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Severe Europe-Wide Recession Likely for 2012

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK (TheStreet) -- Given the speed at which markets move, and given the volatility that accompanies the hopes and fears that occur when the key European leaders meet to try to make progress on the European debt crisis, it is somewhat risky to try to describe what will happen to the European Monetary Union (EMU) in 2012. Something that I write today, in early December, could be obsolete as early as next week. So, I will approach this with what I consider to ultimately be the most likely scenario, why it is most likely, and where the remaining dangers lie.

There are two opposing forces in Europe regarding the approach that should be taken to resolve the crisis:

  • Those that want the European Central Bank (ECB) to act just like the U.S. Fed and rapidly expand its balance sheet, either to support a strengthened European Financial Stability Facility (EFSF), or directly. The ECB has no mandate in its charter to do this;
  • Those that want the causes of the crisis, overspending and out of control deficits via entitlement and social welfare spending, to be addressed. While these folks appear to be the minority among the political class, their strength lies in the fact that the politicians representing the economically strongest EMU member, Germany, hold this view.
  • As an aside, some have wondered why the euro has kept its value high vis-à-vis the U.S. dollar. It is precisely because the ECB hasn't significantly expanded its balance sheet while the U.S. Fed has. In fact, the big worldwide market rally on Nov. 30 due to the "coordinated" central bank policy of insuring liquidity for Europe's banks, was a "dollar" policy, i.e., dollars, not euros were made available. So far, the ECB appears to have remained faithful to its mandate as the guardian against inflation, and nothing else.

    Most Likely Scenario

    The U.S. Fed tripled the size of its balance sheet with some apparent success at keeping its financial system from collapsing and, until now, those actions appear to have had no apparent large unintended consequences. There has been some moderate inflation officially reported (and disputed by some), and some believe that the Fed's balance sheet expansion has been behind the rapid rise in commodity and food prices. But given the apparent success in staving off financial collapse with such policies, the most likely scenario is the first one outlined above, i.e., the use of the ECB or some structure around it (including the EFSF and the International Monetary Fund (IMF)) to directly purchase or partially guarantee the sovereign bonds of the peripheral countries.

    The "bazooka" theory appears to apply here. As long as the market knows that the ECB has a bazooka (the power and authority to print euros), and is willing to use it, it won't have to. As U.S. Treasury Secretary, Hank Paulson found out in 2009 that the "bazooka" theory doesn't always work. Time and again, the capital markets have demonstrated that they are much more powerful than any central bank or sovereign treasury.

    Verifiable Austerity

    The most likely scenario, then, is an emerging consensus in Europe as follows: Through a series of bilateral agreements to avoid having to get 17 separate countries to approve changes to the treaties that govern the EMU, a painstakingly long process, the offending peripheral countries (Italy, Portugal, Spain, and perhaps, Ireland) may agree to some level of verifiable austerity with benchmarks and external audits. In return, Germany and its political allies will permit the ECB to expand its balance sheet either by directly purchasing the sovereign debt of the peripheral countries, or by making credit available to the EFSF or whatever structure emerges.

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