Europe may be slipping into a “deep and prolonged recession” as high levels of government debt, financial market turmoil and political paralysis stoke a dangerous downward cycle, the European Commission said Thursday.
Growth has already stagnated across the region, a major economic zone that includes the 17 countries that use the euro as well as others, such as Britain, that don’t.
The commission slashed its 2012 growth forecast for the region to a mere 0.6 percent but said there was a high probability that growth could slow even further.
As Greece and Italy continued struggling with leadership crises, the report offered a pointed analysis of the depth of the economic dilemma Europe faces and the potential cost to the world economy. The region’s problems have become self-reinforcing — with weak government finances, weak banks, and weak private demand all feeding off of one another, and a weak political response that’s so far been unable to stem the decline.
Unchecked, a slowdown or new recession in Europe would threaten the rest of the world through numerous channels. The flow of imports and exports with major trading partners such as the United States is already dropping. Investment in fast-growing eastern European economies could dry up, undercutting a part of the region that has been a top performer. China and other Asian countries would lose important customers. Bank failures could add to the shock in broad and unexpected ways.
World stock markets reacted modestly to the grim forecast. European exchanges were largely flat. U.S. indices recovered somewhat from a Wednesday sell-off triggered by concerns over Italy’s financial condition.
Several developments helped calm the markets. Greece appointed economist Lucas Papademos as prime minister of a unity government, which is being formed to keep an international rescue program on track. And Italy moved toward appointing respected politician Mario Monti to head an interim government meant to speed economic reform.
Italian bond rates dipped slightly after they jumped to more than 7 percent on Wednesday. Financial analysts interpreted the decline in rates as evidence that the European Central Bank had ramped up its purchases of Italian bonds in an effort to hold down the country’s borrowing costs.
But it may only be a lull.
Whether highly indebted Italy or frugal Finland, the European countries will now be fighting to trim their government deficits and strengthen their banking systems in an increasingly challenging economy.
Even modest growth can help ease a country’s debt burdens, spreading the load across a larger economic base and providing increased tax receipts that reduce the need to borrow.
But stagnation — or worse, an outright economic contraction — would make it harder for even well-performing countries to keep their government budgets on track, keep their banks healthy and avoid another spike in Europe’s already high unemployment.
The commission’s latest survey emphasized that there is no safe haven from the slowdown. Even the euro region’s large economic stalwarts, France and Germany, will see growth plummet to less than 1 percent in 2012, far slower than the commission forecast in the spring.
Growth “is critical to whether you intensify the crisis or provide breathing space,” said David Bowers, managing director of London-based Absolute Strategy Research. “Before this crisis is over, it is going to need a growth narrative.”
The commission report offered a lengthy description of how Europe’s problems developed from initial concerns two years ago about high levels of government debt in Greece to a full-blown crisis of confidence that has put Europe’s economic core at risk of a downturn.
The situation has lead to increasingly sharp political exchanges within the euro zone, as leaders such as Germany’s Angela Merkel push nations like Greece and Italy to speed economic reform. The crisis has also raised tensions between the euro region and the 10 other European Union countries that don’t use the common currency but now are also threatened.
British Prime Minister David Cameron waded into sensitive territory on Thursday when he urged the euro-zone nations to let the ECB take a more direct approach in boosting growth and keeping the government finances of Italy and other nations stable. German officials have insisted that the bank remain focused almost solely on fighting inflation.
Other major central banks, including the Federal Reserve and the Bank of England, play a broader role in supporting economic health. Many analysts say a more activist role by the ECB is the only sure fix to Europe’s problems.
“If the leaders of the euro zone want to save their currency, then they, together with institutions of the euro zone, must act now,” Cameron said in a speech in London. “The longer the delay, the greater the danger.”
For France, the euro zone’s second-largest economy, slower growth means it will likely miss its deficit-reduction targets and need “close vigilance” over public spending as its outstanding debt climbs above 90 percent of annual economic output.
The cost of insuring French debt against default rose on Thursday, despite what French political leaders say will be an unyielding fight to retain the country’s AAA credit rating. Analysts have said that signs of financial distress in France would likely prompt German officials to reconsider their views about the proper role of the ECB.