Matters have been so badly handled that some wonder whether the European Union really ever thought through this euro currency thing. Some are sure it did not. Nobel laureate Milton Friedman certainly had his doubts. Back in 1999, he forecast that the then new currency would not survive the first major European recession. Though he may yet be proven right, the euro, for the time being, will probably hold fast-too much political capital depends on its survival. But as investors wait on a still uncertain outcome, the Greek debacle has made it clear that they now must now rethink their whole concept of sovereign debt.
The problem that the Greeks so thoroughly highlighted turns on issues of control. Unlike most nations, eurozone governments lack complete control over their own currency. The United States, the United Kingdom, Canada and Japan can literally create however much money they need to meet their respective obligations and so offer lenders tremendous assurances against default.
Of course, printing money to make interest payments risks inflation and a drop in the currency's foreign exchange value, both of which hurt creditors by paying them with something a lot less valuable than they had anticipated. But however bad that outcome may be, it's not as bad as default.
Although for the eurozone, where governments have ceded the monetary aspect of sovereignty to a supranational agency-the European Central Bank-nations have little sway over their national currency. As a result, they cannot offer lenders this usual sovereign assurance against default.
Of course, global bond markets have long had experience with sovereign issuers that choose to denominate some of their debt in other currencies. Sweden, for instance, has issued many dollar-denominated bonds in order to sell better in the large, American market. But investors have also long valued these bonds by factoring in a higher possibility of default since Sweden cannot create dollars, but instead must earn them to meet its obligations. But, Sweden's strong finances have kept adjustments to the value of its bonds at a minimum.
The risk is more apparent in the experiences of Latin American governments, which borrowed heavily in dollars in the 1980s. They subsequently did not earn enough U.S. dollars to pay those obligations. And since they were also unable to create dollars, they were left with no choice but to default. And that brought all the attendant losses, delayed workouts and debt-for-equity swaps.
The Greek incident illustrates how eurozone issuers have all along effectively done with euros what Sweden and the Latin Americans did with dollars. Some in the zone are more like Sweden, some more like Latin America, but the overriding theme is that they all lack control, despite the fact that they refer to the euro as their "national" currency. Not one country-whether Greece, Portugal, Ireland, Italy, Spain, or any other nation in the eurozone-have any significant influence on the ECB and, therefore, on euro creation. Perhaps the two great European powers, France and Germany, may enjoy some informal sway with the ECB.
The markets have recognized this greater chance of default and now must treat this eurozone debt differently from conventional sovereign issues.
Eurozone debt is still more secure than corporate debt, of course. National status, even with incomplete sovereignty, still affords such borrowers many more avenues of support than corporations enjoy, not the least of which are the resources of the International Monetary Fund. And in the eurozone, there is also help available from other, stronger members. Perhaps then investors need a special class for French, German, and other eurozone national debt; something between corporate bonds and fully sovereign obligations.
The eurozone could perhaps recapture full sovereign status by issuing debt from a central authority, one with comparable influence on the ECB to that of the Federal Reserve's influence in Washington, D.C. Then investors would get their default assurance. The member states could get their piece of the borrowed funds on the basis of need, perhaps, or according to whatever rule the EU decides is appropriate.
Though such an arrangement might seem fanciful, it is just a formalized version of what stronger members of the zone are already doing for Greece. Still, informal, ad hoc arrangements differ from legal structures. And until members of the zone find some formal solution, investors will need to treat eurozone national debt as something less than fully sovereign.
Milton Ezrati is the senior economic strategist at Lord Abbett and affiliate of the Center on Economic Growth in the Department of Economics at The State University of New York at Buffalo.