Last week the Dow Jones Industrial Average soared almost 500 points (4.2%) on the news that The Federal Reserve in a coordinated effort with five other central banks of the world came to the rescue of European banks. Specifically, The Fed’s action effectively gives these central banks access to a massive pool of new U.S. dollars that they can borrow at a very low rate of 0.5% to fund their banking sectors. Why should this action be viewed with euphoria by the world’s stock markets?

To better understand what is going on you need to know why The Fed took this action. For European banks to lend money they have traditionally borrowed dollars from other banks, money market funds and institutional investors. As the European debt crisis has deepened, these lending sources have slowly pulled back because Europe’s banks are holding ever larger amounts of sovereign debt that is becoming increasingly more likely it will not get paid back.

Since May, U.S. money market funds have reduced their loans to European banks by 42 percent reports the Fitch rating agency. If we could know what the other lending sources for European banks were doing we would likely see the same response. Prudent lending sources seeing the increasing risk of sovereign debt are unwilling to risk their own money by lending it to the European banks. This is just plain common sense. You would do the exact same thing. Therefore the reason The Fed acted as it did last week is because the European banks were starting to experience a liquidity crunch.

It is the equivalent to what happened to Washington Mutual a few years ago. Recall what brought down WaMu was bank customers losing confidence in the long term viability of the bank quietly, but ever so quickly withdrawing their deposits. There was a run on the bank. In the period of a few weeks, WaMu went from being healthy to insolvent. The exact same thing is happening right now to European banks. The only difference is that it is happening across all the major banks in Europe, not just one particular lender like Washington Mutual. So I ask you? Is this something to be euphoric about? Does this justify a 500 point increase in the Dow? Only if you think bad news is good news.

We should be very concerned with what just happened and here’s why:

1. This did nothing to solve the European debt crisis. All it did was to delay the outcome.

2. The Federal Reserve has now become the lender of last resort. In other words when a European bank defaults, which will happen, we the American public will be picking up the tab.

How does that make you feel?  Euphoric?

Sources: What exactly did the Fed do?, by Robert J. Samuelson, The Oregonian, December 2, 2011; Fed Action in Europe Underscores Dollar Primacy, STRATFOR, November 30, 2011.