What Will Be the Global Impact of European Fiscal Austerity?

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 |  Includes: ERO, FXE
by: Brad DeLong

It's not clear that Mundell-Fleming is the right model here. Not that I know what the right model is. Paul Krugman writes:

The Global Transmission of European Austerity: Some thoughts on the fiscal austerity mania now sweeping Europe: is anyone thinking seriously about how this affects the rest of the world, the U.S. included? We do have a framework for thinking about this issue: the Mundell-Fleming model. And according to that model (does anyone still learn this stuff?), fiscal contraction in one country under floating exchange rates is in fact contractionary for the world as a whole. The reason is that fiscal contraction leads to lower interest rates, which leads to currency depreciation, which improves the trade balance of the contracting country — partly offsetting the fiscal contraction, but also imposing a contraction on the rest of the world. (Rudi Dornbusch’s 1976 Brookings Paper went through all this.)

Now, the situation is complicated by the fact that monetary policy is up against the zero lower bound. Nonetheless, something much like this transmission mechanism seems to be happening right now, with the weakness of the euro turning eurozone fiscal contraction into a global problem. Folks, this is getting ugly. And the U.S. needs to be thinking about how to insulate itself from European masochism.

Conventional Mundell-Fleming at the lower bound would suggest two effects: (a) the exchange rate stays the same (the uncovered interest parity condition doesn't change), (b) European demand for U.S. products falls (as Europe sinks deeper into depression). But the sum of these two effects on the U.S. is small.

If you talk to European great-and-goods, they expect fiscal austerity to strengthen the euro--fiscal austerity is supposed to make markets less worried about the riskiness of European governments' debt, and so make people more willing to hold them. It's not clear that you can write down a consistent model in which this works, but it is not clear the world behaves according to a consistent model.