Europe’s leaders braced their nations for a turbulent year, with their beleaguered economies facing a threat on two fronts: widening deficits that force more borrowing but increasing austerity measures that put growth further out of reach.
Saying that Europe was facing its “harshest test in decades,” Chancellor Angela Merkel of Germany warned on New Year’s Eve that “next year will no doubt be more difficult than 2011” — a marked change in tone from a year ago, when she praised Germans for “mastering the crisis as no other nation.”
Her blunt message was echoed in Italy, France and Greece, the epicenter of the debt crisis, where Prime Minister Lucas Papademos asked for resolve in seeing reforms through, “so that the sacrifices we have made up to now won’t be in vain.”
While the economic picture in the United States has brightened recently with more upbeat employment figures, Europe remains mired in a slump. Most economists are forecasting a recession for 2012, which will heighten the pressure governments and financial institutions across the Continent are seeing.
Adding to the gloomy outlook is the prospect of a downgrade in France’s sterling credit rating, a move that analysts say could happen early in the new year and have wide-ranging consequences on efforts to stabilize Europe’s finances.
Despite criticism from many economists, though, most European governments are sticking to austerity plans, rejecting the Keynesian approach of economic stimulus favored by Washington after the financial crisis in 2008, in a bid to show investors they are serious about fiscal discipline.
This cycle was evident on Friday, when Spain surprised observers by announcing a larger-than-expected budget gap for 2011 even as the new conservative government there laid out plans to increase property and income taxes in 2012.
Indeed, even in the country where the crisis began, Greece, the cycle of spending cuts, tax increases and contraction has not resulted in a course correction, and the same path now lies in store for much larger economies like those of Italy and Spain.
“Every government in Europe with the exception of Germany is bending over backwards to prove to the market that they won’t hesitate to do what it takes,” said Charles Wyplosz, a professor of economics at the Graduate Institute of Geneva. “We’re going straight into a wall with this kind of policy. It’s sheer madness.”
Rather than the austerity measures now being imposed, Mr. Wyplosz said he would like to see governments halt the recent tax increases and spending reductions, and instead cut consumption taxes in a bid to encourage consumer spending. More belt-tightening, he said, increases the likelihood that Europe will see a “lost decade” of economic torpor like Japan faced in the 1990s.
In fact, economists and strategists on both sides of the Atlantic have been steadily ratcheting down their growth expectations for 2012.
“Europe is likely to have a meaningful recession in 2012,” said Tobias Levkovich, Citigroup’s chief equity strategist. While Mr. Levkovich does not see that as a significant threat to the bottom line of most American businesses — he estimates that Europe accounts for about 8.5 percent of sales for the typical company in the Standard & Poor’s 500-stock index — the psychological effects on global markets will be magnified if political opposition to austerity increases.
“Powerful street protests could bring it back to the front pages,” he said. “We’ve seen episodic crises in Europe over the past two years. It’s a recurring event.” He expects Europe to remain a key worry for investors worldwide in 2012.
Neville Hill, head of European economics at Credit Suisse, expects gross domestic product in the euro zone to shrink by 0.5 percent in 2012, with the worst of the pain being felt in the first quarter. At the same time, borrowing needs will remain elevated, with Italy and Spain planning to raise more than 100 billion euros in the first quarter alone.
“We shouldn’t underestimate the scale of the challenge the euro zone faces in early 2012,” Mr. Hill said. “Italian and Spanish sovereign borrowers are at the foot of the mountain, rather than the top. The first quarter is a crunch point.”
The Continent’s economic outlook will take center stage on Jan. 9, when Mrs. Merkel and President Nicolas Sarkozy of France will discuss a new fiscal treaty intended to impose stringent budget requirements on European Union nations. Then on Jan. 30, European Union leaders will gather in Brussels to discuss ways to spur growth.