“Is Greece reformable?” The question was asked by a distinguished member of the audience, a Nobel-prize winner, at the end of a lecture I gave at the London School of Economics last year. It captures the crux of the problem facing the weaker members of the eurozone and their capacity to stay the course and remain within the strong-currency union.

The other part of the story concerns the flaws in the structure of the monetary union which make it look more like a political construct than the outcome of a coherent project of economic unification.
Let us take the two sides of the coin in turn. Was Greece right in seeking to join the European Economic and Monetary Union (EMU)? Having steered the country into the club, it would be difficult, though not impossible, to deny the logic of the démarche. GreeceΒ’s economic performance after the oil shock (1973-1975) was poor: low growth, high inflation, high unemployment, large fiscal deficits, fast debt growth, currency devaluation, and inadequate economic and social infrastructure. The lack of macroeconomic discipline and the tendency of governments to succumb to populist demands and vested interests accounted for much of the economic disorder from the mid-seventies to the mid-nineties. The restoration of democracy in 1974 marked substantial progress in human and political rights as well as social justice, but failed to modernize economic and institutional structures and help Greece confront the challenges of the modern globalized world.

Entry into the EMU looked in the minds of the countryΒ’s progressive elites, as an instrument to impose more discipline and, through sharing a single currency, frame economic policies in ways conducive to the pursuit of longer-term goals such as productivity and employment growth. The theory was that the common EMU rulebook would create a system of carrots and sticks which would induce the political system to behave more rationally with respect to the countryΒ’s real needs, while cultural patterns in the society at large would gradually adapt to modern paradigms based on individual effort and civil responsibility rather than family ties and clan or group allegiance.

The period of accession to the EMU (1994-2000) seemed to be consistent with this theory. The economy was rapidly stabilized, with dramatic falls in both the fiscal deficit and inflation, confidence returned, investment picked up, substantial reforms, particularly privatization and market liberalization, were implemented while the growth rate jumped from -1.6% in 1993 to close to 4% in 1997 and stayed at this level for 11 consecutive years.

However, real growth covered only the first part of this period, until about 2004-2005. The other part was a bubble fueled by extensive borrowing, which burst when the global financial crash broke the positive trends in the world economic performance.

What went wrong? The fashionable answer is that Greece falsified the statistics for securing entry without deserving it. Even the specter of Goldman Sachs has been drafted to buttress this claim by reference to a swap agreement that took place in 2001. The propagandists somehow failed to notice that this was two years after the time of entry – Greece was evaluated for fulfilling the criteria in 1999 – and could not possibly have contributed to any fiddling of the numbers.

At a more fundamental level, it has been repeatedly explained (see C. Simitis, “Greece did not cause the euro crisis”, The Guardian, 26.04.2012) that the statistical revisions, which were used to lend support to the falsification claim, did not owe to alterations in numbers but rather to arbitrary and politically motivated changes in accounting methods. It is as if a new CEO taking over a company changes profitability rules retrospectively so that past performance looks like failure.

GreeceΒ’s problems, as they relate to EMU membership, did not arise in the accession period. Rather, they spring from the post-entry period, more pronouncedly from the middle of the last decade.
To understand them, we should place them in the wider context of the debt crisis. Large external imbalances were allowed to emerge over the last decade within the eurozone. The competitive position of peripheral member countries, particularly Greece, Spain, Portugal, Ireland and Italy, deteriorated sharply as measured by unit labour costs vis-à-vis the core countries of the eurozone.

Governments in the periphery ignored warnings and turned a blind eye to the accumulation of credit-fuelled bubbles and public or private debt while they failed to take anti-cyclical fiscal measures or promote structural reforms for improving competitiveness. Large peripheral external deficits were matched by surpluses in Germany and other core countries. The persistence of these imbalances has transferred excess savings to the periphery creating the conditions for extensive borrowing, leading to an explosion of budget deficits and full-blown fiscal crises. The weakness of the competitive position of these economies helped to transform the fiscal crises into debt crises threatening to lead to sovereign defaults and a potential break-up of the monetary union.

Greece seems to be the more extreme example of a wider pattern of failure in the eurozone emanating mainly from a growing core-periphery competiveness gap and the inability to either prevent it or address it in an effective way. Debt growth exposed critical weaknesses in the eurozoneΒ’s economic constitution: national debts are the responsibility of member countries, but the common currency is without a sovereign. Unlike most central banks, the European Central Bank (ECB) cannot act as a lender of last resort which, in conjunction with absence of common bonds (Eurobonds), induced large-scale speculation on intra-European national debts, expressed in widening spreads.

Resolving the crisis demands action on both fronts. The causes of the persistent imbalances should be addressed through a combined effort at fiscal consolidation and strengthened competitiveness by the over-indebted countries themselves, with structural reforms focusing on liberalizing markets and encouraging wage flexibility.

At the same time, at the eurozone level, monetary unification should be extended to the fiscal and financial fields so as to create an integrated economic union. The United States offers a model of such a functioning union. Europe, on account of the specificity of its historical trajectory, cannot emulate the U.S. model. However, in order to make the currency union work, it should take decisive steps in that direction.

