European leaders must try harder to resolve the continent's debt crisis or risk driving the world into another recession, the International Monetary Fund warns in its latest assessment of the global economy.
The travails of the euro zone forced the fund to slice its four-month-old forecast for global economic growth by more than half a percentage point.
Global gross domestic product will expand 3.3 per cent in 2012, as a surprisingly resilient United States economy offsets a mild recession in the euro zone, the IMF predicts in an update of its World Economic Outlook, released Tuesday in Washington.
The revised estimate is not an especially strong number, suggesting it would take little to trigger a second downturn in less than three years. The global economy expanded 5.2 per cent in 2010 and averaged annual growth of 3.6 per cent over the decade before the 2009 recession. In September, the IMF was counting on global growth of 4 per cent this year.
"Global growth prospects dimmed and risks sharply escalated during the fourth quarter of 2011, as the euro area crisis entered a perilous new phase," the IMF report says.
European efforts to shore up the finances of its weakest members, devise a strategy to backstop its banks and stoke economic growth are entering their third year. Investors lost patience at the end of 2011, driving up the borrowing costs of every major European country, with the exception of Germany. The continent's banks are retrenching, which is taking on a toll on the economy by restraining credit. Austerity measures in most nations are further squeezing economic growth.
The cumulative result, according to the IMF, will be an economic contraction in the euro zone of 0.5 per cent in 2012, compared with September's forecast for growth of about 1 per cent. The euro zone will continue to struggle in 2013, managing growth of only 0.8 per cent, the IMF said.
Europe isn't the lone drag on the global economy, only the major one.
The IMF predicts oil prices will remain around $100 per barrel in 2012, as political uncertainty in the Middle East outweighs weaker demand. The U.S., which proved something of a growth engine over the second half of 2011, will slow this year, as high unemployment and stagnant wage growth will constrain consumer spending, the IMF says. With little economic activity in the U.S. and Europe, trade volume will shrink by 2 per cent this year, a blow to export-dependent emerging market countries.
Canada's economy is projected to grow 1.7 per cent this year, down from an estimated 2.3 per cent in 2011 and 3.2 per cent in 2010. That pace would tie Canada with Japan as the second-fastest growing economy in the Group of Seven Nations. The IMF forecasts the U.S. will advance 1.8 per cent in 2012.
"The updated WEO projections see global activity decelerating but not collapsing," the IMF report says. "However, this is predicated on the assumption that in the euro area, policy makers intensify efforts to address the crisis." Failure to do so would increase strains in the financial system, creating a scenario that the IMF says could reduce global growth by 2 per cent.
The new assessment explains why the fund is increasing the pressure on Europe to act. Christine Lagarde, the IMF's managing director and a former French finance minister, told an audience in Berlin that European countries must commit more money to a rescue fund or risk losing to the region's biggest economies to default.
"We need a larger firewall," Ms. Lagarde said in prepared remarks. "Without it, countries like Italy and Spain that are fundamentally able to repay their debts could potentially be forced into a solvency crisis by abnormal financing costs."
In addition, Ms. Lagarde wants European countries to force their banks to bulk up their reserves, preferably in private markets by selling shares, but through government capital injections if necessary. She also said European governments should ease up on austerity, unless their interest rates are so high that they have no choice but to reduce deficits.
That last piece of advice isn't only for European countries.
In a separate report on its members' fiscal policies, the IMF calls the level of planned spending cuts this year "considerable" given the weakness of the global economy. If interest rates are low and if debt loads are sustainable, policy makers should resist the urge to narrow budget deficits until the global economy strengthens, the IMF says.
"Countries should let automatic stabilizers operate freely for as long as they can readily finance higher deficits," the IMF says in the World Economic Outlook. "Among those countries, those with very low interest rates or other factors that create fiscal space, including some in the euro area, should reconsider the pace of near-term fiscal consolidation."
Canada would fit in that group because its debt level is extremely low by international standards. But the IMF's remarks most likely are directed at the U.S. and Germany, big economies that face longer term budget strain, but likely could afford more spending in the short-run. However, domestic political pressure is keeping governments from doing so.