The head of the City's financial watchdog, Adair Turner, warned that the global economy was at risk of a deflationary spiral as the private sector and governments seek to pay off their debts at the same time.

On a day of fresh jitters on the global markets, the chairman of the Financial Services Authority (FSA) said escaping from a debt crisis caused by excessive lending by the banks was proving tougher than policymakers had ever envisaged.

The budget impasse in Washington and fears of a break-up of the eurozone sent shares tumbling on Monday, with the FTSE 100 index down by more than 140 points to close 2.6% lower at 5222.6. Stock markets in Frankfurt and Paris fell by 3%, while New York's Dow Jones industrial average closed down by almost 250 points, a 2.11% fall to 11547.31.

Lord Turner was highly critical of the lax regulation that allowed lenders to extend too much credit during the boom years. Speaking in Frankfurt, he said: "We are far from out of this crisis: it is far deeper and more difficult to escape than many of us initially thought."

He added that the past failure to control adequately either private debt or public debt creation meant that the challenge of reducing debt levels was now so severe that it was likely to require a combination of higher growth, repayments of borrowing, debt writedowns and pumping money into the economy through policies such as quantitative easing.

Turner said there had been a "catalogue of profound errors in the design of our prudential regulation of banks and shadow banks which combined to leave us by 2007 with a massively over-leveraged financial sector free both to extend excessive credit to the real economy, and to create excessive intra-financial system risks."

Banks had been allowed to operate with too little capital and insufficient liquidity on the "erroneous assumption that increased bank leverage delivered social as well as private benefits", Turner said.

Financial markets were left unimpressed by the victory of the centre-right party in the Spanish general election, and were instead unsettled by hints that the credit rating agency, Moody's, might remove France's coveted AAA rating. In Moody's weekly credit outlook, Alexander Kockerbeck, a senior credit officer, said: "Elevated borrowing costs persisting for an extended period would amplify the fiscal challenges the French government faces amid a deteriorating growth outlook, with negative credit implications."

The risk premiums on Spanish, Italian, French and Belgian government bonds rose as investors fled to safe-haven German bunds, while oil prices fell sharply amid concerns that the global economy was losing momentum.

Defending the austerity policies blamed for choking off growth and jobs, Olli Rehn, European economic and monetary affairs commissioner, said: "This crisis is hitting the core of the eurozone. We should have no illusions about this.

"One simply cannot build a growth strategy on accumulating more debt, when the capacity to service the current debt is questioned by the markets," Rehn told a Brussels seminar. "One cannot force foreign creditors to lend more money if they don't have the confidence to do it."

Turner said the crisis was the result of over-confidence in free financial markets and structural flaws in monetary union.

"And underlying both has been a failure to recognise the central importance to economic and financial stability of debt and leverage levels in general and bank credit creation and leverage in particular."

Arguing that policymakers had allowed banks to become excessively risky, Turner added: "The fundamental problem is that we have too much debt in the system – private and public combined. To create a more stable system we need to deleverage, in private and public sectors, to different degrees in different countries. But once you have excessive leverage, it is very difficult to deleverage without depressing the economy."

He noted that it was hard for the private and the public sector to pay off their debts at the same time without depressing demand, risking a self-reinforcing deflationary spiral.

"Given the more limited opportunities for rapid real growth today, and the fact that our current high levels of public debt are now accompanied, as they were not in post-war Britain or America, by high levels of private debt, we have to recognise that the deleveraging challenge today is in some ways more serious than that which we faced at the end of the second world war," he said.