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New blow for eurozone as EU cuts growth forecasts

Drastic reduction in 2012 predictions dashes hope of early end to debt crisis

A prediction of collapsing economic growth across Europe from the European Commission yesterday threatened to ratchet up the eurozone sovereign debt crisis to a new level of intensity.

Warning that a "deep and prolonged recession" across the continent could not be ruled out, the European Union's executive body slashed its 2012 forecasts for growth across the single currency area from 1.8 per cent to 0.5 per cent. Economists pointed out that a drop in growth, particularly in the troubled nations of the eurozone periphery, would make it still more difficult for policymakers to hold the single currency together.

"Growth has stalled in Europe and there is a risk of a new recession," said the Commission's economic chief, Olli Rehn, unveiling the report. He also warned that unemployment across Europe, which has already provoked mass protests in Athens and Madrid, will remain high throughout next year.

The news brings to a troubling end one of the most tumultuous weeks in the EU's economic history. As Greece and Italy struggled to provide the political clarity economists say is essential for their recovery – a technocrat was installed as Prime Minister in Athens yesterday but Italian parliamentarians continued to bridle against such a move in Rome – the spiralling cost of borrowing has threatened to infect other European economies. Yesterday France was moving to the top of the list of nations at risk.

The intense stresses in the €1.9 trillion Italian bond market at least abated slightly yesterday after Wednesday's panic. Italy managed to sell €5bn of one-year bonds and the interest rate on 10-year borrowing dropped below 7 per cent. But the main buyers of the one-year issue were believed to be domestic Italian banks, acting under pressure from the government in Rome. And the fall in the crucial 10-year yield was reckoned by some market participants to be due to bond buying in the secondary markets by the European Central Bank rather than a substantial improvement in private investor sentiment.

The difference between the interest rate charged by the markets on borrowing by the French government and that charged on German borrowing also stretched to its highest level since the foundation of the single currency – a sign that the crucial economic axis of the eurozone itself is coming under strain. Bond investors were also briefly panicked when the US credit rating agency Standard & Poor's accidentally sent out a message indicating, misleadingly, that it had downgraded France's credit rating.

Rome seemed to be moving towards a technocratic caretaker government headed by the former European Commissioner Mario Monti. Yesterday, Mr Monti pulled out of a conference he had been due to chair in The Hague this weekend, after the Italian President, Giorgio Napolitano, asked him to stay in Italy.

US President Barack Obama spoke with his Italian counterpart, Giorgio Napolitano, to express his confidence in his leadership and to be updated on the situation, the White House said. The US president also spoke on the phone to the French and German leaders about the financial crisis.

Meanwhile, in Greece, Lucas Papademos, a former vice-president of the European Central Bank, was named as the leader of a government of national unity in Athens, after five days of haggling.

Emerging from talks with the outgoing Prime Minister, George Papandreou, and the leader of the opposition, Mr Papademos issued a call for unity. He said: "The path will not be easy but I am convinced the problems will be resolved faster and at a smaller cost if there is unity, understanding and prudence." Mr Papademos's first job will be to secure approval for the €130bn bailout package for Greece, agreed in Brussels last month, from the Greek parliament.

In Berlin, the German Chancellor, Angela Merkel, tried to play down reports she has been secretly exploring plans with French officials to break up the single currency. "Germany has had only one goal. That is to bring about a stabilisation of the eurozone in its current form, to make it more competitive, to consolidate budgets," Ms Merkel said.

While investors continued to press for the European Central Bank to do more to support the bonds of distressed European governments, two senior policymakers at the Frankfurt central bank voiced their opposition to any such intervention. "We have gone pretty far in what we can do but there is not much more that can be expected from us. It is now up to the governments," said Klaas Knot, the head of the Dutch central bank, to the Dutch parliament. He was backed by another ECB board member, Peter Praet of Belgium, who said that a central bank should not intervene when there were doubts about a nation's fiscal "sustainability".

