15 December 2011

FED CEO William Dudley: What the euro crisis means for taxpayers and the US economy

The CEO of the Federal Reserve Bank of New York said that although the US economy is currently expanding at a moderate pace, it faces significant downside risks, mostly relating to the sovereign debt crisis in Europe.

Within the European Union, 17 countries share a common currency, the euro. The situation in the euro area is very unsettled, with pressure on sovereign debt markets and local banking systems. The euro area has the capacity, including the fiscal capacity, to overcome its challenges. However, the politics are very difficult, both because the problem has many dimensions, and because many different countries and institutions in the euro area have to coordinate their actions in order to achieve a coherent and effective policy response. Europe’s leadership has affirmed its commitment to the European Union and its single currency monetary union on numerous occasions. And the leadership is working to achieve greater policy coordination in areas such as fiscal policy. Putting all the countries using the euro on a clearly sustainable fiscal path would help restore market confidence. Assuming that Europe ultimately succeeds in managing this situation, a stronger union will emerge that will be viewed as more robust and resilient. This would be a welcome development for the US.

If, in contrast, Europe were not to be fully successful in charting an effective course, this could have a number of negative implications for the US. In particular, there are three possibilities that I would like to highlight.

First, if the European situation were to deteriorate, then the euro area would face even more serious fiscal and economic challenges. As a result, growth within the eurozone would weaken and this would lead to less demand for US goods and services that are exported to Europe from companies and workers here. This would hurt growth here in the United States and would have a negative impact on US jobs. It is important to recognise that the euro area is the world’s second largest economy after the US and an important trading partner. Also, Europe is a significant investor in the US economy, and vice versa. Thus, what happens in Europe has significant implications for the US economy.

Second, if the European situation were to deteriorate, this could put pressure on the US banking system. The good news is that US banks are much more robust and resilient than they were a few years ago. US banks have bolstered their capital significantly, built up their loan loss reserves and have significantly larger liquidity buffers. Also, the direct exposures of US banks to the countries in Europe that are facing the most intense fiscal challenges are actually quite modest.

The bad news is that the exposures of the US banks climb quite sharply when one also considers the exposures to the core European countries and to the overall European banking system. This means that if the crisis were to broaden further and intensify, this could put greater pressure on US banks’ capital and liquidity buffers.

Third, if the European situation were to deteriorate further, financial markets would likely become more stressed. This could tighten the availability of credit to US households and businesses. It could also cause equity prices to fall and this would have a negative impact on Americans’ pension and holdings. This tightening of financial conditions would damage the US recovery and result in slower output growth and less job creation. At a time that US unemployment is very high, this is a particularly unacceptable outcome. In the extreme, US financial markets could become so impaired that this would dry up the flow of credit to households and businesses.

I am hopeful that Europe can effectively address its current fiscal challenges. The Federal Reserve is actively and carefully assessing this situation and the potential impact on the US economy. At this time, although I do not anticipate further efforts by the Federal Reserve to address the potential spillover effects of Europe on the United States, we will continue to monitor the situation closely.

Full speech

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