January 6, 2012 3:41PM

A Fed Bailout for Europe

I had an op-ed in the December 28th Wall Street Journal titled “The Federal Reserve’s Covert Bailout of Europe.” It generated a lot of discussion. Yesterday (January 5th), the Journal printed a letter from William C. Dudley, president of the New York Fed, responding to my piece.

In my op-ed, I focus on the currency swaps between the Fed and other central banks. The largest amount is with the European Central Bank (ECB). The Fed “swaps” dollars to the ECB and receives a like amount of euros in return as collateral. The ECB promises to return the dollars in the future at a fixed exchange rate. In the meantime, the ECB lends the dollars to European banks of its choosing. The Fed does not even know their identity.

Among other things, I point out that, thanks to prior Fed policy actions, there is no shortage of dollars in the world. The ECB could lend euros to their banks and the banks could then purchase however many dollars they needed on foreign-exchange markets.

I conclude that “the Fed is, working through the ECB, bailing out European banks and, indirectly, spendthrift European governments.” (The banks are major lenders to governments.)

President Dudley’s letter is non-responsive to the arguments of my op-ed. He never addresses my observation that there is no shortage of dollars in the world. He gives the game away in the following passage: “Banks with surplus dollars are more likely to lend to banks in need of dollars if they know that the borrowing bank will be able to obtain the dollars it needs to repay the loan, if necessary, from its central bank.”

Dudley is not describing a dollar shortage, but another reality. The reason one bank becomes reluctant to lend to another bank is that the potential lender has doubts about the solvency of the would-be borrower. The reality in Europe today is that banks have good reason to doubt the solvency of other banks because they know their own condition is none too strong.

By implication, Dudley’s letter acknowledges my main point: there is a Fed-financed bailout of European banks in progress. The Fed is implementing it through currency swaps because swaps obscure the nature of the transaction, which is in reality a loan. (The Greek government used currency swaps to hide the size of its fiscal deficits.)

It was widely reported that, in a December 14th meeting with Republican senators, Fed Chairman Ben Bernanke told them that he neither intended nor did he have the authority to bail out Europe. A reasonable person would see a conflict between the chairman’s words and those of the New York Fed president. Moreover, the swap arrangement is non-transparent and at odds with Bernanke’s promise of greater openness within the Fed. That is why I call for congressional hearings on it in my op-ed, and I repeat that call here.