Markets: Keeping the Bears at Bay

Liquidity moves are only short-term fixes. Policymakers and investors need more information—and fast—before the credit crisis can be solved

by Ben Steverman

For a moment there, it was looking like a classic financial crisis: First, fear from the spreading subprime loan mess, then panic, as investors tried bail out en masse. "If enough people decide this is a global meltdown, they can make it happen," says Paolo Pasquariello, a professor at University of Michigan's Ross School of Business who studies financial crises. "The Fed is trying to prevent a self-fulfilling prophecy from taking place."

On a smaller scale, it's like the classic "run on the bank," repeated in economic history and books and movies countless times. As George Bailey, played by Jimmy Stewart, told a crowd of anxious depositors at his family's bank in It's a Wonderful Life: "You're thinking of this place all wrong, as if I had the money back in a safe. The money's not here. Your money's in Joe's house…And in the Kennedy house, and Mrs. Macklin's house, and a hundred others."

The Global Stage

At least the residents of Bedford Falls knew where those houses were. The far-flung, global nature of the subprime crisis means that banks in Europe and Asia could be exposed to foreclosures in the U.S. market.

Indeed, investors' panic this week was spurred by the realization that, for the first time, problems with some U.S. credit markets might be going global. French bank BNP Paribas suspended three hedge funds with subprime holdings because of what it called the "complete evaporation of liquidity in certain market segments" (see BusinessWeek.com, 8/9/07, "Subprime: The Ugly American Hits Europe"). Until then, market worries seemed to be easing a bit. The Federal Reserve refused to cut interest rates on Aug. 7, insisting inflation was a greater threat to the economy than credit-market disruptions.

Recalling September 11

George Bailey was able to ease depositors' fears with some quick thinking and a good speech. It took more than that to ease the rising global panic attack. The European Central Bank acted quickly, and along with the Federal Reserve in the U.S. and various other central banks, pumped hundreds of billions of dollars into the world's banking system.

The last time the Fed stepped in with that kind of liquidity was in the week after the September 11 terrorist attacks, when it injected some $334 billion into the markets from Sept. 12 through Sept. 19, 2001. The Fed said on Friday, Aug. 10, it could purchase even more securities over the weekend if needed and indicated that it is likely to funnel more money into the markets next week.

Such a move would mirror the Fed's actions in 2001 when it made multiple infusions of cash over several days to stabilize the U.S. financial markets, with an initial buy of $38 billion in paper on Sept. 12, 2001. The move on Aug. 10 was the biggest single-day boost the Fed has given the markets since Sept. 14, 2001, when it provided $81 billion in short-term financing to Wall Street.

More Than a Hiccup

Figuratively, here's what happened, says Gabriel Stein of London-based Lombard Street Research: While panicked depositors stood outside the banks wanting to withdraw their money, a van from the central bank was parked out back, unloading cash into the vault. The ECB did "exactly the right thing" by acting as a lender of last resort, he says. "In the short term, [central banks] do have the power to provide a little bit of confidence to the markets," adds Reena Aggarwal, a finance professor at Georgetown University.

But what about the long term? And, by taking swift action, didn't central banks acknowledge that this is no longer just a hiccup for financial markets but a full-blown crisis for the world economy? Fear is the fuel that drives a financial crisis forward.