The plan central banks announced Wednesday could ease financial strains that threaten Europe’s common currency and may tip the global economy into recession.
The Federal Reserve, the European Central Bank, the Bank of England and the central banks of Canada, Japan and Switzerland said they’d make it easier for banks to get the dollars they need to lend.
The move was a powerful confidence-booster, a signal that central banks are prepared to act in concert to encourage lending.
Stocks rocketed in response.
“The coordination was a big thing,” said Michael Hanson, an economist at Bank of America Merrill Lynch. “It had a psychological effect.”
Still, the plan isn’t a permanent fix. It doesn’t address the root of Europe’s crisis: Debt burdens are overwhelming Spain, Italy and some other nations and spreading fears that they’ll default. A default by one or more governments could topple the entire continent’s economy. Skittish banks that hold much of these countries’ bonds have been reluctant to lend to each other.
On Tuesday, the finance ministers of the 17 countries that use the euro failed to reach an agreement on resolving the crisis. Their failure raised the stakes for the leaders of the 27 countries in the European Union who will hold their own meeting next week. Investors will be looking to the leaders to show progress toward a longer-term solution.
Analysts say the eurozone nations ultimately must approve closer coordination of their spending policies so fiscal discipline can be imposed on individual countries.
Here are some questions and answers about the move and the European crisis.
Q. What did the Fed and other central banks do Wednesday?
A. They agreed to make it easier for banks to obtain U.S. dollars to fund loans all over the world. This should lead banks to loosen credit, which had tightened because of Europe’s financial crisis. Many banks lend in dollars because so much trade and investment is denominated in the U.S. currency. The Fed, the ECB and the other central banks agreed to lower the interest rate on dollar loans.
Q. How would this help?
A. The Fed has provided dollars to all five central banks since May 2010. But the interest rates were too high for many banks. The Fed and the other central banks are easing those rates. And the ECB will reduce the collateral banks must provide to get dollar loans. All this should lead more European banks to borrow dollars from the ECB. That’s important because those banks have had less access to dollars through other means, such as American money market funds. The money funds have reduced lending to European banks for fear the banks have too much debt from troubled countries. If those countries defaulted, banks in Europe could collapse.
Q. Does this mean the Fed is “bailing out” European banks?
A. No. Here’s how it works: The Fed provides dollars to the ECB. In exchange, it gets an equal amount of euros. The ECB then lends the dollars to banks. If the banks don’t pay back the loans, the ECB absorbs the loss. The ECB returns the dollars to the Fed at the same exchange rate as the initial swap.
Q. How will we know if this plan works?
A. One sign will be what happens when the ECB offers dollar loans on Wednesday. Most analysts expect many more banks to take advantage of the dollar loans now that the terms have eased.
Q. Will this do anything for governments like Greece and Italy that are on the verge of default?
A. Not really. It might help calm investors’ nervousness about the overall crisis. It could slightly lower rates that those countries pay. But it won’t reduce their debt burdens. It does buy European leaders time by keeping credit flowing. But investors will soon turn attention to the European leaders’ meeting next Friday. Geoffrey Yu, a strategist at UBS, said markets could plummet if that meeting doesn’t produce results.
Q: How did Europe get into this mess?
A: The euro made it easier to do business across Europe and made the continent a potent economic bloc. Yet the experiment was flawed. Countries were harnessed to one another despite different economies and cultures. Banks lent at low rates even to weaker countries like Greece. The euro meant lenders didn’t have to worry that individual countries would run up inflation that would reduce the value of the loans. Governments overspent for years and got away with it because they could borrow at low rates. But once the Great Recession struck, their debts became devastating.
Q: Why is a solution so hard?
A: The ECB and Germany have resisted aggressive action. Many economists want the central bank to buy the debt of Italy and other struggling countries. That would push down interest rates and ease those countries’ borrowing costs. The ECB has bought Italian and Spanish bonds. But it’s loath to do so in a big way. The ECB says it must control inflation, not be a lender of last resort to governments. And it doesn’t want to set a precedent for bailing out financially ailing nations. Germany opposes one idea _ creating joint bonds backed by the whole eurozone _ because it fears its own borrowing costs would surge if it had to borrow jointly with weaker countries.
Q: What options are European officials considering?
A: Things that would have been unthinkable just weeks ago. One option is to have countries cede control of their budgets to a central authority. That authority would stop countries from spending beyond their means. There has also been talk of forming an elite group of euro nations to guarantee each other’s loans. It would require fiscal discipline from any country that wants to join. Once that happens, the ECB might be more willing to buy government bonds aggressively, thereby pushing down interest rates and easing governments’ debt burdens. Analysts say that some progress toward such a solution at the summit next Friday is crucial.
Q: Can Europe’s leaders solve this mess?
A: The coordinated move the central banks announced Wednesday is expected to ease pressure on the financial system in the short run. But a lasting resolution requires persuading up to 17 countries and the ECB to agree to a solution to both ease government debt loads and impose budgetary discipline. “This is not just a crisis of Greece or this or that country,” says Nicolas Veron, senior fellow at the Brussels-based think tank Bruegel. “It’s a crisis of European institutions.”
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