Global economy weekahead: From a soft patch to quicksand

By Emily Kaiser, Asia Economics Correspondent

(Reuters) - The global economy was supposed to be better by now.

Just a few months ago, the prevailing wisdom was that growth was going through a "soft patch" caused by a combination of Japan's earthquake and unrest in the oil-producing Middle East. Once global supply chains got back to normal and oil prices receded, the second-half recovery could begin.

Judging from the tone among world finance leaders who gathered in Washington over the weekend, no one is buying that theory any more.

"The global economy has entered a dangerous phase, calling for exceptional vigilance, coordination and readiness to take bold action from members and the IMF alike," the International Monetary Fund's steering committee warned on Saturday.

Australian Treasurer Wayne Swan spoke of a "somber mood" among policymakers. Financial markets priced in a growing risk that Greece may default, which could touch off a panic worse than what followed the Lehman Brothers bankruptcy.

"The Lehman crisis was about rescuing a company. Now it involves a country's sovereign debt so in a sense, the situation is more severe," said Japanese Finance Minister Jun Azumi.

Yet the strongest statement Group of 20 officials could offer was a promise that, by November, euro area leaders will find a way to "increase the flexibility" of a financial stability fund widely considered inadequate to cope with a crisis which could engulf Italy or Spain.

"If a generous sovereign from Mars came down and paid off every penny of Greece's debt tomorrow, the fundamentals of the European crisis would not be altered," said former White House economic adviser Lawrence Summers.

Europe came under fresh pressure on Sunday to ramp up its crisis response when a top IMF official said the ECB was the only player big enough to "scare" financial markets, which have punished several euro zone countries.

The United States is having enough trouble solving its short-term budget problems. The next act could come as early as Monday, when Congress debates another spending bill. If lawmakers fail to act, a program that assists disaster victims could run out of money by Tuesday.

As for Europe, J.P. Morgan now expects a mild recession -- and this forecast assumes policymakers "move aggressively to provide a huge amount of support for banks and sovereigns."

If they don't, the downturn could be far more severe and no region would be immune.

LOSING TRACTION

There is already evidence the global economy is losing traction. A private survey of China's manufacturing sector, released last week, showed it probably contracted in September for a third consecutive month.

Official government data on factory activity is due on Saturday, and if it confirms a decline, that would deepen concerns about China's capacity to help prop up the world.

The latest batch of data from China points to still-strong domestic growth, although the global slowdown has taken a significant toll on exports.

Indeed, the August purchasing managers' survey showed overall orders increasing even as export orders contracted, suggesting China is still generating solid demand at home. If those figures deteriorate in Saturday's report, it may signal a sharper-than-expected slowdown in domestic activity.

Germany, which joins China atop the list of the world's biggest exporters, is looking even shakier. Its economy barely grew in the second quarter from the three months before, and confidence is fading fast.

The closely watched Ifo business climate index, due on Monday, is expected to record another decline after a precipitous drop in August.

OXYMORONS AND MORONS

With the G20 offering no promise of coordinated action, investor attention returns to what officials in the United States and Europe might do.

The next significant step may come in early October, when the European Central Bank holds a policy-setting meeting. Some economists are predicting a rate cut, which would mark an abrupt about-face for a central bank that was warning about inflation risks just a couple of months ago.

"It seems bizarre that the Fed has been easing monetary policy, partly on concerns about Europe, and yet the ECB, in the midst of a sovereign debt crisis, has hiked rates twice since April," said Nomura economist Paul Sheard.

As for fiscal policy, that looks likely to stay tight in both Europe and the United States -- much to the dismay of some economists who question how the economy can possibly pick up speed when the public sector is applying the brakes.

"The notion of expansionary fiscal contraction is oxymoronic and a bit moronic as well," said Summers, who the former White House economic adviser.

(Reporting by Emily Kaiser in Singapore)