A deal on Greece will not work without deeper reforms

Only radical reforms can produce a thriving economy that lives within its means and provides prosperity and opportunities for Greek citizens – argues think-tank

There were both economic and political reasons why the euro was developed as a project and both economic and political reasons why countries such as Greece should have stayed out. When a country suffers from an adverse economic shock, living standards must decline. Greece has suffered from a huge economic shock and one that has been exacerbated by its membership of the single currency. If a country has a floating exchange rate, the currency of the state suffering from the shock will normally find that it falls in value. It is this that facilitates the reduction in living standards. A country that is in a fixed exchange-rate regime cannot easily adjust its living standards, unless there is a huge fall in real wages in the country concerned. When inflation is close to zero, this means a fall in nominal wages too.

This is the backdrop to the problems in Greece. If, as a young economist, one was to paint a picture of all the problems that would make economic adjustment difficult, one could not do better than to look to Greece – a huge public sector; exceptionally rigid working practices; a dysfunctional tax system; minimum wages. The list is almost endless. To cap it all, the Greek government also has an unsustainable debt burden. This problem is exacerbated by the fall in living standards in Greece – as gross domestic product falls, the debt burden relative to income goes up.

Therefore, there are four aspects to the "Greek problem". The first is ensuring that there is a mechanism to enable wages to fall in the private and government sectors – this is what the so-called austerity measures are all about. Of course, if living standards are falling, this must involve a cut in services provided by the government too. Secondly, we need huge reforms to ensure that there is greater productivity growth and more flexibility in the economy. Relatively speaking, this is the painless side of things – though, reform will be obstructed by the vested interests. Greater productivity growth and greater flexibility will allow austerity to come to an end and the economy to become prosperous again.

However, the shadow of debt is hanging over all of this. It is the inability of the Greek government to repay its debt that is leading to such great urgency in the discussion of the austerity and reform programme; it is the fact that creditors have an interest in the success of the Greek economy that is leading to the outside intervention. But, reform in Greece is necessary for its own sake. The country has come to the end of the road. It can no longer sustain an economic model that involves loading the costs of consumption onto future generations.

Whether Greece remains inside or outside the eurozone, those who have lent the country money will suffer. Either Greece will default further, or it will repay debts in a devalued currency. The fact that the creditors are at the door, though, should not lead the people of Greece to believe that they are the cause of the problem. If the government debt was 10 per cent of national income, the same issues would confront the government. They are just made more acute by membership of the euro and the timing is determined by the way in which the debt crisis is being played out. Reform is necessary in order to produce a thriving economy that lives within its means and provides prosperity and opportunities. As Ronald Reagan said about the United States in 1964 - when it comes to these questions there are simple answers, but no easy answers.

Professor Philip Booth is editorial director at the Institute of Economic Affairs think-tank, in the United Kingdom