The Hindu Business Line : Sub-prime crisis: Europe trains guns on US

The Americans faced fire on two fronts – for keeping interest rates at one per cent for too long, sparking off the housing bubble and for lax control on financial institutions engaged in mortgage lending.

S. Balakrishnan

Accusations flew thick and fast at the annual congregation of the world’s top central bankers at Jackson Hole, Wyoming, in the US.

It is an American show, through and through. In recent years, all issues have taken backstage to the phenomenon of rising asset prices. If one’s memory is right, the last several gatherings have discussed nothing else.

Should central banks worry about asset prices, is the central question. It is here that tempers seem to have frayed this year.

For good reason. Thanks to some deft financial footwork on Wall Street and with helpful nods and winks from the rating agencies, sub-prime mortgages morphed into investments of the highest credit quality.

Those chickens have now come home to roost. The rising numbers of defaults, delinquencies and foreclosures have exposed the soft underbelly of investment portfolios of sub-prime mortgages and their various first and second-order derivatives.

European financial institutions and funds were also into this asset class in a big way. After all, these products were touted as offering extra yield without extra risk and who wants to give up such opportunities?

ECB’s charge

The trigger for the current market turmoil came not from the US, but the French financial entity, BNP Paribas, a couple of whose funds collapsed when their sub-prime mortgage investments soured. This forced the ECB to step in and assure liquidity in the inter-bank market – something which this most ‘anti inflation’ of all central banks must have found galling, as it runs contrary to its present declared monetary stance of tightening liquidity and interest rates.

Naturally, Europe turned to the source of all the troubles – the Fed. The Americans faced fire on two fronts – first for keeping interest rates at one per cent for too long, sparking off the housing bubble and second, for lax control on financial institutions engaged in mortgage lending.

US stance

The weight of non-US opinion was clearly in favour of central bank action against asset price inflation. The American position is eclectic. The former Fed Chairman, Mr Alan Greenspan, did not believe a central bank could even ‘call’ an asset bubble. He was, however, more than ready to ‘clean up’ if a ‘bubble’ burst and could damage the economy.

Europe cannot be happy with Mr Greenspan’s successor either. Mr Ben Bernanke too advocated a hands-off approach in a Jackson Hole paper in 1999.

It is almost axiomatic that low inflation and low interest rates will drive up asset prices. Keeping interest rates soft may be a necessity on broader grounds – for growth reasons and to encourage new investments. Raising interest rates just to deflate asset prices seems to be dubious economic logic.

More than low interest rates, it is the dilution of credit standards in primary lending against ‘hot’ assets and rating securitised mortgage products and their derivatives which is responsible for the current situation.