Central Banks to the Rescue

Posted on: 01-12-2011 in Finance

World central banks have come to the rescue yesterday with an announcement of  “coordinated action” to help the economy.  The U.S. Federal Reserve announced:

The Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Federal Reserve, and the Swiss National Bank are today announcing coordinated actions to enhance their capacity to provide liquidity support to the global financial system. The purpose of these actions is to ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credit to households and businesses and so help foster economic activity.

This news triggered a huge stock market rally on Wednesday: Asian markets had already closed for the day when the news broke.  However, Asian stocks have opened strongly on Thursday.  Japan’s Nikkei is up over 2 percent, the Hang Seng is nearly 6 percent higher and India’s Sensex is 3 percent higher. Whilst it’s nice to see some green on the board after a couple of weeks of falling stock prices we shouldn’t get too carried away with this news.  The coordinated intervention is aimed at helping credit markets which have frozen up over the past few weeks in response to the worsening Eurozone crisis (credit crisis 2.0).  The intervention is aimed at flooding the market with liquidity (probably because a Eurozone bank was on the verge of collapse).  That’s good news in the short-term but it doesn’t solve the underlying problem which is one of solvency, not liquidity. The coordinated central bank action is akin to medics resuscitating a person who’s had a heart attack.  The action will keep the patient alive but their longer-term survival can only be achieved through diet, exercise and drugs.  For Europe and the rest of the world that means dealing with insolvent sovereigns and their banking systems.  The action announced yesterday doesn’t address this. Tellingly, the bond markets were less enamoured with the news than stock markets.  Yields on Eurozone debt did fall yesterday but those falls were much more muted than the dramatic rises seen in global equity prices.