Can central banks stem the market crisis?

The world's central banks have been furiously pumping funds into the financial system to contain the panic in financial markets. (A notable exception is the Bank of England). Will they succeed?

I believe so. Markets tend to overreact. A sharp fall in asset prices will easily plunge highly leveraged institutions such as hedge funds into bankruptcy. But this is temporary in many cases and many funds can move back into solvency once overshooting of asset prices reverses. In the meantime, they need access to funds to tide over redemption calls. As long as central banks provide these, there should not be a problem. Besides, private buyers of distressed funds will also be available. In the case of commercial banks, central banks or the government may even effect a rescue.

The difficulty for central banks is providing liquidity but stopping well short of a bailout. This is necessary to avoid moral hazard in financial markets. Crises such as the one we are seeing today are the result of excesses. Those guilty of these must pay the price. Bailouts mean they will not pay the price. This may solve today's problem but it will create fresh problems down the road. Market players will take huge risks in the knowledge that central banks will save them. Many say that today's problems are precisely the result of Greenspan's willingness to cut interest rates to save falling markets.

In today's turbulent conditions, central banks may not be able to get the balance right. They may go overboard in calming markets. That is bad for financial market discipline. But it will certain prevent the crisis from snowballing. So, yes, central banks have it in them to stem the crisis but they may let it play out for a while to ensure that institutions that got carried away are weeded out.