Jan. 21 (Bloomberg) -- Jean-Claude Trichet and Lawrence Summers accurately warned investors a year ago about being too complacent. Now they see an erosion of confidence that threatens to paralyze the global economy.

Former U.S. Treasury Secretary Summers returns to the World Economic Forum in Davos, Switzerland, this week urging quick action in the form of economic stimulus to head off ``a cascading loss of confidence'' in the U.S. economy after the collapse of its housing market. European Central Bank President Trichet, also traveling to the Alpine retreat, is leading international colleagues in lending emergency cash to banks.

``When you have recessions from bubbles bursting, they tend to be protracted,'' says Summers, a Harvard economist and the university's former president. ``There is the possibility, not yet at all the probability, that a recession could prove long and severe.''

As the hubris that Trichet and Summers decried last year is replaced by fear, an aversion to risk-taking may worsen the outlook for the world economy. Europe's Dow Jones Stoxx 600 Index today plunged the most since the 2001 terrorist attacks.

``Davos was marked last year by an irrational exuberance,'' Josef Ackermann, chief executive officer of Frankfurt-based Deutsche Bank AG, Germany's largest bank, said in an e-mailed response to a question. ``I hope that we don't swing to the opposite this year and give in to an irrational depression.''

Bankers are dumping derivatives that drove the credit boom in favor of havens such as gold and U.S. Treasuries. At the same time, they're constraining lending and eliminating jobs.

Slowing Economy

The MSCI World Index slipped 2.4 percent today, extending its decline from an Oct. 31 record to 17 percent. Stocks also plunged in Hong Kong, India and Brazil. In the past 10 days, Citigroup Inc. cut 4,200 positions after its biggest quarterly loss ever, German investor confidence fell to the lowest level since 1992 and the first signs emerged that China's economy may be slowing.

Another indication that investors are losing their appetite for risk is the increase in stock-market volatility, as measured by the Chicago Board Options Exchange's VIX index. The VIX has more than doubled in the past year, after showing little movement for most of 2006.

As investors convert to less-risky holdings, gold reached a record $914.30 last week, and the yield on the benchmark 10-year Treasury note fell to a four-year low.

``We have to pay for the sins of the past,'' Klaus Schwab, 69, the World Economic Forum's founder and chairman, said in a Jan. 11 interview. ``The mood of Davos has changed.''

Nursing Losses

``I don't know how you can have an optimistic, self- congratulatory feeling today,'' says Stephen Schwarzman, co- founder of Blackstone LP, the world's largest buyout firm.

People nursing losses as they try to enjoy the Davos party circuit can't say they weren't warned. Trichet said at the 2007 forum that a ``reappreciation of risk'' was ``likely.'' Summers compared the confident mood then with the market sentiment that prevailed just before World War I.

Such caution was brushed aside a year ago. John Thain, then chief executive officer of NYSE Group Inc., was in Davos at the time and said ``the financial markets, the world economies are all actually in quite good shape.''

Thain, returning to Davos this week, knows better now: In December, he became chief executive officer of Merrill Lynch & Co., charged with reversing the worst losses in the brokerage's 93-year history after it was battered by $16.7 billion in writedowns of failed investments.

New Capital

On a conference call last week, Thain, 52, said that while Merrill ``will continue to take risks,'' they must be ``sized appropriately'' so they don't have the potential to wipe out profit.

This month, Merrill raised new capital from a group including the Kuwait Investment Authority. Citigroup, the biggest U.S. bank, is getting $14.5 billion from investors including the Singapore government and Saudi Prince Alwaleed bin Talal.

Representatives of such state-run funds may be some of the most sought-after participants among the 2,500 executives, investors, policy makers and academics at the four-day gathering. Russian Finance Minister Alexei Kudrin; Mohamed Al- Jasser, vice governor of the Saudi Arabian Monetary Authority; and Bader al-Saad, managing director of the Kuwait Investment Authority, plan to sit on a Jan. 24 panel discussion about so- called sovereign-wealth funds.

Wall Street banks have raised $59 billion, much from governments in the Middle East and Asia, to shore up balance sheets pounded by more than $100 billion of writedowns.

Trichet's Leadership

The Jeremiahs of a year ago are now preaching policies to limit the damage they foresaw. Summers, 53, was one of the first economists to propose remedies such as tax rebates and extended jobless benefits to avert recession in the U.S.

Among central bankers, Trichet, 65, has led the way in offering emergency funds to financial institutions stung by the jump in credit costs. The measures culminated in the broadest instance of international economic cooperation since the aftermath of the 2001 terrorist attacks, as the Fed, the ECB and central banks in Canada, the U.K. and Switzerland made cash available to commercial banks to keep markets functioning.

``Risks are on the downside,'' Trichet said in Basel, Switzerland, on Jan. 7, pointing to ``the impact of the significant market correction.''

Going Further

Other central bankers are going further, combining rate cuts with injections of cash. Fed Chairman Ben S. Bernanke, 54, said on Jan. 10 he was prepared to take ``substantive additional action'' on top of 1 percentage point of rate cuts since September. Trading in futures markets indicates investors are certain the Fed will cut its benchmark rate at least a half point, to 3.75 percent, at its Jan. 29-30 meeting.

Still, the financial crisis may turn out to be one of the worst ever, concludes a new paper co-written by Davos speaker Kenneth Rogoff of Harvard, the former chief economist at the International Monetary Fund, and Carmen Reinhart of the University of Maryland. Their review of 18 previous slumps found that, on average, financial crises knock 2 percentage points off growth and recovery requires two years. The worst episodes cost 5 percentage points of growth.

``The big question is how deep the losses in the banking sector will be,'' Rogoff said in a Jan. 15 interview. ``They will be at least $300 billion to $400 billion, which would be a moderate crisis. But if house prices continue to drop, we could see two or three times those losses, and it will one of the bigger financial crises.''

Financial Crisis

Nouriel Roubini, founder of New York-based Roubini Global Economics LLC, calculates losses will top $1 trillion. ``The risk of a systemic financial crisis is rising,'' says Roubini, who spent last year's conference warning of a U.S. recession.

For top executives and investors, the danger may be that the mood becomes so dark they talk themselves into recession.

``We tend to be overly optimistic when times are good and overly pessimistic when things go sour,'' says John Snow, chairman of Cerberus Capital Management LP, another former U.S. Treasury secretary and a Davos delegate. ``It has all the makings of a tough year.''

To contact the reporters on this story: John Fraher in London at jfraher@bloomberg.net; Simon Kennedy in Paris at skennedy4@bloomberg.net.

Last Updated: January 21, 2008 13:54 EST