BUSINESS

Federal Reserve Ready To Shield U.S. From Eurozone Crisis

11/29/2011 06:57 pm ET | Updated Nov 29, 2011

As the eurozone crisis continues to develop, pressure for the European Central Bank to act is mounting. Many want the ECB to bail out troubled European countries and their banks, much like the U.S. Federal Reserve did for some American and foreign banks during the financial crisis of 2008. But so far, the ECB has rejected those calls.

President Barack Obama said on Monday at a meeting with E.U. leaders that the U.S. would be willing to help Europe stave off an economic meltdown. But since Congress would likely stand in the way of increased foreign aid, the question arises: If the ECB doesn't act, could the Federal Reserve, which is independent of Congress, step in and rescue the eurozone?

Most economists said the Federal Reserve probably wouldn't go out on a limb to save Europe from an economic meltdown, but said it's already trying to minimize the potential fallout for the European banking system and the United States. Still, it's not a wild question: "Ultimately everybody in the markets believes that the lender of last resort is really the Federal Reserve," Nicholas Economides, an economics professor at New York University's Stern School of Business, told The Huffington Post earlier this month.

It would be difficult for the Federal Reserve to become the lender of last resort for troubled European governments because of self-imposed and political constraints, and it most likely does not want to be in that position, according to economists who are watching the situation.

"The way they have always looked at things was: "'We are the central bank of the United States; we are not the central bank of the world,'" said Jay Bryson, global economist at Wells Fargo Securities, who worked for the Federal Reserve in the 1990s. "If the Germans aren't willing to buy Italian government debt, why should we?"

"Any sort of creativity that you'll see from the Federal Reserve over the next few months, I think, is going to be more on how does this prevent the fallout from coming on the U.S. banking system, rather than actively trying to prop up the European banking system," he added.

As a practical matter, it is unclear whether the Federal Reserve could take the ultimate step toward saving the eurozone: buying hundreds of billions of dollars in troubled European government debt in order to prevent European governments from going bankrupt, which could potentially cause the eurozone to break apart. The Fed did not respond to requests for comment, and regional Federal Reserve banks declined to comment, did not respond to requests or admitted that they did not know the answer.

In the past, the Federal Reserve has acknowledged a simultaneous ability and refusal to bail out other countries. Ben Bernanke, now chairman of the Federal Reserve, said in 2002 the Federal Reserve can buy large amounts of foreign government debt -- in fact, "several times the stock of U.S. government debt." A footnote to Bernanke's speech clarified that the Fed has made a commitment to Congress not to "'bail out' foreign governments," so "in practice it would purchase only highly rated foreign government debt."

The Fed could did not respond to requests for comment as to the minimum credit rating for foreign government debt that could be purchased, as well as whether its promise to Congress not to buy risky foreign government debt is informal or actually in the law.

The Federal Reserve is restricted in its ability to buy foreign government debt. Richard DeKaser, deputy chief economist at Parthenon Group, said that the Fed can buy only highly rated foreign government bonds. For example, he said it could buy German sovereign debt because its credit rating is AAA, but "buying Greek debt would be out of the question because its credit rating is so low." Buying German sovereign debt would be irrelevant because investors still are willing to purchase German bonds, he added.

Diane Swonk, senior managing director and chief economist at Mesirow Financial, said the Federal Reserve only can buy debt with significant collateral, which would limit its ability to buy troubled sovereign debt, though she did not mention credit ratings.

Nonetheless, the Federal Reserve would be unlikely to want to buy large amounts of troubled European sovereign debt -- not only because it views its obligations as primarily to the United States, but also because such a move would attract unwanted political antagonism, Bryson said.

President Obama recently expressed his commitment to helping Europe navigate its way through the sovereign debt crisis, though he was vague as to what that help would entail.

"I communicated to them that the United States stands ready to do our part to help them resolve this issue. This is of huge importance to our economy," Obama said Monday.

The Federal Reserve already is helping Europe prevent its sovereign debt crisis from turning into a full-blown credit crunch. It opened a credit line to the European Central Bank last year that allows European banks with sufficient collateral to borrow an unlimited amount from the ECB, which would be receiving funds from the Federal Reserve. The Federal Reserve also allows European banks with U.S. branches to borrow an unlimited amount from the Federal Reserve as long as they post sufficient collateral.

"It will limit the severity of any ensuing credit crunch," DeKaser said.

The Federal Reserve also has taken steps to try to prevent a panic threatening the solvency of U.S. banks and companies. The Fed announced last week that it would require the U.S.'s 19 largest financial institutions to undergo stress tests, which Swonk said would allow American banks to prove to investors that they have the resources needed to be able to weather an economic meltdown in Europe.

"They're not doing the stress tests unless they knew the banks really could raise the capital and pass them," Swonk said. "The Fed is trying to make sure the spillover just doesn't hit us too much."

In addition, the Federal Reserve could introduce another round of buying mortgage-backed securities to lower long-term interest rates, a process dubbed quantitative easing, some economists said. Another monetary stimulus would help shore up economic growth in the United States "and ultimately abroad," DeKaser said.

But, DeKaser added, when it comes buying troubled European sovereign debt in order to prevent countries from defaulting, "the ball is very much in the European Central Bank's court."

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