May 20, 2010 / 3:18 PM / 10 years ago

Fed's Tarullo says Europe crisis threatens U.S. economy

WASHINGTON (Reuters) - Europe’s debt crisis poses a “potentially serious” risk to the U.S. economic recovery because it threatens global credit markets and large American banks, a top Federal Reserve official said on Thursday.

Daniel Tarullo, member of the Board of Governors of the Federal Reserve System, gestures before testifying before the Senate Banking, Housing and Urban Affairs Security and International Trade and Finance Subcommittee on Capitol Hill in Washington in this September 30, 2009 file photo. REUTERS/Molly Riley

Fed Governor Daniel Tarullo said Europe’s debt woes, if not contained, could cause financial markets to freeze and spark a global crisis akin to the market meltdown of late 2008.

Until last week, Fed officials had been playing down the possible impact to the United States from Europe’s turmoil.

“The European sovereign debt problems are a potentially serious setback,” Tarullo told two congressional subcommittees.

Thursday marked another turbulent day in global financial markets. U.S. stocks plunged nearly 4 percent and investors fled from risky assets around the world. The euro, which this week hit a four-year low, was again under pressure, and the cost of inter-bank dollar borrowing hit a fresh 10-month high.

Investors’ anxiety still centers on Greece, but fears have grown that even the roughly $1 trillion emergency fund put together by the European Union and International Monetary Fund will not be enough to solve Europe’s debt problems.

“Investors are aware that this package cannot ultimately relieve the need for real, and likely painful, fiscal reforms in the euro area,” said Tarullo.

The remarks were an unusually detailed pronouncement on economic matters from a Fed governor who tends to focus on regulatory issues.

“If sovereign problems in peripheral Europe were to spill over to cause difficulties more broadly throughout Europe, U.S. banks would face larger losses on their considerable overall credit exposures,” Tarullo said. “In addition to imposing direct losses on U.S. institutions, a heightening of financial stresses in Europe could be transmitted to financial markets globally.”

To some extent, financial markets are already showing signs of increased strain, buttressing the view of those who believe the Fed will likely leave U.S. interest rates near zero percent until sometime next year.

The U.S. economy has been recovering relatively quickly since hitting a bottom in the summer of 2009. Gross domestic product, the broadest measure of total economic output, jumped at a 3.2 percent annual rate in the first quarter.

But that recovery could be pressured by a reduction in global trade if the European outlook worsens, Tarullo said.

Ted Truman, a former Treasury official who is now a senior fellow at the Peterson Institute, and who testified to the congressional subcommittees following Tarullo, said the threat is very real.

“The risk is that the European situation will spiral out of control, spread within Europe beyond Greece and push Europe back into recession, and further damage the U.S. and global economy and financial system,” he said.

In conjunction with the European stabilization package, the Fed reopened foreign exchange swap lines with central banks in Europe, Canada and Japan to ensure dollar funding would steadily be available to banks. Tarullo told lawmakers the Fed is not planning to do anything else to tamp down the turmoil.

“We don’t have any other actions under consideration,” he said in response to questions.

The Fed came under intense criticism for its role in propping up financial firms during the U.S. crisis, and lawmakers questioned Tarullo closely about why the Fed needed to become involved in the European crisis.

“I’m disappointed that yet again American taxpayers find themselves forced to pay billions of dollars in bailouts, only this time we’re not bailing out profligate American companies, but foreign governments,” said Representative Ron Paul, one of the Fed’s harshest detractors in Congress.

Tarullo defended the swap lines, saying they are aimed at providing short-term liquidity to stop dollar markets from freezing.

“The Federal Reserve swap action is not a bailout for anyone but certainly not a bailout for Greece,” he said.

Tarullo told lawmakers that while the United States must take deficit reduction seriously, the seriousness of its own fiscal situation does not compare with heavily-indebted European countries.

The portion of gross domestic product that the United States pays to service its debt is “substantially lower” than countries in Europe battling debt woes, he said.

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