Tinkering with liquidity will not fix Europe's breakdown

They agreed to lend funds at a cheap rate to the European Central Bank, which will re-lend those funds to banks in Europe. The plan was to ease constraints on liquidity that threatened to prevent European banks from lending to households and businesses.

The EU is now facing its most challenging economic problem to date. Several euro-zone countries with high levels of sovereign debt have had their credit ratings cut by international rating agencies. Greece was unable to service her debt and needs multiple rounds of rescue packages from other EU nations to keep from defaulting. 

The recent euro-zone rescue package was not only to help countries service debts but also to help banks which hold bonds of indebted governments. The European Central Bank promised to help recapitalise banks in Europe that suffered debt write-downs. 

Despite that promise, markets remain concerned about the viability of these banks, with investors eyeing more liquidity as borrowing money becomes more difficult. On the other hand, they also started deleveraging by reduce the size of risky assets. These moves will eventually affect the global economy. For households and businesses, credit will be harder to obtain, or charged at a higher interest rate. If such a situation is prolonged, we face the possibility of a deep recession. 

It is understandable that the US Federal Reserve and other major central banks should step in to ease the liquidity constraints. However, doubts remain as to whether their action will solve anything. 

The root of the problem is the sovereign debts not just in Europe but also in the US itself. 

In the past, people saw sovereign debt (in the form of government bonds) as a risk-free asset. Now, the world has changed and we face the real possibility of developed countries defaulting on their debts. 

So far, we see no obvious route out of this crisis. The measures and actions thus far imposed have only been targeted to solve short-term problems. 

What are the future implications of the latest action, on liquidity? Many economists fear that it will drag down the world economy for years to come. Central banks in Europe and the US will keep interest rates low for as long as possible to prevent the world economy falling into recession. 

 

Padej Piroonsit is head of Treasury Sales at CIMB Thai Bank. The views expressed are the writer’s own.