The credit crunch is a global problem and last Wednesday's announcement by five of the world's major central banks of a co-ordinated intervention to boost liquidity in the financial system was a belated recognition of this fact.
Since August national central banks, individually, have made several unco-ordinated attempts to overcome difficulties in domestic credit markets, but without much success. The credit crunch stems from the sub-prime loan debacle in the United States, but its roots lie much deeper.
World wide, the low interest rate regime of recent years has facilitated the creation of asset price bubbles, notably in the American property market. There, imprudent lending by banks and reckless borrowing by house purchasers ended in loan defaults when interest rates rose and property prices fell. The fall-out is still being felt globally.
The banks, in providing for major writedowns and losses on their sub-prime loans, are struggling to estimate and fund those liabilities.
In recent weeks two of the world's largest banks, Citigroup and UBS, announced huge sub-prime related losses, which added to nervousness in international money markets. Banks remain reluctant to lend to each other, and seem more concerned to hoard cash, either to finance their uncertain loan liabilities, or to improve their balance sheets. The result is a credit squeeze. Were this to continue, then recession would be the inevitable outcome.
On Tuesday the Federal Reserve cut base rates by a quarter point. Nevertheless, interbank rates, the wholesale rates at which banks lend to each other, remained much higher. Governments can now borrow at a lower interest rate than banks, which is both a measure of the liquidity problem in the money markets, and the challenge that the central banks face in addressing it.
Initial investor reaction to their intervention plan, however, was scarcely encouraging. On Thursday, bank shares, globally, were heavily sold, with Irish bank stocks falling by 4 per cent. The very slight fall in interbank rates in response to the joint action by the central banks helps explain the negative investor reaction. Clearly, the financial markets are sceptical that the central bank initiative to ease the tight credit conditions will succeed, at least in the short term.
The central banks have been slow to produce a co-ordinated response to a global credit crisis. They have arrived somewhat late with their rescue plan. They also face some constraints. In the US, the recent interest rate cuts were designed to counter a slowing economy and a housing slump. But with inflation rising, as energy and commodity prices increase, the Federal Reserve's scope for further rate cuts to ease the credit crunch is more limited. And that now puts even greater pressure on the five central banks to succeed with their joint initiative to improve liquidity in the global banking system.