Leader: Sir Mervyn sounds the alarm bells in Threadneedle Street

CENTRAL bankers measure their words carefully and pronounce them calmly. So when Sir Mervyn King, Governor of the Bank of England, says the economic situation is “extraordinarily serious and threatening”, and Sir John Gieve, his former deputy governor, asked what this means, says that prospects range from “grim to catastrophic”, it means the alarm bells are going off at full volume in Threadneedle Street and everyone should prepare for the worst.

If commercial bankers cancel bonuses that would be a welcome sign they have heard Sir Mervyn.

The worst is that the euro effectively collapses as a currency. When this may happen, Sir Mervyn was honest enough to say yesterday, he does not know and neither does anyone else. How it will come about is, however, reasonably clear. Investor confidence in the bonds of a eurozone government will collapse, pushing the rate of interest that a government has to pay on its borrowings to an unsustainable level. Then that government will default on its loans, announcing that it will repay only a certain percentage of what is owed.

This will then spread through the eurozone to all the countries whose economies are perceived as too weak to pay back national debts, causing further defaults, and this will affect Britain in two main ways.

First, it will deepen the recession which already exists in the eurozone as manufacturing indices are beginning to show contraction, while action earlier this week by central banks shows that the commercial banks are experiencing a credit squeeze. Britain’s economy is headed in the same downward direction. It can hardly be otherwise because of the large volume of trade Britain has with Europe.

Second, British banks with stocks of these government bonds on their books will have to write down their value and take a loss, probably a very big one. This loss will be magnified further as recession takes its toll on employment and company fortunes. More mortgages and more company loans will default.

Recession that might turn into a depression equivalent to the 1930s, with massive unemployment and deprivation, is the worst that Sir Mervyn is talking about. It can yet be prevented or, more probably, cushioned, by monetary easing and bond purchases by the European Central Bank. Yet it, driven by German fears of inflation, keeps hanging back, increasing the probability of a euro collapse.

Since Britain and the Bank of England are not much more than spectators of these events, Sir Mervyn’s doom-laden words are directed squarely at Britain’s banks. In effect, he is telling them to pull up the drawbridges and to stock up for a siege. Their capital reserves, which are used to fill gaps in liquidity caused by unexpected losses, need to be higher even that the 12 per cent they are at now.

Banks could achieve that swiftly by stopping lending, but that is completely unwanted as it would worsen the recession. So they have to look elsewhere. An obvious move would be to cancel all bonuses, which would cause much anguish to the investment bankers. Let them wail, for if this crisis is as bad as Sir Mervyn thinks it would be, they will have nowhere else to go.