Central Banks’ Action Hints At US Fears

The sight of the world's largest central banks acting in concert to ease funding strains in global financial markets is about as reassuring as watching an anti-tank ditch being dug. One can't help wondering what's coming next and how effective this defense will be.

European Commissioner Olli Rehn has said there are 10 days to save the euro, his eye on the Dec. 9 summit meeting at which we will see whether the euro zone reaches a decision to trade sovereignty for stability.

The first thing to say about the central banks' action is that it proves that they aren't going to sit on their hands and watch while the euro zone wrestles with itself. There is still a backstop for, as the central bankers' parlance has it, "solvent counterparties with adequate collateral."

Second, from a European perspective it is encouraging to see the Federal Reserve still prepared to intervene on Europe's behalf in any quantity at all, let alone the unlimited volumes in prospect. As has been documented elsewhere, Europe's banks have lost billions in dollar funding from U.S. markets, where patience with European dithering and obfuscation has finally snapped. And despite the attempts to present the action as a multilateral, multivectored mutual-support mechanism, it is clear that the only support offered here is that of dollars to Europe, and chiefly to the euro zone.

It is a significant decision for the Fed to take. Private markets in the U.S., inasmuch as they represent the aggregated choices of U.S. taxpayers, may well feel aggrieved that the Fed is putting their dollars back on the line after they have consciously pulled them off it. And U.S. taxpayers can justifiably point out that if the ECB isn't stepping in to solve the crisis, why should the Fed?

The answer, of course, is interconnectedness. The world over, it is the job of monetary authorities to provide official liquidity when the (normally far greater) amounts of liquidity that private markets make available to economies in normal times dry up.

And in today's world, your neighbor's problem is never far away from being your own.

Given European banks' extensive exposures across the Atlantic, and given the political pressure on them to deleverage anywhere but in their domestic market, the temptation for the banks to liquidate in the U.S. and let the American economy take the strain is huge.

Cheaper access to dollars from the Fed (via the ECB) for euro-zone banks will give them greater incentive to roll over existing liabilities rather than merely shrinking their balance sheets at the current breakneck pace. Anything the Fed can do to stop or slow the process of deleveraging in the short term will support the U.S. economy. This is enlightened self-interest rather than altruism.

For the past year, the swap facility has been priced at a prohibitively expensive 1% over the rate for overnight index swaps, the benchmark interbank rate, in order to discourage moral hazard.

 One of the most striking implications of the latest action is that it suggests the Fed is now persuaded that the U.S. economy has more to lose from doing nothing than from accepting that moral hazard. This, in turn, suggests the euro debt crisis has not only reached the core of the euro zone, but is reaching the core of the world's largest national economy, too. It's one thing for the International Monetary Fund and the Organization for Economic Cooperation and Development to warn, quite another when the Fed actually does something about it.

The problem for financial markets is that the action itself is—like so much else related to the euro story—another small step, when the consensus is calling for a giant leap out of crisis mentality.

Even if the sight of concerted central bank action normally means: "Emergency!" (and it does in this case, too), the funds involved in the ECB's upcoming three-month tender of dollars on Dec. 7 won't make the difference between "Crisis" and "No Crisis." At best, it will ensure that no bank, as it rushes to make its balance sheet look healthy in time for the accountants' and supervisors' year-end visit, will have to fold because it couldn't get hold of dollars to repay maturing debts.

It is, ultimately, just another liquidity action, aimed at buying time to sort the solvent from the insolvent, whether banks or sovereigns. It doesn't, in itself, help us to do the sorting. Nor does it bring us any closer to deciding who will pay for Europe's sovereign debts, or how to shepherd its banking system through a necessary period of shrinkage without killing the supply of credit to the economy.

On the bright side, this is not terra incognita. We were here in 2008 and the system coped, ultimately, with enormous stresses.

The ECB's lending through foreign-currency swaps swelled temporarily by the equivalent of €200 billion ($269 billion) in the wake of Lehman Brothers Inc.'s collapse, preventing a catastrophic domino effect. But if the best we can say is that we're getting better at handling near-death experiences, that is a melancholy consolation.