Why the Debt Crisis Will Only Make Europe Stronger

Speculators have begun betting on an early euro-zone exit by Greece, a politically corrupt, basket-case country that has long cooked its government-debt figures and now faces years of stagnation—if not deflation and depression—as it slashes public deficits and shrinks wages in an attempt to regain competitiveness. In a confidential paper leaked last month, the European Commission warned that "imbalances" between stronger and weaker euro states risk the very existence of the euro itself.

They are wrong. Currency unions don't collapse because weaker members leave them. Were Greece to start printing new drachmas, they would immediately plummet in value against the euro. A super-weak drachma would make Greek wines and vacations very cheap for foreigners, but that gain for Greek competitiveness would be more than offset by bank runs, rampant inflation, and the burden of having to pay back old euro-denominated debts and mortgages with a newly worthless currency. Even if Greece's inept political class decides to take the risk—not unthinkable, since it might be a way to shift blame to outsiders—it would not break the euro zone. The euro would hardly be less stable without Greece, or even without Spain and Portugal. (Together, the three make up only 18 percent of euro-zone GDP.) On the contrary, a euro centered on Germany, France, and a few of the more advanced Central European economies like Poland would make the union stronger, not weaker. The risk of this is not so much the result but the financial and political upheavals in getting there.

The euro zone would break up not when weaker members leave, but when stronger ones no longer see gains from the arrangement. Today, that cornerstone is Germany. Europe's largest economy has emerged from the crisis bruised but with comparatively healthy public finances and an economic model unquestioned by its people. With the German political class so thoroughly invested in the common currency—and German companies dominating Europe more than ever—that scenario seems highly unrealistic.

On the contrary, Germany is working hard to impose its monetary and fiscal discipline on the rest of Europe. At home, it already has a new constitutional amendment prohibiting deficits starting in 2016. Chancellor Angela Merkel vetoed EU bailouts of weaker economies, forcing countries like Latvia and Hungary to seek the tough love of the IMF. The Frankfurt-based European Central Bank, unlike America's Federal Reserve, has a strict inflation-fighting mandate and is prohibited from using monetary policy to jump-start the economy. It has pumped far less money into the EU economy than the Fed has done in the U.S., even at the cost of allowing the euro to rise against the dollar by 20 percent since the start of the crisis. ECB chief Jean-Claude Trichet has told Greece that it must reform on its own, and denied there would be a bailout. Now Merkel is pushing to install German Bundesbank chief Axel Weber to succeed Trichet when his term ends next year to make sure the ECB doesn't soften its course.

As the focus of the economic crisis shifts from the financial to the public sector, there will be more risk and pain. In Latvia, whose currency is pegged to the euro, slashed public spending has accelerated the country's path to depression; GDP is down 24 percent in the last two years. Ireland, which is paring back its deficit with across-the-board cuts in civil-servant salaries, has seen GDP slide by more than 8 percent in the same period. Back in Greece last week, farmers rioted against a planned freeze in their subsidies.

It's no accident that the countries with bubble and deficit problems have also lost labor competitiveness, especially within the euro zone. Ireland, Spain, and Greece have let their wages rise about 20 percent faster than Germany's since the euro's introduction. With Germany now so much more competitive, it has accumulated China-style trade surpluses with weaker euro-zone members. Without the currency safety valve, those countries will have to make deep wage cuts, along with tough product- and labor-market reforms that help raise productivity.

Working out these problems could leave Europe stronger as a political institution. Just as the Great Depression forced the U.S. to impose a tighter federalism, today's economic crisis will likely force Europe into a closer union. Already last week, the EU Commission began pushing reforms on Greece. Through the back door of an economic crisis, the euro zone might then get the kind of political governance that skeptics always warned was necessary for a currency union to work. At the end of the tunnel could be a more integrated Europe, reformed problem economies, and ultimately a more competitive Europe.