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The Joint Swap Lines Are a Confidence Game

European Central Bank
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European Central Bank

If the main purpose of today's joint action by the world's central bankswas to ease the ability of European banks to borrow dollars, why are the central banks of Japan, Canada, England, and Switzerland also involved.

In a word: confidence.

Part of the plan with these major announcements of central bank coordination is to boost confidence in a distressed financial system.

The hope is that by having the entire world, more or less, participate in the action it will send a message that European banks won't have funding trouble because they've got the backing of every central banker that matters.

Confidence is extremely important in a banking system. If the market loses confidence in a banking system, liquidity dries up. One reason creditors can lose confidence in a banking system is that they fear liquidity will dry up soon. The fear feeds itself. A vicious cycle of banking panic emerges.

Today's action is most likely aimed at stemming any panic, preventing a bank run on Europe.

The hope is that if private creditors believe that European banks will not have funding problems, private creditors will continue to extend private credit. In other words, the idea is not just to provide cheaper dollar funding to European banks from the Federal Reserve . It is to convince the private credit markets to continue to provide funding because the Fed swap line is there just in case.

Central bankers have a lot of confidence in their ability to influence the confidence of private markets. The main question this morning and over the coming months is whether this confidence game will work — or whether it is too little, too late.

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