Tim Duy suggests that it is too late for the US:

Here too it is probably already too late. The time to move was this summer.

At a minimum, the Fed could be preparing a credit facility to take European sovereign debt as collateral.  Beyond that, I find it hard to imagine the Fed making large scale European debt purchases.  After all, what will they define as an American financial institution?  Deutsche Bank has a US financial holding company – would a Fed commitment include all of Deutsche Bank’s European bond portfolio? I don’t think the Fed is ready to make such distinctions, especially after the public relations beating they took for lending to foreign banks during the US financial crisis.

I think we all agree that the Fed has the power to stop this crisis the question is when, how and using what facility. In theory the Fed could provide an open ended facility for US banks to unload Italian debt onto the Feds balance sheet.

If the term of this facility is wide enough to encompass any Wile E Coyote moments for Italian debt then it makes sense for US banks to simply arbitrage down the the yield on Italian debt knowing that they can off load it on the Fed in an emergency. This would provide unlimited liquidity to the Italian secondary market, bring down the yield and assure that the primary market stays open.

The major risk in all of this is what happens if Italy exits the Euro. However, I don’t see how an Italian exit is an option for anyone at this point.

Suppose that Italy reintroduces the Lira and pegs it to the Euro. Even with a strong commitment from the Bank of Italy its obvious that the peg is not going to be maintained even for a period of a few years. This in turn means that the interest rate on the Lira has to go sky high to maintain the peg at all.

This crushes the Italian economy and only brings the break of the peg forward.

There is just no way to make a credible commitment to an orderly exit.

And, of course a disorderly exist means a default of Euro denominated debt by all parties in Italy, public and private.

Clearly the Fed cannot be on the hook for this.

 

No,instead I think the only real option here is to divide between banks sitting primarily under the Federal Reserve System and Banks sitting under the Eurosystem.  The Fed should make it clear that institutions which begin shutting down their counterparty risk now will have access to a Term Facility in the event of a shutdown.

My best guess at accomplishing this incentive structure is the creation of Asset Backed Securities built from a combination of European Sovereign Debt and US bank liabilities.

If these securities are considered strong enough – that is if the US portion has done its job – then the ABS will be accepted through the facility. If not then not.

Thus you need to shut down your counterparty risk as fast as possible.

 

As for US subsidiaries of European banks, we just let the chips fall where they may. If the counterparty risk is low enough the system should be fine.

 

A major concern I have is over the US dollar. I think the US can survive a European recession fine in raw import, export terms. My sense is that American sales to Europe are dominated by high margin tech products. The margins will fall, profits will be hammered but there is not a major risk to US production.

How much US industrial machinery is actually manufactured here and shipped to Europe? I don’t know, could it be a lot?

However, we do expect to see a major rise in the US dollar. When I thought the European banking system would definitely hold I though we might actually see the Euro appreciate as the ECB was insanely holding rates high even into recession.

However, this seems an unlikely outcome now. My best guess is a strong appreciation of the dollar and a huge hit to US exports everywhere. US export growth was previously growing rapidly to Asia and middle income countries in general. This will shut down. Since this has been a major source of growth for the US it is deeply disconcerting.

On the flip side the US would see a major drop in the price of oil and gasoline. This is obviously a boon for the struggling US consumer. If it could be enough to spur domestic increases in auto purchases then we could transition effectively.

An increase in domestic auto purchases would beef up growth a bit, possibly unlocking enough household formation to bring forward the boom in multi-family.

In this scenario the US simply does the 2007 to 2011 story in reverse. Exports get hammered while housing and domestic auto rise.

It does seem possible to come out of this thing ok depending on the severity of the screw-up in Europe. The fundamentals in America are still ripe and if lending in America can stay open – and absent a disorderly exit for Italy I think it can – then I think we can make it through.

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