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What exactly did the central banks do?

The other day, six central banks shocked the markets when they decided to join forces to prevent a credit crunch. The Fed, ECB, BOE, BOJ, BOC, and SNB showed that in unity, there is strength. (Whew! That’s a lot of acronyms!) With their coordinated easing efforts, they plan to make sure that there is ample liquidity available in the markets.

Under their arrangement, the Fed will let the ECB and the other central banks borrow as much dollars as they need to loan to banks in the euro zone.

European banks, which are already having trouble getting loans from other banks, stand to benefit the most from the move. Central banks didn’t want a repeat of the 2008 financial crisis when banks were afraid to lend out because they were unsure which institutions were holding bad debt.

How do they plan to carry it out?

Basically, all six financial authorities agreed to reduce the rate on existing U.S. dollar liquidity swap arrangements by a half percentage point. Reduce the what? On the what?! If that sounded like gibberish to you, let me break it down with a simple example:

You see, the ECB currently holds a whopping $2.2 billion worth in loans from the Fed and is paying a 1.08% interest rate. With the Fed’s 0.5% rate cut on temporary dollar loans offered to banks a.k.a. liquidity swaps, the ECB will need to pay only 0.58% on these borrowed funds starting next Monday until February 2013.

Since this rate cut applies to foreign central banks that borrow U.S. dollars, it will help them secure funds at a cheaper cost and consequently reduce the interest rate they charge to commercial banks. In effect, companies and individuals will find it more affordable to borrow money as well. With that, there will be more dollars available for those who use the world’s reserve currency in their transactions.

Aside from that, the central banks also decided to create a temporary mechanism that would make it easy for them to exchange other currencies. In other words, they would all have quick access to the euro, the pound, the yen, the franc, and the Loonie should the need arise.

What does this mean for the global economy?

First and foremost, since the central banks’ moves are aimed at reducing borrowing costs and stimulating liquidity, a credit crunch like that of 2008 could be avoided. This is certainly good news for the European banks and companies struggling to have access to short-term funding thanks to the debt troubles in their region.

However, plenty of economic experts are quick to point out that the coordinated central bank easing isn’t meant to solve the euro zone’s debt woes. Instead, the increased liquidity is only meant to address the EFFECT of these debt troubles. When it comes to trimming their deficits and paying off their obligations, debt-ridden euro zone governments are still pretty much on their own.

Some analysts even pointed out that the central banks’ decision to stage such a dramatic intervention could be indicative of darker clouds on the economic horizon. U.S. Congressman Ron Paul, the Fed’s number one critic, says that the central banks are grasping at straws by flooding the world with money created out of thin air. He also reasons out that these large-scale easing moves could make inflation spin out of control and be harmful for American consumers and the economy as a whole.

But for now, it seems that this coordinated easing effort was enough to turn investors’ frowns upside down as evidenced by the strong risk rally we saw yesterday. Some suspect this “Santa Claus rally” could continue until the end of the year as many predict that the worst is already over.

From a long-run perspective though, this could just be the tip of the iceberg as central banks are scrambling to keep the crisis contained. As they say, desperate times call for desperate measures.