Debt Crisis in the Eurozone - Essay Example

? Debt Crisis in the Euro-zone Debt Crisis in the Euro-zone As the year unfolds, the negative economic and fiscal metrics that plagued major emerging economies in 2011 due to the Euro-zone debt crisis, shows no sign of abating in 2012. A clear indication of this can be referred to statements given by France’s President Nicolas Sarkozy and Angela Merkel of Germany on the New Year’s Eve. In their respective statements, they warned that things with respect to the Euro-zone crisis would be getting dire in 2012. In fact, there is now a clear consensus among economists that the Euro-zone will enter a double-dip recession in 2012, if in fact it has not already done so. Nations such as Greece, Ireland and Portugal, who are currently way deep recession, meet the definition of a full-blown economic depression (Schuman, 2011). The depreciation of the euro relative to the home currency will make Euro-zone exports cheaper in global markets; this as a result would increase the competitive pressure in the home country. At the same time, it was observed in the last quarter of 2011, manufacturing industry weakened from China to Europe and euro region’s debt crisis is expected to darken the outlook of the global economy. Before going any further, it would be interesting to understand why it is necessary and helpful for countries to borrow and then to accumulate debt. Foreign borrowing is seen by governments as an addition to domestic saving, this borrowing helps in connecting to an investment saving gap and thus this leads to gain quicker growth, this is usually considered as final and vital economic goal for any country. The Mundell-Fleming model amalgamates the foreign finance and trade into a macro-economic theory. The theory came into evolution in the early 1960s and was introduced by the great Canadian Economist and the winner of 1999 Nobel Price Award, Robert Mundell. He was also heavily helped and facilitated by the British economist, J. Marcus Fleming. During the time period when this theory came into existence, both these economists were a part of the research team within the famous International Monetary Fund. While carrying out their research towards the Mundell-Fleming model, they enhanced the conventional Keynesian model in to such an open economy system whereby the capital and the goods market were internationally incorporated (Hailu et al, 2011). The Mundell-Fleming model is of the view that under a flexible exchange rate management system, the fiscal policy has almost none or little effect over the final yield or output whilst the monetary system is hugely valuable. This situation shows an entire mirror image when a fixed exchange rate is adopted i.e. the fiscal policy becomes effective rather than the monetary policy. The hypothesis that international money markets are completely amalgamated plays an important role in formulating these results. One of the major suppositions that the Mundell-Fleming model makes is that the economy under consideration is an open economy whereby the financial capital has an ideal mobility. The Mundell-Fleming model and the traditional IS-LM model are similar to each other when expressing the market for goods and services. One of the differences is that the Mundell-Fleming model includes a fresh terminology for net exports; this can be portrayed with the following equation: Y = C(Y -T) + I (r) + G + NX (E) Whereby; Y= The aggregate/cumulative income C= Consumption, I= Investment G= Government purchases (Y – T)= Disposable Income r = Interest rate NX = Net Exports E= Exchange Rate According to this equation, the total aggregate income of any country is the totting up of all these different factors. The consumption factor within the equation is positively dependent upon the disposable income whilst the investments and the net exports are negatively dependent upon the real interest and exchange rates respectively (Serrano et al, n.d.). The Mundell-Fleming model provides an understanding that clearly helps in analysing the consequences of adopting different economic policies within an open economy. These effects are further analysed by assessing the effects being brought upon by the differing exchange rates i.e. fixed or floating. The IS-LM model is different to the Mundell-Fleming model with respect to the economy stance. The IS-LM model considers a closed economy as opposed to an open economy assumed by the Mundell-Fleming model. Besides these differences, the Mundell-Fleming and the IS-LM model have certain common assumptions. Both these models suppose that the price levels are fixed in order to demonstrate the cause of short-term fluctuations in the aggregate income level (Serrano et al, n.d.) A country’s economy is usually monitored and controlled by using different fiscal and monetary policies. These policies are usually set up by the governments or the Central Bank of that particular country. Fiscal policy relates to the effect of the earning and the spending being made by the government in order to stimulate the economy. A government earns its income through different ways, taxation and loans are the two main sources through which a government earns its revenues. These revenues are spent accordingly by the government in order to provide for different services for the general public within a particular country. Monetary policy, on the other hand, relates to issues regarding the interest rate, exchange