The European Commission's twice-yearly economic report forecasts growth in Italy next year will slump to just 0.1 per cent. It predicts that the Greek economy will contract by 2.8 per cent and the Portuguese economy by 3 per cent. Germany, Spain and France are predicted to register growth of just 0.8 per cent, 0.7 per cent and 0.6 per cent respectively.

A report released by the Bundesbank, Germany's central bank, revealed yesterday that German banks have a total exposure to Greece of €27.8bn and of around €118bn to Italy. The report urged policymakers to tackle the "root cause" of the crisis, which it identified as "unsustainable public finances" in a number of eurozone states.

Yesterday, the Labour leader, Ed Miliband, called for an emergency European Council meeting to be convened this weekend. He said: "That meeting must not be allowed to break up until a comprehensive solution has been put in place for the crisis. We are now all paying the price for the failure of leaders at the European Council and then the G20 summit over the last two weeks. That is going to have to change and change now." The former Prime Minister, Gordon Brown, also called for greater urgency from EU leaders and warned that the crisis could spread to France in the coming months.

Impasse: How could the crisis be resolved?

Hopes that an end to the eurozone debt crisis may be in sight have been repeatedly dashed. Four principal avenues of potential escape have been suggested. Some have been rejected as impractical. Others have proved politically impossible.

European Central Bank

Many are pushing for the central bank in Frankfurt to buy up the debt of distressed sovereign borrowers such as Italy and Spain in sufficient quantities to drive down the bond yield, or interest rate, on that debt. This would enable all European governments to borrow at affordable rates. This proposal has been resisted by the German government and members of the ECB who claim it would result in inflation and reduce pressures on governments to reform their domestic economies. Three ECB policymakers reiterated their opposition to a wider programme of distressed bond purchases this week.

Two-tier eurozone

Reports surfaced this week that French and German politicians have been secretly discussing the creation of a two-tier eurozone. Nations with sound finances such as Germany, the Netherlands, France and Finland would form a currency bloc that would be separate from distressed states. This would mean an effective devaluation for weaker states, which would help the likes of Greece, Italy, Spain, Ireland and Portugal with their economic adjustments. But such a division would also mean huge losses for the banks in the northern bloc which hold much of the sovereign and corporate debt issued by southern states (debt that would inevitably plummet in value). Officials from the European Commission also strongly rejected the two-tier plan yesterday.

International Monetary Fund

Several European governments joined forces with China, India, Russia and Brazil at the recent Cannes G20 summit to push for the resources of the IMF to be massively boosted so that the Fund can credibly pledge to stand behind all distressed eurozone nations if necessary. There was also a plan for European nations to pool their IMF credit lines and use them to increase the firepower of the eurozone's own internal bailout fund. But the latter plan was blocked by the Bundesbank, which controls Germany's IMF credit lines. And the former plan was rejected by the US, which wants wealthy Europe to sort out its own problems rather than relying on support from the rest of the world in the form of the IMF.

Closer fiscal union

The President of the European Commission, José Manuel Barroso, has argued that eurozone countries should guarantee each others' debt by issuing common eurobonds. Similarly, some, including the UK Chancellor, George Osborne, have urged European governments to move towards a closer political union and economic union to demonstrate to investors that the eurozone is not breaking apart. But the German Chancellor, Angela Merkel, has vetoed the idea of eurobonds, arguing that joint debt guarantees would allow nations to continue spending beyond their means and then get the prudent Germans to pick up the bill. And closer political union could not take place without a new EU treaty, which would take a great deal of time to draw up and which national parliaments or electorates might reject.

Ben Chu

Please can we join the Euro?

Romania's President, Traian Basescu, has reiterated his country's desire to join the euro. Accord- ing to one report he had to add: "Please don't laugh." German Chancellor Angela Merkel later congratulated Romania on its determination.

Elsewhere, further details from President Sarkozy's overheard G20 comments emerged. Following reports that he called Netanyahu a 'liar', French media revealed the President also called Greek Prime Minister George Papandreou "a madman".