In 2011, European leaders have been unswerving in their commitment to muddling through.
Not for them grand or decisive moves to resolve the euro zone's twin government and bank financial crises. Instead, they have settled on a series of smaller gestures, over which they have haggled publicly beforehand and often afterward. Some actions may have helped their currency union hobble through the year; others will at best reduce the chances of a future crisis.
France's Nicolas Sarkozy and Germany's Angela Merkel in Berlin in July.
"It's not pretty," says Daniel Gros of the Brussels-based Centre for European Policy Studies.
Can the policy makers win ugly? Given it's the season of goodwill, let us examine what could go right in the next few months.
The first reason policy makers might be more optimistic is that the European Central Bank has adopted a more active stance, even though its rhetorical position hasn't changed much.
New President Mario Draghi continues to hold the position that financing governments isn't the job of the ECB. But analysts say it's more important to look at what he's doing, rather than at what he's saying. Under his watch, and in spite of the protests that government finance isn't the job of the ECB, the securities-market program that buys government bonds has continued to expand—to €211 billion ($275 billion)—following significant purchases of Spanish and Italian bonds.
The ECB has also shown itself willing to take more aggressive action, as demonstrated by its decision to offer banks three-year funds for the first time ever this week. The ECB can argue that a more aggressive stance is warranted by banks' deteriorating cash positions and the risk that a credit crunch in the euro zone could develop as a result. But this, to be followed by at least one more such offer in 2012, should help banks overcome a liquidity crunch next year—and what's the harm if they use these funds to buy a few sovereign bonds?
Euro-zone governments are also hoping their current bailout fund, the European Financial Stability Facility, will be able to limp through until they get the permanent fund established in mid-2012.
Their hopes that it could be "leveraged" up to €1 trillion—as agreed at the leaders' October summit—have been comprehensively dashed, and it isn't clear what the plan is when France is downgraded from its triple-A status, which could happen any day. (Ideally, say some European officials, Germany would be downgraded by a similar amount, meaning that euro investors no longer have any triple-A assets to choose from.)
There should be enough usable guarantees to cope with Ireland and Portugal, the fund's two current clients, with Greece's expected initial demands from the fund, and with financing for some bank recapitalizations. But the fund is in no shape to act decisively should Spain or Italy get dragged into deeper difficulties.
So euro-zone governments are also hoping something else will happen: that Italian investors will start to become attracted to Italian government bonds.
Marc Chandler, global head of currency strategy at Brown Brothers Harriman in New York, says European officials "may have to resort to what economists are sure to consider 'financial repression,' which strongly encourages, if not forces, domestic entities to buy more government bonds."
Mr. Gros says Italian private investors—as well as the country's banks and investment institutions—may also begin to see Italian bonds as attractive. With Italy's 10-year bonds yielding 4.5 percentage points more than Germany's, the extra returns over a decade could even start to look attractive for Italian savers.
But if there is a case that muddling through might, just, work with the help of an activist central bank and Italian savers, the path ahead is strewn with pitfalls.
One issue is the sheer size of euro-zone governments' refinancing requirements next year. According to the International Monetary Fund, the Italian state's fund-raising needs in 2012 are equivalent to 23.5% of gross domestic product; Spain's are 20.6% of GDP. Even if Italian savers play ball, what about Spain's?
Greece, the longstanding stone in the shoe of the euro zone, also remains a challenge. It is currently renegotiating private debts to secure a 50% write-down from private creditors. The talks, which Finance Minister Evangelos Venizelos said earlier this week were going well, will have to be concluded in March when €14.5 billion of government bonds comes due. Even if negotiations conclude in time, Mr. Gros says a Greek collapse in the Argentine style—it's 10 years this week since the last Argentine debt default—can't be ruled out.
Last, but not least, are the banks. The plan adopted to boost bank capital agreed by European leaders in October has, say many analysts, made prospects for 2012 even worse. Banks were told to raise their minimum capital level to 9% of assets—based on the market value of sovereign debt in their portfolios. Nicolas Véron, of Brussels think tank Bruegel, argues that the decision to value government bonds according to market value risks amplifying the crisis. (As the value of their bonds fall, banks need more capital. But, in troubled economies, the only option for guaranteeing that capital is the already-struggling government.)
"This is a recipe for massive credit rationing and misallocation, for which there is more and more anecdotal evidence," he argues in a paper published Thursday. Mr. Véron says that euro-zone mechanisms for raising capital should replace at least some of the national guarantees, and that the link between regulatory capital and market prices should be broken. In the meantime, the feedback loop between sovereign credit and bank funding conditions has been reinforced, despite the ECB's efforts.
read more: Olympus Wealth Management
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