Greece, the Euro’s Trojan Horse

Because members of the eurozone have no “sovereign” control over the currency, these governments are more vulnerable to default.

Of all the worries brought on by Greece’s debt problem, the most fundamental is the question it raises about the viability of the euro. Matters have been so badly handled that some wonder whether the European Union (EU) ever really thought through this euro currency thing. Nobel laureate Milton Friedman certainly had his doubts. Way back in 1999, he forecast that the then-new currency would not survive the first major European recession. He may yet be right, though with the amount of political capital at stake, the euro will probably hang together. But while the world waits for the ultimate outcome, investors now, as a result of the Greek debacle, must rethink their whole concept of sovereign debt.

The problem, which the Greeks have so thoroughly, if inadvertently highlighted, turns on questions of control. Unlike most nations, eurozone governments lack complete control over their own currency. The United States, Japan, and most every other country can literally create money to meet their debt obligations if it becomes necessary to do so. 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 this sovereign ability to print money still relieves any worry about outright default. Because, however, national governments in the eurozone have ceded the money aspects of sovereignty to a supranational agency, the European Central Bank (ECB), they have little sway over their national currency and so cannot offer lenders the sovereign assurances other nations can. The risk of default, accordingly, is higher.

Of course, global bond markets have had long experience with sovereign issuers that denominate debt in currencies over which they have no direct control. Sweden, for instance, has long issued dollar-denominated bonds in order to sell better in the large, American market. Though such bonds are the obligation of a sovereign authority, the market—aware that Sweden cannot create dollars and, therefore, possibly can default—prices such bonds less richly than Sweden’s fully sovereign bonds. The difference and the risks involved are that much more apparent with Latin American governments. In the 1980s, many of them borrowed heavily in dollars, and when they could not earn enough greenbacks to meet their obligations, neither could they create dollars and were left with no choice but to default.

Now the Greek incident points out how eurozone issuers have all along effectively done with euros what Sweden and the Latin Americans governments have done with dollars. Some in the zone are more like Sweden, some more like Argentina, but all lack control. However much they refer to the euro as their national currency, not one nation in the eurozone has any significant influence on the ECB and, therefore, on euro creation, though perhaps the two great European powers, France and Germany, may enjoy some informal sway with the ECB.

Since each nation in the zone is issuing bonds denominated in a currency over which it has no sovereign sway, markets now after the Greek crisis will need to adjust and treat eurozone debt, whether Greek or Spanish, German or French, differently from true sovereign issues. The debt, to be sure, is more secure than corporate debt. National governments have many more avenues of support than do corporations. There are, for instance, the resources of the International Monetary Fund (IMF). In the eurozone, there is the potential help from other, stronger members, though the Germans seem reluctant to help Greece. But if this debt is on a higher plane than corporate obligations, it is not the same as a fully sovereign obligation, where the issuer controls the money in which it is denominated. Perhaps, then, investors need a special category between corporate bonds and fully sovereign obligations in which they can class French, German, and other eurozone national debt.

The eurozone could perhaps recapture full sovereign status by issuing from a central authority, one with influence on the ECB comparable to the influence enjoyed by the United States government on the Federal Reserve. Then, investors would get their sovereign 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 at the moment, it really is only a formalized version of what stronger members of the zone are already doing with Greece. Still, informal, ad hoc arrangements differ from legal structures. If and until the members of the zone find some formal solution, investors will need to treat eurozone national debt as something less than fully sovereign

Milton Ezrati, Partner and Senior Economist and Market Strategist, has been widely published in a wide variety of magazines, scholarly journals, and newspapers, including The New York Times, Financial Times, The Wall Street Journal, The Christian Science Monitor, and Foreign Affairs , on a broad spectrum of investment management topics. Prior to joining Lord Abbett, Mr. Ezrati was Senior Vice President and head of investing in the Americas for Nomura Asset Management, where he helped direct investment strategies for both equity and fixed-income investment management.

The opinions in the preceding economic commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. This material is not intended to be relied upon as a forecast, research, or investment advice regarding a particular investment or the markets in general. Nor is it intended to predict or depict performance of any investment. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Consult a financial advisor on the strategy best for you.

Investors should carefully consider the investment objectives, risks charges, and expenses of the Lord Abbett funds. This and other important information is contained in a fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional, Lord Abbett Distributor LLC at (888) 522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.