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2011 was a bad year for Europe. Closing out 2011, entering 2012 naturally brings about the hope that page has been turned, a chapter completed and that 2012 will bring about better and brighter things.

Unfortunately, such expectations are simply fallacious. In terms of the economic and financial fundamentals that really matter, the passing of December 31 to January 1 is simply the passage of any other day – it is no different from the passing of February 26 to February 27 or from August 18 to August 19.

In terms of the economic and financial condition of Europe, all of the determinants of a monumental economic and political fiasco remain firmly in place. And the progression towards an economic and political disaster is relentless.

My task in this essay will be to briefly review the determinants of this fiasco and roughly map out its sequencing and chronology.

New Year’s Cognitive Dissonance

The first few day of the New Year could be expected to bring about a reprieve in terms of the political and financial barometers of the European crisis. The New Year brings about the onset of a very peculiar form of cognitive dissonance. It works something like this:

Because of the cultural traditions associated with the New Year, people are prone to believe that the past ends on December 31 and a new life begins on January 1. For example, at home, people throw the old calendar away and put up a fresh one. At work, the old business plan and budget is thrown away and employees start with a new one. People make New Year’s resolutions in which they say “goodbye” to an “old” life and look forward to a “new” one.

Due to cognitive dissonance, people associate this sort of “page turning” with historical progression. The problem is that with respect to many facts of life, this manner of thinking is fallacious. History is very much path-dependent; what has happened before tends to strongly condition the future. For example, the New Year did not reset PIIGS debts to zero; nor did it eliminate the accumulated Purchasing Power (PPP) distortions that have rendered the PIIGS economically uncompetitive.

These determinants of the ongoing crisis in Europe remain and their deleterious effects continue to accumulate. Far from getting any better, the fundamentals in Europe are only getting worse.

Human psychology is fickle, and events such as the New Year can divert or distort the focus of financial market participants regarding fundamentals. Thus, global equities such as the S&P 500 (SPX) and stocks as diverse as CNOOC (CEO), Petrobras (PBR), Apple (AAPL) and Citibank (C) can rise despite heavy direct and indirect links to Europe. However, Europe’s problems are largely intractable, and it will not take long for this realization to take its place at the forefront the consciousness global financial markets participants.

A List of Narrative Themes

There are certain economic and financial fundamentals and these are shaped into “themes” or “narratives” by the participants themselves and the media that report on them. In reality, these fundamental determinants constantly interact. However, in practice, financial market participants are unable to focus on more than one or two of these themes at any given time. Thus, history seems to play out like a distinct succession of events, when in fact, to a large extent, the force that each of these determinants exerts on history is relatively more constant than a narrative of these events would suggest. What actually seems to change is the perception of the various determinants. These perceptions can and do, in turn, affect the playing out of history.

1. PPP distortions doom the PIIGS. PPP distortions are the single most important driver of the European crisis – and this fact is coming into clearer focus. The S&P sovereign downgrade report acknowledged that the European crisis is not primarily a matter of fiscal profligacy on the part of the PIIGS. The European crisis is, at heart, a balance of payments crisis driven by PPP distortions.

The PIIGS simply cannot grow their economies at an acceptable rate that allows them to pay their debts as long the Euro is their currency. With the Euro as their currency, the PIIGS are fundamentally insolvent. That is the bottom line. It is a reality that cannot be escaped. All of the talk of fiscal union, Eurobonds, ESM, EFSF, and etc. are costly distractions.

Sooner or later, the PIIGS will abandon the Euro, alternative currencies or quasi-currencies will be introduced, nations will default, Europe will undergo massive inflation or some combination of all of the above. There is virtually a zero possibility that one or more of these alternatives will not come to pass. It is only a matter of time. And as political leaders and market participants gain ever-greater consciousness of this, the inevitable will be precipitated.

2. The failure of fiscal austerity. Fiscal austerity simply cannot cure what ails Europe. Fiscal austerity cannot adjust PPPs without triggering default.

But there is another critical reason why fiscal austerity will fail. Austerity simply cannot balance a fiscal budget if the economies that nation is trading with are contracting and overall investment is contracting. Balancing a budget under such conditions is virtually a mathematical impossibility. It becomes an exercise very similar to that of a dog chasing a short tail: it can never catch it.

3. Missing fiscal targets. Austerity under conditions of contracting exports and investments can only produce ever-greater deviations from fiscal targets. Let us take Spain as an example. Spain’s target for 2012 is a fiscal deficit of 4.4% of GDP. The problem is that Spain’s deficit for 2011 will probably be around 8.4% of GDP. Considering that the current run rate of economic growth in Spain is 0% at best, an austere budget that cuts government spending and raises taxes to the tune of 4.0% in order to meet the fiscal target would – all things being equal – produce a GDP contraction of 4.0% in 2012. To this brutal contraction we must add somewhere around 1.5% of GDP contraction from a slashing of regional spending.

The problem is that if Spain’s current projected budget is currently premised on economic growth of roughly 1%. If Spain’s economy is contracting, revenues will plummet and automatic spending (e.g. unemployment insurance) will skyrocket relative to those projected in the current budget. Therefore, at some point during the year, it will become clear that Spain will not meet its targets and new spending cuts and tax increases will have to be enacted. This will cause further economic contraction, another miss of fiscal targets, and so forth.

It is theoretically possible that the vicious circle described above can be averted. This can occur when the nation can count on a growth of exports and/or surge in investments to counteract the contractionary effects of fiscal austerity. Unfortunately, Spain cannot count with either mitigation. The economies of most Spain’s main trading partners will be contracting and therefore Spain’s exports will also contract. At the same time, there is vast overinvestment in the key sectors of the Spanish economy (tourism and real estate) and therefore growth of overall investment cannot be expected. This leaves consumption as the only remaining potential source of growth and it is clear under such depressed conditions, no relief can be expected from this factor.

Therefore, it is virtually a mathematical certainty that due to the contractionary effects of fiscal austerity under current conditions, Spain will miss its fiscal targets.

And this means that Spain, and nations like it, will soon be coming with hat in hand to ask for forbearance on their fiscal targets as well as financing to cover their shortfalls.

4. Perpetual financing crises. Since it is impossible for the PIIGS to meet their fiscal targets, they will continually have to find new sources of financing. It is clear that the private markets have effectively shut the PIIGS out. Therefore, additional financing can only come from one of two sources – multilateral aid and/or central bank financing.

Germany is the big dog in Europe and they have made their position on this abundantly clear: They will not support increased multilateral financing or central bank financing.

The result will be a new financing crisis every quarter and the accompanying political theater: The PIIGS will ask for forbearance and more money and the Germans will do their best to refuse and try to deflect the issue. The net result of this recurring drama being the creation of new and ever more convoluted financing mechanisms given Orwellian acronyms (to supplement the EFSF, ESM, and etc.).

>>> Click here for Part 2

Source: 2012 Europe Outlook: How The Fiasco Will Unfold, Part 1