The Threat That Could Save the Euro

By confronting Athens with the possibility of an exit from the currency, Berlin may finally have prompted overdue reforms.

The Wall Street Journal

By MICHAEL HEISE

July 28, 2015 1:54 p.m. ET

Greece may have reached a preliminary settlement with its creditors, but peace and stability have not yet been restored in the eurozone. Recriminations are still flying between Greece and its creditors, and negotiations for a third bailout package will be fraught with difficulty. Meanwhile, the creditor countries are themselves split. Some, like Germany, insist that the principles underlying monetary union are more important than the membership of any one country. Others, such as France, say that more flexibility is needed to keep the euro together.

The division recently centered on Germany’s Finance Minister Wolfgang Schäuble. In the last stages of the negotiations, he insisted that unless Greece was willing to reform, it should leave the eurozone—at least temporarily. The idea didn’t make it into the official documents. But, critics say, the damage has been done: Without an unconditional commitment to keep the eurozone together, the single currency is doomed to fail.

This misses the point. Giving in to the demands of the Syriza government of Prime Minister Alexis Tsipras—whose policies over the past six months have led Greece to the brink of financial disaster—wouldn’t bode well for the future of the euro either. Within a currency union each government must be responsible for the consequences of its own actions. Mr. Tsipras won the election based on promises he couldn’t finance. In response, Greece was shut out of capital markets.

That left the other European taxpayers to pay for Syriza’s election promises—and they balked at the prospect of this, not only in Germany but in other countries as well. It isn’t surprising that many European governments want to see a serious commitment from Greece to start living within its means. Now Greece has little choice but to find more money at home, including through a value-added tax, which will at least temporarily dampen demand.

A country that is in trouble certainly needs help and solidarity. Greece has received both to an extraordinary degree. A significant share of the money coming from its European partners and the International Monetary Fund since 2010 was used to finance the Greek budget deficit and to reduce the cost of debt servicing. The interest rate Greece pays on its restructured debt is among the lowest in the European Union, and it doesn’t have to repay anything on its European loans until 2023.

Greece’s problem, therefore, is not an excessive debt burden or the amount of bridge financing available. Greece’s main problem is that it doesn’t have a sustainable economic model.

The country was living beyond its means before it joined the euro, and has continued to do so ever since. In the past 20 years, the average Greek budget deficit amounted to more than 7% of gross domestic product. These deficits are but the most visible symptom of a much deeper malaise. Governments had become used to spending more than they were able to collect in taxes. The private sector was stymied by an overbearing and inefficient public sector, a remarkably slow-moving court system and widespread clientelism and corruption. These aren’t deficiencies that can be rectified with a bit more fiscal spending.

The creditor countries and the IMF have been trying to address these fundamental problems for some time now. There have been some promising changes, albeit often slow and half-hearted. But it is such changes that will decide Greece’s economic future.

If these problems aren’t addressed in the third bailout program, it will be worthless. More so than with the first two bailouts, the creditors must focus their attention on the structural changes Greece needs to modernize its institutions and improve its competitiveness. And Athens must assume responsibility and ownership for these changes.

Many people across Europe doubt that Greece is willing and able to do this. But perhaps this time it will be different. After all, Greeks have already had to learn the hard way in their first two bailouts that fiscal consolidation without growth-oriented reforms can be exceptionally painful. And most never really believed that exiting the euro would be an easy alternative. If Athens gets serious about modernization and reform, growth should return swiftly, and with it investor trust in a country that has plenty of human and natural resources.

Mr. Schäuble’s insistence on reform, and the threat of Grexit to back it up, might help to save the eurozone in the end. A softer settlement would have neither helped Greece return to sustainable growth nor been good for eurozone cohesion. Those countries that have gone through big reforms under painful conditions—Cyprus, Ireland, Portugal—would have felt cheated. Political parties in other countries might have been tempted to promise their voters profligate spending in the hope that “European solidarity” would somehow settle the bill.

There will always be conflicts of interest within a currency union. They must be resolved with a cool head and a view to the long run. On those terms, the latest deal with Greece should help to keep the eurozone together.

Mr. Heise is chief economist of Allianz SE.