The Organization for Economic Cooperation and Development said Europe's debt crisis risks spiraling and seriously damaging the world economy.

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

The remarks amount to a warning to European Union leaders who are preparing to gather in Brussels tomorrow to discuss how to revive growth and grapple with a political impasse in Greece, where voters rejected austerity measures in elections on May 6. The euro has dropped more than 3 percent this month on concern that Greece may opt to leave the 17-nation monetary union.

The OECD, which advises its 34 member governments on economic policy, left its 2012 growth forecast for the group unchanged at 1.6 percent as the gloomier picture in the euro area was offset by improving prospects in the U.S.

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

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

Germany's GDP, adjusted for work days, will expand 1.2 percent this year and 1.9 percent in 2013, while France will post growth of 0.6 percent and 1.2 percent, the OECD forecast. By contrast Italy's economy will shrink 1.7 percent and 0.4 percent, and Spain's will contract 1.6 percent and 0.8 percent.

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

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

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

Reform Fatigue

The OECD warned that voters in euro-area countries struggling with austerity measures may not put up with further budget cuts.

“Tolerance for fiscal adjustment may be reaching its limit,” it said. “With recession in a number of countries in 2012 and 2013, a combination of enduring financial fragility, rising unemployment and social pain may spark political contagion and adverse market reaction.”

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

Europe's fiscal compact, which aims to anchor budget restraint in national law and boost supranational surveillance, should be partnered by a growth compact that could include the issuance of jointly-guaranteed bonds to help recapitalize banks and increasing resources available to the European Investment Bank to fund infrastructure projects, the OECD said.

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

The European outlook contrasts with that of the U.S., for which the OECD lifted its growth forecasts to 2.4 percent and 2.6 percent this 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 confidence is picking up in both businesses and households,” Padoan wrote. “The risk of excessive fiscal tightening in 2013 remains to be addressed, failing which, growth would be severely affected.”

China's Slowdown

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

“China's slowdown became more pronounced in late 2011 and early 2012 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 infrastructure projects.”

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

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

Bloomberg News

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Euro Crisis Threatens World Growth

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