Consider the following scenario: After a victory by the left-wing Syriza party, Greece’s new government announces that it wants to renegotiate the terms of its agreement with the IMF and the EU. German Chancellor Angela Merkel sticks to her guns and says that Greece must abide by the existing conditions. Fearing that a financial collapse is imminent, Greek depositors rush for the exit. This time, the European Central Bank refuses to come to the rescue and Greek banks are starved of cash. The Greek government institutes capital controls and is ultimately forced to issue drachmas to supply domestic liquidity.
With Greece out of the eurozone, the focus turns to Spain. Germany and others are at first adamant that they will do whatever it takes to prevent a similar bank run there. The Spanish government announces additional fiscal cuts and structural reforms. Bolstered by funds from the European Stability Mechanism, Spain remains financially afloat for several months.
However, the Spanish economy continues to deteriorate and unemployment heads toward 30 percent. Violent protests against Spanish Prime Minister Mariano Rajoy’s austerity measures lead him to call for a referendum. His government fails to get the necessary support from voters and resigns, throwing the country into full-blown political chaos. Merkel cuts off further support for Spain, saying that hard-working German taxpayers have already done enough. A Spanish bank run, financial crash and euro exit follow in short order.
In a hastily arranged mini-summit, Germany, Finland, Austria and the Netherlands announce that they will not renounce the euro as their joint currency. This only increases financial pressure on France, Italy and the other members. As the reality of the partial dissolution of the eurozone sinks in, the financial meltdown spreads from Europe to the US and Asia.
Our scenario continues in China, where the leadership faces a crisis of its own. The economy’s slowdown has already exacerbated social conflict, and recent developments in Europe have added fuel to the fire. With European export orders canceled en masse, Chinese factories are faced with the prospect of massive layoffs. Demonstrations begin in major cities, calling for an end to corruption among party officials.
China’s government decides that it cannot risk further strife and announces a package of measures to boost economic growth and prevent layoffs, including direct financial support for exporters and intervention in the currency markets to weaken the yuan.
In the US, US President Mitt Romney has just taken office, following a hard-fought campaign in which he derided then-US President Barack Obama for being too soft on China’s economic policies. The combination of financial contagion from Europe, which has already led to a severe credit crunch, and a sudden flood of low-priced imports from China leaves the Romney administration in a bind. Against the advice of his economic advisers, he announces across-the-board import duties on Chinese exports. His Tea Party backers, who were critical in mobilizing electoral support for him, urge him to go further and withdraw from the WTO.
Over the next few years, the world economy slumps into what future historians will call the Second Great Depression. Unemployment rises to record-high levels. Governments without fiscal resources are left with little option, but to respond in ways that will only exacerbate problems for other countries: trade protection and competitive exchange-rate depreciation. As countries sink into economic autarky, repeated global economic summits yield few results beyond empty promises of cooperation.