Analysis: Spectre of second eurozone depression too close for comfort

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 is ultimately forced to issue drachmas in order to supply domestic liquidity.

With Greece out of the eurozone, all eyes turn to Spain. Bolstered by funds from the European Stability Mechanism, Spain remains financially afloat for several months.

But the Spanish economy continues to deteriorate and unemployment heads towards 30 per cent. Violent protests against 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. 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 to the US and Asia.

Our scenario continues in China. The economy’s slowdown has already exacerbated social conflict, and recent developments in Europe have added fuel to the fire. With European export orders cancelled en masse, Chinese factories are faced with the prospect of massive lay-offs. Demonstrations begin in major cities.

China’s government decides that it cannot risk further strife and announces a package of measures to boost economic growth and prevent lay-offs, including financial support for exporters and intervention in the currency markets to weaken the renminbi.

In the US, president Mitt Romney has just taken office, following a hard-fought campaign in which he derided Barack Obama for being too soft on China’s economic policies. Against the advice of his economic advisers, he announces across-the-board import duties on Chinese exports.

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.

Few countries are spared the economic carnage. Those that do relatively well share three characteristics: low levels of public debt, limited dependence on exports or capital flows, and robust democratic institutions.

As in the Great Depression, the political consequences are more serious. The eurozone’s collapse forces a major realignment of European politics. Centrist parties pay the price for their support of the European integration project, and are repudiated in the polls by parties of the extreme right or extreme left. Nativist governments begin to kick out immigrants.

For nearby countries, Europe no longer shines as a beacon of democracy. The Arab Middle East takes a decisive turn towards authoritarian Islamic states. In Asia, economic strife between the US and China spills over into military conflict, with increasingly frequent naval clashes in the South China Sea.

Many years later, Merkel, who has withdrawn from politics and become a recluse, is asked whether she thinks that she should have done anything differently during the euro crisis. Unfortunately, her answer comes too late to change the course of history.

A remote scenario? Perhaps, but not remote enough.

• Dani Rodrik is a professor at Harvard University’s Kennedy School of Government and a leading scholar of globalisation and economic development.