By Ambrose Evans-Pritchard
The Telegraph, London
Friday, November 30, 2007

A clutch of Europe’s top economists have called on the European Central Bank to cut interest rates at its policy meeting next week, warning of severe downturn unless confidence is restored quickly to the banking system.

The concerns came as one-month Euribor spiked violently by 60 basis points to 4.87 percent today, the sharpest move ever recorded. Italy’s financial daily Il Sole splashed on its website that the Euribor had “gone mad.”

The three-month Euribor rate used to price floating-rate mortgages in the Spain, Italy, Ireland, and other parts of the euro-zone rose to 4.77 percent, near its August high and far above the ECB’s 4 percent lending rate.

Thomas Mayer, Europe economist for Deutsche Bank, said the authorities should take pre-emptive action to unfreeze the debt markets and reduce the danger that events could spiral out of control.

“If they don’t do anything, this could go beyond just a normal recession. With this credit crisis it could turn into a very uncomfortable situation, with a real economy-wide crunch that we cannot stop,” he said.

“We’re still seeing considerable stress in the European banking system, especially for smaller banks that can’t get credit. I am afraid we could have another Northern Rock case,” he said.

It emerged today that Germany’s IKB bank had racked up losses of E6.15 billion on subprime ventures, although it has been rescued by a pool of German banks.

Mr Meyer is one of six members of ECB’s Shadow Council to vote for a rate cut at a gathering in London today.

The group of bank economists and leading academics — organized by Germany’s Handelsblatt newspaper — meets before each ECB vote. It serves as barometer for eurozone opinion.

Veronique Riches-Flores, Europe economist at SociΓ©tΓ© GΓ©nΓ©rale, said investors were deluding themselves if they believed that Europe and the rest of the world could carry on growing briskly as the housing slump engulfed America.

“The idea people have in mind that emerging markets can decouple is completely wrong. Emerging markets are only OK as long as the US consumer is OK,” she said.

She warned that the surging euro had become a bigger long-term threat to the region than people realized.

“The problem of the exchange rate is urgent. The euro has appreciated 50 percent against the Asian currencies this decade and that really worries me.”

It is unclear whether the grim mood at the shadow council foreshadows a policy shift at the real ECB. A German-led bloc of monetary hawks in Frankfurt has been on the war path in recent weeks, fearing that inflation could soon become lodged in the system and set off a 1970s-style wage-price spiral. The ECB’s dovish faction tends to keep silent but may have more votes.

German CPI inflation reached 3.3 percent in November, the highest since the launch of the euro. It is approaching levels that could start to erode popular support for the single currency in Germany.

Austria’s ECB governor, Klaus Liebscher, said this week that inflation had become “alarming,” citing a jump in oil, commodity, and food costs, as well as capacity contraints in industry, and a spate of fat wage rises. “There’s a good number of reasons why we can’t be complacent,” he said.

Joachim Fels, head of economic research at Morgan Stanley, said it was an error to dwell on inflation at time when the economy is tipping over, dismissing the latest spike as a hangover effect that would subside next year. The greater risk is monetary overkill. The surge in Euribor spreads amounts to three rate rises, he said.

While 13 of the shadow board voted to keep rates unchanged (none voted for a rise), most agreed that the world is facing an ugly cocktail of buckling demand combined with an oil shock, a stagflation mix that is extremely hard for central banks to combat.

Jacques Cailloux, Europe economist for RBS, said there already clear signs that the US slowdown is spilling over into Europe and the rest of the world, although the markets had yet to wake up to the full implications.

“We’re seeing a contraction in German exports to Asia. I don’t see any evidence that decoupling is happening. The biggest five European banks have $2 trillion of claims on the US economy,” he said.

Jean-Michel Six, Europe economist for S&P, said the great unknown was whether deflating house prices in the Club Med region and Ireland would trigger a serious downturn, and whether banks still had enough oxygen as the credit crunch ground on and on.

“What will be the effect if they have to repatriate mortgage securities onto their books on a massive scale? It could be a major constraint on their ability to lend. This is the first test since the Basel II rules came into force, so we’ll see what happens,” he said.

There is a fear the restrictive Basel II code could force banks to tighten further to meet reserve asset requirements, compounding the credit crunch.

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