Feb.Senate Budget Committee Examines Outlook for the Eurozone
At a Senate Budget Committee hearing on February 1, lawmakers and panelists discussed the Eurozone crisis and its potential implications for the United States. Chairman Kent Conrad (D-N.D.) said the Eurozone crisis “has ramifications across the globe” and poses a clear threat to the U.S. economy. Conrad mentioned the fact that roughly one-quarter of U.S. exports go to Europe and that a slowdown in the region will have a “very real impact on U.S. manufacturers and workers.”
In his opening statement, Sen. Ron Johnson (R-Wis.), who filled in for Ranking Member Jeff Sessions (R-Ala.), said the debt and deficit issue in the U.S. is the “greatest threat our nation faces.” Johnson mentioned that total unfunded U.S. federal liabilities amount to $99 trillion and called that an “incomprehensible figure.”
Simon Johnson, Professor of Entrepreneurship at MIT, said fiscal mismanagement lies at the heart of Europe’s problems, adding that the Eurozone “has already failed.” He said Europe faces a “fiscal problem, on top of a competitiveness problem,” in addition to high debt levels and large trade imbalances. The downside to Europe entering a deep period of recession and austerity is that there will be spillovers to the financial system and megabanks “that are badly run and have far too little capital.” European leaders, “have not addressed those issues and made those systems safer,” Johnson said. While the U.S. economy is at risk, Johnson said there are three steps the U.S. and international organizations can take to mitigate the crisis. They are: 1) establishing protections around the U.S. financial system by suspending bank dividends to ensure financial institutions keep capital on their balance sheets and build up equity in case the Eurozone’s swap market collapses; 2) the Congressional Budget Office (CBO) should score the fiscal impact of a financial calamity and the dangers posed by our financial system as there are “serious, unfunded liabilities in this area;” and 3) the International Monetary Fund (IMF) should build a firewall outside the Eurozone to protect the “innocent bystanders” with whom the U.S. does a lot of trading.
In his opening testimony, Fred Bergsten, Director of the Peterson Institute for International Economics, said that while “Europe is in deep economic difficulty,” he does not see the potential for serial defaults or that the Eurozone will break apart. According to Bergsten, the EU has faced past crises and worked through them, built firewalls and created institutions to avoid a financial disaster, and that the EU members have an economic interest in maintaining the Eurozone. He added that Germany will pay whatever is necessary to keep the EU together and that the European Central Bank (ECB) will play “lender of last resort, even though they can’t say it.” Bergsten said the U.S. should support a successful resolution of the Eurozone problem, and that the IMF should be made available to lend more if necessary. The IMF funding should come from those countries with large trade surpluses, such as China, Russia, and Brazil. He added that the U.S. needs to take this Eurozone crisis as a “wakeup call” as CBO projections point to trillion dollar budget deficits every year for the next decade.
In his opening testimony, Adam Lerrick, Visiting Scholar at the American Enterprise Institute, said the EU crisis is not a currency crisis, but a fiscal crisis compounded by the failure of EU leaders to take corrective action. He called Europe’s woes a “self-inflicted crisis,” and that EU leaders “do not understand markets, do not like markets and believe they can control markets.” He added that disagreements between members of the Eurozone “erode market confidence.” Germany, Lerrick said, wants each EU member country to be responsible for its own fiscal well being, while Southern Europe believes their problems and woes are caused by Germany’s success. Germany has found two tools to enforce fiscal discipline, he said. These are: 1) market forces can prevail where diplomacy has failed as high interest rates can compel politicians to act; and 2) Germany removed the unanimity requirement on EU decisions. Turning to the U.S., Lerrick said no fiscal crisis has erupted yet as the U.S. currency continues to be the world’s reserve currency, but said countries around the world will begin to withdraw investment in the U.S. as “we have not kept up our end of the bargain” due to the U.S.’ failure to institute sound fiscal and economic policies.
