Europe's economic prospects next year are so bleak that 2011, for all the euro's agonies, has every chance of being remembered fondly.

In forging a fiscal compact that aims to put the single currency on a firmer long-term footing, euro zone leaders have set the 17-nation bloc on course for prolonged austerity.

Given powerhouse Germany's insistence on budgetary rigor, policy tightening that reinforces the cyclical downturn was politically predictable. And given the unforgiving mood of the bond markets, such an outcome was perhaps unavoidable.

Still, in the eyes of a number of economists, the euro zone's policy settings risk making the process of whittling down debt tougher than it needs to be.

First, because pro-growth reforms are playing second fiddle to rapid deficit-cutting; and second, because debtor/deficit countries on the euro zone periphery are being asked to bear a greater burden than creditor/surplus countries in correcting the current account imbalances that are at the heart of the single currency's existential crisis.

It's been clear for some time that the stronger north Europeans, led by Germany, need to stop tightening their economic policies and adopt at least mildly expansionary policies, said Fred Bergsten, director of the Peterson Institute for International Economics, a think tank in Washington.

In addition, Bergsten said he was convinced that the European Central Bank (ECB) would quickly follow up last week's quarter-point cut in its main short-term interest rate with two more quarter-point reductions.

In the public discussions, there's been an excessive weighting to austerity, Bergsten told reporters in a conference call. If Europe goes into a deep recession, that obviously makes the adjustment program more difficult to carry out, both in economic and political terms, so the Europeans need to add a pro-growth dimension to the financial engineering that has been the focus of their activity so far.

DUTCH SLOWDOWN

Underlining the speed of the deterioration in the economic outlook, a leading Dutch think tank forecast on Tuesday that the economy would shrink 0.5 percent next year. As recently as mid-September, the Netherlands' Bureau for Economic Policy Analysis (CPB), which advises the cabinet, had projected 1.0 percent growth for 2012.

And underscoring how an economic downturn wreaks havoc with public finances, the CPB revised up its forecast of the 2012 Dutch budget deficit from 2.9 percent of GDP to 4.6 percent -- above the 3 percent limit that the euro zone's leaders vowed last week to respect on pain of quasi-automatic sanctions.

For Dario Perkins, an economist at Lombard Street Research, a consultancy in London, the belt-tightening prescribed by Germany and its ally France is the wrong solution to the euro crisis. Spain and Ireland, now deeply indebted, would have comfortably met the new fiscal rules before the 2008 recession.

Nor does the fiscal pact address future imbalances in the euro zone and the flow of debts they imply, Perkins said in a report.

Deep structural, competitiveness and trade imbalances remain. Austerity does nothing to improve these, except via the unintended route of encouraging depression and deflation, Perkins wrote.

Indeed, austerity merely compounds economic weakness, leading to further austerity. Greece has neatly illustrated this and it's hard to see how rolling this same policy out for a wider set of other European economies could lead to a more favorable outcome, he said.

STRUCTURAL SLOG

In a sign Germany expects a sharp slowdown, Chancellor Angela Merkel said on Tuesday that the euro zone needed growth as well as budget discipline. Smart energy grids and rural broadband networks were two areas where investment could give a lift to the economy.

But for Germany the main route back to growth lies through structural reforms that address an economy's underlying shortcomings such as inadequate education levels and rigid labor laws. By their very nature, deep-seated changes to the very fabric of a society are a long-term undertaking.

This takes years. You don't raise the quality of human capital in three years, said Antonio Garcia Pascual, an economist at Barclays Capital in London.

One way to narrow the debtor/creditor competitiveness gap would be to bring about a depreciation in the real exchange rate of weaker countries by engineering a big shift in relative inflation rates, noted Bank of Canada Governor Mark Carney.

In short, Germany would be asked to put aside its visceral fear of inflation for the good of euro zone balance.

However, it is not clear that ongoing deflation in the periphery and higher inflation in the core would prove any more tolerable than it did between the United Kingdom and the United States under the postwar gold standard of the 1920s and 1930s, Carney said in Toronto on Monday.

With no alternative short-term adjustment path available to Europe, Carney said the combination of fiscal austerity and structural change would mean falling wages, high unemployment and tight credit.

A sustained process of relative wage adjustment will be necessary, implying large declines in living standards for a period in up to one-third of the euro area, he said.

Will bond investors and voters buy into a strategy of prolonged stagnation? Perkins with Lombard Street Research is skeptical. A failed auction or weak economic data could trigger significant market volatility, forcing policymakers into radical measures, he argued.

If the Germans and French really see fiscal union as the only solution, they have to be prepared to pay for it. If they won't pay, the ECB will have to. More likely, some countries will eventually realize the futility of the austerity death-spiral and decide to leave the euro area, he wrote.

(Reporting by Alan Wheatley)

Germany United kingdom