The monetary authority can increase the overall quantity of money available to the economy, but traditional monetary policy tools do not inject new money directly into the economy. Rather, the new liquidity created must be injected into the real economy by way of financial intermediaries such as banks, a Wikipedia entry says.
It goes on to add, “In a liquidity trap environment, banks are unwilling to lend, so the central bank’s newly created liquidity is trapped behind unwilling lenders.”
That definition of a so-called liquidity trap succinctly sums up what’s happening in financial markets. The consensus has so far been that banks are unwilling to lend to other banks because they’re scared the other bank might fail.
But on Friday, three-month dollar Libor—London interbank offered rate, or the rate banks charge each other for short-term loans—was fixed at 4.81% against 4.75% on Thursday.
Why should Libor rates remain high in the UK, in spite of the Bank of England guaranteeing all inter-bank lending? The standard explanation is that inter-bank lending hasn’t picked up because the banks haven’t had time to digest the rescue package. But, what if the reason the banks aren’t lending is not because they’re worried about their counterparties, but because the perilous state of their own health constrains their lending?
After all, you and I will lend money only if our own financial situation is strong. If we are worried about margin calls, or a demand for additional funds to cover positions, why would anybody lend money?
Until the banks are recapitalized, the freeze in the credit markets won’t go away. Also, the longer it takes to fix it, the bigger will be the impact on Main Street.
Reports on Friday indicated that letters of credit, without which international commerce would come to a shuddering halt, were being dishonoured.