27 March 2012

William C Dudley: The economic and fiscal challenges facing Europe

Testimony by William C Dudley, President and CEO 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, on 27 March, 2012.

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 programme began, the euro has stabilised, 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 US exports would decrease.
• Second, deterioration in the European economy could put pressure on the US banking system. 
• Third, severe stresses in European financial markets would disrupt financial markets here, which could harm the real economy. 

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 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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