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Yesterday was a very, very bad day on European stock exchanges, with key indices sliding down massively. To give some examples – UK’s FTSE 100 down 7.8% (the largest fall since 1987’s crisis), France’s CAC 40 down 9%, Germany’s DAX down over 7%, Russia’s RTS down over 19% resulting in Russian stock markets being shut down today again. Asian markets were also sharply down. There are more market casualties – Fortis (a Dutch-Belgian bank) and Hypo Real Estate (a German bank) – and seeking urgent rescue either through cash injections or a quick merger.

Iceland continues to struggle under the weight of its massive banking crisis, trying to avoid national bankruptcy, with the second largest bank Landsbanki now being nationalised – this is in addition to Glitnir about which I wrote recently. Thus, this week the US economic calamities have been demonstrated to well and truly impact global markets – not that we have doubted this earlier.

Cause of the panic: The European stock market slide is attributed to the lack of a coordinated economic front amongst EU’s governments which does nothing to restore confidence in the system at the time when emerging economic data is implying that US is entering a recession. US’s recession will impact the world’s economy due to its global nature. European governments are pursuing their goals in isolation and cannot have seen the depth of the crisis we are about to enter. According to this article, we are staring into the abyss of a systemic collapse, with markets at risk of closure. One recommendation is for the European central bank to lower its interest rate immediately and start acting like the lender of last resort to companies in trouble. Lowering the rate of interest should kick off inflation, one side effect of which will be to reduce the real value of outstanding debt, making debt obligations easier to bear.

UK is also showing deteriorating economic figures, prompting statements that it too is now technically in recession. Meanwhile, European countries are introducing their own measures to address the credit crisis and resulting stock market plunges, but there is no overall agreed policy. This must be reflective of a panic that set in amongst governments, each trying to protect their own skin in the eyes of the very concerned electorate by introducing quick measures. Divided, they stand. Read the rest of this entry »

I stumbled across a great article this morning which explains very well how Central banks (the Fed, the Bank of England, etc) operate on the money markets to inject liquidity into the system in order to stabilise it. This prompted me to consider the bigger question why money and credit is important in an economy.

Central banks and monetary policy: Typically Central banks aspire to maintain a certain target interest rate, and tighten credit (reduce it) when rates are too low, or increase the money supply when the rate is too high when rates are too high. This does not mean printing money: purely issuing notes and coins without reference to economic conditions can and does lead to inflation which, when excessive, is very damaging to the economy (it is outside the scope of this note to consider what is deemed “excessive” or what drives inflation in the first place, although some degree of inflation seems inevitable and healthy). Instead Central banks buy or sell short term Treasury bonds to primary banks (the likes of Goldman Sachs) to manipulate liquidity.

Central banks thus influence available credit through its dealings with primary banks and not small regional banks. If primary banks ceased to exist, e.g. if they went bust, Central banks would lose this existing tool of influencing available total money in the economy.   Read the rest of this entry »

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