Cash injections are the best medicine

ECONOMICS:Central bankers are rarely commended for their actions. But the speed and aggression with which the European Central Bank (ECB) has responded over the past 10 days to incipient panic in European financial markets deserves high praise.

In essence, as credit dried up on European money markets, the ECB stuffed bankers' mouths with money at its key 4 per cent lending rate. The sums involved are stratospheric. By the close of business last Monday, the ECB had poured more than €200 billion in liquidity into European money markets in three working days. In broad terms, this is equivalent to Ireland's forecast gross domestic product next year.

Where trust evaporates, credit collapses. The extension of credit is based on the fundamental belief that debts will be repaid. When this belief is impaired, credit is no longer extended. This not only prompts a generalised credit squeeze, but can, in the limiting case, reduce the money supply. Similarly, where defaults occur, they run through today's highly-integrated global financial system like a virus, laying low many in their wake.

Again, the domino-like effect of defaults acts to contract the availability of credit and the supply of money. The ECB's highly-aggressive stance in recent days can be seen as a pre-emptive strike designed to prevent the emergence of these destructive forces. A credit collapse triggered by the ending of a speculative boom cannot be contained within the narrow confines of the financial markets. In the absence of countervailing action by the monetary authorities, its effects spill over into the real economy, causing factory closures, job losses and general hardship. If mismanaged, the effects can last for years. It has happened before.

In October 1929, Wall Street crashed following the bursting of a speculative bubble. The crisis in financial markets infected the real economy. The Great Depression of the 1930s followed. In the US in 1933, gross national product was one-third less than it was in 1929. The dollar value of production in the US economy did not regain its 1929 level until 1941. By 1933, nearly 13 million Americans - one in four of the US labour force - were unemployed. One in five of the labour force was still unemployed in 1938.

How did the Great Crash of 1929 trigger the Great Depression of the 1930s? The orthodox interpretation, current until the mid-1960s, subsumed two strands.

First, the depression was taken as proving the Keynesian proposition that the economy had no inherent self-righting tendencies. Certainly, in the short run, markets would not automatically gravitate back to a full-employment equilibrium following a shock.

The economy could settle at an "under-employment equilibrium" and there would be no tendency for it to move unless it was kickstarted by government. Only government, by raising the level of demand through additional expenditure or tax cuts, could restore the economy to full-employment levels of output.

From a current perspective, the second strand was even more important. The inability of the US central bank - the Federal Reserve board - to prevent the panic in financial and credit markets from infecting the real economy was taken as proof of the limits of monetary policy. Like a piece of string, monetary policy could be pulled to rein in a boom, but it could not be pushed to offset a depression.

These Keynesian orthodoxies were overturned by Milton Friedman in the mid-1960s.

Friedman identified the proximate cause of the Great Depression as a major decline in the money supply after 1929, and he pointed the finger at the Fed as the culprit.

While the specific causes of the Great Depression are still a source of controversy, few commentators now neglect the importance of the precipitate decline in money and credit.

Writing as late as 1998, Friedman had this to say: "We demonstrated . . . that the Fed was largely responsible for converting what might have been a garden-variety recession, though perhaps a fairly severe one, into a major catastrophe. Instead of using its powers to offset the depression, it presided over a decline in the quantity of money by one-third from 1929 to 1933. If it had operated as its founders intended, it would have prevented that decline and, indeed, converted it into the rise that was called for to accommodate the normal growth in the economy. Far from being a failure of the free-enterprise system, it was a tragic failure of government."

Following the meeting of the general council of the ECB at the beginning of this month, ECB president Jean-Claude Trichet said that financial markets in the recent past had been characterised by "a degree of under-pricing of risks, some under-assessment of risks". The bank was seeking an orderly and smooth re-appreciation of risks, and he urged market participants and investors to "keep their composure, maintain their sangfroid" during this transition. This they signally failed to do.

But the ECB has kept its collective head where other market players panicked. By continuing to supply liquidity on demand at prevailing interest rates, it has thus avoided the illiquidity trap into which the Fed fell after 1929.

It is, as yet, too early to call the final outcome. Markets remain volatile and sentiment has the shakes. It is to be hoped that nerves will be steadied by the repeated doses of ECB liquidity. If this proves the case, then the market disturbances of recent weeks will be relegated to a footnote in financial history. The European economies could then proceed to grasp the economic growth that is at hand.

But, whatever the outcome, the ECB deserves the laurels for seeking to prevent a market shock from degenerating into an economic downturn.