The euro was intended to promote a European-wide, highly-integrated, efficient capital market that would enhance growth and help cure the continent of the dreaded "euro sclerosis" disease. To an economist, one of the truly fascinating developments in the continuing saga of the euro zone crisis is the extent to which the project of European Monetary Union (EMU) is having the opposite effect.

To be sure, only a few years ago, the architects of the euro zone could claim success in creating an efficient pan-European capital market that intermediated savings from, say, Germany, to fund investments in, for example, Greece and Spain. The fact that Greece and Spain could borrow at rates only a few basis points over German bunds was cited as evidence of the efficiency of the capital market. Over the past several months, however, Europe has witnessed a quiet fragmentation of its capital market. As Stephen King points out in the Financial Times, the rates at which the banks of different euro zone members pay to raise short term funds are widening and cross border bank flows are shrinking.

Part of the problem is collateral. The financial system can be thought of as an inverted pyramid resting on an apex of collateral supporting the vast, complex network of financial transactions above. (See earlier posts, here and here.) Reduce the size of that collateral, and the whole of the pyramid shrinks. That is what is at play in Europe. The value of sovereign bonds used as collateral is shrinking, as periphery country bonds are no longer considered "risk free."

At the same time, credit worthy national governments and central banks are reluctant to allow “their” good collateral to seep out. The result is a kind of reverse game of “hot potato”: instead of trying to get rid of good collateral, the objective of the game is to hoard it in order to support financial transactions in your country to support the financial system’s "inverted pyramid." Of course, this is not the result of any overt policy action on the part of national governments or central banks — that would be inconsistent with the commitments of EMU. It is, rather, the result of behaviour under uncertainty and a retrenchment from risk-taking; though national regulators in core countries are undoubtedly not discouraging the practice.

If collateral is part of the problem, so too is the euro itself. In recent months we have seen the evolution of thinking from “the exit of a member is impossible” to “exit of some weaker members is possible” to the view expressed by a growing number of observers that “exit of some is probably inevitable.” That evolution in thinking is hugely important in terms of the integration of the capital market. In the halcyon pre-crisis glory days of the euro, exit was unthinkable. That certainty allowed financial markets to ignore exchange rate risk. And, as any good student of international finance will tell you, in that environment, with reasonably efficient capital markets, the process of arbitrage will drive the prices of assets of comparable risk together. That was indeed the case; it accounts for the remarkable convergence of sovereign bond yields in euro zone countries, as financial markets blithely assumed that no member of the euro zone would ever be allowed to default.

But as the perceived risk of euro exit has increased, we have seen bond spreads between German bunds and the bonds of periphery sovereigns return to levels prevailing before the introduction of the euro. In some respects, this is gratifying for anyone who teaches international macroeconomics: Europe has unwittingly provided an excellent test of the theory. And, yet, it is deeply troubling because it was all so predictable. This whole episode underscores the dangers of “incomplete integration” — moving ahead with the integration of markets before the governance arrangements needed to support efficient market outcomes have been erected.

Moreover, we have seen this movie before. To repeat myself, Europe has re-created the dysfunctional gold standard of the inter-war years that did not promote automatic, symmetric adjustment of external imbalances; that system led to the hoarding of gold in the countries with strong balance of payments positions (France and the United States).We all know how that turned out.

The beggar-thy-neighbour responses to financial and economic shocks of the early 1930s led to a fragmentation of the global economy, as country after country adopted policies designed to protect themselves from the troubles of others, but which shifted the adjustment burden to their neighbours. Unfortunately, those policies invited retaliation and eventually the gains from international trade and finance were lost. The result was a fragmentation of the global economy that propagated stagnation and created a backlash against financial and economic integration.

So, is growing financial fragmentation in Europe a prelude to globalization backlash? One more question that clouds the outlook in the New Age of Uncertainty.