Central Banks Step In to Shore Up Confidence

The European Central Bank, in an aggressive move announced after European governments unveiled their latest response to a spreading sovereign-debt crisis, said it will buy European government and private bonds “to ensure depth and liquidity in those markets which are dysfunctional.”

The Federal Reserve quickly joined with the ECB, agreeing to reopen a program employed during the 2008 financial crisis in which it lends U.S. dollars to the ECB in exchange for euro, allowing the ECB to lend dollars to European bankers starved for the U.S. currency. The Fed said it also would make dollars available to the British, Canadian, Japanese and Swiss central banks.

The scope of the ECB’s action surprised some central bankers outside Europe. The decision marks a significant escalation for the ECB, which previously had been reluctant to follow the U.S. Federal Reserve and Bank of England in buying even government debt in the open market.

Such a step is “very good news” said Sebastien Galy, currency strategist at BNP Paribas in New York, who said it could lead investors to head back into the kind of risky assets they had been selling out of late last week, such as emerging markets and stocks.

The ECB decision to buy public and private debt came just three days after ECB President Jean-Claude Trichet said ECB officials “did not discuss this option” at their meeting Thursday. But the reaction of markets around the world—and the agreement of fiscal authorities to put substantial sums on the table—apparently changed the ECB’s stance.

The ECB insisted the move won’t affect the total amount of credit it provides to the euro zone. “In order to sterilize the impact of the above interventions, specific operations will be conducted to reabsorb the liquidity injected,” it said. It also said that “in light of tensions” in European money markets it would open lend unlimited amounts for three months at a fixed rate at the end of May and June.

For months, U.S. officials have argued privately that Greece’s financial woes were a European problem for European officials to resolve. But sharp drops in U.S. stocks last week and new signs of strain showing up in short-term lending markets convinced Fed officials that European government debt woes were on the verge of becoming a U.S. problem—and if unaddressed could threaten the momentum of the U.S. economic recovery by shattering confidence and disrupting credit flows to businesses and consumers.

The Fed’s move—in combination with the show of force by European governments and the ECB—is an attempt to shore up rapidly waning confidence in markets, confidence that had been eroded by apparent disarray in Europe.

ECB officials had been hinting to the Fed for several days that they might turn to it to reopen the swaps, which were ended in February as the global financial crisis appeared to be abating, to help relieve stress on European banks. Mr. Trichet was in regular contact with Fed Chairman Ben Bernanke for several days and asked him to reopen the lines as the weekend approached.

Fed officials insisted that European governments and the ECB take more forceful action to stem the crisis before they would get involved, and became persuaded such forceful action was taking shape this weekend.

The Federal Open Market Committee, the Fed’s main decision-making body, voted to approve the lines Sunday morning. U.S. officials have been saying for days that the European response to the crisis was too slow and too small for the circumstances, quoting former Mexican President Ernesto Zedillo’s maxim that markets overreact so policy must overreact.

The decision could come with a political cost for the Fed. Its international swap lines have been criticized by some lawmakers as too secretive and as a U.S. bailout of foreigners, a characterization Fed officials strongly dispute. “These facilities are designed to help improve liquidity conditions in U.S. dollar funding markets and to prevent the spread of strains to other markets and financial centers,” the Fed said in a statement late Sunday night.

One of Mr. Bernanke’s first calls Sunday night was to Senate Banking Committee Chairman Christopher Dodd (D-Conn.), who is shepherding a financial regulatory overhaul through the Senate that could sharply reshape the Fed’s powers.

Fed officials believe the swap program was one of its most successful interventions aimed at stemming a global crisis, when many banks overseas became strained for dollar funding. In their normal course of business, they borrowed dollars in short-term lending markets and used those dollars to finance holdings of long-term U.S. dollar assets, like Treasury or mortgage bonds. When those markets dried up, the swap lines helped to prevent overseas bank funding crises in 2008. Fed officials see the swaps as a low-risk program, because its counterparties in these loans are foreign central banks, and not private entities.