The Organization for Economic Cooperation and Development saidEurope's debt crisis risks spiraling and seriously damaging theworld economy.

“The risk is increasing of a vicious circle, involving high andrising sovereign indebtedness, weak banking systems, excessivefiscal consolidation and lower growth,” OECD Chief Economist PierCarlo Padoan wrote in the organization's semi-annual report on theglobal economy. Such a downside scenario “may materialize and spillover outside the euro area with very serious consequences for theglobal economy,” he said.

The remarks amount to a warning to European Union leaders whoare preparing to gather in Brussels tomorrow to discuss how torevive growth and grapple with a political impasse in Greece, wherevoters rejected austerity measures in elections on May 6. The eurohas dropped more than 3 percent this month on concern that Greecemay opt to leave the 17-nation monetary union.

The OECD, which advises its 34 member governments on economicpolicy, left its 2012 growth forecast for the group unchanged at1.6 percent as the gloomier picture in the euro area was offset byimproving prospects in the U.S.

Gross domestic product in the euro region will shrink 0.1percent this year and expand 0.9 percent in 2013 instead of postinggrowth of 0.2 percent and 1.4 percent as predicted last November,the Paris-based OECD said today.

“Such persistent weakness reflects underlying economic, fiscaland financial imbalances within the euro area, which have been theroot cause of this crisis and barely begun to unwind,” Padoan said.“Recovery in healthier countries, while welcome, is not strongenough to offset flat or negative growth elsewhere.”

Germany's GDP, adjusted for work days, will expand 1.2 percentthis year and 1.9 percent in 2013, while France will post growth of0.6 percent and 1.2 percent, the OECD forecast. By contrast Italy'seconomy will shrink 1.7 percent and 0.4 percent, and Spain's willcontract 1.6 percent and 0.8 percent.

The OECD urged the European Central Bank to stand ready toresume buying government bonds in the secondary market shouldmarket turmoil increase.

Volatility in sovereign bond markets “could have repercussionsfor the stability of the banking system and ultimately publicfinances,” the OECD said. That may require a policy response that“could involve further action by the ECB through its governmentbond purchasing program.”

In any event, given declining inflationary pressures, “there isroom for further monetary easing,” it said. The ECB has already cutits benchmark interest rate to a record low of 1 percent.

Reform Fatigue

The OECD warned that voters in euro-area countries strugglingwith austerity measures may not put up with further budgetcuts.

“Tolerance for fiscal adjustment may be reaching its limit,” itsaid. “With recession in a number of countries in 2012 and 2013, acombination of enduring financial fragility, rising unemploymentand social pain may spark political contagion and adverse marketreaction.”

Given the risks inherent in fiscal adjustment, the OECD calledfor austerity measures to be “as growth-friendly as possible,”arguing “much can be gained in efficiency of public spending andthrough a composition of taxation that is least harmful togrowth.”

Europe's fiscal compact, which aims to anchor budget restraintin national law and boost supranational surveillance, should bepartnered by a growth compact that could include the issuance ofjointly-guaranteed bonds to help recapitalize banks and increasingresources available to the European Investment Bank to fundinfrastructure projects, the OECD said.

“Such moves could pave the way to a broader issuance ofeuro-bonds,” Padoan said.

The European outlook contrasts with that of the U.S., for whichthe OECD lifted its growth forecasts to 2.4 percent and 2.6 percentthis year and next. In November, the organization predicted a U.S.expansion of 2 percent in 2012 and 2.5 percent in 2013.

“In the U.S., growth should continue to strengthen as confidenceis picking up in both businesses and households,” Padoan wrote.“The risk of excessive fiscal tightening in 2013 remains to beaddressed, failing which, growth would be severely affected.”

China's Slowdown

The OECD expects the Japanese economy to expand 2 percent thisyear and 1.5 percent next year. In China, which isn't a member ofthe OECD, growth will be 8.2 percent this year and 9.3 percent nextyear, according to the OECD's latest forecasts. That's less thanthe 8.5 percent and 9.5 percent growth rates it projected inNovember.

“China's slowdown became more pronounced in late 2011 and early2012 as first exports and then inventories fell,” the OECD said.“If growth continues to weaken in the second quarter of this year,the government should speed up implementation of key infrastructureprojects.”

Padoan warned that five years after the onset of the financialcrisis, policy makers have failed to rebuild confidence that is thebasis for growth.

“As long as confidence is not rebuilt on a solid basis with theright policy choices, downside risks will prevail,” he said. “Thisis important everywhere but particularly so in the euro area, wherecrisis management goes hand in hand with the building of theinstitutions needed for a monetary union to work properly.”

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