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Decisive policies must be urgently put in place to stop the Euro area sovereign debt crisis from spreading and to put weakening global activity back on track, says the OECD’s latest Economic Outlook.

The Euro area crisis remains the key risk to the world economy, says the report. Concerns about sovereign debt sustainability are becoming increasingly widespread.

If not addressed, recent contagion to countries thought to have relatively solid public finances could massively escalate economic disruption. Pressures on bank funding and balance sheets increase the risk of a credit crunch.

Another serious downside risk is that no action would be agreed to offset the large degree of fiscal tightening implied by current law in the United States. This could tip the economy into a recession that monetary policy could do little to counter.

“Prospects only improve if decisive action is taken quickly,” says OECD Chief Economist Pier Carlo Padoan. Padoan adds that in the euro area, the risk of contagion needs to be stemmed through a substantial increase in the capacity of the European Financial Stability Fund, together with a greater ability to call on the European Central Bank’s balance sheet.

"Much greater firepower must be accompanied by governance reforms to offset the risk of moral hazard,” he adds.

Improved prospects would also depend on the enactment of a credible medium-term fiscal programme in the United States.

The Outlook’s baseline scenario assumes that policy-makers take sufficient action to avoid disorderly sovereign defaults, a sharp credit contraction, systemic bank failures and excessive fiscal tightening.

It sees GDP across the OECD countries slowing from 1.9% this year to 1.6% in 2012, before recovering to 2.3% in 2013. Unemployment in the OECD area is also projected to remain high for an extended period, with the jobless rate staying at around 8% through the next two years.

“We are concerned that policy-makers fail to see the urgency of taking decisive action to tackle the real and growing risks to the global economy,” Mr Padoan said during the launch of the report in Paris. “We see the US  growth recovering only slowly, the euro area entering into mild recession and Japan growing faster because of reconstruction, but this boost is temporary and will fade away.”

US GDP is projected to rise by 2.0% in 2012 and by a further 2.5% in 2013, after an expected expansion of 1.7% this year.

Euro area growth is forecast to slow down from 1.6% this year to 0.2% next year, before picking up to 1.4% in 2013.

In Japan, GDP is expected to expand by 2% in 2012 and 1.6% in 2013, following a contraction of 0.3% in 2011, which reflects the impact of the earthquake and tsunami and subsequent reconstruction activity.

Chinese economic growth is seen easing to 8.5% in 2012, from 9.3% this year, before climbing back to 9.5% in 2013. Weaker activity in China and other emerging-market economies together with modest falls in commodity prices should put inflation in these countries on a downward trend, allowing some easing of monetary policy.

Under the baseline scenario, weak activity, low levels of inflation and predominantly downside risks should trigger strongly accommodative monetary policy in OECD countries.

Central banks should provide ample liquidity to calm tensions in financial markets and prepare contingency plans that could be implemented swiftly if needed, says the OECD.

On the contrary, a continued lack of effective action could trigger an alternative, downside scenario where the outlook becomes much bleaker. This scenario could be prompted by a worsening of existing concerns about the banking system, contagion in euro-area sovereign debt markets or an excessively tight fiscal policy in the United States linked to the current political gridlock.

In the Strategic Response section of its Outlook, the OECD identifies country-specific policies that should be implemented if the macroeconomic situation derails: the financial sector must be stabilised, the social safety net protected and monetary policy eased further.

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