Hobbled by political uncertainty and a European-wide debate over the merits of austerity versus growth policies, the eurozone sovereign debt crisis is once again putting the global economic recovery at risk (NYT). The world's number one economy, fragile and hampered by slow growth, is not immune. "The U.S. is tied into the global economy through interest rates, through trade, through exchange rates, through credit spreads, through bank borrowing costs, and so if Europe spirals downward, it will certainly impact us," explains economist Richard H. Clarida. The unraveling of the eurozone would have a serious indirect impact on the U.S. financial system by re-pricing risk upward while pushing stocks down, Clarida argues. At the same time, Clarida says, as the U.S. dollar rises and the euro falls, the United States faces the possibility of a "headwind to exports."
How is the U.S. financial sector exposed to the eurozone? And what are possible developments in the eurozone sovereign debt crisis that might put the U.S. financial sector at serious risk of contagion?
There are several channels of exposure between U.S. institutions and Europe. Obviously, there's direct exposure. But that's relatively modest from the point of view of branches of U.S. banks holding securities against Europe. But obviously U.S. banks are global and have operations in many of the European countries.
Were there to be an unraveling or severe dislocation [in the eurozone], then the contagion would not be directly on the balance sheet [of U.S. banks], but on just the overall re-pricing of risk.
Were there to be an unraveling or severe dislocation, then the contagion would not be directly on the balance sheet [of U.S. banks], but on just the overall re-pricing of risk. The cost of the capital of the banks would go up, spreads would go up--and as credit spreads rise, the assets on banks balance sheets would lose value, even if not directly tied to Europe. So clearly, a disorderly Greek exit or just unraveling of the commitment to the Eurozone would have serious repercussions in the U.S.--over and above any direct exposure.
What are the implications of the euro crisis for U.S. business confidence and U.S. household wealth?
The channels are indirect, so that when concerns about the crisis are elevated, we do see several impacts. One--we tend to see U.S. interest rates fall, at least on government bonds, so that's a good thing. On the other hand, credit spreads and the cost of borrowing tends to rise because of general riskiness. Also, stock prices fall, and our ability to export is hurt if the rest of the world is not doing well. On balance, it is a negative for the economy when Europe is under duress.
What are the implications of the euro crisis for mortgage rates for average U.S. citizens?
On balance, it is a negative for the [U.S.] economy when Europe is under duress.
Mortgage rates are historically quite low--in part because of the Fed's policy of keeping interest rates low, but also because there is a flight to quality bid, a flight to safety bid now. We see it every time there is disruption globally--people want to buy Treasuries, and that factor has been a very important development that has been keeping mortgage rates low. Most mortgages now are Fannie Mae and Freddie Mac, which are under a conservatorship arrangement with the U.S. government. They're about as close as full faith and credit as you can get to government securities, so they benefit from that flight to quality. Importantly, before the summer of 2008, before Fannie and Freddie had that designation, we did see a lot of disruption in the mortgage market. But I think the combination of Treasury policy and Fed action has really made mortgages trade pretty closely to Treasuries--so they tend to benefit from that.
In terms of the flight to safety, how does a weakening euro and rising dollar affect the U.S. economy, particularly in terms of the potential spike in the cost of U.S. exports?
It's a matter of degree. Right now the euro has moved from a peak of $1.46 about a year ago down to $1.26 now, and that's a pretty significant move. Although policymakers in Europe are discreet about this, they're not unhappy that the euro is at $1.25; it's good for not only a powerhouse like Germany, but its good for the periphery on balance. And the movement in the dollar that we see, at least on a broad index, is not, to date, a huge headwind to exports. Obviously, if we were to get another 20 percent move more broadly, that would be a different story. But I basically think that currencies broadly have readjusted to reasonable levels at this point. Any further crisis definitely runs into becoming a headwind for U.S. exports.
What can U.S. leaders do to protect the U.S. economy from the euro crisis, and to influence European policymakers?
The movement in the dollar that we see, at least on a broad index, is not, to date, a huge headwind to exports.
Secretary Geithner has been very involved in interfacing with his counterparts in the European finance ministries. He has a lot of views about that. He has publicly said that he's told them that they need to try and get ahead of the curve. Obviously the U.S. made a lot of mistakes [in the 2007-2009 financial crisis] but one thing certainly that the U.S. got right was once we had the crisis--and once it became clear it was a threat to the economy and financial system--we did get bold action. In particular, we decided to use 2009 as a year to stress test our banks in a credible way and then to recapitalize those banks that needed to be recapitalized, and to discourage them from paying out dividends until they had recapitalized. The UK did something similar and that was a very favorable development. The challenge that Europe faces now is that they really didn't make that hard decision to go that road in 2009, and here they are in 2012 trying to now recapitalize and stress test their banks in a credible way--in a much more challenging environment. That would be the sort of general advice that U.S. officials are sharing with Europeans--to try and get ahead once and for all on the banking problems.
Are there any final thoughts you would like to share regarding eurozone debt contagion to the U.S. and global economies?
We're all in this together. The U.S. is tied into the global economy through interest rates, through trade, through exchange rates, through credit spreads, through bank borrowing costs, and so if Europe spirals downward, it will certainly impact us. There are limits to what we can do. The IMF, for example, has done an excellent study just about six months ago that indicated that were Europe to tip into a major recession, which they defined as a 3.5 percent decline in GDP, then that would tip the U.S. into a recession, too--regardless of the Fed's policy response.