Quote of the Day: November 30, 2011
The 70% Solution: Taxing the Rich Department

Mark Thoma on Coordinated Central Bank Intervention

Mark Thoma:

WCBS News: Central banks in the U.S., England, Canada, Japan and Switzerland along with the European Central Bank announced on Wednesday that they are taking steps to make dollars readily available to troubled banks in Europe. The plan is to reduce the cost of loans between central banks -- these are known as liquidity swaps -- so that dollars are cheaper to obtain.

What are the central banks doing?

The worry is that the financial troubles in Europe will cause problems similar to when Lehman failed in the U.S. An event such as a default on government loans, a bank failure or even just the fear that such events are just around the corner can cause short-term money markets to tighten up. If this happens, then it will be harder for banks to obtain the money they need to fund their operations. Many banks make money by borrowing short and lending long, and make a profit on the spread between short and long interest rates. When the short-term money markets dry up, these banks lose the ability to obtain the money they need to stay liquid and that puts them in danger of failing.

Why are the central banks taking this step?

One reason is to make sure that the banks have the liquidity they need to stay afloat. A widespread domino-like cascade of bank failures would be disastrous and this provides insurance against that possibility. In addition, even without bank failures a loss of liquidity is troublesome. As liquidity dries up, interest rates rise and the loans that businesses and consumers need become harder or impossible to get. That can have a large negative impact on economic activity.

How does the plan work?

These swaps are loans between central banks. For example, the Federal Reserve in the U.S. might swap dollars for euros with the European Central Bank, and then the European Central Bank can lend those dollars to banks that are in troubleā€¦.

[N]ote that while this move can ease financial market conditions, it does nothing to address the underlying problems creating those conditions. So this is no substitute for the difficult decisions that Europe must make to overcome its troubles.