The European Crisis

I hope everyone is having a nice holiday season.  This past week, I read some testimony concerning the European financial crisis.  Two Fed officials testified before the House of Representatives’ TARP Subcommittee.  I thought that a quick summary might help to frame what is at stake (and there is also a postscript at the end of the story).

The first testimony comes from Steven B. Kamin (Director, Division of International Finance, Board of Governors of the Fed’l Reserve System).  Realize that Mr. Kamin was justifying / defending recent Fed policy (reducing the pricing of dollar swap lines) – so this means that it’s always possible that his testimony is making the risks sound greater than they are.  Here were some of his key thoughts:

1. The combination of high debt levels and low growth prospects in several European countries using the euro has raised concerns about their fiscal sustainability.

2. This has led to substantial increases in their sovereign borrowing costs.

3. Pessimism about their fiscal situation, in turn, has helped to undermine confidence in the strength of European financial institutions, increasing their cost of raising funds and threatening to curtail their supply of credit.

4. These developments have placed significant strains on global financial markets and have weighed on global economic activity.

5. The financial stresses in Europe are undoubtedly spilling over to the United States by restraining our exports, helping to push down business and consumer confidence and adding to pressures on US financial markets and institutions.

6. Of note, foreign financial institutions, especially those in Europe, are finding it more difficult to fund themselves in dollars.

7. A great deal of trade and investment the world over is financed in dollars, so many foreign institutions have heavy borrowing needs in our currency.  These institutions also borrow heavily in dollars because they are active in U.S. markets, purchasing government and corporate securities as well as making loans to households and firms.  (This makes it harder for US households and businesses to get loans.  He also argued that this could raise the cost of funding for US financial institutions.)

8. Although the breadth and size of all of these effects on the US economy are difficult to gauge, the situation in Europe poses a significant risk to US economic activity and bears close watching.

New York Fed President Dudley also testified before the same subcommittee.  Here were his comments:

1. Although the US economy is currently expanding at a moderate pace, we face significant downside risks, mostly relating to the sovereign debt crisis in Europe.

2. If the European situation deteriorates, the euro area would face even more serious fiscal and economic challenges.  As a result, European growth would weaken and this would hurt US exports (and hurt our jobs).  The European market is the world’s second largest economy (after the US).  Europe is also a significant investor in the US economy.

3. If the European situation deteriorates, this could put pressure on the US banking system.  While US banks have bolstered their capital, the exposures of the US banks climb quite sharply when you consider the exposure to the core European countries and to the overall European banking system.

4. If the European situation deteriorates further, financial markets would become more stressed.  This could hurt the availability of credit.  This would also hurt our retirement savings and result in lower output and job creation.

The Postscript

Of course, since all of this testimony, the ECB has loaned 489 billion euros ($641 billion) to European banks.  The assumption is that the banks will take the cheap funding and buy sovereign debt, temporarily easing the crisis.  This is the European version of kicking the can down the road (they probably do this in speedos) and it delays the day of reckoning.

Happy New Year!

Have a great week.

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