Question & Answer Session
Conrad asked the panel to assess the adequacy of Basel III and describe the impact they are having on Europe’s current challenges. Johnson said the problems with Basel III are not only about increased capital requirements, but about how international governments think about how much capital is needed by using risk-weighted assets. He called risk-weighted assets “deeply flawed” and that the “way it’s being implemented is very problematic.” The current surcharge on banks “is not enough” to protect banks from potential massive losses stemming from the current European crisis, he said. To bolster financial stability, Johnson called for the suspension of dividend payments “across the board” that would be “well received.”
Bergsten said that regulators and international governments “should err on the side of caution, going to higher rather than lower capital requirements” to achieve financial stability. Bergsten said the current crisis has had little spillover to emerging market economies because they have faced recent crises and responded aggressively by opting for more risk-averse systems, including significantly higher capital requirements than those called for by Basel III. Johnson added that a 20 percent capital requirement “is not an unusual level of capital in these conservative systems that have previously faced crises.”
Lerrick said “every regulation will be circumvented,” and that regulators will always be one crisis behind. He added that banking “should be a boring business. It should not be a high flying business where you take risks,” and that it should be “very similar to a utility.”
Sen. Jeff Merkley (D-Ore.) focused on derivatives exposures and their “unknown nature.” Merkley said “it is an incredible thing that just in this European and American sector we can’t quite get our hands around who is underwriting, who is holding, and what happens if companies have to perform on those insurance contracts.” Merkley asked the panel whether banning naked shorts is “valuable or not.” Johnson said some financial institutions are still banned from shorting sovereign debt and that this is a “somewhat misguided approach.” He added that a lot of people in the markets want to insure against risk and use the credit default swap (CDS) market “if this were a transparent market.” Currently the market is not transparent and megabanks are able to quickly take proprietary trading positions to “bet the house,” Johnson said Instead of banning “this or that financial instrument,” Johnson suggested it is better to move these markets toward greater transparency rather than shift the risks to more “murkier areas” as a result of a ban.
Merkley then asked whether efforts are underway in Europe to create clearing houses and exchanges. Johnson said “not at the level that would matter,” and European leaders are “dragging their feet on this.” He added that the “lack of transparency in this huge market… is deeply troubling.” Bergsten said a fundamental problem in the European financial regulatory context is that “they still do it largely at the national level,” and still have not gotten the European monetary union to encompass European-wide financial regulation. Derivatives and other financial instruments “cry out for international regulation,” Bergsten said. Bergsten added that the Basel III regulations are “inadequate” and that “one of these days we have to take a leap and do a globalized Dodd-Frank.”
Conrad asked the panel whether the Federal Reserve, if faced with another financial crisis, has the ability along with the U.S. Treasury, to “take over” troubled financial institutions. He also asked the panel whether the Federal Reserve has the ability to guarantee money market funds as they did during the previous crisis. Johnson said such authorities cannot bailout individual companies, nor put taxpayer money at risk in the same way as the AIG bailout. Johnson added there is “broad authority” to liquidate a systemically important institution in an orderly manner, which will buffer the financial system at the same time. He added that the Federal Deposit Insurance Corporation (FDIC) is “moving in the right direction” and that the “ability to credibly threaten to bankrupt such a company” without using the bankruptcy code, “that’s a very sensible goal,” he said. If the market believes other megabanks could fail, “then those megabanks would not be able to borrow so cheaply, would not be able to take on big risks” and take on massive exposures across borders. On money market funds, Johnson said the Federal Reserve powers are “much more constrained” relative to 2008, but former and current Fed officials have said that “when needed, they will come in and save the day, which I think will include guaranteeing money markets.”
Conrad responded that the Federal Reserve Chairman Ben Bernanke told Conrad on Tuesday that “he does not believe they would be able to guarantee money market funds as they did in the 2008 crisis.”
Lerrick said that no matter what the regulations say or what law Congress has written, “when push comes to shove … every government will forgo the rule of law and change the rules right then and there.” He pointed to the Chrysler bankruptcy as a case in point.
Bergsten said he is “not sure you’d even have to ignore the law” as the International Economic Emergency Powers Act, which applies to U.S. international financial economic involvement, could be invoked to do almost anything. He added that the law gives the executive branch the authority “to do almost anything under the guise of dealing with an international economic emergency.”
