EU Debt Crisis by no Means Solved

The EU Debt Crisis

This past Wednesday was an excellent example of just how clueless investors are. There was a coordinated announcement by all major central banks that they would provide dollar liquidity to EU banks. The Dow went up 490.

What the banks promised were U.S. dollar swap liquidity facilities. This is being done because U.S. banks are reticent to provide short term loans to EU banks. The situation is nearly identical to the liquidity crisis of 2008. If interbank lending stops because banks don't trust that other banks are solvent then the central banks must take over.

This is akin to putting foam on the runway when a plane with landing gear trouble is about to land. The fact that the foam is there may be good news but the bigger picture is that nothing good is about to happen. The damages are being mitigated but in the present EU situation the underlying causes are fiscal and are not being addressed.

The goal is to get U.S. dollars into the hands of EU banks. Note that the U.S. Federal Reserve is not lending dollars to European banks. It is lending dollars to foreign central banks and those banks are responsible for the loans. Here is the Fed's reasoning as to why it is exposed neither to default not changes on currency values:

Dollars provided through the reciprocal currency swaps are provided by the Federal Reserve to foreign central banks, not to the institutions obtaining the funding in these operations. The foreign central bank receiving dollars determines the terms on which it will lend dollars onward to institutions in its jurisdiction, including how the foreign central bank will allocate dollar funds to financial institutions, which institutions are eligible to borrow, and what types of collateral they may borrow against. The terms governing these loans of dollars are in all cases released to the public by the foreign central banks. As the Federal Reserve's contractual relationship is exclusively with the foreign central bank and not with the institutions obtaining dollar funding in these operations, the Federal Reserve does not assume the credit risk associated with lending to financial institutions based in these foreign jurisdictions. The provision of dollars and receipt of foreign currency, and the receipt of dollars and return of foreign currency at the swap’s maturity date, both occur at the same foreign exchange rate so that the Federal Reserve is not exposed to movements in foreign exchange rates.

The Fed would lose money only if the ECB collapsed.

The fact is that this is an omen of recession in Europe. So we have impending EU recession, serious slowing of China's growth and +2.0% GDP growth here. This is what is driving a +490 point day for the Dow.

Some of the EU nations need to clean up their fiscal acts. So does the U.S.