INTERNATIONAL observers watch anxiously for the latest chapter in the long-running Yugoslavian drama. Leaders from the breakaway republic of Slovenia have met with federal authorities, and mediators from the European Community continue to press for a compromise peace plan.But the question remains: Can the republic leaders cool seething ethnic rivalries enough to avoid a melt-down of this Slavic amalgam created by Woodrow Wilson in the aftermath of World War I? The source of the conflict is a affliction called nationalism that awakened from dormancy with the death of Yugoslav ruler Josip Broz Tito in 1980. The Balkan strain of nationalism is insidious, born of subtle distinctions among the Slavic peoples of southeastern Europe, exacerbated by 1,000-year-old memories of imperial grandeur, and inflamed by a visceral need to redress a wide range of atrocities and indignities (both real and imagined). Throughout the country, politicians incite nationalist fervor to gain support for their cause. Although monumentally misguided, the Serbian strategy to block the ascent of the Croatian representative in the federal presidency exactly four days before Croatians voted overwhelmingly to secede from the fragile union was utterly in character. Yugoslavia brings new meaning to the phrase "all politics is local." Regional disputes go to near-ridiculous lengths. There is even controversy over the location of Tito's grave. For all his faults, Tito held the country together for more than three decades. Now the Serbs want to send his remains back to Croatia (because he was a Croat), and the Croatians decline to accept them (because he was a communist). Even so, at least some Yugoslavians recognize the seriousness of diverting attention from the imperative of implementing political and economic reforms. Yugoslavia's ties to the West as the leading nonaligned nation, and Prime Minister Ante Markovic's economic reform initiative, led to widespread optimism during 1990. But unless the present political situation can be stabilized, it is doubtful the various republics can effectively implement reforms. At a recent public forum, Ante Cicin-Sain, governor of the National Bank of Croatia, acknowledged the theoretical soundness of the Markovic plan, but accused Serbian Deputy Prime Minister Slobodan Prohaska and his compatriots of lacking the political courage to implement the monetary reforms essential to stabilizing exchange rates and prices. Mr. Cicin-Sain charged that the Serbians flagrantly undermine national monetary policy with their local fiscal policy, by granting generous subsidies to collective farmers and by retaining other vestiges of the discredited communist system. The political turmoil has already had quantifiable costs for Yugoslavia. Though it has never missed an interest payment on its national debt, Yugoslavia is unable to borrow money for capital projects because of a lack of creditor confidence, while Hungary (with a far larger debt burden) continues to have access to international markets. PERHAPS we should not expect too much of a country whose national airline reserves the entire left side of the plane for passengers who smoke. Given the political landscape of Yugoslavia, it is tempting to shrug our shoulders. But this is dangerously shortsighted, since the country's breakup could bring broader instability bred by civil war and a return to totalitarianism in the region. The West can offset these tendencies by initiating cooperative regional arrangements to make clear to the Yugoslavs that dialogue and peaceful resolution of conflicts will be rewarded. One such effort involves the governments of Italy, Austria, Hungary, and Czechoslovakia, as well as Yugoslavia, in the so-called Pentagonal Initiative, which may serve as a prelude to association with, or membership in, the European Community. But before that can come, the seemingly intractable ethnic conflicts must be resolved. This can only be accomplished by the Yugoslavs themselves. Leaders in the country must recognize that, despite their differences, they are in a far stronger position to seek and receive economic assistance if they can quell the warring ethnic factions and establish long-term political stability. It is often said that "Yugoslavia makes far more history than it can possibly use," and this tradition has never been more evident. These days, many ask whether Yugoslavia, as a nation, makes any sense. I put that question to one of the new reform-minded ministers of the Macedonian republic. "Yes," he said unhesitatingly, "Yugoslavia makes sense culturally, economically, linguistically, and even ethnically. We are all South Slavs. It is just stupid politics that is tearing us apart."