Today I’m sitting down for a conversation across a continent and an ocean. Our guest is Professor Matthias Matthijs of the Johns Hopkins School of Advanced International Studies (SAIS). He is the editor of the renowned and timely book “The Future of the Euro,” and a two-time recipient of the Max M. Fisher Award for excellence in teaching at SAIS. We will be talking about the Eurozone crisis and the lessons other small-state economies and their policymakers can learn from Greece’s unfortunate situation.

Q. Professor Matthijs, thank you for sitting down with me. As your former student, it is exciting to chat with you in a professional context. With the events in Europe, we know you have been called for a lot of interviews, so we thank you for your time.

A. Absolutely. It’s an honor. It’s great to see former students do well and move up in the world!

Q. Let’s start by talking a bit about how the Eurozone came into what analysts are calling the “Graccident” and the subsequent deal made with Greece’s creditors (I guess one positive thing here is how “Greece” lets us wordsmith catchy names). What’s the short and fast history here? 

A. The basic story is that the Eurozone, for political reasons, was set up in a minimalist fashion in the early 1990s at Maastricht. Europe’s leaders constructed a common currency in a mainly technocratic fashion, around a powerful and independent central bank with a narrow mandate to conduct monetary policy and fiscal rules to keep member states from diverging too much from one another. We know now that this was naïve at best. Currency unions only function if they are embedded in broader economic, financial, social, and political institutions, as is the case with all historical cases of successful experiments with common currencies, including in the United States, federal Germany, and confederal Switzerland. 

As capital started flowing from North to South in the mid-to-late 1990s to take advantage of the higher interest rates over there, financial imbalances started building up across the Eurozone, with huge budget deficits in Greece, and current account deficits in Spain, Ireland, and Portugal. Investors did not believe the ‘no bailout’ clause of the Maastricht Treaty and assumed Greek debt was as good as German debt. Once Angela Merkel’s government made it clear in late 2009 that there would be no easy bailouts, markets panicked, and we had the beginning of the euro crisis. The euro crisis has been ongoing since then, largely as a result of the EU’s response, i.e. a combination of fiscal austerity and structural reforms with painstakingly slow progress towards building those missing unions. So far, real progress has only been made in building a banking union, and even that remains a two-legged stool at best. But the EU’s policy in austerity has been particularly damning in Greece, where the economy has shrunk by 25%. All indicators point towards a Greek economy that is shrinking even further right now.

Q. So the situation is pretty dire. Let’s go to those typical questions of political economy: As the crisis continues who stands to lose? Who – if anyone – stands to benefit? And I think the one thing we are most interested in is: Who is to blame? 

A. In broad terms, the Northern creditor countries have had a relatively good crisis while the Southern debtor countries have suffered. The main losers of the crisis in Southern Europe so far have been the weakest, i.e. the unemployed who see their benefits cut, workers who experience falling real wages, and contractual service workers that are forced to work part-time due to a slumping economy. However, the crisis has also been painful for elites in those countries, as they stand to lose their privileged and protected positions in the political economy due to structural reforms. However, if the crisis continues, the main losers may well be the EU elites and technocrats who have gained the most from European integration. The crisis may reach a tipping point and send EU integration into reverse – Grexit being the obvious candidate, but closely followed by a Brexit – a British exit from the European Union.

Q. In your book “The Future of the Euro” you and Mark Blyth are heavily critical of austerity. Can you explain why you think it is a poor policy decision, and if so, why has it become the bread-and-butter of the Troika when debtors take their liquidity assistance? 

A. The main issue with austerity is that it makes political sense, but is very poor economics for countries that are experiencing recessions. It is simply disastrous for countries like Greece, which have been in a depression. Don’t take my word for it, but listen to Olivier Blanchard at the research department of the IMF, or my colleagues Carlos Végh and Guillermo Vuletin at SAIS. They have shown that the multiplier effect – i.e. the effect on the real economy of fiscal policy – is much larger than we think during downturns. To give you a ballpark figure: if Greece cuts government spending by 100 billion euros, it will do damage to its economy by shrinking national income by 300 billion. If the goal is to cut the Debt-to-GDP ratio, it is not enough to focus on the numerator. One also has to focus on the denominator. Over the past 70 years, we have seen that most countries have lowered their debt-to-GDP ratios by growing out of it (i.e. expanding the denominator) and less by cutting deficits and debt (i.e. lowering the numerator). 

From a political view, of course, it is extremely costly to throw more ‘good money after bad.’ The intuition of austerity appeals to voters in Northern Europe. It’s the hangover after the party. Everybody needs to tighten their belts. While this is sound logic for an individual or a family, it can have dire consequences for economies as a whole, as we have seen in Greece, where the debt-to-GDP ratio is predicted to reach 200% by the end of 2016.

Q. Now Austerity has its fans as well. My colleague and I had a good coffee debate about this the other day and he told me something to the effect of: “Austerity means that countries do not expend more than they earn. What is bad about that? Those who argue against austerity want to throw new debt at old debt in order to reduce debt.”  What from your research and observations causes you and Mark to think austerity exacerbates sovereign debt crises and is there a third way to what seem to be intense polemics over cutting or raising government spending? 

