15 December 2011

Douglas J Elliott: What the euro crisis means for taxpayers and the US economy

Testifying before the US House Subcommittee on TARP, Financial Services and Bailouts of Public and Private Programs, Douglas Elliott discusses the likelihood that the euro crisis will cause Europe to plunge into a deep recession and the US into a mild recession. Elliott warns that the crisis is likely to get worse before it gets better.

Potential solutions

Last week's Euro Summit took a number of useful steps that lay the groundwork for the ultimate solution to the problems. However, these steps focus on the medium-term, leaving considerable risk in the next three to nine months. During that time, it seems quite likely that something will spook the financial markets enough that Spain or Italy will find itself temporarily unable to borrow from the private markets at an acceptable interest rate. This would set in motion a degree of contagion across countries and in the financial sector that the eurozone leaders could not allow to continue. At that point, I believe they will finally bite the bullet and come up with a source of funds massive enough to reassure the markets that financing will be available from the public sector to the full extent needed.

The eurozone has the resources on its own to quell the crisis, if they utilise the full power of the European Central Bank (ECB) in combination with stabilisation mechanisms funded by the national governments in the eurozone. They have previously established the European Financial Stability Fund (ESFS) which has about €250 billion of untapped resources. This can be magnified modestly by various forms of financial leverage, although not to the extent eurozone leaders had previously hoped. The ESFS could also be bolstered by additional national commitments and by the upcoming European Stability Mechanism (ESM), which is a superior vehicle for providing support to troubled national governments and markets. The ESM is now slated to be up and running by the middle of next year.

The key, however, is likely to be the ECB. It has the power to create euros in unlimited amount, thereby giving it the financial punch to reassure the markets. Obviously, "printing money" can create unacceptable inflation if pursued to an excessive extent, but this does not appear likely to be a problem in the current context, given the recessionary conditions in Europe and the relatively small amount that would be needed in relation to the size of the European economy. There are also ways to offset the ECB's bond purchases to avoid expanding the money supply and the ECB has been doing such sterilisation to this point, although it need not continue to do so.

There are also political and institutional constraints on the ECB, however these could be overcome fairly straightforwardly if there is the political will in the eurozone to harness the ECB more fully. Ultimately, of course, governments should be taking these quasi-fiscal support actions, not the central bank, so it is critical that the eurozone has a method of passing the responsibility on to governments and government-created facilities over time.

The role for America

Although the eurozone could handle this crisis with its own resources, and clearly bears the key responsibility, there is likely to be a very useful role for the IMF to play. First, adding some IMF funding to the mix would help reassure financial markets that the total resources necessary would truly be available. Second, it would be a clear sign that the rest of the world stands ready to help Europe through its troubles, which should also be viewed positively by the markets. Most importantly, the IMF is in the best position to impose conditionality on lending to troubled eurozone countries, since it is viewed as more dispassionate and less political about Europe's situation than would be true for purely European institutions. It has the history and technical resources to credibly impose conditions on disbursements of funds as they are needed. Further, it can provide a great deal of technical advice, which is more likely to be taken when the IMF is also a provider of funding. We listen more carefully to people who are also providing us money.

The markets may need to see total resources of as much as €2 trillion credibly available to support Italy, Spain, and the other eurozone countries that could need support if the crisis gets worse. Knowing these funds are committed should reassure markets and reduce the amount of such public funds that have to be used in practice. However, the full amount must credibly be available in order for this reassurance to work.

I believe that the IMF's currently available funds, plus funds recently promised to the IMF from the eurozone and any matching funds other nations may provide, would be sufficient for the IMF's share of any comprehensive solution to the crisis. The IMF currently has available resources of a bit under $400 billion, the eurozone has pledged another €200 billion, and there are likely to be further funds from other countries. Therefore, I do not believe that additional US resources would need to be committed to the IMF to handle this crisis. The Europeans should provide the great bulk of the support, with the IMF funding providing a useful augmentation of sufficient size to ensure the IMF has the leverage to impose its conditionality effectively.

If we reach the point where a comprehensive package of up to €2 trillion is needed, and if the European governments and their central bank step up appropriately with a credible plan and the necessary resources, then the US should support an IMF role, for the reasons I have outlined. The risk to US taxpayers would be very low. The eurozone can solve its problems without further defaults, in which case neither the IMF nor private investors would lose money on lending to these countries. Even if one or more defaults were to occur, the IMF has an excellent track record of being repaid, principally because IMF loans are senior to other national obligations. Let me stress that. This is very different from the TARP programme, in that IMF loans are in the most favoured position available to a creditor, having a priority in repayment higher than other lenders. In the TARP programme, we deliberately put taxpayers in at an equity level, which is much riskier, in order to reassure other suppliers of funds that it was safe to continue to deal with the banks, thereby stabilising our financial system. Finally, in the extremely unlikely event that the IMF lost money anyway, we would absorb less than a fifth of the cost, since most IMF funds come from other nations, including European ones.

Our taxpayers and other citizens are already at great risk from the euro crisis. If it goes badly wrong, our citizens and the businesses they own will lose large sums of money both here and abroad. Federal government tax receipts will fall significantly, eventually requiring taxpayers to pay more than they would otherwise have done. Supporting IMF intervention would reduce the total risk to America by much more than the quite modest financial risk that our share of the IMF funding would represent.

There are a few other things that America can do, principally along the lines of the Fed swap facilities with the ECB and the provision of technical advice. However, this is a European problem and they will need to provide the backbone of any solution.

Full testimony

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