The Hollow Euro: Specter of Inflation Haunts Europe

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Finance Minister Schäuble will soon need this support. If nothing else, he intends to trim the missing billions from the 2011 budget by scaling back state social services. This could include cuts to family allowances and welfare payments for the long-term unemployed. "Whether it's social services or state subsidies, nothing is taboo," says a high-ranking aide to Schäuble.

Restructuring state finances won't be enough, however, to stabilize the euro over the long term. What is most urgently needed is to remove the congenital defects that plague the common currency. In this respect, the key thing will be a better coordination of member states' economic and financial policies.

On top of that, the Stability and Growth Pact, which sets rules for budgetary behavior within the euro zone, needs to be given new teeth. Any violations of sound financial policies must automatically trigger sanctions or fines, instead of the current system, where majority decisions are needed before such measures are taken.

Looking at the Books

Proposals made by EU Economic and Monetary Affairs Commissioner Olli Rehn foresee exactly those kinds of tougher regulations. Rehn intends to bolster the euro by having member states surrender additional sovereign rights. He proposes that all states be subject to central budget coordination in Brussels. Before national parliaments approve their budgets, Rehn and his team want to have a look at the books and raise objections if necessary. Euro zone finance ministers would also get the chance to review draft budgets before they are presented to national parliaments, under Rehn's plan.

Rehn's initiative puts politicians in the individual member states as well as the entire monetary union in a dilemma. On the one hand, in order to support the euro, it is absolutely necessary to have centralized supervision and control. On the other hand, the commissioner's proposals could be attacked as being undemocratic. They call for an impersonal bureaucracy with no democratic legitimacy to have a greater say in member states' budgets than national parliaments, with their freely elected representatives.

Not every member of parliament will take such a loss of power lying down. The responsibility for the state budget, which parliaments managed to wrest from monarchs in earlier centuries, is often rightly referred to as parliament's prerogative. In Germany there is yet another stumbling block. In its June 2009 decision on the Lisbon Treaty, the German Constitutional Court put the brakes on Germany's further integration within Europe, by giving the German parliament a bigger say in EU matters. But increased integration is exactly what Rehn's plans would entail.

Can the Euro Survive?

It is by no means certain whether and how the euro can survive in its current form. Whether it will be a strong or a weak currency, and whether or not it will win back the confidence of citizens and investors, depends primarily on the ability of the ECB to actually collect back the money that it has spent on purchasing government bonds. "We will withdraw all the additional liquidity that we supply," promises ECB President Jean-Claude Trichet in an interview with SPIEGEL.

Technically the withdrawal of liquidity does not present a major problem -- the central bank merely has to roll back its emergency programs. The ECB gives commercial banks, for example, so-called tenders on a weekly basis. If the central bank were to suspend these operations for a while, it would allow it to withdraw liquidity from the market.

It could also sell bonds to withdraw money from the market. Or it could resort to the time-honored tool used to reduce the amount of money in circulation: It could raise interest rates.

The difficult part about all of these actions is finding the right timing. If the central bankers act too soon, they risk smothering the current economic recovery. If they wait too long because they cannot resist the pressure from politicians, prices could spiral out of control.

Then it would be nearly impossible to keep the currency from plummeting.

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• Part 1: Specter of Inflation Haunts Europe
• Part 2: Gigantic Wave of Debt
• Part 3: Social Services in the Crosshairs