Central Banks to the Rescue: Should We Be Encouraged or Terrified?

Strong action by the world's stewards of monetary policy was necessary -- for now. Hardly anyone believes that the central banks' actions are more than scotch tape over a shattered EU.

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Central bankers around the world are very, very worried about Europe, and they're starting to do something about it. This is equal parts terrifying and encouraging.

That's the critical takeaway from the liquidity injection - a fancy way of saying, turning up the spigot on global lending - embarked upon on Wednesday by the Federal Reserve, the European Central Bank, and four other central banks from around the globe. The coordinated effort will make it cheaper for foreign banks to borrow U.S. dollars from their central banks, which is important, because those banks have found it increasingly expensive to borrow dollars elsewhere to maintain cash flows.

The substance of the announcement, though, is far less important than the symbolism. Don't be fooled by Wednesday's early stock-market rally: Hardly anyone believes that the central banks' actions are anything but scotch tape over the shattered window of the European economy.

"It doesn't change any of the fundamental issues in Europe," Michael Cloherty, a researcher for Royal Bank of Canada Capital Markets, wrote in an analyst note on Wednesday. Later he added: "We don't think this is a real game-changer."

What could be a game changer is the notion that central bankers are preparing to fill a leadership vacuum that fiscal policymakers worldwide have left open. Europe's fundamental problems are much bigger than liquidity shortages - they start with skyrocketing borrowing costs for troubled governments and the growing threat of cascading bank failures across the continent.

The worse those problems get, the higher the chance they infect the entire global financial system, which remains highly interconnected across national borders - and weakened by the lingering effects (and unlearned lessons) of the 2008 financial crisis. Another worldwide recession is not out of the question.

Ben Bernanke and his fellow chief central bankers may be our best hope to prevent one. While heads of state fuss over fiscal treaties - or insist that only Europeans should have to solve this crisis, or only Greeks and Italians, or whomever - central banks can act, together, to slow or stop the flow of contagion from Europe to the outside world. They could buy up debt from distressed European governments, for example, or serve as lenders of last resort for flailing banks.

Injecting liquidity, in other words, should just be the first step.

"Central banks are absolutely worried and right to be worried," said Viral Acharya, a New York University economist who writes extensively about financial risk, in a phone interview. But, he added, "We have seen that central banks trying to lend to undercapitalized institutions doesn't solve the problem... What they really need to do is recapitalize the entire European banking system in one fell swoop."

Bernanke told reporters early this month that he is "ready if necessary to provide whatever support the financial system needs and the broader economy needs in case things should worsen."

Things have worsened. The support has begun.