The Dow Jones rose 4% yesterday. From the NY Times:
On Wednesday, the Federal Reserve, the Bank of England, the European Central Bank, the Bank of Japan, the Bank of Canada and the Swiss National Bank, trying to bolster financial markets as the euro zone grinds on, announced that they would reduce by about half the cost of a program under which banks in foreign countries could borrow dollars from their own central banks, which in turn get those dollars from the Fed… The move is intended to free up liquidity and ensure that European banks have funds during the sovereign debt crisis… It was unclear even after Wednesday’s move whether banks would loosen up lending or whether the market enthusiasm would last… The dollar fell against an index of major currencies. The euro rose to $1.3433 from $1.3328.
So what does that mean? What is the “program” by which world banks are able to borrow dollars? All I can figure is that the “program” is to borrow dollars from the source of dollars, namely the Fed. If the Fed reduces the cost to the banks of borrowing dollars — i.e., by lowering the interest rate it charges — then the Fed can expect demand for dollars to go up. How does the Fed meet that demand? By printing more dollars: that’s why the dollar is also called a Federal Reserve Note. So this move is an indication that the Fed is prepared, based on increased demand, to expand dramatically the supply of dollars in the world economy.
Why will easing access to dollars alleviate the debt crisis in Europe? Because most of the lenders of last resort for the Greek and Italian governments aren’t the European central banks but the money markets, which lend short-term for higher interest rates. Evidently most of the money markets are majority owned by Americans and deal in American currency. The money markets aren’t limited to investing only their depositors’ money; they can also borrow, using their deposits as collateral, just like any other financial institution. If the money markets spot a high-yield lending opportunity like, say, a European government that’s been cut off from its usual cheap source of funds, they borrow low in order to lend high.
What if the borrower gets in too deep and can’t pay back the loan? This is what happened when the housing bubble burst. Solution: get a bailout. Have the Fed print more dollars; the banks borrow from the Fed for cheap; the money markets borrow from the banks for cheap. Then the money markets can prop up their balance sheets without having to sell their “toxic assets,” which in this case are the debts owed by the Italian and Greek governments. Then make sure that the borrowing governments pay back their loans: impose another round of austerity, expand government-owned production, whatever it takes. Just make sure that those governments don’t do like Iceland and Argentina and default, telling their lenders to go fuck themselves so they can dig themselves out of the hole and start over, deploying what Paul Krugman calls the “bankrupt yourself to recovery” model.
But that’s next year, and it’s not a sure thing. For right now, the money markets have access to more cash that they can lend at high interest rates to those same governments. Will it help right those floundering ships, or is it throwing good money after bad? We’ll worry about that later, say the money market managers. Of course it’s their call whether they’re going to continue lending to Greece and Italy, or whether they’ll pass on their own lower borrowing costs to their debtors. The stock market is betting that they will: bank stocks were the biggest gainers in yesterday’s trading.
If the “program” works, there will be a lot more total dollars in worldwide circulation. That means that any individual dollar is worth less, and so the dollar sinks against other world currencies. That means that the price of purchasing American goods goes down relative to goods produced in other countries, which should signal an expansion of production among other US industries, especially since they too can borrow dollars more cheaply than before. The devaluation of the dollar also means that American workers will cost less for employers to hire, so maybe domestic unemployment goes down. The flip side of that coin is that the American worker’s paycheck will have less purchasing power, an effect achieved not by cutting the amount of dollars being paid out but by cutting the value of those dollars. But it’s far from a sure thing that business expansion will happen in America, since third-world workers will still be cheaper than their American counterparts even after devaluing the dollar. And devaluing the dollar is also likely to mean an increase in domestic prices for goods and services, which might further suppress consumer purchasing within the US.
So this big banking move should enhance the position first of banks and then of other businesses that do a lot of business in American dollars. It might increase US employment while simultaneously decreasing the real income of American workers. And Greece and Italy might still decide they’d rather not pay back their enormous and crippling national debts, thereby collapsing the balance sheets of the money markets and second-tier banks that continue lending to them. So we’ll have to wait and see.
There’s one thing we can be sure of though: the central banks will always survive, because they can always crank up the printing press to make more money for themselves. There is one move that would pull the rug out from under the sure thing: the national governments that borrow from the central banks could decide to tell those banks to fuck off and start printing their own money. Argentina did it, and so did Iceland, and their economies and governments are doing fine. What if Greece and Italy did it? What if the US did it?