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taking stock

Maybe European policy makers were full of holiday cheer. Or they were simply determined to end another dismal year of crisis on an upbeat note. Whatever the reason, their final summit of 2012 achieved a genuine breakthrough on the issue of a single, region-wide bank watchdog and even managed to devote some time to the vaunted road map toward closer fiscal and economic integration. Along the way, they also handed over the next chunk of bailout cash, €34.4-billion ($44.7-billion), to insolvent Greece. And only six months late.

"There is no doubt today about the integrity of the euro zone," French President François Hollande declared. "Europe cannot now be taken by surprise."

That's a rather bold statement, considering that the still unresolved debt crisis has done nothing but surprise smug European officials at every turn since erupting in Greece nearly three years ago and spreading havoc across the euro zone. Still, even skeptical analysts acknowledge that the leaders definitely made progress this year, particularly on the financial and regulatory fronts. A new bailout mechanism is in place; Greece is still in the monetary union; Spain and Italy are paying less to tap the bond market; and the European Central Bank has won expanded powers, including the eventual supervision of a big chunk of the European banking system.

"The euro zone is still alive and it is moving in the right direction, even if it sometimes moves at a very slow speed," Carsten Brzeski, senior economist with ING in Brussels, said in a note to clients titled "All is Calm, Not All is Bright."

That's because deep divisions between Germany and France over the pace and direction of reforms have yet to be bridged, economic conditions in the battered southern countries continue to deteriorate and key elections in Germany and Italy could add another layer of uncertainty in 2013.

"Elevated levels of protectionist rhetoric during the German election campaign [next fall] ... are likely to adversely impact the euro area's capacity to continue kicking the proverbial can of 'peripheral solutions' down the road," warns Constantin Gurdgiev, adjunct professor of finance at Trinity College in Dublin. In other words, the debt crisis could get a lot worse in a hurry if it becomes a political football in the country whose taxpayers are reluctantly footing much of the bailout tab.

But that's not about to happen, assures veteran consultant Daniel Stelter, who keeps close tabs on the public mood in his home country from his perch in Berlin.

For one thing, German Chancellor Angela Merkel's popularity has been soaring, thanks to a relatively stable economy, low unemployment and her forceful demands that the euro zone's basket-cases stick to the austerity path if they expect to see further bailout money. The latest monthly poll puts Ms. Merkel's approval rating at just above 80 per cent – and her three-year-old coalition government at a high-water mark of 62 per cent – an astonishing level for any elected politician, let alone one late in a second term and sending so much money to governments that most Germans dismiss as undisciplined borrowers and profligate spenders.

"The good news for her is that nobody is standing up and saying: 'We will stop paying,'" says Dr. Stelter, a senior partner with the Boston Consulting Group. "The man on the street is happy, as we have full employment and everything is good this Christmas." Indeed, 72 per cent of Germans in the latest survey regarded 2012 as a good year for them personally.

Ms. Merkel should take advantage of that popularity and push for a European redemption fund that would pool the euro region's excess debt and refinance it with euro bonds, Dr. Stelter argues. Instead, she is doing everything possible to postpone the inevitable writedown of Greek debt, until after the next election. "If I were her, I would rather do it now, because the probability that the public will forget about it by next September is high. If you don't do it now, the risk of a blowup [before the election] is still pretty high."

Here is Dr. Stelter's most optimistic scenario for 2013: "Well, the best is that austerity works, the slowdown ends and we see kind of a stabilization thanks to more growth with exports, more demand from Germans and a weaker euro, weaker oil prices and a good U.S. economy. … Combine this with a true banking union and some joint liabilities for bank and government debt and we can muddle through, with the Germans paying more and more."

Then, at my request, he sketches a worst-case alternative outcome to the next chapter in this never-ending story. "I do not think that a breakup happens next year, but we could well see the next step towards it." The triggers would be a continued deep recession across southern Europe, a downturn in Germany that hurts imports from Spain and other battered economies; and increased political tensions that would turn governments even more inward-looking.

But for now, Dr. Stelter regards Europe as "astonishingly stable," considering the depth of the crisis and the damage it has caused. And that's worth celebrating, as another year of turmoil comes to a close.