William C Dudley: The economic and fiscal challenges facing Europe
Testimony by Mr William C Dudley, President and Chief Executive Officer of the Federal
Reserve Bank of New York, before the Subcommittee on Domestic Monetary Policy and
Technology, Committee on Financial Services, United States House of Representatives,
Washington DC, 27 March 2012.
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Introduction
Chairman Paul, Ranking Member Clay, and members of the Subcommittee, my name is Bill
Dudley, and I am President of the Federal Reserve Bank of New York. It is an honor to testify
today about the economic and fiscal challenges facing Europe, and the Federal Reserve's
efforts to support financial stability in the United States. Financial stability enables
U.S. businesses and households to maintain their access to credit and ensures sustained
economic growth. This is why promoting financial stability is an important objective of the
Federal Reserve, and other central banks around the world.
Let me preface these remarks by stating that the views expressed in my written and oral
testimony are solely my own and do not represent official views of the
Federal Reserve Board, the Federal Open Market Committee (FOMC) or any other part of
the Federal Reserve System. Additionally, because I am precluded by law from discussing
confidential supervisory information, I will not be able to speak about the financial condition
or regulatory treatment or rating of any individual financial institution.
The U.S. economy is currently expanding at a moderate pace, and strains in global financial
markets, although having eased recently, continue to pose significant downside risks to the
economic outlook. Because developments in Europe will have an important bearing on the
prospects for growth and jobs here in the U.S., the Federal Reserve is monitoring the
situation there closely. This is also why we have taken special steps in recent months,
together with other central banks, to support the flow of credit to households and businesses.
Europe
The economic situation in Europe has been unsettled for the better part of two years, with
pressure on sovereign debt markets and local banking systems. High debts, large deficits
and slow growth in several European countries have called into question the sustainability of
the entire euro area. The resulting strains in European markets have affected the
U.S. economy.
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 union on numerous occasions. And the leadership is working harder than ever to
achieve greater coordination in areas such as fiscal policy. A more robust and resilient
European Union would be a welcome development for the United States. Three recent
developments are especially encouraging in that regard.
First, liquidity concerns have eased significantly following the European Central Bank's
(ECB) long-term refinancing operations in December and February. Through this program,
the ECB provides three-year loans to European banks at low rates, accepting a wide array of
collateral in return. Hundreds of banks accessed the program in each operation, and the
ECB lent nearly €1 trillion in total. As a result, the cost of funding throughout Europe has
declined since the program began, the euro has stabilized, and the sovereign bond market
has improved. Changes in the ECB's collateral rules and reserve requirements have also
had a positive impact.
Second, earlier this month, the Greek government worked with European leaders and its
largest creditors to restructure the bulk of its €206 billion of outstanding privately-held bonds.
This not only reduced Greece's total indebtedness, it helped calm persistent worries that a
disorderly Greek default could become the trigger for a global economic crisis. Shortly after
the debt restructuring, the EU approved a €130 billion aid package for Greece. Together,
these measures will provide key support to Greek leaders as they pursue the difficult fiscal
reforms that are essential over the long term.
Third, leaders in most euro area countries have approved a new treaty designed to increase
fiscal coordination. The new rules already appear to be making a difference. Both Spain and
Italy recently completed 2012 budgets that move their deficits closer to EU targets. Further,
Spain and Italy took their fiscal actions in close consultation with finance ministers from other
countries in the euro area, demonstrating a healthy ability to work together. While difficult
work still lies ahead, countries in the euro area have made meaningful progress toward
achieving long-term fiscal sustainability.
Looking to the future, the difficult work that remains also presents special risks - both for
Europe and the United States. If Europe fails to chart an effective course forward, this could
have a number of negative implications here. In particular, there are three areas of potential
risk that I would like to highlight for the Subcommittee today.
First, if economic conditions in Europe were to weaken significantly, demand for U.S. exports
would decrease. This would hurt domestic growth and have a negative impact on U.S. jobs.
