Injecting liquidity into the market

Central banks around the world, including the ECB, the Fed and the Australian Reserve Bank, have been busy "injecting liquidity" into the marketplace.

I'm still trying to work out what all this means, but from what I can gather, this action is designed to prevent market panic attacks by allowing banks and other financial institutions to borrow money from the central bank. Normally, these financial institutions would borrow from the marketplace, but the "credit crunch" that is going on (as a result of the "subprime meltdown") means that this sort of thing is necessary.

From what I can gather, it basically means that these central banks are lending money to institutions that the marketplace finds very difficult to lend money to.

There's a few problems with this that I am running around my head.

The first is that these injections of liquidity are akin to money printing. Central Banks have the ability to create money out of thin air and these "liquidity injections" are a result of this. Done too often and too loosely, such actions are inflationary. This is a problem at the moment because inflation in the world economy is pressuring upwards and central banks have been increasing interest rates to reduce this pressure. The recent "liquidity injections", however, are actions which exacerbate inflationary pressures - which means that the central banks are pursuing two mutually contradictory policies.

The second problem is that these "liquidity injections" are preventing the marketplace from functioning properly. I'm no fan of "the market is God" philosophy, which means that limits do need to be placed on market actions... yet in this case I'm not so sure. The market has reacted against the "subprime meltdown" by punishing those responsible for it... yet when central banks "inject liquidity" they are limiting this punishment. I suppose so long as the central banks eventually reverse their actions by removing liquidity from the marketplace over the long term then that should be fine.

The third problem is that there is only so much central banks can do. They can't keep on "injecting liquidity" all the time. Eventually the market has to correct itself and that means that certain institutions have to go bankrupt. What we're seeing at the moment is merely short-term actions and reactions. "Injecting liquidity" will hopefully result in a softer landing, but the plane still has to get damaged on the way down.

1 comment:

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