Picture the scene: you are a pension-fund manager in a country far removed from Europe. Your pension plan is ticking over nicely and it’s your duty to ensure that this substantial nest egg of contributions retains its value in future. A report about investment opportunities in the brand new euro zone catches your eye.

The year is 2001 and the euro has just been launched in countries with an impressive reputation: Italy, France, the Netherlands, Germany and Spain – how could you resist? You travel to Madrid to clinch a cast-iron deal in Spanish government bonds. Everyone’s a winner: in Madrid they’re already dreaming of a high-speed rail link with Pamplona, funded by your pension contributions. And for you, the future looks bright as you contemplate the interest you’ll soon be receiving on your Spanish government bonds.

The champagne’s on ice, the deal is all but sealed. But suddenly you find yourself wondering: “Who can offer me a guarantee that Spain will always have enough money to pay out me and my thousands of pension-fund contributors?”

Other people’s money
An uneasy silence descends on the negotiating table in Madrid. “Uhm … listen, they take care of all that euro stuff in Frankfurt.” Determined to get to the bottom of things, you give the champagne a miss and head for Frankfurt.

Alarmingly, when you put your question to the European Central Bank, you are greeted with the same unsettling silence.

“Uhm, our main purpose is to serve the European consumer, to control inflation. Don’t make the mistake of thinking we have any control over how the Spanish or the Dutch manage their budgets. And if there’s one thing we don’t have it’s a licence to print money in order to guarantee government bonds.”

You return home and tell your bosses “The euro zone? Forget it. All they do there is play with other people’s money.”

Beyond the euphoria
Be that as it may, when the euro zone was set up, it sparked vigorous global trade in European bonds.
“The mood was euphoric. The world economy was one big collection of bubbles, so we all skipped blindly down the same path,” says Paul de Grauwe, a renowned professor of economics at the University of Leuven and the London School of Economics. “Everyone knew that this creature, the euro zone, was not fully formed. But at the time, it didn’t seem like a problem.”

That is, until the financial crisis broke out in 2008. In order to keep their country’s banks from collapsing, government leaders dug deep into the state’s coffers. No reason for panic, surely? If we run out of cash, we can simply issue more bonds. But Professor De Grauwe argues that this was a serious mistake. The euphoria evaporated: investors stopped partying and started wondering who was actually guaranteeing all that nice, shiny paper issued in the name of Greece, Ireland or Spain.

System error
“The answer, of course, was no one,” says De Grauwe. And that is the essence of the system error that caused the current crisis. The Bank of England, for example, outside the euro zone, can guarantee investors in bonds that there will always be cash to back them. But the European Central Bank cannot do the same. It simply doesn’t have the mandate.

Greece was where the rot first set in, since it was the country with the weakest government apparatus in the euro zone. “But the system error was already in place and that’s something you can’t blame on the Greeks,” says De Grauwe. “Every currency in Europe was linked to the almighty Deutschmark. In effect, the Germans determined monetary policy throughout Europe. That was a bitter pill for the French, needless to say.”

President Francois Mitterrand saw monetary union as his chance to put an end to German hegemony. At the same time, Germany’s sentimental Chancellor Helmut Kohl saw the euro zone as a vehicle for his idealistic visions of no-more-war. German reunification and the euro zone had to happen and fast, before both leaders retired.

Professor De Grauwe recalls “Economists throughout the world were critical. A single currency without political agreements and without a sovereign central bank? Who was going to check the budgets in all those countries? Who could investors count on? This was a recipe for disaster!” The critics were brushed aside and branded doom-laden euro sceptics. But now disaster has struck.

Unanimous decisions
But how bad can it be? After all, we now have an emergency fund with hundreds of billions that can be used to bail out countries and banks alike. Can’t we turn that into a sovereign central bank? The professor explains: “Decisions on when to use the emergency fund have to be unanimous. So if the Dutch government, for example, bows to pressure from a powerful euro sceptic like Geert Wilders and unilaterally blocks aid to Italy, that means no aid.”

On Wednesday’s “summit of summits”, it will be up to Angela Merkel and Nicolas Sarkozy to correct the historic error of their predecessors. Nothing less than new financial system is needed, shored up by political-economic governance. Governance that can offer guarantees to the outside world and discipline wayward souls within the fold.

Edge of the abyss
But one thing is lacking: trust. The northern Europeans are horrified by the prospect of a central bank that can be used by Sarkozy, Berlusconi and other European spendthrifts as a licence to print money. But at the same time, the Germans, the Dutch and Europe’s other disciplinarians know all too well that half-measures are no longer enough. “We are standing at the edge of the abyss,” says Professor De Grauwe. “And sometimes that’s the place where history is made.”

(dd/rk)