Transcripts of the monetary policymaking body of the Federal Reserve from 2002–2008.

The European banks are particularly exposed, much more so than U.S. banks or Japanese banks. A big chunk of that exposure is to central and eastern Europe, and as you suggest, we see significant risks to the European banks as a result of that exposure. What makes it even a little dicier is that exposure is concentrated in several countries, particularly Sweden, Austria, and to a slightly lesser extent Italy. Recently there has been significant economic turmoil in Hungary and Ukraine. The Fund has stepped in, and the EU has helped as well with large financing packages. The latest one we’re watching very closely is the situation in Latvia, where the exchange rate is significantly overvalued. The external position looks very, very dicey. The Fund is in there negotiating a program. There has been a lot of back and forth about what should be done with the exchange rate regime. The banking system also looks vulnerable—so what should be done with the banks? It is not exactly clear how all that is going to be resolved. My personal feeling is that, given the risks—and the Europeans recognize the extent of the risks—if Latvia goes, it could blow out the rest of the Baltics and then sweep around into Central and Eastern Europe and then feed back into Western Europe. So I see the risks there as being of first order for the Europeans.

Given that recognition, I think that the EU and major European governments are going to do what’s necessary to make sure that the situation in Latvia stabilizes at least for a while. The end game over the next several years is very much an open issue for a lot of these economies that were in ERM-II and evolving into hoping to adopt the euro. I think that there are potentially some very pronounced vulnerabilities and some painful adjustment that will need to happen in some of those Central and Eastern European countries. So absolutely that is a major risk. It’s one we’re watching as closely as we can.

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