So today, you’ve probably seen the news that the European Central Bank, the Federal Reserve, and a bunch of other central banks made a “liquidity injection” into the markets.
Liquidity injection? What the hell does that mean?
During that time, a few metaphors came to mind to explain how this works. A flu shot! A machine!
But the easiest to understand is one you’ll easily grasp if you’ve ever driven a car.
Let’s start with a quick recap.
Europe, as we know, is in dire financial trouble. Countries like Italy and Greece are having trouble paying the high, high interest on their bonds because everyone thinks they’re weak (the same way that if your credit score is weak, you pay higher interest). A lot of European banks bought the bonds of those countries, and the weaker the bonds get, the weaker the banks get. Because the banks are sitting on these horrible bonds, no one wants to do business with the banks.
The chief problem here is that the European banks do business in euros, but they need lots of dollars. They need dollars because they lend to American companies, and because American money-market funds put money into those European banks. The dollar is how international business is done. So usually, these European banks trade in some of their euros for dollars. But right now, they can’t do that. Because honestly -- why would you take a weak, tattered euro for a good, solid dollar? This is hurting the European banks a lot, and it could even freeze their businesses. Imagine if you went into your local grocery store and tried to buy milk by paying in yen. You wouldn’t get your milk, and you couldn’t drink your coffee, and you’d function more slowly. The European banks have the same problem. They’re trying to buy American milk with euros, and the store clerks are kicking them out.
At the same time, politicians in Europe are dithering around and can’t agree on how to save these countries. The longer the dithering, the more worried investors get that their bonds will be worthless. The worries reached a high pitch this week, with a bunch of analysts bracing themselves for a potential collapse of the eurozone.
Okay, so here’s where we start using our imaginations. Imagine that the world economy is a highway. There are lanes marked in white, so you can change lanes, you can swerve, and you can hit other cars. Imagine that the American economy is a car in one lane; picture it as a giant gas guzzler, maybe a Humvee.
Then the European economy is driving in another lane. Picture the European economy as a 2001 Mercedes towtruck -- it still has power, but it’s definitely seen better days. The driver is the European Central Bank (the ECB); the president, Mario Draghi, is the one really behind the wheel. The ECB’s Mercedes tow truck is also towing another car behind it: a Ferrari, which belongs to the European banks. That bankers’ Ferrari drove way too fast for too long, took too much risk, and ran out of gas completely. So now the European Central Bank is driving the tow truck Mercedes and dragging that Ferrari filled with bankers behind it.
All these cars run on gas, of course. The best gas is premium unleaded: That’s the dollar. Everyone prefers to use the premium unleaded dollar because it keeps the cars running fast and clean and they get more miles to the gallon. The euro is like regular unleaded; it will do in a pinch, but your mileage isn’t as good, and if you can afford premium, that’s better. The yen would be, say, diesel fuel -- it only works in a few cars, and sometimes you’d rather get a new car than drive one that runs on smoky diesel.
So Europe, in its Mercedes tow truck running on regular unleaded fuel, has been driving really fast on the economic highway. Now the gas gauge is getting low -- the euro’s quality burned out fast -- so that European Mercedes tow truck is now slowing down, and it’s even swerving a little out of desperation. It knows it’s going to run out of gas and it’s kind of panicking.
The American Humvee is lumbering along in its lane, and sees the European Mercedes tow truck slowing down and swerving. The American Humvee could ignore that and stay in its lane, hoping that defensive driving will save it. But it knows that if the European Mercedes tow truck stops, especially with that Ferrari behind it, it is extremely likely to cause a crash. That could cause a multi-car financial pileup that would send everyone to the economic hospital and close the economic highway for months, if not years, for the cleanup. The American Humvee is facing a conundrum: keep driving in its lane and take the risk that it may never make it to the destination, or stop and help the struggling European Mercedes tow truck.
The driver of the American economic Humvee is the Federal Reserve in the form of a bearded fellow in the driver’s seat -- Ben Bernanke. He knows what a pain it is to tow that Ferrari -- he jumpstarted a bunch of banker Ferraris back in 2008 and nearly drained his battery. Bernanke’s Humvee has a few extra gallons of that good premium unleaded dollar in the back -- just in case, because remember, it’s a gas guzzler -- and it can get more any time it wants (The Federal Reserve runs the gas pumps that make premium unleaded dollars).
The swerving, slowing European Mercedes tow truck needs some of those good premium unleaded dollars, and it needs them badly. It needs some for itself, and it needs some to give to that Ferrari behind it so that it can stop towing the heavy thing.
But the European Mercedes tow truck can’t get any gas cheaply. The gas stations are all owned by European bondholders, and they’re charging crazy prices -- $10, $15 a gallon in some cases. You wouldn’t believe some of these prices.
It’s getting dire now -- every bondholder gas station is gouging this heavy, European tow truck. The European Mercedes two truck can’t afford to pay all that money to fill up -- it just doesn’t have the cash! -- so it keeps on driving, hoping to find a gas station it can afford.
So the Federal Reserve driver of the American Humvee makes a decision: It’s going to stop and siphon some of its premium unleaded dollars into the European economic cars so that they can keep running. It also gives the European Mercedes tow truck a few extra gallons of premium unleaded gas dollars at a far cheaper price than any of the gas stations.
The purpose of the extra gallons is so that the Mercedes tow truck can fill the gas tank of that Ferrarri owned by the bankers. The bankers want to drive their own Ferrarri, and the Mercedes tow truck wants to stop towing that damn sportscar.
The siphoning and selling of the premium unleaded dollars is today’s “liquidity injection.” The dollars are the liquid.
By the time all the siphoning is done, the American economic Humvee hasn’t exactly saved the day -- these Mercedes and Ferrari guys are going to have to buy their own gas sometime, after all. But at least they can keep going for maybe a hundred more miles without causing a giant crash, and maybe they’ll even find an exit and save everyone the trouble.
Sure, the American Humvee could have kept going on its way, but if it did, it would feel like it contributed to the two European cars stopping and crashing and potentially closing the road forever. So by sharing its gas (those premium unleaded dollars), the American Humvee is not just being a Good Samaritan; its acting in enlightened self-interest.
And that’s what happened in the markets today.