The risk of recession in the euro zone is mounting, according to a closely watched business survey, signalling that a vicious cycle of fiscal austerity and economic contraction threatens even some of Europe's biggest economies.
The gloomy outlook comes as political differences among European leaders over how to handle the worsening debt crisis have given way to increasingly personal attacks.
After enduring months of criticism from other European leaders, Italian Prime Minister Silvio Berlusconi on Monday issued a defiant statement that lashed back at EU authorities and his euro-zone peers.
"No one in the Union can appoint themselves as administrator and speak in the name of governments elected by and made of the people of Europe. No one can give lessons to a partner," he said.
Germany and France have complained he isn't pushing ahead fast enough with an economic overhaul.
The economic report released Monday, the purchasing managers' index for October, showed that business activity in the euro zone is faltering, with France in particular entering a sharp slowdown.
The worsening outlook could force France's government to make deeper budget cuts to protect its triple-A credit rating, further hurting its economy and adding to doubts about Europe's ability to pay for bailouts of the euro's weakest members.
Gathering signs of a European recession this winter are compounding the problems facing euro-zone leaders, who will convene in Brussels on Wednesday for yet another emergency summit to find a way out of the region's debt crisis. The leaders are expected to sign off on a plan to recapitalize euro-zone banks, beef up the bloc's bailout fund and restructure Greece's crushing debts.
Separately, euro-zone leaders are considering setting up a special-purpose vehicle that would be used to attract public and private funds and would buy bonds and raise funds to recapitalize banks, a senior European Union official familiar with the continuing discussions said Monday.
Mr. Berlusconi on Monday sought to shift attention from Italy's debt woes to the funding crisis facing European banks, a problem he said was "in particular Franco-German." The premier cast the crisis as one of governance, stemming from the restrictive mandate of the European Central Bank. The euro, he said, was the only major currency lacking "a lender of last resort ready to structurally defend [the currency's] credibility in the face of aggressive financial markets. This situation must be corrected once and for all."
To repair financial markets' confidence in the currency zone, governments must also convince investors that they have the financial firepower to back up their rhetoric about defending the euro. The worsening economic outlook is likely to add to doubts about the depth of Europe's financial reserves.
Only two major players—Germany and the European Central Bank—appear to have much financial firepower left, but neither is keen on using it.
The PMI for the euro zone fell nearly two points to 47.2 in October, according to data services firm Markit, the lowest level since the region exited its last recession in mid-2009. Economists had expected a smaller decline. PMI readings below 50 signal a drop in business activity.
One bright spot in the report was a slowdown in inflation, giving the ECB added flexibility to lower interest rates if needed.
Monday's report provides detail for only Germany and France, which make up half of euro-zone GDP. Data from other countries are due to be published next week.
The survey reflects the growing loss of confidence of European businesses in the outlook for their home region.
"For growth, I only see it outside of Europe in South America, North America and parts of Asia," said Stefan Kirschsieper, owner of German tool maker Walter Kottmann GmbH, which makes chisels for electric hammers in the construction industry. Mr. Kirschsieper expects his export-oriented company's revenue to be flat in 2012, after rising roughly 30% this year and last.
In France, car makers Peugeot SA and Renault SA said Monday they would idle factories in France, Slovakia and Slovenia for several days this week to reduce inventories.
France's weakening economy is a worry for the euro zone because the bloc's strategy for supporting crisis-hit countries such as Greece and Portugal since the sovereign debt crisis began two years ago has been that the core economies—Germany and France—would be able to support economic growth across the region.
The strategy holds that the two countries also would retain the financial muscle to fund bailouts, giving cash-strapped nations time to reduce their deficits and overhaul their economies.
Instead, France is sliding closer toward financial trouble: Financial markets are worried about the health of some of its biggest banks, which are heavily exposed to Europe's struggling south, while economists say France could lose its triple-A credit rating if its fiscal outlook worsens significantly.
A credit downgrade could not only raise France's borrowing costs, but jeopardize the ability of the euro zone's bailout fund to tap bond markets cheaply, because the fund's super-safe credit rating relies on guarantees from triple-A euro members led by France and Germany.
The picture that PMI surveys paint of Italy is grimmer still. Italy's economy, the euro zone's third largest, shrank four-straight months through September, according to the most recent data available for Italy.
Bond investors have grown increasingly nervous about Italy's high public debt and lack of growth, selling Italian bonds and driving up its borrowing costs to levels analysts say potentially threaten the country's solvency.
The jitters have forced the ECB to intervene in bond markets since August to prevent a self-fulfilling run on Italian debt.
With France starting to look like one of the euro bloc's patients instead of the doctors, French President Nicolas Sarkozy may find his negotiating position weakened when he sits at the table in Brussels this week to hammer out a grand plan to save the euro zone. France has already given up on its demand to enlarge the euro-zone bailout fund with help from the ECB, amid German and ECB resistance.
"You can't ask the others to clean their house if you haven't put yours in order," noted Dominique Barbet, economist at BNP Paribas. If the French government cuts its growth forecast to 1% from 1.75%, it would need to find about another €8 billion in savings to meet its budget targets, BNP estimates.
Jean Pisani-Ferry, director of Brussels-based think tank Bruegel, said France should focus less on fiscal belt-tightening and more on jump-starting its economy, even if it means higher deficits in the near term. The worsening economic outlook "calls into question the short-term focus on fiscal policy and the wisdom of achieving fiscal targets at specific times," he said. Rapid growth early in the winter and early spring should propel Germany to a second-straight year of 3% growth. Analysts expect growth of around 1% next year, enough to keep German unemployment low but not enough to boost France and others.
Germany continues to skirt contraction, thanks in part to a rise in service-sector activity. However, manufacturing shrank for the first time in more than two years, and exports slumped by the most since May 2009, according to the PMI report.
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