By Philip Whyte

The collapse of market confidence sparked by the parlous state of Greece’s public finances is forcing the EU to review how the eurozone is run. This is entirely welcome. The crisis has cruelly exposed fault-lines in the system of governance – and confidence is unlikely to be restored unless these flaws are rectified. There are profound disagreements, however, about what these flaws are. Broadly speaking, there is a narrow view and a broader one. If the eurozone is to extricate itself from its current mess, it is essential that the broader prevail.

The narrow view – advanced by Germany – holds that the eurozone’s difficulties are the result of government irresponsibility. The way to restore market confidence, then, is to force wayward governments, starting with Greece’s, to mend their ways by repairing their public finances. Errant behaviour, moreover, must be discouraged by strengthening fiscal rules and imposing tougher penalties on miscreants – for example, by withholding EU structural funds, suspending countries’ voting rights, or, in extremis, expelling rogue states from the eurozone.

Germany’s view is not totally wrong. Greece’s behaviour has been egregious and the incontinence of its government has played a key part in the country’s difficulties. The eurozone’s budgetary rules have been repeatedly flouted by member-states (including Germany). Public finances are weak and need to be strengthened over the medium term. Eurozone governments have to reassure markets that they are not profligates. In short, crafting a more credible framework for fiscal policy in the eurozone must form part of the task of reconstruction.

The problem with Germany’s position, however, is that it is one-eyed. The eurozone’s problems are not reducible to budgetary indiscipline alone. In the years leading up to the global financial crisis, Spain was running a budget surplus, not a deficit. The weakening of the country’s public finances since 2008 is not, therefore, connected to government irresponsibility before the crisis. Nor will budgetary austerity solve Spain’s underlying economic problems, which are high levels of private-sector debt and a dramatic a loss of trade competitiveness.

The Commission is therefore right to argue for a much broader reform of the way the eurozone is run. The proposals that it published on May 12th do not neglect the need for strengthening the weakened Stability and Growth Pact, or for deepening fiscal policy co-ordination. But the Commission also wants to beef up the Eurogroup’s surveillance of macroeconomic imbalances. This surely makes sense. Imbalances between members cannot simply be ignored – particularly in the absence of a fiscal union to transfer funds to depressed areas.

Nevertheless, some countries – Germany among them – are reluctant to allow the question of imbalances to get more airtime in the Eurogroup. Not coincidentally, enthusiasm for discussing imbalances is weakest among the countries that run large trade and current-account surpluses. This reticence is as easy to understand as it is impossible to justify. The countries believe their surpluses are badges of their ‘competitiveness’. As they see it, it is for deficit countries to become fitter, not for surplus countries to become flabbier.

The position of the surplus countries, however, is misguided. To start with, trade surpluses tell us nothing about economic dynamism. German politicians often liken their country to a toned athlete who is trouncing the international competition. They should think again. Yes, Germany has world class companies producing first-rate products. But productivity growth in recent years has been so weak that output per head is now below the eurozone average. The only reason German unit labour costs have fallen is that real wages have too.

The surplus countries are also incoherent. They condemn irresponsibility in the deficit countries, yet remain wedded to their own surpluses. This makes no sense. Deficits and surpluses are umbilically linked: one entails the other. Only in an Alice in Wonderland world would it be possible for the trade gap in ‘Deficit-land’ to decline without an offsetting adjustment in ‘Surplus-land’. Why do surplus countries struggle to accept this? The answer must be that they have grown reliant on the foreign irresponsibility that they like to decry.

If European policy-makers are to restore the financial markets’ flagging faith in the eurozone, they must persuade investors that the region is not heading for a prolonged economic slump. The Commission’s proposals on eurozone governance rightly identify many of the key elements that would provide such reassurance: a rebalancing of demand within the eurozone from the deficit to the surplus countries; supply-side reforms to raise the region’s long-term growth potential; and credible plans for fiscal consolidation over the medium term.

The danger, however, is that the minimalist German view will prevail, with reforms to eurozone governance focusing primarily on fiscal policy, the Commission’s proposals on macroeconomic surveillance being emasculated, and supply-side reforms being taken as seriously as they were under the Lisbon agenda (that is, not very). Should this scenario transpire, the eurozone could find itself condemned to permanent crisis, with chronically weak growth across the region as a whole, and politically destabilising debt-deflation in the south.