For testimony and a webcast of the hearing, please click here.
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At a Senate Budget Committee hearing on February 1, lawmakers and panelists discussed the Eurozone crisis and its potential implications for the United States. Chairman Kent Conrad (D-N.D.) said the Eurozone crisis “has ramifications across the globe” and poses a clear threat to the U.S. economy. Conrad mentioned the fact that roughly one-quarter of U.S. exports go to Europe and that a slowdown in the region will have a “very real impact on U.S. manufacturers and workers.”
In his opening statement, Sen. Ron Johnson (R-Wis.), who filled in for Ranking Member Jeff Sessions (R-Ala.), said the debt and deficit issue in the U.S. is the “greatest threat our nation faces.” Johnson mentioned that total unfunded U.S. federal liabilities amount to $99 trillion and called that an “incomprehensible figure.”
Simon Johnson, Professor of Entrepreneurship at MIT, said fiscal mismanagement lies at the heart of Europe’s problems, adding that the Eurozone “has already failed.” He said Europe faces a “fiscal problem, on top of a competitiveness problem,” in addition to high debt levels and large trade imbalances. The downside to Europe entering a deep period of recession and austerity is that there will be spillovers to the financial system and megabanks “that are badly run and have far too little capital.” European leaders, “have not addressed those issues and made those systems safer,” Johnson said. While the U.S. economy is at risk, Johnson said there are three steps the U.S. and international organizations can take to mitigate the crisis. They are: 1) establishing protections around the U.S. financial system by suspending bank dividends to ensure financial institutions keep capital on their balance sheets and build up equity in case the Eurozone’s swap market collapses; 2) the Congressional Budget Office (CBO) should score the fiscal impact of a financial calamity and the dangers posed by our financial system as there are “serious, unfunded liabilities in this area;” and 3) the International Monetary Fund (IMF) should build a firewall outside the Eurozone to protect the “innocent bystanders” with whom the U.S. does a lot of trading.
In his opening testimony, Fred Bergsten, Director of the Peterson Institute for International Economics, said that while “Europe is in deep economic difficulty,” he does not see the potential for serial defaults or that the Eurozone will break apart. According to Bergsten, the EU has faced past crises and worked through them, built firewalls and created institutions to avoid a financial disaster, and that the EU members have an economic interest in maintaining the Eurozone. He added that Germany will pay whatever is necessary to keep the EU together and that the European Central Bank (ECB) will play “lender of last resort, even though they can’t say it.” Bergsten said the U.S. should support a successful resolution of the Eurozone problem, and that the IMF should be made available to lend more if necessary. The IMF funding should come from those countries with large trade surpluses, such as China, Russia, and Brazil. He added that the U.S. needs to take this Eurozone crisis as a “wakeup call” as CBO projections point to trillion dollar budget deficits every year for the next decade.
In his opening testimony, Adam Lerrick, Visiting Scholar at the American Enterprise Institute, said the EU crisis is not a currency crisis, but a fiscal crisis compounded by the failure of EU leaders to take corrective action. He called Europe’s woes a “self-inflicted crisis,” and that EU leaders “do not understand markets, do not like markets and believe they can control markets.” He added that disagreements between members of the Eurozone “erode market confidence.” Germany, Lerrick said, wants each EU member country to be responsible for its own fiscal well being, while Southern Europe believes their problems and woes are caused by Germany’s success. Germany has found two tools to enforce fiscal discipline, he said. These are: 1) market forces can prevail where diplomacy has failed as high interest rates can compel politicians to act; and 2) Germany removed the unanimity requirement on EU decisions. Turning to the U.S., Lerrick said no fiscal crisis has erupted yet as the U.S. currency continues to be the world’s reserve currency, but said countries around the world will begin to withdraw investment in the U.S. as “we have not kept up our end of the bargain” due to the U.S.’ failure to institute sound fiscal and economic policies.
