The US Federal Reserve and European Central Bank on Tuesday, September 11, took the exceptional step of pledging to bail out the global financial system. The move signaled the extent of the alarm within the two main guardians of global liquidity at the risk of a credit crunch after the terrorist attack on the World Trade Center, the heart of capitalism.
"The Federal Reserve is open and operating. The discount window is available to meet liquidity needs," the Washington-based Fed said. "After the unprecedented and tragic events in the United States today, the Eurosystem stands ready to support the normal functioning of the markets," the ECB said.
"The Eurosystem (of euro-zone central banks) will provide liquidity to the markets if need be." Their announcement means that if finance houses come under pressure to supply credit to third parties or become exceptionally exposed because they can no longer honor contracts, then the central banks will provide funds on easy terms.
Indicating the depth of concern about the potential for systemic risk, the US and European central banks said within hours of the attacks that they would supply liquidity as necessary, effectively casting aside their usual benchmarks for setting interest rates.
The Swiss Central bank also said it would provide cash if the banking system needed it. "We are going to proceed with a new examination of the situation on Wednesday morning. And if it's necessary, and if the banks ask for it, we will give them liquidity," it said.
The statements are highly unusual and are important for the mere fact that they are as a signal to reassure the financial world. The extent to which they provide funds also has big implications for the global economy.
Investors rushed on Tuesday to move their capital into low risk investments — safe government bonds with a fixed return, triggering a fall in bond yields. The higher the demand for these government bonds, the higher the price rises and the lower the fixed return is worth as a percentage of the purchase price.
In Europe bond yields fell sharply. The yield on the German benchmark 10-year bond fell to 4.744 percent from 4.858 percent, on the French OAT to 4.861 percent from 4.968 percent and on the benchmark British gilt-edged security to 4.861 percent from 4.910 percent. However, any emergency relaxation of monetary conditions, if applied and if it lasts, carries substantial risks of inflation.
The key words during the stock market crash in October 1987 came from the Federal Reserve when it said it would stand by the banking system. Central banks tend to this approach to avoid repeating the errors of restrictive policy in the 1930s, after the stock market crash, which led to the Great Depression.
But many analysts now say, with hindsight that in 1987 central banks in industrialized countries generally over-estimated the threat of strains in the financial system and eased monetary policy too much. The consequent increase in the money supply was one of the factors, which fed overheating.
The central banks then responded by increasing interest rates and in the early 1990s there was a protracted slowdown. A lasting increase in the price of oil, because of concern that Tuesday's attacks in the United States will implicate the Middle East, would also be inflationary.
The head of equity investment management at Group Robeco Gestion in Paris, Yves Maillot, commented: "The war against Iraq over Kuwait precipitated a recession in the United States. In 1989 activity and markets peaked and the US and European economies were set for a strong correction. "And in 1990 the conflict with Iraq precipitated a recession in the US. Overall it prolonged the slowdown which lasted about 18 months."
Referring to responses in the financial world to the attacks, he said: "What happens in the heat of the moment is that equity markets fall, bonds rise as interest rates, yields fall. "But perhaps markets will have turned out to have over-reacted." ― (AFP, Frankfurt)
© Agence France Presse 2001
© 2001 Mena Report (www.menareport.com)
