Central bankers this morning flexed a little muscle by, in effect, insuring money markets in Europe. It was the collapse of money markets and short term interbank lending in 2008 that cratered the North Atlantic economies and brought on the Great Recession. With that experience fresh in central banker’s minds, this morning’s action avoids a repeat of what happened in 2008.
Professional investors immediately bought equities which have been underpriced due to the anxiety created by Europe’s well chronicled sovereign debt struggles.
Being the lenders of last resort is good, but central bankers still need to attack the underlying problem of sovereign debt by, first, buying the debt en masse. A couple trillion in sudden purchases, as in one or two days, would send the debt rocketing up in price as leveraged short sellers in the shadow banking system run to cover their shorts. This would create huge losses in these synthetic markets (the markets use derivatives, not the underlying assets) not only for the shorts, but for the longs as well because counterparties would not be able to make good their side of the derivative contract.
After this ‘shock and awe’ bond purchase has killed the shadowy derivative based market, the central bankers can unwind their positions in the real bond market at their leisure. And they will have few time constraints because most of the European bonds they bought will have been bought at huge discounts. As for the derivative market, it won’t come back anytime soon due to the massive losses of its former participants. These losses, by the way, will be matched in profits by central banks.
Equity and bond markets have evolved into pure casinos over the past couple decades. The emergence of shadow banking, money markets beyond the reach of central bank supervision, has enabled huge leverage. Central bankers were caught unawares in 2008 when this shadowy, synthetic derivative market collapsed because the underlying asset (housing) collapsed and central bankers discovered their regulated banks were participating in a big way. To say these bankers were upset is a huge understatement. They were, and remain, furious over the matter.
Central bankers have a monopoly on money and speculators in the shadow banking system need to be reminded in a very painful way about this fact of life. It’s time for central bankers to take out the synthetic, inherently leveraged, markets–particularly in our current context the bond markets. The same kind of power will need to be applied, sooner or later, to the commodity markets where speculative activity by non-producers/sellers has overwhelmed legitimate purposes and causes expensive and totally uneccessary short term price volatility.