Wednesday, September 28

Central banks step in to stifle debt crisis

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By John W. Schoen, Senior Producer

As European banks find it increasingly harder to get cash they need to operate, central banks from around the world opened their vaults Thursday to head off another credit crunch like the one that crashed the financial system in 2008 and sent the global economy into a deep recession.

Exactly three years to the day after the collapse of Lehman Brothers touched off a credit panic, confidence in European leaders is fading as they scramble to head off a default on Greek debt and ease fears that Italy may headed for the same fate.

After a year and half of failed attempts at a solution, the world economy has entered A “dangerous new phase” International Monetary Fund Managing Director Christine Lagarde said in a Washington speech Thursday.

 “Without collective resolve, the confidence that the world so badly needs will not return,” Lagarde said.

The crisis stems from a downward economic spiral that has trapped Europe’s weaker economies, starting with Greece. Burdened by a debt load that exceeds its gross domestic product, the Athens government has been forced to cut spending and raise taxes to convince stronger economies like Germany and France to backstop its bonds. But those budget cuts have sent the Greek economy lurching in reverse, shrinking economic growth and forcing deeper cuts in services and higher taxes.

For a time, the hope was that the crisis could be contained to Greece and the weakest “peripheral” economies in the European Monetary Union. But the confidence contagion has now spread to Italy, Europe's third largest economy. This week, after the Italian government failed four times to trim its budget, investors demanded a huge premium to buy a fresh round of Italian bonds. The final budget plan, approved Wednesday, calls for tax increases that will create an even bigger drag on Italy's economy.

Germany and France, the last hope of a European bailout, have seen their economies grind to a halt as the crisis widened. Investors have bailed out of European bank stocks, fearing they could lose large chunks of capital if governments default on the bonds they hold. Some bank stocks are now trading for less than half the reported value of the assets on their books, a sign that investors believe those assets will inevitably have to be written down.

European leaders have been working for more than a year to assemble a financial backstop, similar to the reponse by the U.S. Treasury and the Federal Reserve to the collapse of credit markets in 2008. The European Central Bank has stepped in on a limited basis to buy Greek and Italian bonds to prop up those markets. But those efforts have not been big enough to calm jittery bond investors.

Treasury Secretary Timothy Geithner, one of the architects of the plan to stop the 2008 financial crisis, was in Poland Thursday pushing a similar plan to European officials to help stop the current problems.  

The European Union has established a bailout fund, the European Financial Stability Facility, or ESFS, which stands ready to intervene if a default appears imminent. But most observers doubt that the $750 billion euro fund is adequate.

Geithner was expected to suggest to EU leaders that they leverage the fund to make it more effective in fighting the contagion.

International Monetary Fund Managing Director Christine Lagarde speaks to CNBC about the financial crisis in Europe.

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