ECB's Trichet sounds alarm over Europe's credit contraction

The eurozone's financial system is under "severe strain" and risks setting off a downward spiral as the banking crisis and economic recession feed on each other, according to European Central Bank president Jean-Claude Trichet.

By Ambrose Evans-Pritchard
Last Updated: 8:16PM GMT 23 Feb 2009

"What has become increasingly clear since the intensification of the crisis in mid-September is that strains in the financial sector are spilling over into the real economy," he said. "This has set in motion a process of negative feedback."

Mr Trichet said the bank was disturbed by signs of an fully-fledged credit crunch as banks shut off lending to healthy borrowers. Credit has contracted in absolute terms for the first time in recent weeks.

"There are indications that falling credit flows reflect tight financing conditions associated with a phenomenon of deleveraging. If such behaviour became widespread across the banking system, it would undermine the raison d'etre of the system as a whole" he said.

The ECB has been caught off guard by the ferocity of the recession, which is now ravaging Europe's steel, car, aeronautics and chemical industries. The bank's hard line has led to criticisms from trade unions and business leaders as the eurozone's economy contracted at an annual rate of 6pc in the fourth quarter of 2008.

Mr Trichet's warning is a clear sign that the ECB will cut interest rates below 2pc at its next meeting in March. It has stood aloof in recent weeks as central banks worldwide tore up rulebooks and explored extreme measures.

In recent days a string of ECB governors have at some form of quantitative easing, although the ECB is constrained by EU law from buying bonds issued eurozone states.

Mario Draghi, the Bank of Italy's governor, said the lesson of the 1930s was to take pre-emptive action to head off debt deflation early in a crisis, adding it was an error to resist cutting rates to zero should it be necessary.

Professor Tim Congdon from the London School of Economcs said the contraction of eurozone credit was "extremely disturbing" but inevitable after moves in October to force banks to raise their capital ratios. "It was a catastrophic decision," he said.

http://www.telegraph.co.uk/finance/4789 ... ction.html