The euro zone is turning into a more balanced and potentially more dynamic economy thanks to market pressure and the constant demand for structural reforms, a study showed on Monday.
The three-year-old sovereign debt crisis, started by unsustainably high debt in Greece, has forced Athens, as well as Ireland, Portugal, Spain and Italy to embark on ambitious economic reforms to win back market confidence.
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The reforms, while painful and at times a blunt instrument, have driven labor costs down and helped bring about an "internal devaluation" that has sharpened competitiveness.
The annual report, prepared by the Brussels-based Lisbon Council think-tank and Berenberg bank, said Greece was now the leader in economic reforms towards healthy economic fundamentals, followed by Ireland, Estonia, Spain and Portugal.
"Almost all countries in need of adjustment ... are slashing their underlying fiscal deficits and improving their external competitiveness at an impressive speed," the report said.
Greece, Ireland, Portugal and Spain have all applied for euro zone loans to help them cope with the effects of the sovereign debt crisis.
"All of the four euro zone countries that have been granted external assistance - Greece, Ireland, Portugal and Spain - have strengthened their adjustment efforts over the last 12 months," the report said.
"In other words, under the pressure of crisis, the countries that need to shape up fast are doing so. The results reveal no trace of a 'moral hazard', that is of a hypothetical risk that outside support could blunt the readiness to adjust," it said.
The report, called the 2012 Euro Plus Monitor, showed that external imbalances, which were one of the reasons for the debt crisis, were diminishing.
It said real unit labor costs were falling sharply in Greece, Ireland, Portugal and Spain. On the other hand, wage moderation, long seen as holding up internal German demand, has ended - suggesting that the private sector in the euro zone's southern half was moving to catch up with Germany in terms of competitiveness.
"More than anything else, this shows that serious structural adjustments can happen - and are happening - within the confines of the monetary union," the report said.
It said that while the euro and its governance structure still needed to be improved further, they were already providing an important framework in which countries can successfully reform themselves.
"If the euro zone gets through the current acute crisis and stays on the reform path, it could eventually emerge from the crisis as the most dynamic of the major Western economies," the study said.
The study said that to overcome the sovereign debt crisis policy-makers must end concerns about an imminent disaster in reforms and debt cuts in Greece and the contagion this causes by providing a clear vision for keeping Greece in the euro.
They must also avoid any overdose of austerity and shift their focus to pro-growth structural reforms, it said.
"Austerity is a potent medicine. It has to be applied in the right dose. A lack of the necessary medicine can kill a patient. But so can an overdose," the study said.
"As a general rule, we would stipulate that no country should tighten its fiscal policy, or be asked to do so, by more than 2 percent of its annual GDP in any year, except if the country had relaxed its fiscal stance in the previous year by more than 1 percent of its GDP," it said.
"In the absence of additional policy mistakes, the euro crisis could thus fade somewhat in 2013. But as the success of frontloaded fiscal adjustment depends on the opportunity to raise exports amid depressed domestic demand, the euro zone remains hostage to the global business cycle," it said.
(Reporting By Jan Strupczewski; Editing by Giles Elgood and Patrick Graham)