L’ISLE-SUR-LA-SORGUE, France (Reuters) - The euro zone’s repeated failure to tackle its debt crisis is catapulting the bloc toward recession, raising the specter of dangerous spillovers to the rest of the world economy.
Whittling down the euro area’s mountain of debt was always going to be a long slog, even without the unpredictable political dramas in Greece and Italy that overshadowed last week’s summit of the Group of 20 major economies in Cannes on the French Riviera.
But the inability of euro zone leaders to convince their G20 counterparts that they were getting a grip on events has made the task that much harder. Confidence, already fragile, has frayed further.
“It’s no wonder that people aren’t spending when all you hear every day is about ‘the crisis’,” said Michel Quintao, co-owner of a wrought-iron workshop in this corner of southeast France, some 200 km (125 miles) from Cannes.
Even before the G20 meeting and an inconclusive pair of euro zone debt-crisis summits last month, the corrosive effect of flagging confidence was taking a toll on growth.
The euro zone’s composite purchasing managers’ index, a timely gauge of business sentiment, fell sharply in October to 46.5 from 49.1 in September, while German manufacturing orders slumped 4.3 percent in September.
Jim O’Neill, chairman of Goldman Sachs Asset Management, said the figures suggested the 17-member euro zone was already in, or close to, recession - explaining why the European Central Bank cut interest rates last Thursday, to the surprise of many investors.
O’Neill said the spread of economic weakness from the periphery to the core of the euro zone was in large part due to contagion via the financial markets, especially the relentless pressure on Italian bonds.
“They desperately need somehow to stabilize Italian financial markets,” O’Neill said.
Undermined by market mistrust of Prime Minister Silvio Berlusconi’s government, Italy’s 10-year bonds yields soared to a euro era high of 6.4 percent last week.
That is close to levels that made the debt-service burdens of Greece, Ireland and Portugal unsustainably onerous and triggered bailouts by the euro zone and the International Monetary Fund. But Italy, with 1.9 trillion euros in public debt, is simply too large to bail out.
O’Neill said it boiled down to vanishing confidence. After all, until July, Italy was relatively untouched by the maelstrom despite weak growth that has averaged just 0.6 percent a year since the euro was created in 1999. Even now, its cyclically adjusted budget position is one of the strongest of any major economy.
“It’s a crisis of confidence: Italy needs leadership and supply side reforms to boost growth,” O’Neill said.
As Europe bumbles, the rest of the world is watching anxiously, fearful of the fallout.
The United States is perhaps only half-way through its own debt workout. Recovery from the 2008/2009 recession is the weakest on record and, even though economists have marked up their forecasts for fourth-quarter growth, a slump in Europe could revive fears of a relapse.
“The risks associated with the euro area’s slide into recession are meaningful,” economists at J.P. Morgan wrote in their weekly Global Data Watch publication.
Asia is currently the region with the strongest economy, but it too would not escape unscathed if Europe took a big hit.
Indeed, Rob Subbaraman, Nomura’s chief Asian economist based in Hong Kong, said sentiment was already being tested. Companies and the man in the street were anxious.
“Growth is cooling but it’s not collapsing,” Subbaraman said. Still, he said it was fanciful to imagine that Asia could decouple from its major Western markets. “Asia is very much integrated into the global economy, and if things deteriorate, we’ll get hit hard again,” Subbaraman said.
It was telling that Australia, whose reliance on commodity exports makes it a good barometer of global demand, saw fit to cut interest rates last week for the first time since April 2009. The Reserve Bank of Australia (RBA), the central bank, said a ‘mildly restrictive’ policy was no longer appropriate.
“The RBA has a very good track record on monetary policy, yet they felt compelled to take their foot off the brake,” Subbaraman said.
China, which sends 20 percent of its exports to the European Union, has tirelessly pressed for a resolution to the euro zone’s problems, although President Hu Jintao, like other G20 leaders, conspicuously declined in Cannes to contribute to the bloc’s rescue fund.
Ting Lu, a Bank of America Merrill Lynch economist based in Hong Kong, is forecasting robust 8.7 percent year-on-year growth for China this quarter and 8.6 percent in 2012. But he said a sharp slowdown could not be ruled out in the event of an economic slump in Europe or a break-up of the euro.
“Our central case is a soft landing. We do have a scenario for a hard landing, but it’s not because of domestic Chinese issues,” Lu said.
In short, the world economy is increasingly hostage to the fast-changing politics of the euro zone. For want of leadership, uncertainty and fear are sapping the spirits of entrepreneurs, investors and consumers.
“Let me be clear,” Canadian Prime Minister Stephen Harper said in Cannes. “Moving the European plan forward remains critical to restoring confidence and growth in the global economy.”
Editing by Erica Billingham