Europe's faltering financial swagger

Gloom returned to financial markets overnight as investors worried that the European heartland is now at risk of tumbling into recession.

According to economists, the latest fall in the eurozone's purchasing managers' index to 48.7 in March, from 49.3 per cent in February, indicates that the region's output probably declined by around 0.2 per cent in the first quarter of 2012. This follows a fall of 0.3 per cent in the final three months of 2011.

But investors are concerned that the French and German economies now appear to feeling the effects of the debt crisis that is ravaging many of the peripheral eurozone economies. The latest survey showed that German manufacturing output contracted unexpectedly in March.

At the same time, eurozone manufacturers are also grappling with the recent spike in oil prices, which have pushed the input prices to a nine-month high.

The deterioration in the eurozone's economic performance comes despite the European Central Bank's move to inject more than €1 trillion into the region's banking system, which has boosted financial market confidence.

In an interview with Germany's Bild newspaper published on Thursday, ECB boss Mario Draghi appeared confident that the eurozone's debt crisis was abating.

"The worst is over but there are still risks,” he said. "The situation has stabilised. The key data for the eurozone – such as inflation, the current account and, crucially, the public deficit – are better than in, for example, the US. Investor confidence is returning.”

But critics argue that the ECB's actions have left Europe with a zombie banking system. Many European banks are completely hooked on ECB liquidity but are still reluctant to lend to each other, or to provide credit for businesses. Meanwhile, the glum economic outlook has caused many European businesses to cut back their investment plans, which will dampen future economic activity.

The latest figures come just days after Berlin unveiled its latest financial projections that will see it reach its goal of a balanced budget by 2016. As a result of a constitutional amendment known as the "debt brake”, Germany must reduce its federal structural deficit – which excludes one-off items – to 0.35 per cent by 2016.

This year, however, the German structural deficit is expected to rise – to 1 per cent from 0.7 per cent last year – because the German government will have to borrow more money to finance its share of the eurozone's new bailout fund.

This has prompted an attack from influential Bundesbank boss Jens Weidmann. In an interview with the German Sddeutsche Zeitung newspaper published Thursday, Weidmann, who was previously a top economic adviser to German Chancellor Angela Merkel, acknowledged that Germany was doing relatively well compared to other European countries. "But it's not exactly ambitious when the federal structural deficit is expected to rise this year, and the federal government only wants to balance its budget in 2016," he said.

Weidmann also complained that Germany had previously missed opportunities to make bigger cuts to its budget deficit in years when its economy had performed strongly. "The mistakes of the past should not be repeated," he said. What's more, he argued that Germany had a special duty within Europe to quickly reduce its deficits.

But Weidmann isn't the only critic of Merkel's deficit reduction plans. Others point out that her plans for reaching a balanced budget by 2016 are heavily dependent on continued strong tax revenues rather than spending cuts. They point out that if the German economy were to falter, tax revenues would dwindle, shattering plans for a balanced German budget.