fiscal deficits and public debt are fueling concerns about sovereign risk in many advanced economies.

As a result, sovereign risk today is a greater problem in advanced economies than in most emerging market economies.

Yet the risk premia on non Treasury assets have soared to barely believable heights the annual interest rate premium for holding a CD issued by a private bank now stands at five percentage points.

But sounder fiscal policy might lead to even higher inflows as the country s external balance and sovereign risk outlook improve.

It would be unfortunate if governments requiring financial institutions to be more prudent in managing risk were at the same time asked to turn a blind eye to sovereign risk.

If systemic risk can cause this kind of cascading sequential imbalance, then the sovereign needs to be alert, competent at identifying rising systemic risk, and able to take corrective action early.