Europe's crisis point: without changes, monetary union will inevitably collapse and the euro disappear.

• Author: Mayer, Thomas

In the run-up to European monetary union, many economists warned that the single European currency would not survive if it were not backed by a single European state. When the treaty on monetary union was concluded, leading politicians therefore promised that political union would quickly follow. But agreement on political union proved elusive. EMU went ahead anyway. Developments at first seemed to prove the skeptics wrong. Since 2009, however, the deficiencies in the design of EMU have become apparent. Despite all efforts of governments, EMU would probably have collapsed already if the European Central Bank had not acted as its lifeguard. But the monetary order that has emerged in the course of the rescue operations for the euro is deeply flawed. For the euro to survive in this order, a proper state is needed to support it. But the emergence of a European state is not on the political horizon. Without a single European state as its guardian and guarantor, the euro must be reconstituted in a commodity money order, the order originally intended for it in the Maastricht Treaty. If this is not done, the question is not whether but only when EMU will collapse and the euro disappear.

MONEY ORDERS ACCORDING TO EUCKEN

Walter Eucken, a key proponent of the German ordo-liberal school of economics, distinguished between commodity money and credit money systems. In the first system, money represents a commodity that has become a means of exchange and store of value by social convention. A pure form of a commodity money system is money fully backed by gold or silver. In the credit money system, money is lent into existence by private banks and hence backed by bank credit. Credit money can be created out of commodity money such as gold through fractional reserve banking, or it can be created on its own in association with fiat central bank money.

According to Eucken, existing monetary orders are mixtures of the pure systems, with one or the other system exerting the dominant influence. Today, our global money order is dominated by the credit money system coupled with fiat central bank money. There, money is created in a private-public partnership: Commercial banks produce book money via credit extension as private debt money, with the central bank managing the money production process and issuing central bank money to the public in the form of bank notes.

Already under the gold standard of the nineteenth century, when central bank notes were backed by gold and credit money was created through fractional reserve banking, the need for a lender of last resort to banks became apparent. Central banks, which originally were created as government funding agencies, assumed this role. In 1873, Walter Bagehot, a British economist, described the task of a lender of last resort: it should lend freely, but at a penalty rate and against good collateral. Bagehot's rule implied that the lender of last resort should only help solvent banks suffering from temporary liquidity crises. Those receiving assistance from it must have good collateral they can post as security and they must be able to afford high interest payments. If they cannot do this, they must declare insolvency and be wound down.

But the bankruptcy of a bank can have negative spillover effects on other banks when scared depositors want to exchange the book money banks created through credit extension against central bank money on a larger scale. To avoid bank runs, deposit insurance was introduced. In the United...