Different dilemmas in America and the eurozone

Where is the European Central Bank? The attention of financial markets seems to be riveted on the US Federal Reserve, which has by now cut interest rates by 300 basis points and is widely expected to cut by more soon. By contrast, the ECB has not moved rates at all since the outbreak of the crisis in August last year and speculation about whether it will cut any time soon has in effect ceased.

Moreover, the Fed has announced a series of innovations in the way it implements monetary policy. Again, the ECB has been much less active, adjusting its armoury of monetary policy instruments only marginally over the past few months.

Why this transatlantic difference? Is the ECB right to shun the activism of the Fed? It is usually assumed that the ECB has been largely inactive because it places a greater (absolute?) weight on combating inflation. However, the main difference may be another one: the Fed faces a different problem from that of the ECB.

At first sight one might assume the Fed and the ECB were facing the same problem, since housing prices have risen way beyond equilibrium levels on both sides of the Atlantic.

But in the US the housing boom has been accompanied by a boom of mortgage lending, with an increasing proportion in the subprime segment. In Europe mortgage lending has grown more moderately, without much of a subprime element.

However, another, seldom mentioned, difference is even more important: in the US, most mortgages are "no recourse", which means that the lender (the bank) has no recourse to the owner of the house. If the value of the house is lower than the mortgage on it the borrower can just walk away and simply send the keys to the bank. This is called "jingle mail", and it is becoming more common throughout the US as house prices are declining almost everywhere.

This "no recourse" nature of US mortgages means that a fall in house prices leads to severe problems for the banking system because mortgages still make up almost half of all lending by US banks. By some estimates the US banking system might lose all of its capital if house prices were to fall by 20-25 per cent, as they must if they are to go back to average pre-bubble valuations.

In Europe borrowers cannot just walk away from a mortgage, since they remain liable for any difference between the value of the property and the amount of the loan. In Europe a fall in house prices may make consumers poorer and less willing to spend, but it does not threaten the stability of the banking system.

Another often overlooked transatlantic variance lies in a more subtle difference in the mandate of the two central banks. The main difference is not so much the emphasis on inflation, but the financial system. The website of the Federal Reserve proudly proclaims that it "provides the nation with a safe, flexible and stable monetary and financial system". This is totally different from the eurozone, where the stability of the financial system is not even mentioned among the secondary objectives of the ECB.

Given these two differences, it is no mystery why the Fed had little choice but to slash interest rates, hoping that this would help the banking system, whereas the ECB has not moved an inch. However, since rate cuts cannot stabilise house prices in the short run it is also clear to the Fed that even cutting 300 basis points cannot stop the crisis from spreading.

This is where the second difference comes in: the Fed had to overhaul rapidly the instruments by which it provides liquidity to the banking sector. Until last week it accepted only government paper as collateral. Now it is accepting a wide variety of private sector assets, even the mortgage-backed securities the market shuns. By contrast, the ECB has accepted private sector collateral for years. There was little need to change instruments in response to financial market difficulties.

Monetary policy thus cannot be judged independently from the state of the financial system. The ECB is facing a different problem and is thus right to concentrate on the fight against inflation, whereas the Fed is driven by a deterioration in financial market conditions that it ultimately will not be able to control alone.

As jingle mail spreads, the US government will have to intervene to save the US banking system.

The writer is director of the Centre for European Policy Studies in Brussels

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