When you’re trying to slay the monster of impending financial disaster, which weapon should you use, a silver bullet or a cannon blast?

Last week Henry Paulson, the US Treasury Secretary, loaded the Government’s pearl-handled revolver and took aim at the great American housing crisis. He was the man behind the plan announced by President Bush to persuade mortgage companies to freeze interest rates on their loans to hard-pressed borrowers.

Mr Paulson is right to be concerned. Aside from the troubles in the financial markets that we have seen in the past few months, the “resetting” of adjustable-rate mortgages (ARMs) poses a truly torturous challenge for the American economy. In the next few years about $150 billion (£73 billion) in sub-prime loans will reset, from their initially low “teaser” interest rates - fixed for two to five years - to a market rate that, in many cases, will be three or four percentage points higher.

This would be bad enough even if these loans had been made to quality borrowers - but the sub-prime dimension makes the problem so much worse. Normally, borrowers faced with resetting ARMs would simply exercise the God-given right of every American to refinance their mortgage, at very low cost, perhaps into another lower-rate ARM or into a regular fixed 15-or 30-year mortgage.

That new rate would be substantially below the rate to which the loan would have reset and so the borrower would avoid the worst of the increase in interest payments.

Yet millions of these loans were advanced in the exuberant market conditions of 2005 and 2006 at exceptionally high loan-to-value ratios. Many sub-prime borrowers got mortgages that were 95 per cent or more of the value of their homes - some were 100 per cent. Since those mortgage deals were done, the prices of most of the homes that represent the security on those loans have fallen.

This will put many of these borrowers into negative equity, which means, especially with the sub-prime market now largely shut, that they will not be able to refinance and will be stuck with the new high interest rate.

The Treasury is trying to persuade mortgage service companies not to go ahead with the resets so that borrowers can go on paying at the original low interest rate and the risk of a further downturn in the housing market can be minimised. Only certain borrowers would qualify for this deal - those with generally good credit records and those who have tiny amounts of equity (if any) left in their homes. By targeting the next serious crisis, the plan evidently helps.

But there are serious problems with it. In the short term, it might not be big enough to prevent the next phase of the housing debacle. In the longer term, it seriously skews incentives for lenders and borrowers because it penalises those who did not borrow so rashly in the past few years - their mortgage rates will still reset at the higher levels. Worst of all, it might run afoul of the common law by denying a stream of revenue to investors who bought the loans as asset-backed securities on the assumption that they would make more money when the interest rates reset.

So if the silver bullet doesn’t work, perhaps the cannon-blast approach will? Tomorrow the Federal Reserve is expected to roll out the big gun again and cut its key interest rates, as the Bank of England did last week. Another .25-basis-point reduction in the federal funds rate is a broadside across the whole economy against the threat of recession.

But there are growing concerns that the cannon fire of monetary policy may not be all that effective in helping the economy, either.

The Fed has already cut overnight interest rates by .75 basis points in the past three months, but the actual effect on lending costs that most borrowers face has been small. For example, three-month Libor (London Interbank Offered Rate) has fallen by only a few basis points over the same period. The general fear and loathing in the credit markets means that, despite cuts in official rates, the borrowing costs faced by many companies, on commercial paper, for example, have actually increased sharply.

So is the Fed firing blanks? There are good reasons to be more sanguine. The central bank, of course, has only one tool, really: the overnight rate. Fed officials remain confident that their monetary policy will work to ease conditions as planned.

The reduction in overnight rates does help some borrowers. Some categories of consumer loans, for example, are pegged to the Fed funds number. Furthermore, while the interbank market remains crimped by high rates, Treasury yields have decreased sharply in recent weeks, and that helps.

Also, lower short-term rates should, other things being equal, lead to further weakening of the dollar, which at present is a significant stimulus. In any case, monetary policy works with a lag of six to nine months - the benefits of this autumn’s rate cuts will not be fully felt until early next summer.

Of course, it may be late in the day by then. But there is no reason yet to think that the big gun is any less useful in these trying times than the silver bullet.

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