House Subcommittee on International Monetary Policy and Trade

The Eurozone Crisis and Implications for the United States

Thank you Chairman Miller, Ranking Member McCarthy, and members of the subcommittee, for inviting me here today. My name is Douglas Elliott. I am a fellow in Economic Studies at the Brookings Institution, although I am here in an individual capacity and not representing the institution, which does not take policy positions.

The Euro Crisis is deeply concerning, in part because the path it follows is likely to be the main determinant of whether the United States goes back into recession. If Europe were to be shaken by a series of nations defaulting on their government debt, I am convinced that the continent would plunge into a severe recession. Their recession would trigger a recession of our own, although a less severe one, through a number of links across the Atlantic.

First, there is trade. Over $400 billion of our exports in 2010 went to the European Union[1]. We should expect to lose a significant portion of this while Europe is in deep recession. At the same time, European firms would likely gain market share at the expense of American sales and jobs, as the Euro depreciated and difficulties in selling within Europe spurred greater export efforts. Beyond Europe, emerging market countries like China also export substantial amounts to Europe and would find their growth slowing considerably. Our exports to those nations would be hit.

Second, there is investment. U.S. firms have over $1 trillion of direct investment in the European Union. Profits from those operations, which are significant for our global firms, would decline markedly. We also have large sums invested in other nations, outside of Europe, that would be caught up in the same synchronized economic decline.

Third, there are financial flows. U.S. banks, and their subsidiaries, have $2.7 trillion in loans and other commitments to eurozone governments, banks, and corporations, and roughly $2 trillion more of exposure to the UK[2]. U.S. insurers, mutual funds, pension funds, and other entities also have a great deal committed to Europe. Credit losses would set back the progress we have made in moving beyond the financial crisis. Those losses would be exacerbated by problem loans in the rest of the world, including our own country, induced by global economic problems.

Fourth, there is the effect on business and consumer confidence. We saw a taste of this in August, when problems in Europe quickly communicated themselves to our own financial markets and to confidence levels. Individuals and businesses are already scared. They would surely pull back on spending and investment still further if the European situation went badly wrong.

The combined effects of these four channels would almost certainly be enough to put us back in recession, although it is difficult to quantify the effects precisely, especially since there are numerous scenarios for exactly how the Euro Crisis could blow up.

Europe will probably muddle through, even though the process will be ugly and frightening. However, there is perhaps a one-in-four chance of a truly bad outcome, leading to a series of national defaults that include Greece, Portugal, Ireland, Spain, and Italy. There is also a small chance of one or more countries leaving the Euro, which would create still more damage. My one-in-four probability estimate is necessarily a very rough one. There are many different ways things could go wrong, since the eurozone is made up of 17 nations with their own political, economic, and financial systems. Each risk has a low probability, but there are a multitude of those risks, so they add up. I have attached a short paper giving more details about the crisis, particularly why it is so hard to solve and how it may proceed from here. The paper can also be found on the internet at: http://www.brookings.edu/papers/2011/0822_euro_crisis_elliott.aspx

The actions expected to be announced this week may well improve the situation, but will be far from sufficient to resolve the core problems. First, government leaders are unwilling to increase their national commitments to the European Financial Stability Facility beyond the previously agreed 440 billion euros, which is clearly inadequate to reassure markets, especially since much of that is already committed. Therefore, they are looking for ways to leverage those funds to get closer to the 2 trillion euros or so of capacity that is really needed. It appears this will be done by providing guarantees or insurance on a portion of the value of bonds issued by troubled eurozone countries. This is better than doing nothing, but is unlikely to restore markets in those countries to anything like normal operations. Knowing that the first 20% of potential losses on Portuguese or Italian bonds will be absorbed by someone else is not that reassuring when investors in Greek bonds are about to be hit with losses of 40-60%. The type of investors who would be lured by such guarantees are the ones who look for fat returns from somewhat riskier investments, which suggests that bringing them in will not appreciably reduce the interest rates paid by these governments. Instead, government bond markets need the much larger capacity and liquidity provided by the kind of investors who look for safe, liquid investments.  That will not happen without solving the underlying problems or providing guarantees backed by more creditworthy countries or multi-lateral bodies.

Second, a bank recapitalization that adds approximately 100 billion euros of capital is also a step forward, but, again, will not lay investor fears to rest. The IMF recently estimated that sovereign debt problems had eaten away at least 200 billion euros of economic capital from the European banks. Adding a figure half that large is unlikely to impress markets. Looked at another way, 100 billion is about one-tenth of the approximately one trillion euros of capital already held by the 90 large European banks that would be subject to the new requirements. It also represents less than half a percentage point of the 27 trillion euros of assets owned by those banks.

The technical details of the recapitalization will matter as well. If designed badly, the plan could even do harm by encouraging European banks to cut back on lending and to sell existing assets, potentially creating fire sales such as contributed to the financial crisis in 2008. A serious credit crunch would likely plunge Europe into recession.

Third, strong-arming investors into “voluntarily” accepting losses of 40-60% on their Greek government bonds will certainly add to the risks of contagion if market concerns about other troubled eurozone countries spike again at some point.

Whatever happens this week, we would be wise to prepare, in case the crisis worsens. We should continue to strongly encourage the Europeans to take the necessary steps. We should continue to provide U.S. dollar swaps to the European Central Bank for them to use to help their banks with dollar-based funding needs. Our regulatory agencies should continue to monitor the exposure of our financial institutions to European risks, but without making the Euro Crisis worse by over-reacting.

Finally, we should stand ready to consider ways in which the IMF might provide further assistance to Europe. The Eurozone has the joint resources to solve its own problems, but participation by the IMF brings multiple advantages. First, it increases the total pool of resources, in order to reassure extremely jittery markets. Second, it can impose some discipline on the borrowers through conditionality on its loans, which is easier for an outside party to demand. Third, it can provide quite considerable technical aid in dealing with economic restructurings, such as are needed in this case. This technical advice carries more weight when the IMF is also committing money.

This is a European problem and they will need to provide the backbone of any solution, but it is strongly in our interests to help in any reasonable way that we can.

Thank you for the opportunity to testify. I welcome any questions you have for me.


Footnotes
[1] I generally use figures for the European Union rather than the narrower eurozone, because the UK and other EU members that do not use the euro are so closely tied to the eurozone countries that I believe they would also be severely impacted.
[2] My colleague, Domenico Lombardi, has a good summary of the financial exposures in testimony he gave to the Senate, available at http://www.brookings.edu/testimony/2011/0922_european_debt_crisis_lombardi.aspx