A. Don't get me wrong. Austerity is not always and everywhere bad. The main problem in Europe is that everyone has been turning to austerity at the same time. There is a fallacy of composition here and a paradox of thrift. The only way austerity works if is not everyone is doing it at the same time. Since everyone cutting back also means people’s incomes (and therefore their demand) will be cut, resulting in layoffs and lower revenues for firms, leading to further declines in incomes. It’s similar to countries all wanting to export more than they import. This is logically impossible. We may have done a successful flyby by Pluto, but that still does not mean we as a world are trading with other planets. The world economy as a whole has to be in balance. Many Germans seem to believe that Southern Europe can become its own export powerhouses like China or Japan. But Berlin forgets that it can only be an export powerhouse because others are not. The European Union is made up of multiple varieties of capitalism – some are driven by exports, others by investment or domestic demand. The point is that there is a complementarity there which makes the whole machine work.

Q. I like that reference to our Johns Hopkins scientists that worked on the Pluto mission! And what about structural reforms in Greece? They have been bad or nonexistent in the previous five years, but could be a cheap option to get Greece in a position to start deleveraging. Should more money be transferred to Greece even if structural reforms are lacking?

A. I think there has actually been a lot more progress on structural reform than many people give the Greeks credit for. The Syriza government of Alexis Tsipras is committed to doing this and is in a much better position than his predecessors to take on vested interests. Even though, of course, a leftwing group like Syriza has its own sacred cows! If you look at the Greek civil service, for example, its employees have been cut by almost one-third from roughly 900,000 workers to about 600,000. Now, you can’t say that this amounts to nothing. The problem with structural reform is that they only pay off in the longer term. Combined with austerity in the short term they also tend to make things worse rather than better. After all, if you make it easier to hire and fire during a recession, what do you think firms will do? Hire or fire more workers? The only way structural reforms can work – as they did in Germany in the early 2000s – is if they are combined with short-term fiscal and monetary stimulus to soften the blow and if the rest of the country’s trading partners are growing at healthy rates. 

Q. Now will this affect the EU’s political clout in any way? Georgia has invested a lot of political capital in the Eastern Partnership. Could it lose influence in the Former Soviet Union?

A. The EU is in a tricky situation vis-à-vis Russia and the broader Eastern Partnership. The problem is that there is no money. I’m afraid that the EU has bitten off more than it can chew in Ukraine. There is also the broader geopolitical game – not least in the energy sector. Add to that the fact that Tsipras’ Syriza faction – given their anti-nazi and communist history – have huge sympathy for their much bigger and Orthodox brothers in Moscow. That’s why keeping Greece in the euro is about more than just the common currency. It’s also about broader strategic questions in the Eastern Mediterranean and the Black Sea. Together with the risk of contagion, this is probably the main reason why the United States is so worried about Greece.

Q. Now I’ll put you on the spot somewhat. Is the monetary union still a worthy experiment, or is it proving too complicated a beast to manage? 

A. If Europe is willing to build the missing unions – financial, fiscal, and political – to make the common currency work, then it will prove to be a worthy experiment. However, I am not optimistic at the moment. For better or worse, democratic legitimacy today remains with the nation-states. In good economic times, fixed exchange rates bring a tremendous amount of benefits, but when things take a turn for the worse, there are advantages from having exchange rates and economic policy flexibility. If the European Union is not able or unwilling to take a giant leap forward in political integration, I do not see how the euro can ever be on a solid footing. Then the Eurozone will stumble from crisis to crisis. That does not mean the euro will collapse, as the political will to keep it together is much stronger than many analysts sometimes believe. But there are limits. And we are pushing at those limits right now in Greece. As my colleague Jonathan Hopkin put it in The Future of the Euro, we are in the midst of an experiment in how far southern European electorates are willing to go in the name of investor confidence and policy credibility.

Q. Let’s also turn to the lessons learned here. I’m sure small-state economists will be analyzing Greece for a long time, but what could Georgian policymakers learn from this crisis when it comes to managing Georgia’s sovereign debt? My research shows that Georgia hovers around 37% of GDP, which is not too bad all things considered, but how can small states be proactive in preventing sovereign debt crises? 

A. The main difference between Georgia and Greece is that the latter cannot print its own currency. While the UK’s debt-to-GDP ratio is about as large as Spain’s, the UK can borrow at much cheaper rates. The main reason is that the UK has the Bank of England, and Spain has to rely on the goodwill of the ECB. The sovereignty therefore still matters a great deal. So, Georgia should think twice before it considers joining any future monetary unions!

Q. One more, and perhaps the most important question: Any plans to visit Georgia soon? The wine and khachapuri are waiting! 

A. I would love to since I’ve never been. The Caucasus region is one I do not know much about and would love to learn a lot more about. So, I will be waiting for an invitation from smart former students!

Q. Once again, our guest today was award-winning professor and author, Matthias Matthijs of the Johns Hopkins School of Advanced International Studies. Professor, thank you so much for your time and excellent analysis.

A. You’re welcome. The pleasure was all mine! This was fun.