It may be hard to imagine that Europe's crisis could worsen, but it just has. EU leaders failed at their summit two weeks ago to produce anything of substance. China and Brazil are clearly reluctant to come to the rescue by providing a large injection of foreign cash. And the recent Group of 20 leading and emerging economies summit in Cannes produced no agreement on steps that might have helped to resolve the crisis.
Now there is the collapse of the Greek government. The trigger may have been the outgoing prime minister George Papandreou's ill-advised decision to call for a referendum on the EU's rescue package (which implies further severe austerity measures); but the fundamental problem is that a brutal recession made the government's demise all but inevitable.
The formation of a national unity government does not mean that the Greek problem is behind Europe or the world. On the contrary, the new government's position will be no more tenable than that of its predecessor. Until there is hope, however remote, that Greece can begin to grow again, the problem will not go away.
Even worse for financial stability, Mr Papandreou's announcement of a referendum provoked Angela Merkel, the German chancellor, and Nicolas Sarkozy, the French president, into breaking an important taboo. Previously, European leaders had averred that the euro was forever, repeating at every turn that they would do whatever it took to hold the monetary union together. Last week, in a dangerous departure, Mrs Merkel and Mr Sarkozy told the Greeks that it was up to them to decide whether they wanted to keep the euro.
Their statements were designed to beat Greek politicians into submission, and may have succeeded, at least for now. But they also opened the door to destabilising speculation. The temptation to bet against continued Greek participation in the euro is now greater than ever. As investors place their bets, the balance sheets of Greek banks and the Greek government will deteriorate further, which could cause bearish expectations to become self-fulfilling.
The greater danger is that where Greece leads, Portugal and Italy will be forced to follow. Anyone who doubts this need only think back to 1992, when the European Monetary System fell apart.
In September of that year, Helmut Schlesinger, the Bundesbank president, made some reckless comments about how devaluations within Europe's system of supposed stable exchange rates "cannot be ruled out". Mr Schlesinger's unguarded remarks signalled that the Bundesbank was not willing to do whatever it took to preserve the system - a signal that encouraged investors to place massive bets against the British pound and Italian lira. The result was the collapse of Europe's exchange-rate mechanism.
If Mrs Merkel and Mr Sarkozy are serious about preserving the euro, they will have to repair the damage caused by their reckless remarks. They should acknowledge that the only entity with the capacity to stabilise the situation is the European Central Bank (ECB). And they must give the ECB the political cover that it needs to do what is required to preserve the system.
Specifically, the ECB must do much more to support economic growth. Its decision to cut rates by 25 basis points at the first policy meeting under Mario Draghi, its new president, is the one ray of light in an otherwise darkening sky. But 25 basis points are a drop in the bucket. With Europe headed for recession, the danger of rising inflation is nil. Still, given German sensitivities, Mrs Merkel should use her bully pulpit to reassure her public.
More controversial, the ECB needs to increase its purchases of Italian bonds. Unless yields on those bonds fall to German levels, there is no way that Italy's debt arithmetic can be made to add up. But Mr Draghi has indicated that he is reluctant to see the ECB become a lender to governments. Reassuring the markets by adopting structural reforms, he has observed, is properly the responsibility of those governments, not of the central bank.
But structural reforms cannot be accomplished overnight. Italy needs time to put its pro-growth reforms in place. Not providing that time would sound the death knell for the euro.
Here's where the political cover comes into play. Mrs Merkel and Mr Sarkozy need to make the case that if the euro is to become a normal currency, Europe needs a normal central bank - one that does not merely target inflation like an automaton, but that also understands its responsibilities as a lender of last resort.
Meanwhile, Italy, now under the watchful eye of the IMF, needs to move ahead with those pro-growth reforms to reassure the ECB's shareholders that the central bank's bond purchases are not money losers.
If it does, maybe there will be reason to hope that the European project's darkest hour signals the coming of dawn.
Barry Eichengreen is a professor of economics and political science at the University of California, Berkeley. His most recent book is Exorbitant Privilege: The Rise and Fall of the Dollar
* Project Syndicate
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