Bernanke: U.S. Recovery Might Not Survive Another European Recession

In an economic policy hearing before Congress, the Federal Reserve chairman addressed some vital questions about the U.S. economy

600 bernanke REUTERS Kevin Lamarque.jpg

Congress got a few hours to grill Federal Reserve Chairman Ben Bernanke on Capital Hill today. In a hearing before the Joint Economic Committee, the nation's top Central banker provided an update on his economic outlook. Little new was said. But once he began taking questions Bernanke provided some interesting comments on a number of important issues facing the economy.

Unemployment and the Twist

Of course, one of the biggest problems on the minds of some members of Congress was unemployment. Bernanke explained the Fed's new efforts to help in his prepared testimony. But he was also asked what would be achieved. According to Bernanke, Operation Twist -- the policy through which the Fed will sell shorter-term securities and buy longer-term securities -- should push down longer term interest rates by about 20 basis points. He also said that this would be equivalent to a 50 basis point decline in the Federal Funds Rate. Of course, the Fed can't push that rate any lower, since it's already being held close to zero.

This provides some color as to how much impact the Twist might have, but it doesn't tell the entire story. Mortgage interest rates could fall by even more than 20 points, due to the Fed's other new policy of reinvesting mortgage securities.

Greece and the EU

Possibly the most pertinent problem to the U.S. economic recovery is how the European debt crisis shakes out. In particular, Bernanke was asked about the effect of a Greek default on the U.S., which at this point looks more and more inevitable. Direct exposure of U.S. banks to Greece is minimal, he said.

Instead, Bernanke worried more about how the default occurs. If it's messy, then Europe could bring down the U.S. with it. But Bernanke asserted that if orderly default occurs, then the U.S. banks should be fine. He further stressed, however, that banks have stronger oversight and much more capital than they did in 2008 to avoid a financial crisis if sizable losses arise from their European exposure.

Bernanke was also asked what the U.S. central bank is doing to help. He explained that the Fed has a swap line with the European Central Bank. This allows the ECB to trade euros for dollars. So if ECB runs into liquidity problems, dollar infusions could help.

The Fed chairman insisted that this swap arrangement would not lead to losses, because the Fed isn't providing a loan. But I wonder: if the euro declines in value due to a European crisis worsening after a large swap transaction occurs, couldn't the Fed's balance of euros result in a loss?

Bailouts and Too Big To Fail

Bernanke was also asked about what help the Fed would provide U.S. institutions if another crisis occurs. He stressed that, due to last summer's Dodd-Frank financial regulation bill, the Fed could no longer bail out specific institutions like it did with AIG and others during the 2008 crisis. But the Fed does remain the lender of last resort, said Bernanke, and could provide a broad-based lending program to avoid liquidity problems if banks' funding dried up.

But could another financial crisis result in the need for Congress to bail out banks again? Bernanke doesn't think so. He pointed to the reforms that Dodd-Frank provided. Those included stricter supervision, additional capital, and the non-bank resolution authority -- a new mechanism through which the government could wind-down large failing financial firms. Although he said he could not completely rule out the need for more bailouts in the future, he did not believe that would be necessary due to these changes.

Overall, Bernanke appears to believe that the recovery has weakened since earlier this year but that a double dip is not inevitable. It sounds like he thinks that it depends, in large part, on what happens in Europe. If the situation there does not spiral out of control, then the slow recovery may continue. But if Europe gets messy, then the U.S. could be in trouble.