The euro zone's debt crisis has become the biggest threat to the global economy and a break up of the currency zone can no longer be ruled out, the OECD said on Monday, slashing its forecasts and urging the ECB to play a bigger role in defusing the crisis.

The euro zone has already entered a mild recession but much worse could follow unless policy makers take decisive action to get ahead of the market, the Organisation for Economic Cooperation and Development said in a stark warning.

'There is a risk to the euro, let's not deny that,' OECD chief economist Pier Carlo Padoan told Reuters in an interview. 'But I would like also to say that there is a possibility of avoiding that risk.'     

A worst case scenario of continued inaction in the euro zone and the failure of US lawmakers to agree a spending-reduction plan would usher in a devastating downturn for the world economy, the Paris-based OECD said.

In the absence of decisive action from euro zone leaders, the European Central Bank (ECB) alone has the power to contain the bloc's crisis, the OECD said. In the United States, however, the Federal Reserve had little ammunition left.

'We are still seeing policy behind the curve,' Padoan told a news conference. 'This cannot be accepted any more.' 

'Time is running out and every time we lose the occasion to act effectively the price or cost for having positive outcomes goes up,' he added.

Padoan said that the absence of credible action from policymakers was sapping households and companies' confidence as well as fueling damaging volatility on financial markets.

While solid growth in big emerging economies would provide a boost, slumping global trade would drag on Chinese output, the OECD said.

Its twice-yearly Economic Outlook forecast that world growth would slow to 3.4 percent in 2012 from 3.8 percent this year. That marks a sharp fall from its previous outlook in May, when the OECD estimated the world economy would grow 4.2 percent this year and 4.6 percent in 2012.

Separately forecasting global growth of 3.5 percent in 2012, Morgan Stanley warned in a report that, in a worst case scenario, policymakers' inaction in both Europe and the United States could lead to much lower growth of 1.9 percent, with recessions in many major economies. 

Struggling to contain an unprecedented debt crisis, the euro zone has already entered a recession and will eke out growth of only 0.2 percent in 2012, the OECD said, slashing its forecast from 2.0 percent in May.

'The euro area crisis represents the key risk to the world economy at present, with concerns about sovereign debt sustainability having become increasingly widespread,' the OECD report said.     

If major economic shocks such as the default of a euro zone member or the collapse of a big bank were avoided, then the global recovery would likely resume over the course of 2012.

The OECD said many key questions about the euro zone's response to the debt crisis remain unresolved, raising doubts about even the bloc's most solid economies, as demonstrated by  Germany's difficulties placing bonds with investors last week.

'What we see now is contagion rising and hitting probably Germany as well,' Padoan told Reuters in an interview. 'So the first thing, the absolute priority, is to stop that and in the immediate the only actor that can do that is the ECB,' he added, urging the central bank to commit to a creating a cap on government bond yields as a way of calming the crisis.     

With the Federal Reserve already flooding the financial system with liquidity, the US central bank has even less room to act if the world's biggest economy hits a downturn. That prospect was made all the more real by the failure of Congress to agree a deficit-reduction plan, without which deep spending cuts would be triggered.

'The resulting fiscal tightening, which would come automatically, would in our view likely generate a recession in the United States,' Padoan said.

Provided that the Congress does reach an agreement, then the US economy is set to grow 1.7 percent in 2011 and 2.0 percent in 2012, down from May forecasts of 2.6 percent and 3.1 percent respectively.

With world trade growth projected to slow to 4.8 percent in 2012 from 6.7 percent this year, even China would not be spared a sharp slowdown, the OECD said.

It forecast that growth in the emerging Asian economic power would slow to 8.5 percent in 2012 from 9.3 percent in 2011. Slower global trade and confidence knocked by the euro zone's debt crisis could trip up Germany, which the OECD estimated would grow only 0.6 percent in 2012 after a 3.0 percent expansion in 2011. Europe's biggest economy has probably entered a shallow recession at the end of the year, the OECD said.

In a rare bright spot, the Japanese economy was seen rebounding sharply after this year's earthquake and tsunami to achieve growth of 2.0 percent in 2012 following a contraction of 0.3 percent in 2011. - Reuters