Saturday, December 15, 2007

What Bankers Fear

When airport rescue crews are worried that a damaged plane may have a crash landing, they sometimes spread the runway with foam to reduce the probability of fire on impact. That's what the Federal Reserve and other central banks are doing in pumping liquidity into severely damaged financial markets.

Make no mistake: The central bankers' announcement Wednesday of a new coordinated effort to pump cash into the global financial system is a sign of their nervousness. The global credit squeeze that began last summer still hasn't run its course, and the central bankers fear that the stressed financial system could pull the world economy into a deep recession.

Thus the bankers' decision to shower the system with money, through a new system of auctions that will allow banks to borrow more cheaply than they can through the commercial interbank market. What's unusual is that five leading central banks agreed to act as a joint rescue committee.

The aim isn't so much to prevent a downturn -- the bankers aren't sure that's possible, or even desirable -- as to mitigate its effects. Fed officials have decided that they need to let the adjustment happen in financial markets, with prices of mortgage-backed securities and other assets falling to levels that will allow the markets to clear.

"Helicopters start dropping bundles of cash," read the headline on a column by Martin Wolf in Thursday's Financial Times. This image of free money recalls the facetious prescription of John Maynard Keynes that to get money in circulation again during the Great Depression, the government could simply bury it underground and encourage unemployed workers to dig it up. This time the bankers won't even have to dig.

Fed officials want to avoid two mistakes made in past financial crises. They don't want to be overly harsh, as banking authorities were after the real estate collapse that hit New England in the early 1990s. Back then, regulators forced banks to clean up their balance sheets by selling off assets in a falling market, which made the downward cycle even worse.

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