It is important to recognize that the euro area is the world's second largest economy after the
U.S. and an important trading partner for us. Also, Europe is a significant investor in the
U.S. economy, and vice versa. Thus, what happens in Europe has significant implications for
our economy.
Second, deterioration in the European economy could put pressure on the U.S. banking
system. As the recent round of stress tests revealed, U.S. banks are much more robust and
resilient than they were a few years ago. They have bolstered their capital significantly, built
up their loan loss reserves and have significantly larger liquidity buffers. The direct net
exposures of U.S. banks to the so-called "peripheral" European countries are actually quite
modest. The good news in the United States means that we are better able to handle bad
news from Europe.
With that said, the exposures of U.S. banks climb sharply when one also considers their
exposures to the core European countries and to the overall European banking system.
U.S. money market mutual funds, in particular, have significant European holdings. This
means that if the crisis were to broaden further and intensify, it would put pressure on the
capital and liquidity buffers of U.S. banks and other financial institutions.
Third, severe stresses in European financial markets would disrupt financial markets here,
which could harm the real economy. Stress in the financial markets causes banks to more
carefully husband their balance sheets. When that phenomenon occurs, the availability of
credit to U.S. households and businesses becomes constrained. Such conditions could also
cause equity prices to fall, impairing the value of Americans' pension and 401(k) holdings.
This would damage the U.S. recovery and result in slower output growth and less job
creation. At a time when U.S. unemployment is very high, this is a particularly unacceptable
outcome. In the extreme, U.S. financial markets could become so impaired that the flow of
credit to households and businesses would dry up.
U.S. dollar swaps
In today's globally integrated economy, banks headquartered abroad play an important role
in providing credit and other financial services in the United States. About $1 trillion in
worldwide dollar financing comes from foreign banks, $700 billion in the form of loans within
the U.S. For these banks to provide U.S. dollar loans, they have to maintain access to
U.S. dollar funding. At a time when it is already hard enough for American families and firms
to get the credit they need, we have a strong interest in making sure that these banks can
continue to be active in the U.S. dollar markets.
Banks headquartered outside the U.S. make extensive use of dollars in their financing
activities. In part, this results from the fact that the U.S. dollar is the world's number one
currency - a status that brings with it many benefits for our country. It is in our national
interest to make sure that non-U.S. banks remain able to access the U.S. dollar funding they
need to continue financing their U.S. dollar assets. If access to dollar funding were to
become severely impaired, this could necessitate the abrupt, forced sales of dollar assets by
these banks, which could seriously disrupt U.S. markets and adversely affect American
businesses, consumers and jobs.
One way we can help to support the availability of dollar funding, and ensure that credit
continues to flow to American households and businesses, is by engaging in currency swaps
with other central banks. Such swaps are a policy tool the Federal Reserve has used to
support dollar liquidity for nearly fifty years. Most recently, the Federal Reserve established
dollar swap lines with major central banks during the global financial crisis of 2008, and
reactivated them in May 2010. Last November, the FOMC, cooperating with five other central
banks, reduced the rate being charged on these swaps to increase usage.
The swaps are intended to create a credible backstop to support - but not supplant - private
markets. Banks with surplus dollars are more likely to lend to banks in need of dollars if they
know that the borrowing bank will be able to obtain the dollars it needs to repay the loan, if
necessary, from its central bank.
Ultimately, these dollar swaps are designed to support financial stability, and avoid an
unnecessary tightening in financial conditions, so that economic activity and job creation in
the United States can continue to recover. Our principal aim is to protect U.S. banks,
businesses and consumers from adverse economic trends abroad. I am pleased that the
swaps seem to be working. In conjunction with the ECB's long-term refinancing operations,
the swaps have helped European banks avoid the significant liquidity pressures we feared a
few months ago and have reduced the risk that they would need to sell off their U.S. dollar
assets abruptly.
Conclusion
In sum, 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 U.S. 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.
Thank you for your invitation to testify today, and I look forward to answering your questions.