Fed Governor Says U.S. Could Feel Europe’s Pain

The pace of bad news is picking up and will ultimately become a self fulfilling prophecy. So what you say? I think it will lead to a drop in the stock market like has happened previously.

Aivars

Fed Governor Says U.S. Could Feel Europe’s Pain
By SEWELL CHAN
Published: May 20, 2010

WASHINGTON — A top Federal Reserve official warned Thursday that Europe’s debt problems could amount to a “significant external shock” to the United States economy, harming American banks and exporters and stalling the global recovery.

Daniel K. Tarullo told a House panel that another credit squeeze was “not out of the question.”

The official, Daniel K. Tarullo, said in testimony at a House hearing that the Fed’s decision last week to reinstate dollar liquidity swap lines with the European Central Bank and four other central banks was a crucial measure to minimize the risk of further financial turmoil arising from the Greek fiscal crisis.

“In the worst case, such turmoil could lead to a replay of the freezing up of financial markets that we witnessed in 2008,” Mr. Tarullo told members of the Financial Services Committee.

Despite a nearly $1 trillion financing package assembled by the European Union and the International Monetary Fund, the downturn in stock markets and continued tight financing in Europe reflected persistent uncertainties, said Mr. Tarullo, who was President Obama’s first appointment to the Fed’s board of governors.

The United States is “in a very different position” than the debt-stricken European countries, he said. But their problems could hold lessons.

“Their experience is another reminder, if one were needed, that every country with sustained budget deficits and rising debt — including the United States — needs to act in a timely manner to put in place a credible program for sustainable fiscal policies,” he said.

Two subcommittees called a joint hearing after the Fed’s decision last week. Other experts also provided strong warnings on the state of the international economy.

Edwin M. Truman, a senior fellow at the Peterson Institute for International Economics, said the new financing package in Europe was “ambitious and demanding.” He added: “It may fail, but it is in the collective interest of the United States and the international community to give the people and authorities of Greece time to implement at least the first phase of their program.”

The European Union has responded to economic imbalances since the late 1970s by providing financing without requiring adequate fiscal adjustments, with the result that European countries turned to Brussels rather than Washington for relief, Mr. Truman said.

“During those decades, policy makers in Washington were generally content that E.U. countries were not borrowing from the I.M.F. because the I.M.F. could then concentrate its limited resources elsewhere,” Mr. Truman said in a written version of his testimony. “However, in retrospect U.S. policy makers should have promoted European adjustment assertively, including through the I.M.F.”

He added: “As a former Federal Reserve official, I hold myself partly to blame for this failure.”

Carmen M. Reinhart, an economist at the University of Maryland, College Park, said that a restructuring — or a partial default — by Greece seemed probable but was “no panacea.” While other European conditions may not require a restructuring of government debts, she said, “there is a pressing need to facilitate a restructuring of private debts, notably those of financial institutions.”

At most, the newest financing package buys time for other heavily indebted countries in Europe to impose austerity measures and restructure private debts, but “it does not change Greece’s, nor anyone else’s, levels of outstanding debts and their even more worrisome profile in the period ahead,” Ms. Reinhart said.

Peter Morici, a professor at the University of Maryland’s Smith School of Business, predicted that a default by Greece would result in much higher borrowing costs for Portugal, Spain and potentially other countries. “Crisis could easily spread from Europe to the United States, much as the recent U.S. mortgage and broader financial crisis spread to Europe,” Professor Morici said.

Mr. Tarullo laid out how that contagion could spread. If sovereign debt problems were to broadly affect Europe, American banks could face large losses on their overall credit exposures, as asset values declined and loan delinquencies mounted. Money market mutual funds that hold commercial paper and certificates of deposit issued by European banks also would be hurt. The result could be a further contraction in bank lending.

“Although we view such a development as unlikely, the swoon in global financial markets earlier this month suggests that it is not out of the question,” Mr. Tarullo said.