And Yet, the Debt Issue Remains

 | Nov 30, 2011 | 2:00 PM EST
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Liquidity problems are different from solvency problems, but both need to be addressed in assisting the global economy. Today, we've seemingly gotten the first issue resolved. In an effort to prevent the European sovereign debt crisis from triggering a 2008-style credit crunch, central banks globally are providing liquidity to the markets. This coordinated action has come from the European Central Bank (ECB), the Federal Reserve, the Bank of Canada, the Bank of England, the Bank of Japan and the Swiss National Bank.

The central banks are providing more dollar liquidity to the markets and lowering the cost of funding above the overnight index swap (OIS) rates, with the Fed cutting that rate by 50 basis points from 100. By providing access to funding, banks can avoid paying costly rates that could hinder their operations, and thus allow financial markets to function and continue to provide credit to businesses and consumers.

Meanwhile, China also eased its monetary policy by lowering the reserve requirement for its banks by 50 basis points, down from a record 21.5%. That's a move focused on boosting growth, rather than on fighting inflation, as it had previously been doing. Still, in my opinion, the action isn't a dramatic one. China is trying to engineer a "soft landing" with an attempt to lower inflation by easing growth just enough. Now, however, its efforts have shifted more to fostering economic growth. Given China's dependence on exports, leaders now are more concerned with the health of the global economy, especially in Europe, as inflation has become a secondary concern. To wit, in October exports rose by their lowest rate in almost two years and inflation eased to 5.5%, the smallest gain in five months.

These actions will help the global economy by ensuring that financial markets can function smoothly, and markets are rallying sharply on the news. For European banks, funding costs in dollars had risen to their highest levels in three years thanks to concerns about the future of the eurozone, and the attendant difficulty of European leaders in addressing the debt crisis and increasing the firepower of the rescue fund.

Thus, today we seem to have the liquidity issue (we hope) solved, but does it really change the fact that a number of countries in Europe still have far too much debt? Providing liquidity to the financial system does not resolve Italy's economic and political issues, nor does it help Spain with its own matters. Italy, I might remind you, is the third-largest debtor nation in the world, with debt of roughly $2.5 trillion. It's also the third-largest economy in Europe, and the eighth-largest in the world. Spain, for its part, is the fourth-largest economy in the eurozone.

Further, today's liquidity news seemed to overshadow an important development. Finance ministers, meeting in Brussels, delayed action till next week on major financial issues -- such as the concept of a closer fiscal union that would guarantee more budgetary discipline. European Union Monetary Affairs Commissioner Olli Rehn said, "We are now entering the critical period of 10 days to complete and conclude the crisis response of the European Union." During a press conference last week, he noted, "There is no one single silver bullet that will get us out of this crisis."

So, the liquidity problem has been ostensibly resolved. However, we still need to find some way for European countries, either collectively or individually, to be able to repay their debts. Those haven't gone away. It doesn't appear that the ECB will agree to buy troubled European debt, either, especially given Germany's strong reluctance here.

As far as China's actions are concerned, the signaling is important, of course -- it explicitly states a bit of a shift in China's emphasis on growth. But the move isn't large, relatively speaking, to have a meaningful impact on China's trading partners' exports to that country. In the U.S., for example, direct exports to China account for only about 0.6% of gross domestic product. Of course, that figure doesn't account for the involvement of U.S. firms operating in China, and a slightly higher growth rate there can translate into more sales for some U.S. companies. Still, it might not be sufficient to move the needle on the U.S. economy -- which, by the way, seems to be showing improved growth fundamentals, as I've written in several recent columns.

As I see it, though, the move in China is really more about fine-tuning its emphasis on growth instead of inflation. I do believe, though, that it recognizes the interdependence of all global economies, as well as the risks of having too tight a monetary policy in the face of recessionary risks in Europe. After all, the EU is China's biggest trading partner. By helping boost domestic demand, perhaps China can offset some of the slow growth in exports, and thus achieve its soft landing.

Overall, though, despite today's actions, it really does come down to the basic function of solvency. The best way to address that would be for Europe to take a more coordinated approach to fixing debt woes there. Only when the underlying problem of the debt is solved will I be truly relieved. Still, having the big problem of liquidity addressed is one big step forward.

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