The crisis of confidence in the Greek economy has done more than roil sovereign debt markets. In addition to acting as a speed bump to the global recovery, Greece’s economic issues have called into question the structure of Europe’s Economic and Monetary Union, as well as the accuracy of credit ratings and the future of the debt market itself.

Classical Greek tragedies were always big on omens – omens that went unheeded. The current Greek crisis may not lead to the disasters that once held audiences spellbound, but it has certainly borne out the warnings of many experts. Much needs to be done to put European sovereign debt on more solid ground. Though there have been a number of wake-up calls – from Iceland to Ireland to shaky underpinnings in Portugal, Italy and Spain – the Greek debacle may be the one that finally gets the sovereign debt market infrastructure moving in the right direction.

One major corrective action would be to put long-term economics ahead of short-term political compromise and take a realistic look at the pace and scope of European market integration, says Scott Mather, managing director and head of global markets desk at Pacific Investment Management Company (PIMCO). Mather notes that the European Union (EU) desire for political unity often served to mask instabilities in individual countries. Worse, such priorities may have helped accelerate the imbalances that led to the latest crisis.

“Although the rules in place were designed to limit unsustainable budget deficits, the enforcement mechanisms were weak and routinely circumvented,” Mather says. “This lack of enforcement allowed countries to ignore significant reforms in better economic times and to accumulate large amounts of debt.”

In Greece’s case, the country’s primary budget balance, excluding interest payments, showed a surplus prior to its membership in the EU’s Economic and Monetary Union (EMU). But since it traded the drachma for the euro in 2003, it has been in deficit, largely due to a loosening of fiscal policy.

The easy credit that Greece received based on its membership, plus generous public spending in the run-up to national elections, drove the country’s deficit above 12 percent of gross domestic product in 2008. The result, in April Standard & Poor’s downgraded Greece’s sovereign debt to BB+, below investment grade, with the other two rating agencies downgrading close to a non-investment grade rating.

In addition to encouraging budget deficits, the euro has given member countries the illusion of convergence while tending to give less focus to major differences in fundamentals such as the degree of labor force participation, productivity levels and general competitiveness from one country to another.

“The economic crisis brought to light the uneven nature of the economies,” says Laura Sarlo, a senior sovereign debt analyst at investment management firm Loomis Sayles & Company. “Politicians and populations have balked at the system of transfers and subsidies that implicitly helped sustain the system. The countries under the most pressure are those that had large twin deficits, both current account and fiscal.”

The next act

Steven Major, global head of fixed income research at HSBC Bank plc. takes the idea of unevenness a step further. In a paper on European sovereigns, he notes that the EU countries are not true sovereigns in that they cannot issue bills and bonds in their own currency or create money as in other countries such as say, the United States or United Kingdom. Nor can they devaluate their currencies. By contrast, countries that have these capabilities also have the most policy flexibility and the best growth potential. In times of crisis, nations outside the 16 Eurozone countries – at least, those with strong currencies and established economies – can use these capabilities to stave off default or stimulate their consumption through monetary policy.

Such differences have largely been ignored by sovereign debt markets, according to Major. “An appreciation that not all sovereigns are the same is rarely emphasized at a time when credit ratings have become a major focus,” he notes.

Even though credit ratings have received considerable criticism in the fallout from the recent crisis, they continue to hold sway over valuations. “For a true sovereign, there is not much ‘credit’ for an agency to rate,” Major says, owing to its ability to create money. He suggests that a more accurate metric would be to compare credit-default swap levels with ratings (see “Sizing Up Sovereigns”).

In addition to using better valuations, policy makers and market participants must learn that the overall amount of indebtedness does indeed matter, according to PIMCO’s Mather.

“Many players are now beginning to understand that rapid debt growth can be a source of instability and sow the seeds of economic crisis,” he says.

Another key lesson is the need for greater overall harmonization of the EMU, which is the currency block for the euro.

“One sustainable solution for the euro area would be the full adoption of a federal fiscal system,” says Sarlo of Loomis Sayles, though she quickly adds that, given the “aversion to a federal system,” this solution is probably not likely.

“The most likely outcome is a patchwork solution whereby the euro area tries to eliminate the acute pressure on Greece, prevent acute pressure from spreading to other countries and allow policymakers to rebuild the EU’s Stability and Growth Pact to better ensure sound fiscal policy across economies,” Sarlo says.

In the short term, however, market participants can expect the risk premiums of sovereign debt to rise, which will inevitably have an impact on equity and credit markets, according to Major.

“The debt-laden sovereigns will not be able to grow as they face multi-year austerity programs, and for the Eurozone economies in the weakest positions, there could be outright deflation.”

Character development

Major predicts that these weaker economies will be a drag on global growth for many years to come, even though he expects the more vibrant emerging countries to partially offset the effects of the laggards. Mather agrees.

“We are still in an early phase of market acknowledgement of the importance that debt plays in both economic development and instability,” Mather says. But like Major, he expects a rising risk premium to be built into both bond and equity markets in countries with the least stable debt dynamics.

Ultimately, of course, the EMU will decide its own fate, much of which, as the classical Greek dramatists understood, is derived from character. The will toward unity has certainly played a major role in making the euro a strong currency and sovereign debt more attractive. But other character aspects, such as determination, compromise and flexibility, are almost certainly the qualities that will make European sovereign debt markets global contenders.