Source: The New York Times, Economic View, By TYLER COWEN, Published: May 26, 2012

As problems mount in the euro zone, it’s increasingly evident that we’ve been witnessing an institutional failure of monumental proportions.

What is to be done about Greece? Simply keeping it in the euro zone won’t help much, even if it’s possible.  The continuing crisis has sapped confidence in banks not only in Greece, but also in Spain, Italy, Portugal and Ireland, though to varying degrees.  Unless there are explicit guarantees to these banks soon, the market will likely take a further turn for the worse.

An absence of guarantees could prompt a broader chain reaction of capital flight and bank collapses across several countries.

The basic problem is that many people won’t keep their euros in a Greek bank, and perhaps not in a Spanish bank, either, when those euros can be moved to Germany or some other haven.

Yet German citizens do not appear ready to guarantee Spanish banks or, by extension, the whole credit system of Spain and the other periphery nations. Guarantees of that scope are probably impossible and may also require constitutional changes in some nations.

We thus face the danger that the euro, the world’s No. 2 reserve currency, could implode.  Such an event wouldn’t be just another depreciation or collapse of a currency peg; instead, it would mean that one of the world’s major economic units doesn’t work as currently constituted.

We are realizing just how much international economic order depends on the role of a dominant country — sometimes known as a hegemon — that sets clear rules and accepts some responsibility for the consequences.  For historical reasons, Germany isn’t up to playing the role formerly held by Britain and, to some extent, still held today by the United States.  (But when it comes to the euro zone, the United States is on the sidelines.)

THERE appears to be a power vacuum, and the implications are alarming. We may be entering a new world where international cooperative arrangements, in environmental areas as well as finance, are commonly recognized as impossible.  If the core European nations cannot coordinate effectively, what can we expect in dealings with China, Russia and other countries that have less of a common background and understanding?

In the euro zone, we are seeing two refusals to cooperate: Germany won’t renew financial pledges to Greece without Greek compliance on previous agreements, and Greece doesn’t want Germany to control its national budget.  Both seem reasonable positions, and maybe they are, but reasonable positions can apparently destroy an international agreement rather easily.

Is there a way out?  To seek a binge of pro-growth government spending, in the hope of stimulating economies, is to assume what already stands in doubt. The crisis has reached a head partly because the market already lacks trust in the periphery governments to invest money for sustainable economic growth.

There is also talk of forming a true fiscal union, but that seems to be doubling down on a bad idea.  If the euro zone cannot summon enough cooperation now, how is any union requiring tighter cooperation supposed to work?  How would national budgets be set and approved?  A credit collapse remains a real possibility.

Is it too late for monetary policy to make a difference?  The other euro-zone nations might allow Greece to leave, while guaranteeing payments for food and fuel, both of which Greece imports, for a reasonable period.  Higher price inflation might then depreciate the euro, limit the need for difficult downward wage adjustments, and help Spain and Italy improve their competitiveness.  The inflation could come through central bank bond purchases from the troubled nations, thus easing their debt problems.  That may be the only useful option still on the table.

But that’s also not easy.  First, economically healthier nations may be reluctant to accept the inflation, which would represent a rather direct, continuing redistribution of wealth to the troubled debtor countries.

The second problem is that some of the banking systems in the periphery nations may be too broken for monetary policy to take hold.  Imagine the European Central Bank trying to infuse new money and credit into Spain, while bank deposits move quickly to Germany, Switzerland and other safer places.  Again, why would anyone want to keep money in the bank of a fiscally troubled nation?  That loss of confidence will not be easily repaired.

Since December, the European Central Bank has lent more than a trillion euros to euro-zone banks, but that has bought no more than a few months of peace.  It isn’t clear how much more can be done.  It probably is about time to judge the euro zone as a failed idea — and rarely is it wise to double down on failed ideas.

What is most disturbing is that the euro-zone nations are democratic, protective of basic liberties, and have advanced intellectual and research communities. The final lesson of this debacle is that smart nations with noble motives can make very big mistakes.  And that should concern us all.