The world’s six most important central banks, minus the People’s Bank of China, yesterday announced a plan to cut the cost of dollar swaps to banks outside of the US. What it essentially means is that the Federal Reserve will lend dollars more cheaply to other central banks (read: the ECB) so that they can in turn lend these dollars more cheaply to their member banks. The idea is that this measure should ease the liquidity crisis which now affects even interbank lending (it is bad enough when banks stop lending to people and companies, but it is really bad when they stop lending to each other!!).
Is this in any way a solution to the euro crisis? Not at all. At most, it eases some of the pressure on European financial institutions that are having trouble with their short-term funding (and remember, these loans are in dollars). The measure announced is by no means a “dollarization” of European debt – the Fed is not about to buy up Italian or Spanish bonds, much less Greek ones.
It is a vital step, however, as there are rumors circulating that one or more big European banks were facing a major liquidity event – within days, possibly within hours of the announcement. If this is true, and the scale and coordination of the action suggests that it is, then the Fed had no choice in the matter. The alternative would have been a messy major bank declaring its inability to meet obligations – bankruptcy if you will – and with Europe on the brink of disaster, this would have been the spark on the primer that blows up the euro.
Of course, the fact that “one or more” European banks were being squeezed into insolvency by a lack of interbank liquidity is extraordinarily frightening and should not be understated. It is almost impossible to understate the prospect of a systematic collapse of banking across Europe – and that’s what this central bank action was intended to prevent, or at least forestall. What it also indicates to Common Sense is that the situation in Europe is spiraling out of control. Events are moving faster than human actors can control them and we shall be lucky to reach the December 9th summit. Assuming that anything important comes out of that summit (more on this in another post).
As a side benefit, let’s not forget that those dollar loans have to come from somewhere, even though they are only numbers in databases in New York and Frankfurt. Common Sense is very willing to bet that Mr. Bernanke, seeing the hapless euro threatening to fall below the year’s minimum with no end in sight, decided not to lose the opportunity to bolster the single currency and remove pressure on the dollar (read: QEII and 3/4). Why? Because the Fed wants to keep a weak dollar to support exports, reduce imports and stabilize the current account. No sense letting Europeans export more cheaply to the US.
After the announcement, the dollar tanked against all major currencies, particularly the euro (see chart below). Well done, Ben! Let no crisis go to waste.
Cavalry or Calvary? A bit of both really, but mainly a dose of pragmatism to avoid a cataclysm. More of that is needed here in Europe.