There’s now a real sense of fear creeping into the world economy from Europe, one not just infecting markets but political leaders as well.

Italian Prime Minister Mario Monti upped the rhetoric stakes overnight with a warning that there’s only a week left to save the eurozone. His scary comments came at the end of a day when the consensus seemed to move from bumbling through on Europe, to growing concerns that the global economy was slowing, possibly to a halt.

Monti said that if next week’s summit of EU leaders failed to settle the eurozone’s problems, the 17 countries (and the rest of Europe and the world) faced a potential death spiral. Monti is to hold talks tonight, our time, with German Chancellor Angela Merkel (whom Paul Keating got stuck into yesterday, and rightly so), new French President François Hollande and Spain’s Prime Minister Mariano Rajoy, in the hope that the single currency’s big four countries can pave the way for a breakthrough at next week’s meeting.

According to Monti, “there would be progressively greater speculative attacks on individual countries, with harassment of the weaker countries”, including those that had abided by the rules “but which carry with them from the past a high debt”.

We have heard similar fears expressed before previous EU summits, but that was with Greece, Ireland and Portugal in the spotlight. Nothing was resolved and now the focus is no longer on the peripheral economies but Spain and Italy. The eurozone and the rest of Europe have drifted to where there is now a very real possibility that Monti’s forecasts may very well come to reality.

There is now a belief that the world economy is being dragged to a standstill by the problem in Europe, the still slowing Chinese economy and the wobbles in the US, and the falls in US markets. The price of oil overnight reflected those concerns, though the US dollar rose for the usual “safe haven” reasons, the Aussie dollar fell to about parity as the greenback strengthened. The most revealing news this week wasn’t the way the US Federal Reserve extended its attempts to lower long-term interest rates; it was the Fed’s downgrading of its forecasts for US growth and employment for 2012 and 2013. Those changes were a real shock as they added to emerging fears that Europe was hurting the US economy more than anyone was willing to admit. The Fed admitted as much in its statement and commentary by chairman Ben Bernanke. That forced markets to focus on the US outlook.

But what added to the impact of the Fed’s changes and comments was the way early surveys of manufacturing activity in China and the US for June and final surveys for Europe showed that the world’s major economies were slowing. Chinese manufacturing had another month of contraction; the 48.1 reading in the survey from HSBC is the lowest in seven months. But to further confuse the issue, some economists cautioned that the May surveys showed a big fall, but actual production data for May showed a small improvement.

Just on a domestic note, none of this is shaping up well for the opposition’s hopes for a big price spike as a result of the carbon price. With the Aussie dollar holding steady and oil prices falling significantly (now down to $US79 a barrel), deflationary pressures outside the resources sector are set, if anything, to intensify. Electricity prices are going up, of course, but inflation outside the heavily regulated utilities sector may further fall in the current and next quarters. Tony Abbott’s Get Smart act — “the carbon price will destroy the economy like wrecking ball … would you believe a cobra strike? … how about a python squeeze?” … might yet suffer a further metaphor downgrade (cranky blue-tongue perhaps?) In fact petrol prices will be weakening as the carbon tax starts next weekend.

Adding to the global pressures was the late rumours (later confirmed) that Moody’s was cutting the ratings of 15 of the world’s biggest banks, including majors in the US, Switzerland, France, Germany, the UK and Canada. The common factor in the downgrade is that all 15 have big global investment banking businesses. Australia’s Macquarie saw its ratings cut earlier in the year in the same review. The move will force all the banks to pay more for borrowings and to put up billions of dollars in extra collateral for their vast holdings of credit and other derivatives. They could lift funding costs for Australian banks, but our AAA sovereign rating and the banks’ AA ratings should protect them and enhance their appeal to offshore investors.

In Europe, the Markit eurozone composite purchasing managers’ index, (a combination of the services and manufacturing sectors), held steady at 46.0 this month, the lowest since the recession in June 2009. But economists said the real story is that the downturn in the eurozone’s private sector is becoming entrenched, driven by falling new orders and employment levels. The June survey was the fifth consecutive month activity has declined across the 17-nation bloc, with the slump now impacting Germany more harshly than previously thought. Earlier data from Germany showed its manufacturing sector contracted at its fastest pace since June 2009, while its service sector barely expanded, posting its worst reading in seven months. France saw falls in manufacturing and services.

“Of particular concern,” said one economist, “is the near-record deterioration in business optimism, combined with marked falls in employment and purchasing by companies. This suggests that firms are preparing for conditions to worsen in the coming months, with the darker outlook often attributed to uncertainty caused by the region’s ongoing economic and political crises.”

In Madrid, the Spanish government said independent auditors had found that the country’s banks may need up to €62 billion in extra capital, to be filled mostly by that bailout announced two weeks ago. The news came after Spain’s medium-term borrowing costs spiralled to a euro-era record on Thursday. The €62 billion estimate is a worst-case outlook that assumes a steep recession in Spain this year and next and 20%-plus fall in house prices over the next 18 months. The base case is for between €16-25 billion of new capital, based on a 2% fall in growth over the next 18 months and an 8% plus fall in house prices in the same time. Naturally, the Spanish government prefers this disastrous scenario estimate over the nightmare worst-case one.

Eurozone finance ministers have met in Luxembourg to discuss how to channel up to €100 billion  in aid to Spanish lenders hit by the collapse of the country’s property bubble. Spain will make a formal request in the next few days for the bailout. To smooth the way for this deal, the leaders of Germany, Italy, France and Spain will meet in Rome on Friday.

There’s a lot to talk about for the eurozone. Less than 24 hours after those stories emerged from the G-20 leaders meeting in Mexico about how two EU funds would support Spanish and Italian sovereign debt, German Chancellor Merkel helpfully described the idea as “purely theoretical” once she was back on German soil. And one of the country’s opposition left-wing opposition parties indicated it would challenge one of the bailout funds ( the European Stability Mechanism) in the country’s powerful court, which will further delay German ratification of the fund.

Tonight Europe will be watching the grudge match of the year — maybe the decade — Greece versus Germany in the second Euro quarter final. But not even that will be enough to distract worried markets and their inhabitants. German Finance Minister Wolfgang Schaeuble reckons his country will win 3-1. And that’s a positive, unhedged statement of belief and not “purely theoretical”.

Peter Fray

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