The day fear hit the markets

Fear. If there was one word to sum up the world's financial markets yesterday, it was that. No one wanted to buy shares and, yet again, no one much wanted to lend money.

Richard Fuld, the former chief executive of Lehman Brothers, told Congress his bank had been blown away by a "storm of fear". That storm shows no sign of subsiding. Banks are one thing; countries quite another. yet now, almost unbelievably, the credit crisis seems on the point of claiming its first victim among sovereign nations – Iceland, whose banks have been badly exposed to the global chaos and where they are now closed. There is talk of Iceland having to join the EU simply to be bailed out, like a national Bradford and Bingley.

The Asian markets felt the fear first, and Tokyo slumped to a four-year low, as did China. Emerging markets dropped by their biggest margin in 20 years led by Russia's bourse, suffering its worst day since the Bolsheviks took over. As the fear moved West, there was not much hope then for London, and so it proved.

The FTSE 100 index suffered its biggest one-day points fall, with banking and mining shares taking a hammering as the fallout from the financial crisis once again overwhelmed global markets. The FTSE ended 391.1 points lower, down 7.85 per cent, the third-biggest percentage decline in its history, leaving the index back at levels not seen for more than four years.

At this rate, in 10 days' time, the entire London stock market could be purchased with the small change you have in your pocket. In Europe, the fear was equally potent – Paris was down 7 per cent, Frankfurt down 8 per cent and Madrid down 9 per cent.

The credit markets remained stubbornly frozen, despite renewed efforts by the central banks to lend the system money, and even the oil price slumped to below $90, way off its near $150 a barrel peaks seen earlier this year. And on Wall Street, the Dow Jones industrial average of leading US stocks fell below the 10,000 mark for the first time in four years.

Of the myriad fears stalking the world's financial system, perhaps the most terrible is that the ability of the world's governments to control events is ebbing away. Yesterday the President of the World Bank, Robert Zoellick, almost admitted as much. "The G7 is not working," he said. "We need a better group for a better time" – not a hopeful curtain-raiser for the G7 finance ministers' summit at the IMF/World Bank meeting in Washington at the end of this week.

After the successful passage of the $700bn (£400bn) Paulson Plan to rescue America's banks passed through Congress on Friday, this tsunami of fear was not supposed to happen. The EU summit at the weekend; the meeting of Gordon Brown's National Economic Council yesterday, and the Chancellor's statement to parliament; the announcement of a $900bn lending programme to the banks by the US Federal Reserve: all of these too were designed to reassure.

They may have achieved the opposite effect, drawing attention to the fact that the authorities may have little left with which to counter the force of nature that the credit crisis has become. Certainly the unilateral decision by Germany to offer a guarantee to her nation's savers, especially set against the warmly co-operative words of the EU communiqué, and the botched rescue of the stricken Hypo Real Estate mortgage bank, fuelled fears that the authorities were not quite up to the challenge. President George Bush told the world that "it's going to take a while" for his financial rescue plan to work.

And if the authorities run out of ammunition, what then? The new fear is that the credit crunch is about to visit upon the "real economy" the damage it has inflicted on the financial and property sectors. That is certainly frightening the markets as they assess and reassess the probabilities of a slump, one that will leave no corner of the globe untouched, not even China. Hence the decline in mining stocks and much else.

The credit crisis could soon begin to throttle otherwise perfectly healthy companies. Willem Buiter, a former member of the Bank of England's Monetary Policy Committee (MPC), explained: "A few of the larger and better-known corporates can bypass the banks and issue directly in the capital markets, but this option is not open to smaller and newer firms. All they can do is hunker down and cut back first on fixed investment, then on working capital and ultimately on employment.

The economies of the euro area and the UK have entered a recession that is likely to be both deeper and longer than seemed likely even a month ago."

The CBI became the latest voice to virtually beg the Bank of England to cut interest rates at the next meeting of the MPC on Thursday. Its Deputy Director-General, John Cridland, said: "In the light of the current turmoil in the markets, the damage to confidence and implications for the real economy, the CBI believes that the Bank of England should cut interest rates by half a point when it meets on Thursday."

Almost every economist in the City now believes the Bank will reduce rates, perhaps by a half-percentage point to 4.5 per cent. Some predict a fall to as low as 2.5 per cent next year, the lowest since 1951. The snag, as central banks around the world have discovered, is that the commercial money markets are so seized up that these cuts are hardly passed onto borrowers and house-buyers.

The credit crunch inspires a fear that no mere government can overcome.

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