Wednesday, December 19, 2007

Central bank blitzkrieg

Central banks showed what sort of fire power they are capable of on Tuesday when the European Central Bank injected a massive Euro 350 bn into the markets. This follows coordinated injection earlier by various western central banks and the US Fed in a bid to ease liquidity fears. Banks have been shy of lending to each other because they don't quite know how creditworthy the counterparty is and they are also hoarding cash to deal with the deepening impact of the sub-prime crisis. This has caused the inter-bank rate to rise sharply over central bank's bechmark rates.

Will it all work? Well, the intervention is certainly better than sitting idle. It reduces the possibility of bank collapse arising from liquidity problems in the short-run. Long-run, conditions will return to normal only when there is clarity about where a given bank stands in terms of losses. Over the next two quarters, once accounts are finalised and released, a measure of clarity should return.

The criticism against these moves and also against any cuts in interest rates is that these increase moral hazard- they benefit traders who are eyeing their year-end bonuses. There is merit in this criticism but this is not a problem we can focus on for now- it should be dealt with at the firm-level by restraining bonuses for people who took foolish risks. The costs to the wider economy from doing nothing are huge. But central banks should certainly tighten regulation once conditions in the world economy stabilise.

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