In his influential 1910 tract "The Great Illusion," the writer Norman Angell argued that nations were so financially and economically interdependent that war would damage the winner as much as the loser. Under these circumstances, he argued, no nation would be foolish enough to start one.
His analysis about the economic catastrophe of war would prove correct; his conclusion about government decision-making was tragically wrong. Four years later, the countries of Europe would join in horrific conflict.
The warnings about the economic consequences of a Greek exit from the euro zone—which could follow from a default on its debts, but isn't an inevitable consequence of one—suggest it is an outcome that rational policy makers would seek to avoid.
It would be "a financial and economic disaster not only for Greece, but also for 16 continuing euro-area member states," argued Willem Buiter, Citigroup's chief economist, in a research note this month. It would trigger "bank runs in every country deemed, by markets and investors, to be even remotely at risk of exit from the euro area." Investors and lenders to these countries would, in effect, go on strike. The effects would reverberate around the world.
Others estimate that a withdrawal by Greece or any other weak economy could cost the country 25% or more of gross domestic product in the first year. Even if a strong economy left, the price it would pay would be huge.
But if exit from the euro, at least at a time of financial panic, appears deeply undesirable, is it avoidable?
Euro-zone governments have already maneuvered themselves unwittingly into multiple feedback loops, which have increased the risks to the currency. The prospect of a Greek default is viewed as increasing the chances of others, which in turn is seen to threaten banks holding billions of dollars of government bonds. The bill for rebuilding the banks lies with already indebted governments. If confidence continues to wane, a run on a country and its banks could drive a country from the euro zone.
Financial experts argue that technical solutions still are available to stem such a panic. They involve large sums of money. The most convincing of the solutions center on two pillars: the financial strength of Germany, far and away the strongest economy in the euro zone—more so than ever now that France and its big banks have been touched by the crisis—and the European Central Bank.
Herein lies the rub. There is, with the exception of the ECB, no euro-zone organization parallel to the institutions that would address such a crisis in a nation state, nor the centralization of power to make it possible.
The European Commission, the European Union's executive arm, has little independent power because most big member states like it that way. The European Council, the collection of the 27 governments, cannot act without the agreement of most of them. The European Parliament is, well, the European Parliament.
Even when there's action, it is slow. Commission President José Manuel Barroso pointed out in his state of the European Union address this week that European democracies collectively operate at a much slower pace than financial markets.
Germany, one of the keys to resolving the crisis, is a sovereign nation, whose leader presides over a country where people increasingly object to paying the bill for what they see as other people's profligacy. In phase after phase of the debt turmoil, the difficulties of German politics have led to crisis management in a reluctant, piecemeal and incomplete fashion.
Indeed, as European democracies operate, they expose the euro's weakest links. The parliaments of Slovakia and Finland, two countries with populations of around five million people, can hold up a critical expansion of the bailout funds. Italy, the euro zone's third-largest economy, now drawn into the crisis, is run by a weak prime minister, Silvio Berlusconi, viewed with ill-disguised scorn in many euro-zone capitals.
The crisis has revealed a lack of trust among the governments and the peoples of the euro zone. The Greek government abandoned its right to trust by lying repeatedly about its economic statistics, its people the victim of stereotypes. Italy and its leader aren't trusted to act responsibly. Their euro-zone partners believe that only if the ax is hovering over these governments' necks will they submit to discipline; but the hovering ax generates angst in the financial markets.
The salutary warning of "The Great Illusion" may yet be belied by events. The one institution that economists say can step in and end the immediate panic—though not deliver the essential long-term fixes—is the ECB, which can bring unlimited funds to bear without conditions attached. It is constrained from doing so by concerns that it not be viewed as subservient to governments, that it not be seen as directly financing governments, and by worries about inflation.
Even in the rarefied world of central banking, a central bank that presides over a break-up of its own currency area would be regarded as having failed, whether or not it kept inflation below its 2% target.
Yet its incoming president, Mario Draghi, is Italian. Because of that, many ECB watchers believe he will seek to prove his inflation-fighting credentials to suspicious Germans and avoid being seen as bending the rules to help out Italy. Mr. Draghi's freedom of action may be thus constrained. His predecessor, Jean-Claude Trichet has no such restrictions. Next month, his last in office, could be worth watching.
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