(Reuters) - Britain's economy shrank far more than expected in the second quarter, battered by everything from an extra public holiday to government spending cuts and the neighboring euro zone crisis.

Finance minister George Osborne said figures released on Wednesday showed Britain had "deep-rooted economic problems," adding that the slump in the second quarter was disappointing even when taking into account one-off factors that hurt.

Britain's gross domestic product fell 0.7 percent compared with the first three months, the sharpest fall since the height of the global financial crisis in early 2009, the Office for National Statistics said, showing a bigger drop than any of the economists surveyed in a Reuters poll last week had expected.

Output in Britain's service sector -- which makes up more than three quarters of GDP -- contracted by 0.1 percent in the second quarter after growing 0.2 percent in Q1 2012.

Industrial output was 1.3 percent lower, while construction -- which accounts for less than 8 percent of GDP -- shrank by 5.2 percent, its biggest drop since the first quarter of 2009.

The figures confirmed that Britain remains mired in its second recession since the start of the financial crisis, with the economy shrinking for a third consecutive quarter.

The broad-based slump will fuel pressure on the government to get the economy growing again after a crisis that has left many Britons poorer with rising prices and higher taxes eating up meager wage increases.

However, Osborne believes he has no money left for a meaningful spending boost, having staked his reputation on a tough plan to eliminate a budget deficit, still around 8 percent of GDP. The lack of growth also puts this goal into question.

Sterling hit its lowest in nearly two weeks against the dollar after the data, and two-year government bond yields hit a record low on speculation that the Bank of England may have to provide more economic stimulus than expected.

The central bank has already embarked on another 50 billion pound program of gilt purchases with newly created money to soften a grim economic outlook, but the dismal numbers boosted speculation that it may cut interest rates later this year.

"This is terrible data. Frankly there's nothing good that comes out of these numbers at all," said Peter Dixon, an economist at Commerzbank.

"The economy looks to be badly holed below the water line at this stage. It's a far worse period of activity than we'd expected," he said.

OLYMPIC REBOUND

Britain is due some kind of boost over the coming months as production looks set to rebound from the hit from the extra public holiday to celebrate Queen Elizabeth's Diamond Jubilee in June, and from the ticket sales and visitors' spending during the London Olympics that it is hoped will boost growth.

But the overall outlook remains poor.

Many Britons have reined in spending since the crisis and business are holding back investment as the lack of demand and fears about the spillovers from the euro zone crisis weigh on confidence, with the lack of credit hurting smaller firms.

"There are a great many so-called 'zombie businesses' teetering on the edge and operating on fine margins, and many directors are becoming increasingly weary after several years of tough trading," said Julie Palmer of business recovery and restructuring specialist, Begbies.

But business surveys have so far painted a less dire picture of the economy, and unemployment has been falling over the past few months, leading some economists to voice doubts about the official data.

The Confederation of British Industry's monthly survey showed that manufacturers' order inflow unexpectedly improved in July, though their quarterly survey showed dwindling confidence among firms about their outlook.

The CBI's director-general, John Cridland, said businesses were not reporting a sharp contraction in outlook.

"The overwhelming view is that right now the economy is flat rather than negative, and there is potential for Britain to get back into growth later in the year," he said.

The ONS said it was too early to provide an estimate of the Jubilee effect, but warned that this and the wettest spring on record added "uncertainty", increasing the scope for revisions.

Before the data, economists had penciled in a 0.4-0.5 percent hit, meaning that at least some of the fall in second quarter output represents an underlying contraction.

AUSTERITY

The weak economy remains the biggest headache for the government and the opposition Labor party seized on the latest slump to reiterate its call for a change in policy.

"We need some action from the chancellor (finance minister), not excuses ... and digging a deeper hole for the country," Labor finance spokesman Ed Balls said in a BBC interview.

Last week the International Monetary Fund slashed its growth forecast for Britain by more than those for any other advanced economy, and warned the government and BoE that they will need to rethink their approach if the economy fails to pick up by early next year.

Eliminating Britain's structural budget deficit over the next five years is the central political goal of Britain's coalition of Conservatives and Liberal Democrats, but the opposition Labor Party says the pace is too rapid.

Over the past month the coalition and BoE have announced several measures to ease the flow of credit to households and businesses, as the euro zone debt crisis saps demand in Britain's major export markets.

But for now, any change to the fiscal austerity program is opposed both by finance minister Osborne and BoE Governor Mervyn King, who fear it could trigger a loss of confidence in Britain's commitment to long-term deficit reduction.