rate and the optimal level of money within the country and its economy. The main aim of the fiscal policy is to lower the unemployment and its effect within the country’s economy whilst the aim of the monetary policy is centred on the issuance of currency, interest rates and the inflation level within the economy. The respective authorities should re-align their objectives and coordinate with each other to stabilize the economy within the European country under consideration. As reflected in the debate of early 1960s, whereby many different economists requested for a joint attempt of both the fiscal and monetary policy in order to tackle the issues related to vast deficits and enormous inflation rates. Economists and the government within the client’s country should also consider the use of both fiscal and monetary policy in order to properly stabilize the country (Mankiw, 2010). The policies may not be highly effective if these are carried out independent of each other hence it would be highly beneficial to join both the fiscal and the monetary policy while addressing any issue within a country’s economy. The amalgamation of both these policies would help greatly in achieving desired results and sound and effective policies would result in alleviating the economy. Furthermore, fiscal and monetary coordination boards should always be present in order to support policy harmonization through proper operational and institutional arrangements (Serrrano et al, n.d.). The incorporation of the international capital market and the allowance for a variance within the exchange rate was not an evident characteristic of the global economy during the 1960s era. After the collapse of the Bretton Woods system, this was characterized by high financial combination and floating exchange rates, than the economic reality of the times in which the model was originally developed. This feature of the analysis along with the success of the theoretical guesses in matching empirical facts influenced Mundell-Fleming model among both the academics and policymakers. There are many different criticisms that have been raised with respect to the Mundell-Fleming model. One of the major set-back is considered to be the model’s assumption of perfect capital mobility. This shortfall was identified by Mundell and he clearly stated that this assumption should not be taken literally. Besides this major criticism, there have been many other issues relating to the Mundell-Fleming model. The model is considered inflexible and static and it is because of this reason that the model is unable to tackle problems in the long run, besides the transitional changes within the private wealth/capital and the government finance. This limitation of the model was answered by Rudiger Dornbusch (1976) whereby he brought in more refined, , "rational" (rather than static) private agents” expectations into the model. This theory brought an “overshooting” consequence which illustrated that after a monetary expansion, the exchange rates would reduce extra in the short run as compared to the long run (Floden, 2010). The Mundell-Fleming model is of the view that if a flexible exchange rate prevails within a country, the output level would not be really affected by the fiscal policy whilst it can be clearly ascertained from this that the monetary policy within that country would be tolerating the major share of weight of the macroeconomic management. This can be considered because of the fact that the monetary policy’s main aim would be to control inflation. The model is relevant to its effect of output movements and it ignores the effect of factors such as consumption and leisure time. . The model is also deemed to include a biased resolve considering its logic and assumption and it is because of this reason that the conclusion drawn is usually invalid. An example to this situation would be where the model would be used within a flexible exchange rate economy clearly ignoring the effect on the price level caused by changes to the exchange rates. By fixing the value of exchange rate with Euro, the traders within the economy i.e. both the importers as well as the exporters would be given a bit of a guarantee that the currency rate would not fluctuate and hence such an environment would provide greater confidence to both the exporters and well as the importers within the country. Such fixing of the exchange rate would also reduce speculative activities and would also help in creating a disciplined atmosphere within the country whereby the firms operating domestically would be able to restrict/reduce their respective costs and would further help the domestic firms to maintain a better competitive edge within the international market. Besides the benefits to the local firms, the government would also avail some benefits from such a fixation of exchange rates. This fixation would help the government in stimulating the economy through reduced inflation rates and hence reduced interest rates. These reduced interest rates would not only encourage public spending but will also help enhancing the trade and investment within the country. Countries usually following the fixed exchange rate policy have a very strict stance over the inflow and outflow of capital within the country. This strict stance helps the countries in avoiding the fixed exchange target from getting destabilized. Countries within the 1950s and the 1960s era adopted the fixed exchange