Mervyn King paints bleak picture

Analysis BY Hugh Pym BBC economics editor

Mervyn King says banks were near to collapse

He does not make many speeches outside the set piece events like the Mansion House dinner.

So when Mervyn King rises to his feet with something to say it is always worth listening.

Even more so when he provides his first public thoughts on the banking crisis of the last few weeks.

And, speaking in Leeds, the Governor of the Bank of England has not left his audience in any doubt about the gravity of the situation for the financial sector and its impact on the wider economy.

He tells us it is "difficult to exaggerate the severity and importance of those events. Not since the beginning of the First World War has our banking system been so close to collapse".

He goes on to explain that on 6 and 7 October, bank funding started to dry up and radical action was needed to ensure the survival of the system.

He paints a bleak picture of the short-term outlook for the UK.

He does not say in so many words, but the Bank of England, along with counterparts at the Treasury and the Financial Services Authority, seem to have found themselves looking over into an abyss with unthinkable consequences if they fell.

That sounds scary but the cheerier news from the Governor is that he believes the recapitalisation of leading banks has stopped the rot.

'Restoration of confidence'

He says the co-ordinated plan by governments to inject funds into banks in return for shares or similar investments "is having a major impact on the restoration of market confidence in banks".

The key three-month interbank lending rate has fallen for the seventh successive day. He believes that, as far as the banking crisis goes, the corner has been turned.

But the battle for leading economies is far from over.

Mervyn King believes it will take time before normal levels of lending by banks to the real economy are restored. And he paints a bleak picture of the short-term outlook for the UK.

The Governor makes clear that the banking crisis of recent weeks has dealt a severe blow to confidence in the economy and rationed the supply of credit even more than before.

He uses the "R" word, the first high level policymaker to do so: "indeed, it now seems likely that the UK is entering a recession".

'Lower inflation'

Until then the majority of the committee were preoccupied with the inflation threat and were minded to hold off on rate cuts till they were sure inflation was coming down.

But the severity of the credit crisis shifted the thinking dramatically.

Now, says the Governor, the balance of risks to inflation has "shifted decisively to the downside". In other words, with oil and gas prices falling, the inflation threat is lifting.

The worry for the Bank is that inflation will recede so sharply that it will undershoot its 2% target as the economy bumps along through a recession.

Mervyn King believes it will be a "long, slow haul".

The banks have been propped up and actions taken to stave off collapses should do the trick.

But for millions of households and companies, the next year will be far from comfortable as the real economy struggles to get back on an even keel.

So there you have it. You heard it from the Governor himself.

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