Two months ago the chairman of the Commons Treasury Select Committee asked the Governor of the Bank of England if the British taxpayer was being “taken for a mug” in bailing out the banks. “No,” Mervyn King replied. But his latest report on UK credit conditions will alarm taxpayers all the same.

In the fourth quarter of last year it was hoped that a series of dramatic interest rate cuts and rescue packages for the banking system would restore banks' confidence to the point that they resumed lending on a significant scale to each other and to homebuyers and businesses.

It has not happened. Credit remains impossibly scarce for most first-time buyers and thousands of small and medium-sized businesses. Lenders expect it to become even more so in the next three months, triggering rising numbers of bankruptcies and lay-offs, and the possibility of a new bailout within weeks.

There is a sound - if not reassuring - reason for the continued paralysis of credit markets: banks are still rebuilding shattered reserves. While taxpayers may be suffering in their role as borrowers, their interests as shareholders in newly nationalised banks are being protected. But the credit freeze cannot be allowed to continue indefinitely. If it does, the banks will be among the most conspicuous casualties.

The credit conditions survey published yesterday makes for exceptionally bleak reading. Slightly fewer lenders in the fourth quarter of 2008 than in the third said that conditions were tightening, but the scarcity of mortgages was still twice as acute as the Bank of England had expected given the Government's interventions. The number of new mortgages issued in November reduced by two thirds compared with the same month in 2007, and their value shrank by 90 per cent. Loans were no easier to find for businesses. Three times as many lenders as expected reported tightening credit availability.

The financial crisis has made a mockery of the Bank of England's forecasting expertise. But it has also stung lenders so badly that even with a £37 billion bailout cushion, and with demand for credit unexpectedly robust, they have foresworn not just excessive risk but any risk at all.

This is understandable, but also unsustainable. Bank lending, or lack of it, has a natural tendency to exaggerate downturns as lenders' reserves and shareholders become their paramount concerns. Their need to strengthen loan-to-asset ratios is especially acute now because the collapse in the market for complex financial instruments at the heart of this crisis has left banks with losses on a scale that no one has yet been able to measure, let alone absorb. Furthermore, the Government has stated repeatedly that it will not micromanage lending decisions even in banks in which it has a controlling stake.

This is as it should be. Markets may not have lent wisely in recent years, but governments are even worse at allocating credit. Gordon Brown and the Chancellor have tried to set broad lending targets, but this, too, is doomed by their two conflicting priorities: until the banks have been recapitalised, their needs and those of businesses and homebuyers will be all but incompatible.

Whether or not he is forced into a fresh bailout, Mr Brown must resist the populist case for leaning on the banks to increase lending, and make a longer-term commercial argument: the longer that credit markets remain frozen, the worse the damage to banks' loan books as ordinarily creditworthy businesses go to the wall. What may be prudent for an individual bank becomes suicidal for the system as a whole. Lord Myners, the Financial Services Secretary, has warned banks against “reckless caution”. The time is fast approaching when that warning must be heeded.