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The mood in Europe is growing more sour by the day Add to ...

This wasn’t supposed to be a crisis meeting.

A year ago, the Group of Seven finance ministers were in an upbeat mood. The deep recession was ending and growth was making a comeback. The German economy was on fire. And, though wounded, most banks were still standing and the equity markets and corporate profits had come roaring back.

The mood began to sour a few months ago as the European debt crisis deepened and austerity programs began chewing into growth. Today it’s foul and getting worse.

As the Western world teeters on the brink of a fresh recession, the two-day meeting of G7 finance ministers and central bankers in Marseilles will not be a champagne-soaked occasion. There is more work to be done and the ministers and bankers are running out of options.

Another barrage of grim economic news came only the day before their meetings are to begin. On Thursday, the European Central Bank and the Organization for Economic Co-operation and Development sharply lowered their growth forecasts. Both warned that the economic outlook was clouded with particularly high “uncertainty.”

The sharp slowdown puts the central bankers in a difficult position. It increases the odds that the austerity programs they have put in place will fail. It also means they may have to find ways to stimulate their economies to prevent unemployment rates from soaring – a difficult undertaking when most governments are tapped out.

The ECB expects the 17-country euro zone to grow between 1.4 per cent and 1.8 per cent this year, down from its June estimate of 1.5 per cent to 2.3 per cent. In 2012, the bank expects growth between 0.4 per cent and 2.2 per cent against its previous forecast of 0.6 per cent to 2.8 per cent.

The outlook from the OECD, which represents the world’s most advanced economies, was equally downbeat. It said quarterly growth in the second half should average less than 0.2 per cent a quarter – an annualized rate of less than 1 per cent.

Perhaps most worrisome was the outlook for Germany, whose extraordinary rebound in 2010 had convinced many economists and investors that the worst was over for the euro zone. The OECD forecast that Germany would see annualized growth of 2.6 per cent in the third quarter before contracting by 1.4 per cent in the fourth.

If the German contraction were to extend into the first quarter of 2012, the country would officially be in recession. A prolonged economic reversal in Germany, Europe’s biggest economy, would have the potential to kill euro zone growth and accelerate the debt crisis.

As growth slows, the ECB and other central bankers are leaving interest rates steady. In Brussels, ING Bank economist Carsten Brzeski said “further hikes are off the table.”

Some economists think the ECB, which had hiked rates twice this year as growth and inflation risks returned, will be forced to reverse course later this year (in an ill-timed move, the ECB raised rates in the summer of 2008, just before the collapse of Lehman Brothers). The OECD urged central bankers everywhere to consider rate cuts. “Policy rates in most OECD economies should be kept on hold,” its economists said. “If in the coming months signs emerge of the weakness enduring or the economy risks relapsing in recession, rates should be lowered where there is scope.”

The waning growth in the Western world in general, and in Europe and Germany in particular, has some economists and strategists wondering whether the G7’s Marseille meetings will concentrate on stemming a new crisis instead of managing recovery.

The ministers may even conclude that the austerity programs in place in every euro zone country may be too severe, to the point they’re backfiring. A G7 fact sheet written before the meeting notes that “in conditions of slow growth, care must be taken to ensure this necessary fiscal consolidation does not thwart recovery.”

Marshall Auerback, global portfolio strategist at Denver hedge fund Madison Street Partners, thinks the finance ministers will have trouble claiming that the austerity programs will work when the private sector is retrenching. He notes that budget deficits in the euro zone remain high in spite of the spending reductions and tax hikes.

Britain is one country suffering revenue shortfalls as growth wanes. Government revenue rose by only 4.3 per cent in the first four months of the current fiscal year, well short of the 7.7 per cent projected for 2011-12. The economy of Greece, whose austerity program is the euro zone’s severest, is deteriorating by the day as the spending reductions kill jobs and state investment programs. Greece is “on a knife’s edge,” German Finance Minister Wolfgang Schauble told lawmakers this week.

On Thursday, the Greek statistical agency reported that the country’s economy shrank by at an annual pace of 7.3 per cent in the second quarter, against a contraction of 8.1 per cent in the previous quarter. Unemployment rates are close to record highs and credit-default swaps on Greek debt surged to a record, signally a greater than 90-per-cent chance the government will default on its debt.

Mr. Auerback doubts that the euro zone will be able to use exports to speed its recovery since the member states cannot devalue the currency. “I don’t think we’ve reached bottom yet,” he said.

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