New York:
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 epicentre 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 favoured 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 per cent 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 per cent 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 centre 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.
There are some bright spots as Europe enters 2012. The recent drop of the euro currency against foreign rivals like the yen and the dollar makes European exports more competitive - a critical advantage for Germany, Europe's largest exporter and its largest economy. German unemployment now stands at 5.5 per cent, the lowest since German reunification.
About 15 per cent of the euro zone's gross domestic product comes from German consumer spending, more than the contribution of Greece, Spain, Portugal and Ireland combined, according to Mr. Hill.
The first test for the Continent will come this Thursday, when France is expected to raise as much as 8 billion euros. On Jan. 12, Spain plans to auction 3 billion euros worth of euro debt, followed by Italy the next day with 9 billion euros. Along with governments tapping the market, European banks are also expected to keep borrowing heavily as loans come due.
In the first quarter of 2012, about 215 billion euros worth of euro zone bank debt must be rolled over, according to Julian Callow, chief European economist at Barclays.
Over all, Mr. Callow said, "the big picture is one of very restricted visibility. The choice is whether you get a mild or more severe recession."
Despite a move by the European Central Bank on Dec. 21 to provide 489 billion euros in cheap, long-term credit to European banks, the central bank remains reluctant to take more aggressive steps to become the lender of the last resort as the Federal Reserve did in the wake of the financial crisis in the United States in 2008.
In particular, the European bank has remained steadfast in its opposition to buying up sovereign debt outright, for fear of encouraging a return to the kind of deficit spending that got countries like Greece - which continues to rely on bailout money - into trouble in the first place. But the bank's move to inject liquidity on Dec. 21 was seen as a kind of backdoor way of supporting government bonds, since it is likely that a substantial portion of the money the banks borrowed was quickly parked in sovereign bonds.
Rates have fallen since then, especially on short-term notes. At an auction Wednesday of Italian six-month bills, the yield fell to 3.25 per cent from a record 6.5 per cent yield a month earlier. But plenty of caution remains - a sale by Italy Thursday of longer-term debt, including 10-year bonds, managed to raise only 7 billion euros instead of the 8.5 billion euros that had been forecast.
"Europe is going about this the hard way," Mr. Callow added. "It's not really using the central bank to alleviate these pressures in a dominant way."
In addition, with governments in Spain, Portugal, Italy and Ireland planning more austerity measures, Mr. Callow said, "this is likely to fuel growing political and social tension. The markets will be closely watching the level of domestic support."