Germany’s approach to repairing the euro area’s finances, by holding the feet of feckless governments to the fire and forcing them to make difficult adjustments, has lately fallen out of favor. The case of Slovenia, though, suggests the tough-love strategy might yet have some merit.

Austerity has become a bad word in the euro area. It is blamed for an ever-worsening recession and, in some countries, a significant drop in living standards. When the European Union announced last week that it would give Slovenia and other euro-area countries more time to achieve deficit-reduction targets, analysts breathed a collective sigh of relief.

The reprieve, which subverts agreements made back in 2011 to reaffirm the euro area’s commitment to fiscal responsibility, arguably illustrates the kind of flexibility that Europe’s leaders should embrace more broadly. In Slovenia, however, the relaxation could represent a huge missed opportunity -- one that could make the difference between the tiny country being forced to ask for a bailout or not.

Slovenia was among the first euro-area nations to run afoul of the macroeconomic imbalance procedure, a mechanism created in 2011 to monitor compliance with the currency union’s new rules. In April, the EU flagged the country’s high degree of corporate indebtedness. More than half of bank loans in Slovenia are to the nonfinancial corporate sector. Of these, more than 30 percent are nonperforming.

Ambitious Program

The Slovenian government responded with an ambitious reform program. Among other things, it pledged to inject 900 million euros ($1.18 billion) of capital into its three largest banks, and to move soured assets from these lenders to a bad bank, the Bank Asset Management Company, starting in June. Slovenian Finance Minister Uros Cufer also agreed to bring in an external auditing company to conduct an asset-quality review of the nation’s banks and to verify the size of the hole in this sector.

To raise money for the bank recapitalization, the Slovenian government announced it would sell 15 state-owned enterprises. This is even more ambitious than the Portuguese privatization program, widely considered to be the model for struggling euro-area governments.

If the government actually follows through, the country can avoid a bailout. This statement represents a bit of a U-turn from my previous writing on Slovenia. The reason is that the country’s debt and deficit are still manageable. Even in the worst-case scenario, the cost of recapitalizing the banks and funding the bad bank amounts to no more than about 10 percent of Slovenia’s gross domestic product. This would increase the government’s debt burden to about 75 percent of GDP, still less than that of most other euro-area governments, including Germany.

That said, the trends in Slovenia are worrisome. Public debt has more than doubled from 22 percent of GDP in 2008 to almost 55 percent in 2012. This is partly because an economic slump, expected to continue for at least another year, has been eroding the denominator, GDP. The share of nonperforming corporate loans at Slovenia’s three largest banks tripled from about 10 percent in 2009 to 30 percent in 2012. The banks’ distress will keep cutting into lending, pushing still more corporate borrowers to the brink.

The Slovenian government has been masterful at delaying difficult reform, particularly in the banking sector. If there is no real pressure to finally clean up the banking sector and push through the sale of state assets, the flow dynamics may keep worsening public debt, government deficits and bad bank loans. Now that the EU has loosened fiscal targets, it’s hard to see where the pressure will come from. The government has raised enough money to cover its financing costs well into 2014, so rising borrowing costs are not an immediate concern.

Europe’s leaders have good reason to shift from harsh conditionality and punishment for disobedient countries to a relaxation of targets. Slovenia, however, may prove that one-size-fits-all policies don’t work for everyone.

(Megan Greene is a Bloomberg View columnist and chief economist at Maverick Intelligence. She is also a senior fellow at the Atlantic Council. Follow her on Twitter at @economistmeg. The opinions expressed are her own.)

To contact the writer of this article: Megan Greene at megan@maverickintelligence.com

To contact the editor responsible for this article: Mark Whitehouse at mwhitehouse1@bloomberg.net