In fact, the policies initiated by the eurozone in order to tackle the debt crisis were not adequate for bringing about the desired results. They focused on exceptionally harsh austerity measures in the over-indebted countries including cuts in public sector salaries and pensions and tax rises while structural reforms, in particular privatizations, market liberalization, opening up closed professions and downsizing the government sector, were either neglected or poorly monitored. In the absence of the devaluation weapon that is available in countries possessing national currencies, these policies led to a deep and prolonged recession, limited gains in competitiveness and overshooting of fiscal deficit targets owing to systematic recession-induced shortfall in tax revenues. Failing to take more effective measures at the eurozone level in order to alleviate the effects of austerity, such as official debt forgiveness, extended deficit reduction schedules and financial assistance for public investment projects, made the situation worse.

GreeceΒ’s GDP has fallen by 20% in four years and is expected to decline by another 4.5% in 2013. Unemployment has reached 27% of the labor force and has exceeded 60% for young people. The adjustment program had to be revised with packages of new measures which, however, have not proved to be more successful than the initial ones. The recent release of the pending tranche of the bail-out loan has considerably reduced, but not eliminated, the risk of default and an eventual exit from the euro area. Even the International Monetary Fund has been forced to admit that it significantly underestimated the damage that austerity would do to European Union growth rates.
Poor design and implementation of the adjustment programs undoubtedly accounts for a substantial part of the blame concerning the persistence of crisis conditions. Pursuing structural reforms faces many obstacles. For instance, the Greek governmentsΒ’ Β‘revealed preferenceΒ’ over the last couple of years has been to spread misery horizontally through austerity than confronting the special interests which block reforms such as businesses in protected markets, public-sector trade unions and closed professions.

However, the pace of reforms is also very slow on the eurozone governance front. Obtaining agreement is difficult as the unification agenda touches upon sensitive issues including the allocation of fiscal resources within the monetary union as well as transposing sovereignty from national to European institutions. Eurobonds are not even placed on the negotiations table, the volume of rescue funds remains very low in relation to the size of aggregate European public debt, the ECB uses by-passes so as to intervene in the sovereign bond markets, the prospects for banking union have not yet firmed up while fiscal policy coordination is inadequate and lacks institutional solidity.

“Too little, too late” and “muddling through” are the attributes that are customarily attached to the initiatives taken at the eurozone level. This, coupled with the weakness of the reform efforts of several governments in the over-indebted countries, goes a long way to explain the inability of the eurozone to overcome the crisis and set the union on the course of economic recovery and steady growth.

The implications of this analysis on GreeceΒ’s future relationship with the eurozone are mixed and conditional. It should, at first, be recognised that the model of the EMU acting as a driving force for reform and modernization seems to have worked during the accession period and the first years of membership, but collapsed thereafter.

The causes of the collapse concern both, the flaws in the constitution of the eurozone and the failure of GreeceΒ’s political system to adapt to the rigor required for participating in a strong-currency union. The eurozoneΒ’s defects consist, essentially, in the absence of federal structures in the fiscal and banking fields, which created space for indiscipline in fiscal and lending policies of peripheral countries expressed in extensive borrowing and excessive debt growth. Signals favoring laxity were reinforced by the underpricing of risk in sovereign debt markets which operated for quite some time under the illusion that the EMU was a fully-fledged economic union where differences in fiscal positions did not matter. The political systems in peripheral countries were happy to exploit the extended room of maneuver by fostering the impression that prosperity could be sustained by deficit spending and easy lending rather than a determined effort to boost productivity and reinforce competitiveness. In a system where both, the threat of sanctions and the internal drive for self-discipline, are weak disorder is the inevitable outcome.

GreeceΒ’s prospects within the eurozone hinge on whether the countryΒ’s political system will find the strength to act decisively on reforms, and whether the eurozone will move more boldly on the road to unification so as to provide the right mix of sanctions and rewards for supporting the effort.
The answers to these questions remain uncertain at the time of writing. GreeceΒ’s political system, despite the emergence of a reform-oriented government after last JuneΒ’s elections, appears fractured and weak while the forthcoming German parliamentary elections in the autumn of 2013 postpone necessary decisions at the eurozone level.

The cost of GreeceΒ’s possible exit from the eurozone would, however, be immense for the country itself and quite considerable for the eurozone as a whole. The Greek people would suffer a further substantial fall in living standards – due to currency devaluation and instability – and lose most of the incentives required to move forward with the structural reforms which are essential for surviving in the modern globalized economy. A cull in the monetary union will weaken confidence in the cohesion of the remaining members, and therefore provoke lasting damage to stability and its overall economic prospects. Muddling may persist for some time but, eventually, there are grounds for hoping that positive decisions will be taken by all sides concerned. The cost of failing will be very high, particularly for the countries taking the route of exit.

(Article submitted for publication in Foreign Affairs)