Will the Fed's move to help Europe hurt the U.S.?

(MoneyWatch) 

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 trouble.

Why can't the European Central Bank provide liquidity in euros? Why are dollars needed?

The dollar is still considered a safe haven, and when troubles erupt in financial markets, the demand for dollars goes up considerably. Providing extra euros doesn't help when the banks want to be in dollars.

Is there any possible downside? As a taxpayer, will it cost me money to help the Europe mess?

Since these are loans between central banks -- the U.S. Fed will not lend to any foreign banks directly -- there is essentially no risk to the U.S. If the Fed makes a loan to the European Central Bank, and the ECB lends the money to a bank that later fails, it is the ECB that is on the hook for losses, not the U.S. The European Central Bank would still be obligated to pay back the U.S. in full.

The other possible downside is that the short-term expansion in the Fed and other central bank balance sheets that would come with these loans will stoke inflation fears. But since these loans have an expiration date (i.e. the balance sheet will be expected to contract at some point in the future), this shouldn't be a big problem.

Finally, note 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.

[klhoughton100]

"Why can't the European Central Bank provide liquidity in euros? Why are dollars needed?

The dollar is still considered a safe haven, and when troubles erupt in financial markets, the demand for dollars goes up considerably. Providing extra euros doesn't help when the banks want to be in dollars."

And yet we still hear from economists on all sides of the Economists Political Spectrum (i.e., from Karl Smith and Nick Rowe to you and Paul Krugman) the claim that being the World's Reserve Currency does <em>not</em> convey special benefits.

So much for that.

[benagyerek]

Why are dollars needed?
European banks have substantial dollar assets (ABS, CDOs, etc) that are funded by short term dollar liabilities (notably CDs).
That short-term dollar funding has dried up because US investors, particularly money managers, have lost confidence in the eurozone.
That means that eurozone banks must either (i) find replacement dollar financing (now being provided via the ECB-Fed swap), or (ii) run a dangerous USD/EUR currency mismatch, or (iii) dump their dollar assets.
Option (iii) would not only cause losses to eurozone banks, as such fire-sales severely depress market prices for the assets being dumped, but will also hurt US banks who MTM based on these same asset prices, as well as US borrowers who may find their cost of borrowing rises substantially in line with rising market yields.

[Tyranosopher]

Another twist: Germany does not want to give in to France and company at this point yet. Thus the ECB will loan to the IMF which then will loan to the sinking countries. So Germany let help happen, but does condone it directly.

Still one more twist: Europeans need dollars to buy oil. If inter-bank money transfers are stopped, they cannot do this. Idem for trade in general.

[dwb2100]

obligations of the ECB are not risk free. Who pays them if the Euro fails and the ECB goes away?

[Conan776]

Well then... the Fed won't have to buy wall paper for a while :)

[noloyalisti]

Who cares what happens to America and its citizens huh. As long as the filthy rich Banksters make billions for the Top 1%. Our country is completely effed up by right wingers and their criminal masters on Wall Street, it's just that simple.

And there are STILL numbskull idiots out there like Republicons screaming for lower taxes, less regulation and even more for the greedy Top 1%. Enough is enough.

[THETRUTHisme]

Step By Step, and Slide by Slide, the US continues to "Sip with Socialists", drinking the same poison tea; of ever higher debt, less and less private sector, and an ever expanding "social safety net" that will soon collapse from the shear weight of the people that are all in it. The trouble is: the "end points have NO support", and will soon SNAP, and the "Net" will fall with a mighty boom of crushed people and businesses, beneath it.

[noloyalisti]

It is not the "social safety net" that is the problem, especially here in the US. It was the Bush Crime Family wars and the tax cuts for the rich.

[mullerohana]

Pfft, no cost to the American taxpayer? Where do you think the Federal Reserve Bank gets its dollars from, in order to lend them? They print it. When this happens, it is simply a hidden tax on everyone who owns dollars. Make me pay 5 cents for every dollar I have, or make my dollars worth 5% less - there is no difference.