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2012 Annual Report

No Absolute Turning
Point for the European
Sovereign Debt Crisis

The crisis in Europe cast a shadow on the U.S. recovery last year. Concerns of a Greek exit from the euro zone intensified, and the larger economies of Spain and Italy were engulfed in the crisis. The United States was not immune from events overseas—it felt the impact in financial markets, trade activity, and business and consumer sentiment.

As the European debt crisis dragged into its third year, events across the Atlantic again cast a shadow over the U.S. economy's fragile recovery. The crisis, which began in 2009 with Greece at its epicenter, spread to other heavily indebted economies, including Ireland and Portugal, and engulfed the larger economies of Spain and Italy (see the interactive timeline).

The crisis appeared to subside early in 2012 following moves by the European Central Bank to provide low-interest loans to euro area banks. However, within months the crisis intensified anew as political developments in Greece jeopardized the country's €130 billion (roughly $169 billion) bailout and continued membership in the euro zone. Renewed concerns about a Greek exit, coupled with Spain's banking and fiscal troubles, also heightened worries about the euro's future and caused investor sentiment to plummet.

Meltdown averted

A watershed in the European sovereign debt crisis finally came in late July, when European Central Bank President Mario Draghi pledged that the central bank would, within its mandate, do "whatever it takes" to preserve the euro. His statement shored up confidence in the common currency, causing an upswing in global stock markets and the cost of Spain's borrowing to fall from precipitously high levels (see the chart). In September, the European Central Bank followed through with a commitment to buy unlimited amounts of government bonds from ailing euro zone countries. The terms of the Outright Monetary Transactions program required that countries first subscribe to one of the euro zone's two rescue funds. Governments would also have to agree to reforms and external oversight of their fiscal matters.

Sentiment about the European situation improved over the second half of the year and strains on global financial markets eased somewhat. Strong action by the European Central Bank averted a euro zone meltdown and gave European policymakers breathing room to push through necessary reforms. For more on the European debt crisis, listen to a conversation with the Atlanta Fed's Galina Alexeenko and Stephen Kay (see the video).

European crisis became a global concern

The global economy was ultimately spared the shock of a Greek exit from the euro zone in 2012—but it was not immune from the crisis. Nor was the U.S. economy; it felt the impact of developments in Europe through several channels, including exports, business and consumer sentiment, and financial markets.

Roughly 20 percent of U.S. exports are destined for Europe, so it was perhaps not surprising that U.S. exports suffered. As European economies weakened and entered into recession, U.S. exports to the euro area were flat in 2012, after the previous year's double-digit growth. The drop in sales to Europe also played a key role in the notable deceleration of U.S. export growth in 2012, noted Galina Alexeenko, director of the Regional Economic Information Network at the Atlanta Fed's Nashville Branch. The slowdown was a particularly discouraging turn of events because exports had previously been one of the few bright spots in the U.S. economic recovery.

The crisis also weighed heavily on U.S. consumer and business sentiment. The uncertainty surrounding the situation in Europe clouded the outlook for U.S. firms. Many of the Atlanta Fed's business contacts in the Southeast noted that the anxiety over European stability added yet another layer of uncertainty to their hiring and investment decisions, Alexeenko explained. The August issue of the Atlanta Fed's Southeastern Insights captured this sentiment when it noted that many firms were having a difficult time forecasting, in part due to the European debt crisis. The report, which is typically released in the days following each FOMC meeting, stated that "limited visibility is resulting in a reduction or postponement in capital investment and hiring plans for several large businesses that represent most sectors of the economy."

U.S. financial markets, which are closely intertwined with those in Europe, also felt the spillover effects of the crisis. Developments across the Atlantic affected the prices of U.S. financial assets, including equities, Treasury debt securities, and the exchange value of the dollar. As Alexeenko explained, negative news from Europe would usually result in a decline in U.S. equities (along with European stock markets) and falling yields on Treasuries as investors flocked to less-risky assets. Heightened concerns about the situation in Europe also tended to strengthen the exchange value of the dollar.

Worries about the European situation also showed up in the lending decisions of U.S. and foreign banks operating in the United States. Respondents to the Federal Reserve's quarterly survey of senior loan officers reported tightening lending standards for borrowers with significant exposure to Europe. Concern among U.S. banks appeared to peak in the July survey, when a significantly higher share of banks than in the previous quarter reported tightening standards on loans to European banks and their affiliates. Several months later, in the October survey, the number of banks responding that way dropped.

Considering the many opportunities for negative spillovers from the European crisis, it is perhaps no surprise that events across the Atlantic ranked among the top risks to the U.S. economic outlook. Federal Reserve Chairman Ben Bernanke highlighted those concerns in his July testimony before Congress. He noted that U.S. banks had strengthened their capital and liquidity positions and stood in a stronger position to weather a crisis, but "European developments that resulted in a significant disruption in global financial markets would inevitably pose significant challenges to our financial system and economy."

The Fed responded

In response to the crisis, the Fed and other foreign central banks took coordinated actions to ease strains in financial markets. Going back to 2010, the Fed established temporary U.S. dollar swap lines with five foreign central banks. The swap arrangements provided liquidity to global money markets and helped minimize the risk of strains in financial markets overseas spreading to U.S. markets. In December 2012, the Fed extended the swap arrangements through February 1, 2014.

Concerns about spillovers from the European situation seemed to dissipate somewhat as the year drew to a close. By the end of the year, there were glimmers of hope that the worst had passed. The feared Greek exit did not materialize, and the European common currency remained intact. However, the United States by then faced its own impending crisis—in the form of the so-called fiscal cliff. The showdown over the looming automatic spending cuts and tax increases shifted to the forefront after the November elections and gave U.S. consumers and businesses yet another source of uncertainty with which to contend.