By Peter Boone and Simon Johnson

According to Friedrich von Hayek, the development of welfare socialism after World War II undermined freedom and would lead western democracies inexorably to some form of state-run serfdom.

Hayek had the sign and the destination right but was entirely wrong about the mechanism. Unregulated finance, the ideology of unfettered free markets, and state capture by corporate interests are what ended up undermining democracy both in North America and in Europe. All industrialized countries are at risk, but it’s the eurozone – with its vulnerable structures – that points most clearly to our potentially unpleasant collective futures.

As a result of the continuing euro crisis, European Central Bank (ECB) now finds itself buying up the debt of all the weaker eurozone governments, making it the – perhaps unwittingly – feudal boss of Europe. In the coming years, it will be the ECB and the European Union who dictate policy. The policy elite who run these structures – along with their allies in the private sector – are the new overlords.

We can argue about who exactly are the peasants, the vassals, and the lords under this model – and what services exactly will end up being exchanged. But there is no question we are seeing a sea change in the post-war system of property, power, and prosperity across Western Europe, just as Hayek feared. An overwhelming debt burden will bring down even the proudest people.

The ECB-EU approach will not of course return countries to reasonable levels of growth – the debt overhang is simply too large. The southern and western periphery of the eurozone cannot grow out of their debts under these arrangements, and so will stumble from stabilization program to stabilization program – just like Latin America did during the 1980s. This is bound to be acrimonious, leading to hostile politics, social unrest, and more economic crises.

The International Monetary Fund will do just what the EU and ECB asks to keep the charade in place. The old days when all member countries got nice presents from the euro zone are long gone; now it is all instructions and austere requirements. But enough resources will be provided to keep rolling everything over.

The top three French players – President Nicolas Sarkozy, Jean-Claude Trichet (ECB), and Dominique Strauss-Kahn (IMF) – seem to be enjoying themselves; presumably they think they will end up running things. More surprising is the reaction of other European leaders, who genuinely seem able to convince themselves that what they are doing makes sense – as opposed to being a series of crazed improvisations.

The market is telling them that their euro rescue schemes make no sense, and the market is probably right. Faced with the ugly reality of the loss of confidence in European finance and institutions, the Germans and even the normally sensible Swedish government are increasingly blaming “irrational” markets and speculators for homegrown problems.

The currently preferred messy solution of the EU leaves the world at risk of shocks like we observed this week. This particular iteration may blow over, but another will arise when there is backlash in Athens, Dublin, Lisbon, or – heaven forbid – Madrid.

Meanwhile, rational market participants are selling debt of risky nations, and getting out of the euro. The whole fiasco is now leading to a messy shift away from risky assets all around the world, and the cost to the world of such volatility is not small. Debt peonage looms for a wide range of countries that were recently thought immune to serious fiscal crisis, including the United States and UK.

It is inappropriate for the Europeans to subject the rest of the world to these large, chronic risks. Europe should also recognize how disorderly insolvencies end – it is never pretty. The 1970s crisis in Britain is the model for what may go wrong. Ongoing large strikes, populations disenchanted with all authority, and great economic disruption are inevitably the outcome. When the assets are very cheap, deep-pocketed investors from the US, China, India and of course Russia will swoop in for the crown jewels.

What should be done? It is time to look in the mirror and recognize the problem. Several nations in Europe are bordering on insolvency, and it is now pretty clear that we shouldn’t just “bandage” that over for a few years with large aid packages.

To deal with this insolvency we need to restructure the debts of those nations. But this has to be done in a way that does not destabilize Europe’s fragile banking system. And it needs to be credible enough so that once restructured, the troubled nations will be able to finance themselves easily.

Europe now has the 750bn package of assistance in place, and they should use it to fix the problem once and for all. The ingredients for a solution include:

Announcing an orderly restructuring of the periphery countries’ debt (Greece, Portugal, Ireland and possibly others also). This should start with a standstill and a program of fiscal financing while budget cuts are put in place.

Regulatory forbearance should be explicitly provided to all European banks, with a backstop of ECB liquidity, and a 500bn euro support program to provide capital injections – as was done in the United States, 2008-09.

The nations that are not restructured need to be supported via ECB liquidity lines that guarantee the rollover of their government debt.

The G20 needs to provide support to prevent chaotic foreign exchange markets but also accept a large further devaluation of the euro. At some point the G20 will need to intervene to support the euro via central banks.

Such a comprehensive package of measures would be painful, but it is the only realistic solution to this chaos. It would also restore some credibility to Mr. Trichet and the ECB, who, at this stage, appear captives the fiscal crises in the euro zone.

Unfortunately, there is no leadership today in Europe that could take such decisive actions, so Europe will only reform itself dragged kicking and screaming through successive crises until the current, and many ensuing, problems are resolved.

The UK and US need to prepare themselves for more storms. The United States will be in the more pleasant position as the world’s safe haven, but this will only encourage America’s profligate politicians to spend more and build more debt.

The UK will bear much more pain from euro devaluation and financial dislocation, all exacerbated by its own large deficit and debts. We might well see one more invasion across the channel, this time by bond vigilantes who question Britain’s ability to rein in inflation as it builds too large debts.

At the end of this great tumult, Europe and the UK will have sound fiscal regimes. Debt will be defaulted on or inflated away, and nations will have dramatically cut spending.

Hayek’s predicted demise of western society will prove correct, but welfare systems will prove the victim, rather than the mechanism, erased by a political and financial elite gone awry.

An edited version of this article appeared in the Sunday Telegraph (UK) this morning.