rate policy; hence it seemed fruitless to stabilize the economy by implementing monetary policies. The monetary policies in this scenario seem really inactive as the governments implementing fixed exchange rate policies must provide whatever amount of money that is asked of them at the respective fixed prices. Besides this factor, fixing the exchange rate would also result in the rigidity of the monetary policy as the policy would not change with respect to the changes in the economy. The three main issues that may arise would be loss of monetary independence, loss of adaptability to export changes and extraneous volatility (Hailu et al, 2011). Crisis within a country would lead to imbalances. These imbalances within an economy usually lead to different results such as current accounts deficits, negative balance of trade, reduction in government funding, minimum wages, higher taxes and all of these factors would result in slow economic growth and this would thus reduce the aggregate demand. For example, if there would be a crisis within a country such as unemployment, the currency of the country implementing the fixed exchange policy would not with respect to the Euro because the exchange rate would be made fixed with it. On the contrary, a varying exchange rate, would lead to a fall in the value of the currency and save somewhat on the need of the workers’ wages to fall. While analysing the consequences of the debt crisis on cumulative income, exchange rate and the trade balance within the client’s country, many different factors would have to be considered. The Macroeconomic crises have been a regular issue within the Eurozone for the last few years. These crises have led to a reduction in the standard of living and this reduction in the living standards can be primarily attributed to different factors such as the fall in the income level and a rise in the level of unemployment. Ultimately this reduction in the living standard is because of the decreased cash flows from trade that have eventually brought upon a reduction in purchasing power of the consumer.   The debt crisis in the Euro zone has affected the global economies, as majority of Europe’s banks need to be repaired now, or they have a plan to recapitalize them. The economy of Greece is in need of a more drastic debt restructuring. Along with that, Euro zone’s bailout fund, the European Financial Stability Facility, or EFSF, is too small to fight the debt crisis arising in the Eurozone. On the other hand, the industries are facing a sharp decline with respect to the inflows, a slowing global economy and on-going financial market turbulence, while the broader euro-zone debt crisis continues to shatter confidence of the investors. European Union has to increase the fund’s capabilities by using it to guarantee private bondholders against losses on sovereign debt purchases (Kelch et al, n.d.). Countries such as the clients’, having low fiscal deficits, clear monetary and exchange rate policies are less likely to face macroeconomic crises. Such countries are able to tolerate the effects of volatile capital flows. An intrinsic trade inequity led to a debt crisis within the European region. As the entire region is using the same currency and there is no varying exchange rate that can act as a re-balancing device between countries having trade deficit and surplus. Degradation of a currency is another sign of weakness that usually leads to a decline but this is not the case with the euro-zone. The euro-zone is found to have a lower inflation rate as compared to the United States and there is no threat or a danger of an increase as the wages within the region remain reduced. Thus, this would relieve the European Central Bank as they would not have to finance the low and gradually disappearing deficits (Mankiw, 2010). The euro’s long-run survival requires the correct mix of adjustment by debtors, debt forgiveness where this is not enough and bridge financing to convince nervous financial markets that the debtors will have the time needed for adjustment to work. Europe needs the political will to mobilize and stabilize the Eurozone to avoid any further debt crisis in future. Bibliography Floden, M. (2010). The Open Economy Revisited: The Mundell-Fleming Model and the Exchange-Rate Regime. Stockholm School of Economics. Available at: http://www2.hhs.se/personal/floden/files/floden_chapter12.pdf Hailu, D., Weeks, J. (2011). Macroeconomic Policy for Growth and Poverty Reduction: An Application to Post-Conflict and Resource-Rich Countries. Economic and Social Affairs. Available at: http://jweeks.org/2011%20DESA%20108.pdf Kelch, D., Shane, M., Torgerson, D., Somwaru, A. (n.d.). European Financial Imbalances: Implications of the Eurozone Sovereign Debt Problem for U.S. Agricultural Exports. A Report from the Economic Research Service. Available at: http://www.ers.usda.gov/Publications/WRS1102/WRS1102.pdf Mankiw, N. G. (2010). Principles of macroeconomics. Mason, OH, South-Western Cengage Learning Schuman, M. (2011). Europe’s new debt crisis agreement: the good, the bad, the ugly. The Curious Capitalist. Available at: http://curiouscapitalist.blogs.time.com/2011/10/27/europe%E2%80%99s-new-debt-crisis-agreement-the-good-the-bad-the-ugly/ Serrano, F., Summa, R. (n.d.). Mundell-Fleming without the LM curve: the exogenous interest rate in an open economy. Available at: http://www.depfe.unam.mx/70aniversario-ie/serrano_summa.pdf Read More