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Great news from the Fed! Wait, what did it do?

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We live in a time of such economic strangeness that small events — for good and ill — inspire outsize reactions. A case in point is the response to Wednesday’s announcement by the Federal Reserve that, cooperating with the European Central Bank (ECB) and other government banks, it would “provide liquidity support to the global financial system.”

Probably 9,999 out of 10,000 Americans, including many professional investors, didn’t have a clue what the Fed was talking about. No matter. The Dow Jones Industrial Average jumped 490 points, or 4.2 percent. We weren’t alone. Stocks rose around the world. Whoopee!

You should treat this skeptically. What the central banks did won’t accelerate the economic recovery, here or abroad. It won’t resolve Europe’s deepening debt crisis. Its virtues are defensive: It might avert a new credit squeeze or possibly stop a full-blown financial crisis, a la Lehman Brothers. We are so hungry for good news and so fearful of bad news — and, in general, so confused about what’s going on — that events get twisted out of proportion. The stock market’s wild day-to-day swings (a.k.a. “volatility”) are a barometer of our ignorance.

So what did the Fed do?

To understand that, you need to know two things about Europe’s banking system. The first is that it’s much bigger than its American counterpart. The economies of the United States and the European Union are roughly equal; each represents about one-fifth of the world economy. In the United States, banks’ assets (loans and investments) total about $14 trillion; Europe’s banks are about three times this, says Douglas Elliott of the Brookings Institution.

“The European banking system is much larger in proportion to the economy than the American banking system,” says Elliott. “The providers of funds in Europe are mainly banks. In the United States, the providers are banks and capital markets” — the latter meaning mainly the sale of stocks, bonds and commercial paper to investors.

The second thing you need to know is that European banks make a lot of loans in dollars. Economist Hyun Song Shin of Princeton University has estimated that dollar loans and investments by banks in the euro zone (the 17 countries using the euro as a common currency) now total about $3 trillion. Though this may surprise Americans, the main explanation seems clear. Dollars are widely used to make settlements in world trade; multinational companies use dollars for their global operations; and European banks use dollars to buy U.S. securities for their portfolios.

But to lend dollars, Europe’s banks have to get them from somewhere — and there’s the rub. The getting is tougher. Banks have traditionally borrowed dollars in “wholesale” markets from other banks, money market funds and institutional investors. As the debt crisis has deepened, these lenders pulled back because Europe’s banks, holding large amounts of suspect government debt, looked riskier. Since May, U.S. money market funds reduced their loans to European banks by 42 percent to $224 billion, reports the rating agency Fitch.

“You have the beginnings of a credit crunch in Europe,” says economist Thomas Philippon of New York University. Banks “are limiting their dollar activities. French banks have large operations in Italy — and they’re shrinking. Austrian banks have large operations in Eastern Europe — and they’re shrinking.”

Given banks’ importance, a widening credit crunch would make a bad economic outlook for Europe worse. A sudden drying-up of dollar funding could even trigger a panic. Some banks might become insolvent.

Enter the Fed. It lends dollars to the European Central Bank through temporary “liquidity swap lines.” The ECB can lend them to European banks needing dollars. In theory, this should cushion a credit crunch and protect against a Lehman-like panic. The earliest “swaps” date to the 1960s. The present versions began in late 2007. The ECB is responsible for repaying the dollars, as are other central banks. The United States has never lost a dollar through these swaps to foreigners, according to Edwin Truman, a former top Fed official.

What the Fed did was change the interest rate it charges on swap loans from about 1 percent to 0.5 percent. This makes borrowing dollars more attractive. In late 2008, these swaps reached a peak of $580 billion; before Wednesday’s announcement, the latest total was $2.4 billion.

All this seems sensible, if technical. It doesn’t make the global economy better; but it might prevent it from getting worse — and possibly much worse. It might justify a good day for stocks. But nearly 500 points? This seems a stretch: mostly wishful thinking.

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