It was one of those moments that happens only every 10 or 20 years the world's main central banks acting in concert to try to assert their authority over financial markets. So this was big. Let me try to explain its significance and what it means for the future.
In the past, it has usually been a currency crisis that has provoked this concerted action for example, the over-strong dollar that led to the Plaza Pact in 1985, when the yen's weakness was threatening world trade. The banks agreed to cap the dollar and support the Japanese currency on the exchanges. The meeting took place at the Plaza Hotel in New York, rather than a more official location, to ensure secrecy. The intervention was effective, partly because the markets were on the turn anyway. And when, two years later, the dollar had fallen far enough, the pact was followed by the Louvre accord, which confirmed that exchange rates had adjusted to reasonable levels. More controversially, under the accord, central banks sought to maintain the main currencies within unpublished bands. That worked for a while but was eventually abandoned and has not been tried since.
I had been expecting some kind of central bank action to support the dollar, though this time it would have needed to include support from the Chinese and probably Indian authorities too. As it has turned out, my concerns about global imbalances have been overtaken by concerns about global liquidity, and so the concerted action has taken a slightly different form. There are precedents, most notably the money market pressures around the stock market crash of 1987, when the US Federal Reserve and other central banks piled funds into the markets and cut interest rates. But on that occasion there was only informal co-operation between the banks.
Since the autumn, the central banks have been trying to pump funds into the markets but on a piecemeal basis. That failed in the sense that the gap between their official rates and money market rates did not return to their usual relationship. You would expect the key money market rate, the three-month one at which banks lend to each other, to be about a quarter of a percentage point above the central bank rate. If you look at the left-hand graph, you can see how that was the state of affairs in the UK until August. Then in September and again in November a gap opened, making monetary policy much tighter than the Bank of England expected.
This was not just a UK problem. The right-hand graph shows the gap between the three-month inter-bank rate and the comparable interest swap rate. Don't ask about the detail, it is nerdy, and I am grateful to Capital Economics for the graph and for noting that a similar pattern has occurred for sterling, euro and dollar deposits.
This is serious because banks need to trade deposits with each other to balance their books, both every day and more particularly over the year-end period when they finalise their accounts. If they cannot rely on doing so, they cannot safely make new loans. There is a price for a loan but there is also the question of its availability. There is no point in central banks cutting interest rates if the funds are not available. It was because their previous efforts to push money into the system had not solved the problem that last week they said they would act together.
The first reaction is that the move has been only a partial success. Bank shares, far from rising, plunged on Thursday, though they recovered a bit on Friday.
I am not worried about this. At the time of both the Plaza intervention and the post-crash injections of liquidity in 1987, there were serious doubts in the markets over whether the action would be successful. In the case of foreign exchange intervention, those concerns are legitimate because the firepower of the central banks is tiny compared with the size of the market. But there are no limits to the amount of liquidity they can put into the banking system, and I think by January the money markets will be functioning reasonably well again.
Unfortunately this only solves part of the problem. There seem to me to be two main risks.
One is the condition of the banks and the impact of this on lending. I have spent a bit of time talking with bankers in recent weeks and it is hard to overstate how frightened they are. Very few of them remember the 1987 squeeze they are working in a world that is beyond their experience. They had become far too cavalier about risk and deserve censure for that, but now they will become far too cautious. Perfectly creditworthy borrowers will be unable to get their money, particularly smaller companies and would-be homeowners. Banks will be more cautious for a decade, maybe longer.
The other risk is that the action taken to ease conditions will be successful in the short run but damaging in the longer term because it will eventually lead to higher inflation. Already inflationary expectations are rising. We have had a long period when goods prices have been pretty stable, even falling, while asset prices have been soaring. Now the goods we buy in the shops will go up in price but the value of our homes will be stable or go down. We are not used to that and coping with these strains will lead to a more sombre period in all sorts of ways.
We all know there are tougher times ahead. As yet, the financial market shenanigans have had very little obvious impact on the real economy, but we can all feel that this is about to change. That concerted action last week was one of the essential elements of restoring confidence within the banking system a first step. But we are not through this by any means. There are more bumps ahead, as Paul Tucker, head of markets at the Bank of England, said last week:
"We must try to avoid a vicious circle in which tighter liquidity conditions, lower asset values, impaired capital resources, reduced credit supply and slower aggregate demand feed back on each other."