Martin Wolf: The helicopters start to drop money


By Martin Wolf
Financial Times, London
Wednesday, December 12, 2007

The central bank helicopters are planning a co-ordinated drop of liquidity on troubled market waters. The money to be dropped now is not that large. But if this does not work, more will surely follow. The helicopters will fly again and again and again.

One point is clear: Central banks must be pretty worried to take such a joint action. For what is remarkable about Wednesday’s statement is that five central banks -- the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank -- are co-ordinating their (different) interventions. Their hope must be that this action will trigger not panic ("what do the central banks know that I do not?") but confidence ("now that the central banks are prepared to intervene in this way, I can at last stop worrying").

It is easy to understand why central banks should have decided to take heroic action. Confidence has fled the markets in a four-month long episode of "revulsion." As a result, monetary policy is not being transmitted to the ultimate borrowers as central banks wish. Particularly worrying has been the widening of gaps between three-month inter-bank lending rates and policy rates in the dollar, euro, and sterling markets. Spreads in the last of these have recently become enormous -- at more than 100 basis points.

Yet this is not the only indication of distress. In the US, for example, the spread between the rate of interest on 3-month treasury bills and AA-rated asset-backed commercial paper has widened to 270 basis points from a mere 30 basis points earlier in the year. This is revulsion indeed.

So why might Wednesday's co-ordinated interventions succeed where previous actions have not? In a word, the answer is: stigma.

Central banks have become increasingly worried about the unwillingness of banks to borrow from them. These banks reasonably fear that exceptional borrowing is a signal mainly of distress. The hope of the central bankers is that by auctioning funds to a wide group of institutions such anxiety would diminish, if not disappear. That hope is strengthened by the fact that these actions are joint: They are evidently aimed at lifting sentiment rather than saving specific institutions.

Will this work? The answer is that if the fundamental problem in the markets is lack of liquidity (that is, panic), rather than insolvency, and if central banks are believed willing to offer liquidity to solvent institutions without limit at what the latter consider a "reasonable" discount, then symptoms of stress should indeed disappear.

Yet these are both important provisos. In particular, there is good reason to believe that a good part of the stress is caused by worries over solvency -- indeed by the reality of threatened insolvency in at least some cases. True, central banks or, more precisely, the treasuries that stand behind them, could eliminate that concern too, by buying up every piece of paper, good, bad, and indifferent. But that would also be an open-ended, possibly very expensive and certainly unpopular bail out.

Moreover, even if today's stress is indeed a liquidity problem (something that we do not now know), there remains the question of the scale of the intervention required. Assume, for example, that central banks end up buying a vast amount of paper and so providing liquidity to institutions that have deliberately taken on big risks, by lending long and borrowing short. They have then validated those strategies, after the event.

So does the action by the central banks give us good reason to stop worrying?

Only if you like huge rescue operations of incompetent bankers, would be my answer. They may well get the markets back into order. They may, in this way, rescue economies from the threat of recessions. But that is not the end of the story. The bigger the rescue has to be today, the more stringent regulation of financial institutions will have to be in future.

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