With governments laboring under too much debt and banks hobbled by too little capital, 2012 is shaping up as another year of hard slog for Europe's economy that could yet test the single currency to destruction.
The Netherlands on Thursday became the latest country to report that output shrank in the third quarter, lending credibility to forecasts that the broader euro zone will soon be in recession if it is not already.
A generation that gorged on debt is now adjusting to what some are calling the Great Stagnation. Talk of a lost decade, like Japan in the 1990s, no longer seems outlandish.
So far so familiar. What worries economists is that the longer the deleveraging of government and bank and household balance sheets drags on, the greater the risk of market or policy accidents.
If the economy is already at stall speed, an unexpected shock could send it into a deep dive. In an age of globally integrated supply chains and capital markets, the impact on the rest of the world could be severe.
Entering 2012, we are facing uncertainty on the grandest of scales, HSBC economists led by Stephen King said in their latest quarterly report.
The good news was that euro zone policymakers recognized that a break-up of the 17-member bloc could spark another great depression. But, despite signs of greater urgency, investors for the most part remained unconvinced that a strategy was in place to ease the debt burdens straining the single currency.
This loss of faith is reminiscent of the collapse in confidence in 2008, when the wheels came off the global economy. Back then, forecasters completely failed to grasp the gravity of the situation. The same may be true today, HSBC said.
As the world economy slumped after the collapse of U.S. investment bank Lehman Brothers in 2008, governments had room for maneuver. Today, with fiscal austerity in fashion and interest rates near zero across the developed world, firepower is limited.
Indeed, with the risk of recession on the rise, debt dynamics are in danger of spinning out of control, HSBC said.
The European Central Bank acted decisively on Wednesday to limit the immediate danger by lending banks a whopping 489 billion euros in cheap three-year loans. The cash injection will reduce the risk of a credit crunch and fire sales of assets by banks shut out of the wholesale funding markets.
But the ECB is at best buying time to help weaker euro zone members put their finances back in order and recoup competitiveness lost as a result of having weaker productivity and higher labor costs than core countries led by Germany.
It is the sheer magnitude of this task that is unnerving markets. Take Greece, which is racing to thrash out sweeping pro-growth structural reforms demanded by the European Union and the International Monetary Fund to unlock a 130 billion euro loan needed to stave off default.
This is a process, as we've seen in IMF program countries, that takes well over 10 years and that's as long as Greece will need with the help of financial support and technical assistance missions from the EU and the IMF, said Antonio Garcia Pascual, an economist at Barclays Capital in London.
Yet Greece is already in the fourth year of a deep recession. And even if the EU-IMF program succeeds, its debt in 2020 would still be a suffocating 120 percent of GDP.
How long will voters endure austerity imposed from abroad and, at the same time, go along with sweeping changes to everything from pensions to labor laws and the prizing open of long-protected professions and industries?
Structural reform is essentially about a society changing its way of life, a senior European central banker said. It's not obvious that creating extra liquidity can make those fundamental reforms easier.
QUESTION OF BALANCE
New modeling by Goldman Sachs dramatizes the challenge facing countries on the periphery of the euro zone.
In order to stabilize the net debt of the entire economy these countries need a sizeable adjustment in their current account deficits. This in turn points to the need for a depreciation in the real, or inflation-adjusted, exchange rate of as much as 44 percent in Portugal, 35 percent in Greece and Spain and 20 percent in Italy, Goldman estimates.
That means prices would need to rise less, or even decline, relative to the euro zone average for about 15 years in the case of Greece and Spain and almost 20 years in Portugal, requiring savage wage cuts in the process.
This required correction immediately throws up another huge problem: if the periphery is holding inflation down to zero to cut costs, core countries will have to tolerate prices rising above 3 percent if the ECB is to keep euro area average inflation on target at no more than 2 percent.
This might be problematic for the ECB as certain core countries (such as Germany) could potentially have difficulties accepting such higher inflation for a prolonged period of time, wrote Goldman economist Lasse Holboell W. Nielsen.
GLOBAL DEBT MESS
The euro zone is not alone in its struggles to manage excessive debt. Japan's gross public debt has soared to more than 200 percent of GDP.
The deterioration has not prevented the government from selling its bonds at low and stable yields, but a new IMF working paper warns that over the medium term, the market's capacity to absorb new debt is likely to diminish as the population ages and appetite for riskier assets recovers.
The result could be a worsening of Japan's debt dynamics that poses a threat to financial stability.
Without a significant policy adjustment, the stock of gross public debt could exceed household financial assets in around 10 years, at which point domestic financing may become more difficult, IMF economists Waikei Raphael Lam and Kiichi Tokuoka wrote.
And in the United States, alongside what most economists see as an unsustainable public-sector debt trajectory, families still have too much debt accumulated in the go-go years before the great financial crisis.
Household debt as a percentage of disposable income peaked in mid-2007 at 135 percent of GDP. It has since declined to around 120 percent but remains more than 20 percentage points above its 30-year average, according to Nathan Sheets, global head of international economics at Citi in New York.
He said it was reasonable to assume deleveraging would continue at the same steady rate - which would prolong the process into the second half of this decade - but the pace could quicken markedly in the event of a collapse of asset prices, a sharp drop in disposable income or a renewed tightening of financial conditions.
Which brings us back to the mountain the euro zone still has to climb in 2012.
Given the ongoing stresses in Europe, such risks are not just abstract possibilities but rather all-too-plausible outcomes that need to be carefully considered, with an eye to reducing potential vulnerabilities, Sheets said in a report.
(Editing by Mike Peacock)