Central bank credit exceeds their grasp
James Saft is a Reuters columnist. The opinions expressed are his own.
To judge by equity markets, central banks have all the credibility in the world, but their reputation just may exceed their actual power.
Markets rallied furiously on Wednesday after six leading central banks acted to give banks access to easy money, a coordinated bid to unblock funding markets which threatened to seize up due to fears over European debts.
The group — the Federal Reserve, the European Central Bank and the central banks of Japan, Britain, Canada and Switzerland — agreed to offer dollar swap lines at a half a percent less interest than previously and pledged to keep these lines in place until early 2013.
In some ways the jubilant market reaction makes sense, though we should be careful about concluding that the outcome of the European crisis has improved by 4 percent simply because shares went up by about that much. Over the long term, central banks have a very hard time affecting the value of anything, though they are excellent at changing the price of things.
What the moves — which are similar to steps taken in 2008 after the collapse of Lehman Brothers — do accomplish is to lessen the chances that a bank gets caught short and collapses because it can’t access dollar funding. The very understandable unwillingness of U.S. banks and money market funds to provide dollars to European banks, many of which are full to the gills with now doubtful European government bonds, had raised this as a real possibility, and a move to mitigate that is welcome. The very existence of the central bank backstop will somewhat ease funding markets, though the days of money market funds lending money cheaply to European banks may well have ended.
What the moves are not is sufficient in and of themselves to resolve the crisis and remove the risk to the global economy. Central banks are intended to provide liquidity to solvent institutions so that they do not get brought down by short-term market crunches. At the extreme edges of central bank actions — and that is where we find ourselves, that distinction between solvent and insolvent actually ceases to matter.
After all an “insolvent” bank with an unlimited (in time and size) liquidity line is, in the long term, solvent once again. What that bank is unable to do, unfortunately, is play its role as an inter-mediator of capital, making loans and priming economic growth.
THE LONG CREDIT CRUNCH
So, in lessening the chances of a self-fulfilling crisis, the central banks are to be praised.
The rest of the account ledger is a lot less encouraging. One of the principal global threats coming out of the European situation is the possibility of a new credit crunch, something that is arguably already taking place in Europe. European banks need to recapitalize to protect themselves from losses they have and will suffer on euro zone government debt, as well as on losses yet to come from corporate and consumer loans in the region.
That recapitalization still has to happen and until it does, economic growth, globally but especially in the euro zone, will be slowed. The experience of Japan shows clearly that keeping zombie banks alive only extends the pain out over a longer period, and very possibly makes things worse by cutting off the opportunities of new and fitter banks and businesses which won’t get funding because we pour our resources into the banks and businesses we already have.
And of course the move does nothing to solve the thicket of problems facing the euro zone. Europe still needs to come to some understanding about how it is going to proceed and knit itself more tightly together through a fiscal union, or how it will extricate itself from its current mutual death grip.
That really comes down to what Germany and the ECB do. To preserve the union as it stands, Germany is probably going to have to sign on for several years of chunky transfers southward. Unlike the banking crisis, there is really no way to do this with smoke and mirrors, the flow of funds is going to require more than a pledge.
Secondly the ECB has to become far more aggressive and far less stiff necked, all at the same time, perhaps an impossible task given its history and bylaws. That means more rate cuts, of course, as their decision to hike in the spring must be one of the largest mistakes in recent financial history, but also somehow make available funds, perhaps to the EFSF or IMF, that somehow are used to purchase bonds directly from Italy and whoever needs money next.
It’s a tall order.
The central banks have bought time, but at a certain point the meter won’t take any more coins, even freshly minted ones.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article.)