Question & Answer Session
Conrad asked the panel to assess the adequacy of Basel III and describe the impact they are having on Europe’s current challenges. Johnson said the problems with Basel III are not only about increased capital requirements, but about how international governments think about how much capital is needed by using risk-weighted assets. He called risk-weighted assets “deeply flawed” and that the “way it’s being implemented is very problematic.” The current surcharge on banks “is not enough” to protect banks from potential massive losses stemming from the current European crisis, he said. To bolster financial stability, Johnson called for the suspension of dividend payments “across the board” that would be “well received.”
Bergsten said that regulators and international governments “should err on the side of caution, going to higher rather than lower capital requirements” to achieve financial stability. Bergsten said the current crisis has had little spillover to emerging market economies because they have faced recent crises and responded aggressively by opting for more risk-averse systems, including significantly higher capital requirements than those called for by Basel III. Johnson added that a 20 percent capital requirement “is not an unusual level of capital in these conservative systems that have previously faced crises.”
Lerrick said “every regulation will be circumvented,” and that regulators will always be one crisis behind. He added that banking “should be a boring business. It should not be a high flying business where you take risks,” and that it should be “very similar to a utility.”
Sen. Jeff Merkley (D-Ore.) focused on derivatives exposures and their “unknown nature.” Merkley said “it is an incredible thing that just in this European and American sector we can’t quite get our hands around who is underwriting, who is holding, and what happens if companies have to perform on those insurance contracts.” Merkley asked the panel whether banning naked shorts is “valuable or not.” Johnson said some financial institutions are still banned from shorting sovereign debt and that this is a “somewhat misguided approach.” He added that a lot of people in the markets want to insure against risk and use the credit default swap (CDS) market “if this were a transparent market.” Currently the market is not transparent and megabanks are able to quickly take proprietary trading positions to “bet the house,” Johnson said Instead of banning “this or that financial instrument,” Johnson suggested it is better to move these markets toward greater transparency rather than shift the risks to more “murkier areas” as a result of a ban.
Merkley then asked whether efforts are underway in Europe to create clearing houses and exchanges. Johnson said “not at the level that would matter,” and European leaders are “dragging their feet on this.” He added that the “lack of transparency in this huge market… is deeply troubling.” Bergsten said a fundamental problem in the European financial regulatory context is that “they still do it largely at the national level,” and still have not gotten the European monetary union to encompass European-wide financial regulation. Derivatives and other financial instruments “cry out for international regulation,” Bergsten said. Bergsten added that the Basel III regulations are “inadequate” and that “one of these days we have to take a leap and do a globalized Dodd-Frank.”
Conrad asked the panel whether the Federal Reserve, if faced with another financial crisis, has the ability along with the U.S. Treasury, to “take over” troubled financial institutions. He also asked the panel whether the Federal Reserve has the ability to guarantee money market funds as they did during the previous crisis. Johnson said such authorities cannot bailout individual companies, nor put taxpayer money at risk in the same way as the AIG bailout. Johnson added there is “broad authority” to liquidate a systemically important institution in an orderly manner, which will buffer the financial system at the same time. He added that the Federal Deposit Insurance Corporation (FDIC) is “moving in the right direction” and that the “ability to credibly threaten to bankrupt such a company” without using the bankruptcy code, “that’s a very sensible goal,” he said. If the market believes other megabanks could fail, “then those megabanks would not be able to borrow so cheaply, would not be able to take on big risks” and take on massive exposures across borders. On money market funds, Johnson said the Federal Reserve powers are “much more constrained” relative to 2008, but former and current Fed officials have said that “when needed, they will come in and save the day, which I think will include guaranteeing money markets.”
Conrad responded that the Federal Reserve Chairman Ben Bernanke told Conrad on Tuesday that “he does not believe they would be able to guarantee money market funds as they did in the 2008 crisis.”
Lerrick said that no matter what the regulations say or what law Congress has written, “when push comes to shove … every government will forgo the rule of law and change the rules right then and there.” He pointed to the Chrysler bankruptcy as a case in point.
Bergsten said he is “not sure you’d even have to ignore the law” as the International Economic Emergency Powers Act, which applies to U.S. international financial economic involvement, could be invoked to do almost anything. He added that the law gives the executive branch the authority “to do almost anything under the guise of dealing with an international economic emergency.”
For testimony and a webcast of the hearing, please click here.