Introduction

Over the last 12 months, the excessive sovereign debt problems in Portugal, Ireland, Italy, Greece, and Spain which all are members of European Union led to a crisis in the global financial system. As the European Monetary Union members use the Euro as the common currency, they do not have abilities to use independent monetary policy, the solution of this debt crisis which can influence the whole global financial system becomes to difficult to be found.

Chart 1: How country debts and budget deficits compare
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Source: Eurostat Newsrelease Euroindicators 2010

According to the Chart 1 above, the debt of Italy is 115.8% of GDP and Greece (115.1% of GDP) is closely followed, while Ireland has the highest budget deficit of 14.3% of GDP and next is Greece (13.6% of GDP). However, the European Union member states were required to have 3% for the ratio of the actual government deficit to GDP as market prices and 60% for the ratio of government debt to GDP at market prices (Treaty on European Union, 1992). It is clear that all member states shown above broke the standard of Treaty on European Union and have excessive deficit and debt relate to the GDP.

Government debt is defined as the government borrowing in order to satisfy the short-term liquidity needs or the longer-term budget capital expenditures (Edirisuriya, 2010). The government debt usually can be caused as an accumulated governmental deficit over several years or several decades. A large scale of debt, especially the sovereign debt, can cause rapid inflation which implied that a high price level of goods and a high level of unemployment, when an economy is running near or at its potential level of output. Therefore, the fiscal policy and monetary policy can be applied to counteract inflation.

Monetary policy

In order to maintain inflation within a target range, the central bank should take monetary policy actions that directed toward influencing the level of interest rates in the financial system. Monetary policy is defined as the actions of a central bank that influence the level of interest rate in order to achieve economic outcomes (Edirisuriya 2010). The monetary policy can be classified as expansionary and contractionary monetary policies. Expansionary monetary policy is simply a policy which expands the supply of currency, while contractionary monetary policy is a policy which contracts the supply of currency (Arnold, 2008).

As the information above, it is clear that there are a large budget deficit in the balance of payments and a rapid growth in debt level in a number of European Union members. Hence, the inflation as a result of excessive deficit and debt is out of the target range set by the central bank. The monetary policies that counteract inflation usually raising the real interest rate when inflation rises, typically by a fiscal deficit that reacts negatively to the level of debt (Aarle, Garretsen and Huart, 2004). In particular, an increase in interest rates will eventually increase long-term rates, slow consumer spending which can reduce inflation and demand for imports. On the other hand, the increase in interest rate will lead to an appreciation of the domestic currency, the size of the current account deficit can be decreased and foreign investment would be attracted.

With the passage of the time, the tight monetary policy can affect the output, employment and prices through monetary policy channel, credit channel, wealth channel and foreign exchange channel (Edirisuriya, 2010). In terms of the monetary policy channel, the European Central Bank may tighten monetary policy by selling government securities to the market, thus the supply of funds will be reduced which can cause higher interest rates. An increase in the level of excess liquidity in financial system at the current period will be followed by an increase of inflation in the ensuring period (Zhang, 2009). The liquidity effect of changes in interest rates is clearly shown. Higher interest rates will increase the cost of funds and ultimately will result in business investment and household expenditure falls (Edirisuriya, 2010). At the same time, through the credit channel, the tightening of monetary policy will increase the level of investment risk, the bank lending may be reduced as borrowers thought it is more difficult to repay higher-cost loans, while investors will withdraw from the market in times of higher loan-default risk as they thought it is more difficult to raise direct finance (Hubbard, 1995). The reduced availability of funds will slow down economic activity which refers to the income effect of changes in interest rates. The wealth channel is defined as the effects of monetary policy changes on asset values (Edirisuriya, 2010). The tightening of monetary policy will result in a reduction in asset values which can remit the result of inflation. Nonetheless, it will also lead to a loss of confidence, a reduction of creditworthiness and a further contraction in economic activity (Edirisuriya, 2010). The rise in interest rates because of the tightening of monetary policy will result in an appreciation of exchange rate which will lead to the debt of members of EMU reduced. Meanwhile, a decrease in exports and an increase in imports will occurred. Therefore, the balance of trade and economic output will be affected by the foreign exchange channel.

The main disadvantage of monetary policy is that the effect lag of monetary policy is certainly much longer and more variable than the effect lag of fiscal policy.

Fiscal Policy

Fiscal policy is defined as the management of annual revenues and expenditures of a government (Edirisuriya, 2010). The national fiscal policies in the European Union are based on three main pillars which are the implementation of sound and sustainable fiscal policies, the reduction of the size of public defcits and the stocks of public debt, and the reduction of the size of public expenditure and taxation (Ferreiro, Garcia-del-Valle and Gomez, 2010).

