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Whatever mix of sanctimony and schadenfreude may have existed among Europeans who'd watched the American economic system explode in recent weeks has surely now evaporated. Major banks in Europe are falling almost as dramatically as they are here. Fortis, Belgium's largest financial-services firm, went under last week and has sold off parts of itself to France's BNP Paribas and the Dutch government. Germany's government and private banks over the weekend had to bail out lender Hypo Real Estate Holding, to the tune of some $67.5 billion. Trading has been suspended on six financial stocks in Iceland, and banks in Spain and Italy will almost certainly soon require some form of government assistance. Ireland's top bankers and prime minister have said that there would have been major bank failings there if not for emergency government action last week.

From this continent, the question arises: Shouldn't the European Union be handling a bank bailout? After all, Europe's largest economies—except for the United Kingdom's—have used a unified currency since 2002, and the European Central Bank sets interest rates for all the countries in the economic union (again, this excludes the United Kingdom but includes the largest economies on the continent).

Thus far, the answer has been no; each country seems determined to pursue its own bailouts. In that fact you can glimpse both the limitations to the European Union as well as its potential unraveling.

It's easy to see how each state's actions to prop up its account-holders undermine the logic behind the European Union. Imagine if it happened here: If the state of New York announced that it would protect bank deposits for its citizens, residents of other states would shift their money to New York-based banks. Other states would quickly be pressured to match the move lest their own banks lose so many depositors that they would go under.

Europe's version of this flight to bank protection began to happen last week. When Ireland announced it would protect all deposits against failure, some U.K. depositors began shifting savings there, while other European banks denounced the move as an unfair competitive advantage. That complaint did not last long; instead, Germany, Greece, Denmark, and others have had to match Ireland's guarantee, and on Monday afternoon, all members signed a statement saying they'd do whatever needs to be done. This is a sloppy way to make Continentwide policy, but at least it probably has a stabilizing effect.

Like so much that seems to go wrong with the European Union, this seeming flaw is in fact how the system is intentionally designed. Even the most aggressive EU economic members—you'd have to put Germany at the head of the list—were never willing to give up certain fundamental economic rights of the state. These include the power to tax, to spend, to put social programs into place, to fine and to incarcerate wrongdoers, etc. The reasons for this should be obvious; any political leader who gives up too much national power to an essentially unaccountable body will be the one who pays the price when things go sour. (Such caution has kept the United Kingdom out of the EU economic club until now, with little prospect of them joining any time soon.)

The dangerous flip side of that coin is that if the EU's economic institutions are weakened by either policy or fate, then the progress that the union has achieved—particularly in once-struggling countries like Ireland, Spain, and Greece as well as the newer Eastern European members—could be threatened.

A lynchpin of this success has been the EU's growth-and-stability pact, basically an agreement among member nations to keep their fiscal houses in order. The pact mandates, among other things, that budget deficits be kept below 3 percent of GDP (something recent American governments have been unable to do). At the hastily assembled summit this weekend, the leaders of France, Germany, Italy, and the United Kingsom announced that the European economy is facing "exceptional circumstances." That phrase was intended to legitimize the individual bank actions mentioned above. But there has long been tremendous pressure on European governments to find ways around the pact, and if "exceptional circumstances" are used as an excuse to do that, then confidence in the EU economy and currency could be undermined. (Indeed, Monday was the worst day for the euro against the yen since trading began in 1999.)

The European Union is, in its details, a frighteningly muddled, multiheaded beast, but from a macroeconomic point of view, it has been massively successful. The currency is stronger than its most passionate advocates would have guessed, and by allowing EU members to trade among themselves without currency-exchange costs, it has been a tremendous boon to trade. Even exports beyond the EU—which you might expect to fall, given the strength of the currency—have more than held their own, essentially doubling over the last 10 years.

None of that, however, can protect against the contagion of unpaid mortgages and the flawed financial instruments built on top of them. And the European Union is already unpopular with many voters for reasons more political than economic. If credit markets seize up and drive Europe into a serious recession, the EU itself could readily become the scapegoat.