Why America Won't Let the EU Fail

They say "no" now, but Obama, Bernanke (and even Romney) would do what they could to fund a euro bailout.

If Europe is threatened with a dire financial crisis, the United States will rush in with a helping hand, despite the insistence of President Obama and other U.S. leaders that taxpayer money would not be committed for this purpose. Europe would have to shoulder the heaviest load, but if those efforts proved inadequate, there is no doubt the U.S. would join. That’s because a collapse of Europe’s financial system would probably cause a worldwide economic downturn and plunge the U.S. into a deep recession.

POLL: Should the U.S. Help with a Euro Zone Bailout? (opens in new tab)

The aid, if needed, would flow mainly through the Federal Reserve, which has ample authority to lend trillions of dollars to such a rescue. Further assistance could include effective commitments from the U.S. Treasury through multilateral lenders such as the International Monetary Fund.

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Politics lies behind the official denials from Obama and Federal Reserve Chairman Ben Bernanke. Conservatives have been harshly critical of debt piled up by the Treasury and the Fed since late 2008, even though most economists say this spending and lending was needed to avert a U.S. depression. And the general public is both worried about government debt and suspicious of the Fed lending to foreigners.

By publicly stating his opposition to U.S. help for Europe, Obama avoids a distracting debate about a euro crisis while he’s on the campaign trail. And though GOP presidential candidate Mitt Romney says he strongly opposes any U.S. funding of help for Europe, you can bet that as president, he too would allow it to flow to contain a global financial slump.

Meanwhile, Bernanke measures his words carefully: He has told Congress he has “no intention” of approving a euro bailout, but has also said that Europe’s problems threaten “significant harm” to the U.S. economy and that the Fed “stands ready to do whatever is necessary to protect our financial system.”

Bernanke fends off questions about help for Europe by claiming he doesn’t have the authority to act. But that’s not true. Long-held Fed emergency powers give it broad authority to lend unlimited amounts of money to governments or even private sector banks in the name of preserving financial stability. Although a vote of the Federal Reserve’s board is needed for some actions, Bernanke can act on his own to stabilize the U.S. dollar. The president can’t fire him before his term ends in 2014, and Congress’ only recourse would be to pass legislation curbing the Fed’s powers, which wouldn’t and couldn’t happen quickly or easily.

The first tool Bernanke would likely use to help Europe doesn’t even require invoking emergency power: currency liquidity swaps. Under a 2007 agreement with the European Central Bank, renewed most recently last November, the Fed can lend unlimited amounts of money to the ECB by purchasing euros with dollars. While these are supposed to be short-term loans, repaid by selling euros later, there is no reason why the Fed could not hold euros indefinitely.

Could such swaps be used for large loans to Europe? They already have. In 2008 and 2009, the Fed loaned over $500 billion to Europe, and after the euro crisis heated up again late last year, the outstanding balances of these swaps went from zero to over $100 billion in February.

Dollar swaps could be crucial if a sharp escalation of the ECB’s lending for bailouts leads investors to flee the euro, driving down its value. Using this route, the Fed could lend billions or trillions, holding on to its euros for years. And American taxpayers would effectively be on the hook. If the euro governments and then the ECB were to default, the ensuing loss, felt in a plunge in the value of the dollar and in higher interest rates, would be the same as if Uncle Sam had sent the money in cash. Even an orderly repurchasing of those dollars later would affect U.S. rates in less noticeable ways. The bottom line is that the Fed’s actions would have an effect similar to a loan from the Treasury.

Arresting a serious and ongoing crisis would probably require the Fed to take a further step, purchasing large amounts of euro-denominated debt -- something it has never done before. This would probably happen in concert with China and other nations and be billed as global response. Still, the political reaction in the U.S. would be severe, and elected leaders might not jump to the Fed’s defense.

That wouldn’t stop Bernanke from taking this step, if he decided it was needed. He’s effectively a lame duck. Few people believe Bernanke wants to serve a third term, beyond January 31, 2014. Even if he did, Romney wouldn’t reappoint him, and if Obama is reelected, Republicans who have become harshly critical of Bernanke’s policies would block his nomination in the Senate.

So he’s free to act on his conscience and would take the Fed into uncharted waters to stop a global crash. That’s just what he did in 2008. Back then, Congress and the White House stalemated over the idea of buying up mortgage debt, so the Fed did it instead, purchasing $1.2 trillion worth. It was a brave and crucial step in arresting the crisis, and it showed that one of the most important duties of a Fed chairman is to take risky and unpopular action to avert economic disaster, especially when no one else will.

John Maggs
Senior Economics Editor, The Kiplinger Letter