Table 1: Comparing the expenditure, revenue and deficit in 2008 and 2009
| |Euro Area |European Union Member States |
| |(% of GDP) |(% of GDP) |
| |Expenditure |Revenue |Deficit |Expenditure |Revenue |Deficit |
|2008 |46.8 |44.9 |2.0 |46.9 |44.6 |2.3 |
|2009 |50.7 |44.4 |6.3 |50.7 |44.0 |6.8 |

Source: Eurostat Newsrelease Euroindicators 2010

According to the Table 1, the large increases of the government expenditure from 2008 to 2009 in the Euro area may be the most likely explanation for the increase of the government deficit to GDP ratio from 2.0% in 2008 to 6.3% in 2009, while the government revenue reduce from 44.9% of GDP in 2008 to 44.4% of GDP in 2009. Oppositely, the increase of the government revenue from 2008 to 2009 is larger than the increase of the expenditure, while the increases of deficit is not significant different with that in the Euro area. Therefore, to counteract inflation which is result of the excessive deficit and debt in EMU, the main instruments of fiscal policy are reducing the government expenditure or increasing the government revenue.

The government expenditure can be funded in different ways: taxation, seigniorage, borrowing money from population or from abroad, or sale of fixed assets such as land (Cordes, Ebel and Gravelle, 2005). In general, if the composition of public expenditures changed, the consequence of government deficit will be changed as the deficit refers to the difference between government expenditures and revenues. Similarly, a fall in government expenditure will reduce the government borrowing requirement, thus, the bank lending increased as a result borrowers would prefer to domestic funds than foreign funds as a lower interest should be paid locally. Meanwhile, the investment from the countries which are not in the Euro area will be increased. Ultimately, the excessive government deficit and debt will be remitted.

Mathieu and Sterdyniak (2003) indicated that the European Commission would like to make sure that each member state will reduce government borrowing through expenditure cuts and not through higher taxations, and that public spending will be productive. Even though the raising of taxation from civics is not preferred by the European Commission, the government revenue still can increase through to raise other compositions. The government can borrow money from population or from abroad by selling Treasury bonds to banks and loaning from other countries. Greece has request the package of emergency loans backed by the Eurozone members and the bilateral loans backed by the International Monetary Fund (IMF) for debt-stricken which total valued of 110 billion euro (Willis, 2010). Meanwhile, the government can sale its fixed assets, such as land. In this crisis, Greece has started putting island land up for sale by auction to save the economy (Moya, 2010).

The time lags which is a weakness of fiscal policy can be classified by the inside lags and the outside lags. The inside lags, which is the analysis of data and decision as to appropriate action within the government, can be quite long as a budget is only handed down once per year; the outside lags, which is the time taken for the policy to have an effect on the economy, is comparatively short because of the direct impact of budget announcements on the economy.

In summary, the noticeable weaknesses of monetary and fiscal policy indicated that only apply to either of them is not the best way to solve the crisis. As the effect lag of monetary policy is much longer and more variable than the effect lag of fiscal policy, the fiscal policy is preferred to apply in the exigent and far-reaching crisis, such as the European sovereign debt crisis, to control the situation in a short time. However, the monetary policy cannot thoroughly remove the negative influences by the European sovereign debt crisis but only can reduce the pressure of the excessive debt. There are interrelations between monetary and fiscal policy: the design of the monetary rule will affect the fiscal policy reactions, and vice versa. Therefore, the best solution for this crisis may be found when appropriate and reasonable use of monetary policy and fiscal policy.

Solutions

The crisis of excessive sovereign debt may be solved by reducing the government expenditure and increasing the government revenue. In March 5th, Greece passed the new public sector wage cuts and tax increases, and estimated to generate savings of 4.8 billion euro (Kitsantonis, 2010). However, the wage and price controls could lead to some problems, such as protection of workers, thus it was impractical to thoroughly solve the crisis if it worked alone (Brunsden, 2010).

The European Union Member States which have excessive sovereign debt can ask for the bailout from population or from abroad. Leaders of the eurozone countries resolved in Brussels to take drastic action to protect the euro from further market turmoil after approving a $110 billion bailout plan for Greece (Willis, 2010). The existent excessive sovereign debt is transfered to the European Union and IMF. If the monetary policy work alone in this situation, the crisis of Greece cannot be defused as the European Union and IMF does not provide the bailout loans without any interest rate, thus Greece has to pay for the bailout loans when the bonds are maturity. Borrowing money and reducing expenditures which are both applied to the fiscal policy authority were not effective solutions when they are work alone.

Another solution can be that the European Central Bank increase the interest rate. However, the change in the interest rate will also affect the liquidity of currency, the individual's income and the direction of inflation become to unsatisfactory, such as excessive falls in the investment and household expenditure and deceleration of economic activity. Therefore, the increase of interest rate is not the most appropriate solution for the crisis of the European Union. At the same time, most states affected by the crisis are member states of European Union and use the Euro as the common currency, thus, the impact of monetary policy is limited and only with the countries not in Euro area.

Conclusion

As the effect lag of monetary policy is much longer and more variable than the effect lag of fiscal policy interrelations