UPDATE 3-Euro zone economy set to shrink in 2012, deficits in focus
* Euro zone to contract 0.3 pct in 2012 - Commission
* EU to show zero growth, economy fragile
* Report shows growing regional divide
* EU says must cut deficits; may show leniency in Spain
BRUSSELS, Feb 23 (Reuters) - The euro zone economy is heading into its second recession in just three years and the wider European Union will stagnate, the EU's executive said on Thursday, warning that the currency area has yet to break its vicious cycle of debt.
The European Commission forecast that economic output in the 17 nations sharing the euro will contract 0.3 percent this year, reversing an earlier forecast of 0.5 percent growth in 2012.
The wider, 27-nation European Union, which generates a fifth of global output, will not manage any growth this year.
Battered Greece will enter its fifth year of economic contraction and Spain and Italy, w hich saw their financing costs pushed up to near unaffordable levels last year, will shrink by around 1 percent , it forecast.
With the euro zone's sovereign debt crisis moving from a chronic to an acute phase, the EU's top economic official warned that there would be little clemency for heavily-indebted countries who must meet strict budget targets even as their economies stall.
There seemed to be some leniency when it came to Spain, however.
" Member states facing close market scrutiny should be ready to meet budgetary targets," said Economic and Monetary Affairs Commissioner Olli Rehn defending his strategy of tough love for countries that live beyond their means .
But he suggested Spain's 2 012 deficit target of 4.4 percent may be allowed to rise o nce all available data was gathered by the EU's statistics agency Eurostat.
"The full information of budgetary figures will be available in the March notification, which will be then validated and (published) by Eurostat in April. On that basis, we work with the Spanish authorities and decisions will be taken once we have a full picture," Rehn said.
Economists are increasingly questioning the EU's strategy for southern Europe as austerity reaches such extremes that some indebted town halls are unable to pay staff, social services shutter and joblessness reaches record levels.
But the Commission said budget cuts were the way to regain investor confidence. "Negative feedback loops between weak sovereign debtors, fragile financial markets, and a slowing real economy do not yet appear to have been broken.
Separately, European Central Bank President Mario Draghi told a German newspaper that the euro zone economy is bouncing back after a very weak end to last year and positive signals have increased since the ECB's rate decision meeting two weeks ago.
The euro zone was last in recession in 2009, dubbed the Great Recession worldwide, when the economy contracted 4.3 percent during the deepest global slump since the 1930s.
ANOTHER BRICK IN THE FIREWALL
A poisonous mix of high public debt, evaporating investor and business confidence and rising unemployment killed off the two-year recovery from the global financial crisis. Despite signs of stabilisation this year, economists polled by Reuters only expect growth to return in 2013.
Inflation for the euro zone this year should come to nearer to what the European Central Bank judges about the right level for stable prices and a healthy economy: 2.1 percent, the Commission forecast.
The growth forecast for the euro zone is a shade more optimistic than the International Monetary Fund's view that output in the currency area will dip 0.5 percent this year. But both agree the bloc will manage only a modest recovery in the final months of 2012.
The forecasts could still worsen. They rely on the assumption that EU leaders will act to resolve the sovereign debt crisis, which is now in its third year and has shattered investor confidence in a region once regarded as one of the world's safest havens.
"The balance of risks to GDP growth remains tilted to the downside amid still-high uncertainty," the Commission said. "The interim forecast continues to rely on the assumption that adequate policy measures are decided and implemented."
EU leaders hold a summit in Brussels next week where investors hope they will agree to raise the ceiling of the euro zone's joint rescue funds and pave the way for more IMF funds to stand behind heavily indebted southern European economies.
But the German government said this week it sees no need to beef up the funds and Rehn called on leaders to strengthen financial firewalls.
"We need to reinforce our financial firewalls so that we're fully equipped to overcome the current crisis and return to recovery," Rehn said.
Adding to the difficulties, the downturn is widening the gap between the wealthy economies of northern Europe and those of the south that are most in need of growth to pay off debt.
Germany and France, the euro zone's two largest economies, are likely to escape recession this year, growing 0.6 percent and 0.4 percent respectively, the Commission said.