Fed, ECB offer aid to global financial system

NEW YORK (CNNMoney) -- Europe is hurting for cash, and central banks around the world are stepping in to give it a boost.

The Federal Reserve, along with five other central banks, acted Wednesday to make it cheaper for banks around the world to borrow U.S. dollars -- a staple of global financial transactions.

It's a big move, meant to not only lower the cost of short-term borrowing for troubled European banks, but also keep the global economy free and clear of an all-out credit crunch as in 2008.

"The euro debt crisis is coming to a head after two-plus years of dragging and hand wringing, and I think what these central banks are trying to do is send a signal to markets that there isn't going to be a huge liquidity crunch like there was in fall 2008," said Cornelius Hurley, a Boston University professor and former counsel to the Fed Board of Governors.

Indeed, world stock markets surged on the news, pushing the Dow (INDU) back into positive territory for the year. But what does it all mean?

The problem: In a smoothly operating credit market, banks lend to each other on a daily basis. But now, Europe's debt crisis has escalated to the point where the region's banks are so jittery, they're reluctant to lend to each other.

The evidence of this is seen in the cost European banks pay to borrow dollars on the open market. Those costs skyrocketed this month, to their highest levels since October 2008, sparking fears that a Lehman-like credit crunch is brewing in the region.

Back then, the Fed opened so-called "dollar liquidity swaps" -- basically credit lines to foreign central banks, as a way to keep dollars flowing in the global financial system. That program has since been extended and revived several times.

Velshi: Banks help Europe buy time

The Fed's lifeline: This time around, the Fed nearly cut in half the rate foreign central banks pay to borrow U.S. dollars. The move was coordinated with the European Central Bank and the central banks of England, Japan, Switzerland and Canada.

While the Fed never said the plan was meant to target European banks, it's certainly implied. Since the Fed set up this facility in September, the ECB has been its largest borrower. Currently, the ECB holds $2.2 billion in outstanding loans from the Fed.

In exchange for those loans, the ECB is paying the Fed a 1.08% rate. But, starting on December 5 and lasting through February 1, 2013, the Fed has slashed that rate to around 0.58%.

In effect, the ECB will soon be getting an even cheaper rate on U.S. dollars, than American banks do (they pay a 0.75% rate at the Fed's discount window).

Overall, these efforts are meant to "ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credit to households and businesses and so help foster economic activity," the Federal Reserve said in a press release.

In addition to the dollar swaps, the six central banks also created a temporary mechanism making it easier for them to exchange other currencies too. That tool gives any of the central banks easier access to euros, Japanese yen, British pounds, Swiss francs and Canadian dollars should they need those currencies to assist their region's banks in a crisis.

"These swap lines are being implemented as a contingency measure, so that central banks can offer liquidity in foreign currencies if market conditions warrant such actions," the Federal Reserve said in a Q&A about the plan.

The backlash: Fed critics pounced on the move Wednesday, saying that pouring dollars into Europe only creates more risks for the Fed. Rep. Ron Paul, perhaps the Fed's most outspoken critic, called the move "inflationary."

"Central banks are grasping at straws, hoping that flooding the world with money created out of thin air will somehow resolve a crisis caused by uncontrolled government spending and irresponsible debt issuance," he said in a press release.

It's important to note -- the Fed's funding does not come from U.S. taxpayers, and is independent from the federal budget.

And, since the European Central Bank will be the one actually making loans to European banks, the Fed is not on the hook if one of those banks fails, said Paul Ashworth, chief U.S. economist with Capital Economics.

In its statement Wednesday, the Fed also stressed that the policy is designed to offer help to foreign banks, and that U.S banks are not in need of liquidity, at least for now.

"U.S. financial institutions currently do not face difficulty obtaining liquidity in short-term funding markets," the central bank said. "However, were conditions to deteriorate, the Federal Reserve has a range of tools available to provide an effective liquidity backstop for such institutions."

China starts easing

The plan is not meant to be an be-all, end-all solution to the euro zone's troubles.

The European Central Bank, which meets next Thursday, is widely expected to lower interest rates to further ease financial conditions in the region and European state heads are still scheduled to meet in yet another summit next week, to discuss more potential solutions.

Meanwhile, the People's Bank of China also announced a plan to increase liquidity Wednesday by lowering its reserve requirement ratio for financial institutions by half a percentage point.