Chairman Miller, Ranking Member McCarthy, and members of the subcommittee, thank you for having me here today. My name is Douglas Elliott. I'm an economics research fellow at the Brookings Institution, but I'm here in a personal capacity and not representing the institute, which has no policy positions.
The euro crisis is of great concern, in part because the path it takes is likely to be a key determinant of whether the United States slips into another recession. I am convinced that if a series of countries default on their government debts and Europe is shaken, the continent will fall into a deep recession. Their recession, though less severe, will precipitate our own through many transatlantic connections.
First, there is trade. More than $400 billion of exports went to the EU in 2010[1]. One should expect a large part of this to be lost while Europe is in deep recession. At the same time, European companies are likely to gain market share at the expense of U.S. sales and jobs, as a weak euro and difficult sales within Europe spurred increased export efforts. Outside of Europe, emerging market countries such as China also export significant amounts to Europe, and growth will likely slow significantly. Our exports to those countries will suffer.
The second is investment. U.S. companies have invested more than $1 trillion in direct investments in the European Union. Profits from these businesses, which are important to global companies, will decline significantly. We also have significant investments in other countries outside Europe that will experience similar simultaneous economic decline.
Third, there is the flow of funds. U.S. banks and their subsidiaries have $2.7 trillion in loans and other commitments to governments, banks and companies in the euro area, and about $2 trillion more in exposure to the UK.[2]. American insurance companies, mutual funds, pension funds, and other entities also make significant contributions to Europe. Credit losses will hinder our progress in overcoming the financial crisis. These losses will be further exacerbated by problem lending in other parts of the world, including our country, caused by global economic problems.
Fourth, the impact on business and consumer confidence. In August, we saw some of this as Europe's problems were quickly reflected in our financial markets and confidence levels. Individuals and businesses are already feeling the fear. If the situation in Europe worsens, they will cut back on spending and investment even further.
The effects of these four channels taken together are almost certainly enough to send us back into recession, but the impact remains uncertain, especially since there are numerous scenarios for exactly how the euro crisis could explode. It is difficult to quantify accurately.
Even if the process is ugly and frightening, Europe will probably have a difficult time. But there is probably a one-in-four chance of a really bad outcome, leading to a series of sovereign debt defaults including Greece, Portugal, Ireland, Spain and Italy. There is also a small chance that one or more countries will leave the euro, which would cause even greater damage. My estimate of his probability of 1 in 4 is necessarily very rough. The eurozone is made up of 17 countries with their own political, economic and financial systems, so there are many ways things can go wrong. The probability of each risk is low, but because there are many of them, they add up. I have attached a short document that explains more about this crisis, in particular why it is so difficult to resolve, and how we will move forward. This paper is also available on the internet: https://www.brookings.edu/papers/2011/0822_euro_crisis_elliott.aspx
The measures expected to be announced this week may well improve the situation, but they will fall far short of solving the fundamental problem. First, government leaders are reluctant to increase national commitments to the European Financial Stability Facility beyond the previously agreed €440 billion, especially since much of it has already been committed. Therefore, it is clearly not enough to reassure the market. They are therefore looking for ways to leverage these funds to bring them closer to the roughly 2 trillion euros of production capacity they actually need. This appears to be done by providing guarantees and insurance for a portion of the value of bonds issued by troubled eurozone countries. Although better than doing nothing, it is unlikely that markets in these countries will recover as normal. When investors in Greek bonds are about to suffer losses of 40-60%, it's no less comforting to know that the first 20% of potential losses in Portuguese or Italian bonds will be absorbed by someone else. It's not a thing. The types of investors who are attracted to such guarantees are those seeking high returns from somewhat risky investments, which means that even with such guarantees in place, the interest rates paid by these governments will be significantly lower. suggests that it is not possible. Instead, the government bond market requires much greater capacity and liquidity, provided by investors seeking safe and liquid investments. That won't happen unless we fix the underlying problems or provide guarantees from more credible countries and multilateral institutions.
Second, although progress has been made in the recapitalization of banks, which will add approximately 100 billion euros in capital, investor concerns remain. The IMF recently estimated that sovereign debt problems have eroded at least €200 billion of economic capital from European banks. Adding half that number is unlikely to shock the market. To put it another way, 100 billion is equivalent to about one-tenth of the roughly 1 trillion euros of capital already held by Europe's 90 largest banks, which are subject to the new requirements. It also accounts for less than 0.5 percent of the €27 trillion in assets held by these banks.
The technical details of the recapitalization will be equally important. If poorly designed, the plan could do more harm than good by encouraging European banks to cut lending and sell existing assets, potentially triggering fire sales like the one that contributed to the 2008 financial crisis. It even has sex. A severe credit crunch is likely to push Europe into recession.
Third, if market concerns about other troubled eurozone countries rise again at some point, powerful investors could “voluntarily” accept losses of 40-60% on Greek government bonds. This will certainly increase the risk of infection.
Whatever happens this week, it would be wise to be prepared in case the crisis worsens. We should continue to strongly encourage European countries to take the necessary measures. We should continue to provide US dollar swaps to the European Central Bank so that they can be used to support banks with their dollar-based funding needs. Our regulators need to continue to monitor the exposure of our financial institutions to European risks, without overreacting and exacerbating the euro crisis.
Finally, we need the IMF to be ready to consider ways to provide further support to Europe. While the euro area has collective resources to solve its own problems, the IMF's participation brings multiple benefits. First, the total amount of resources increases to reassure a highly volatile market. Second, by attaching conditions to loans, a certain degree of discipline can be imposed on the borrower, making it easier for outsiders to make demands. Third, it can provide considerable technical assistance in dealing with economic restructuring, such as is required in this case. This technical advice is even more relevant when the IMF is also committing money.
This is a European problem and they will have to provide the backbone of any solution, but it is very much in our interests to help in the most reasonable way possible.
Thank you for the opportunity to testify. We welcome any questions you may have.
footnote
[1] I usually use figures for the European Union rather than the narrower Eurozone. Because the UK and other EU member states that don't use the euro have very close ties to eurozone countries, so I think those countries will also be severely affected.
[2] My colleague Domenico Lombardi has detailed financial exposures in testimony before the Senate, available at https://www.brookings.edu/testimony/2011/0922_european_debt_crisis_lombardi.aspx.
