It was after 1 a.m. on Monday May 10 when a little-known Dutch civil servant made the suggestion that may have saved the euro. European finance ministers had come together in Brussels late on the Sunday afternoon to thrash out a rescue package to stabilize the common currency. Unconvinced by a 110 billion euro deal for debt-laden Greece eight days earlier, the markets had knocked the euro 4 percent lower against the dollar in the intervening week and pushed bond spreads to new highs.

As the markets headed south that Friday, U.S. Treasury Secretary Tim Geithner had spoken to his European counterparts on an emergency conference call of G7 finance ministers and central bankers. We need a clear, strong, unequivocal financial back stop, he said. President Barack Obama had rung German Chancellor Angela Merkel twice to stress the need for a headline-grabbing package.

With investors in Asia poised to start selling again in just a few hours, the ministers knew they needed to come up with a plan -- and fast. The atmosphere was like the end of the world, said a French diplomatic source who, like many officials who spoke to Reuters for this story, declined to be named. It was a lot like 2008. We had our eyes on the clock because we absolutely had to have an agreement before the Asian markets opened. No agreement would have meant disaster, a major sovereign debt crisis.

There was just one problem: The ministers could not agree on what to do. Thirteen of the 16 euro zone countries, including Austria and Finland, traditional allies of Germany, wanted to allow the European Commission, backed by a euro zone guarantee, to raise money on capital markets and then lend it to member states in acute financial distress.

Germany, Europe's economic heavyweight, hated the idea. Finance Minister Wolfgang Schaeuble, in a wheelchair since a deranged man shot him at an election rally in 1990, had fallen ill on arrival in Brussels and been rushed to hospital. Interior Minister Thomas de Maiziere, a confidant of Merkel, had received a surprise call from his boss while taking an afternoon stroll in the woods, and had flown in from Berlin to hold the line on the loans idea. Anything more than coordinated bilateral loans from member states was unacceptable, he warned, and would be shot down as illegal by Germany's Constitutional Court.

An hour before the opening bell in Tokyo, the ministers took a short break. Some huddled with aides; others paced the halls talking on their phones or tapping out messages on their Blackberries. Spanish Economy Minister Elena Salgado, the meeting's chair, retired to a private office to call Prime Minister Jose Luis Rodriguez Zapatero to discuss new austerity measures.

It was then that Maarten Verwey, director of foreign financial relations at the Dutch Finance Ministry, floated the idea of a temporary Special Purpose Vehicle (SPV). Participants in the meeting said Verwey pointed out that an SPV could raise and disburse funds as needed but might also get around Germany's objections. A few German officials, including Bundesbank President Axel Weber, had hinted at such a solution in other meetings that night.

Verwey was dispatched to test the idea on the German delegation, which relayed it to Merkel, huddled in the Chancellery with a small group of senior cabinet members who were still digesting a major setback for the ruling coalition in a crucial state election hours earlier.

Yes, an SPV would be an acceptable solution, came the reply. Berlin liked it because it would be temporary (the Germans insisted on a three-year limit), it respected the unanimity rule, kept control out of the hands of the Commission, and avoided anything that might look like an embryonic common European bond or a permanent debt management office for the euro zone. As with aid for Greece, Germany had insisted on and won its wish for the International Monetary Fund to be involved.

With German backing assured, Salgado reconvened the ministers just before 2 a.m. to ratify the accord. Christine Lagarde, France's straight-talking economy minister, summed up the moment in a single word: Hallelujah.

Hallelujah, indeed. A 750 billion euro deal to save the common currency and stave off a global debt crisis would have been unthinkable only a few months before. But that was before Greece's financial woes had exposed both yawning fiscal divergences within the euro zone and holes in EU budget rules designed to prevent the very kind of crisis that now threatens Europe's single currency.

As European leaders prepare to meet again on June 17 to map out a new strategy for growth and fiscal governance, it's worth asking what a revitalized, better coordinated, more strongly regulated euro zone would look like. Is a new model possible? Is the euro zone fixable?

TWO GREAT SHOWDOWNS

In private conversations with colleagues, Chancellor Merkel has described the intense market pressures of the past few months as a poker game between investors and politicians. Whoever flinched first, she said, would lose.

In Brussels, Europe raised the stakes. The rescue mechanism -- a 500-billion-euro special lending facility backed by up to 250 billion euros from the IMF -- was an implicit acknowledgement that Europe's existing tools to prevent a breakup of the bloc are woefully inadequate. But it was also a signal to investors who had openly challenged leaders to end the crisis.

Whether it will work or not is uncertain. Both the euro and the bloc remain vulnerable.

A separate showdown is also under way: a high-stakes slugfest pitting euro zone leaders and their competing visions of the currency union against each other.

In one corner -- Germany and Merkel, the pastor's daughter from East Germany who stands accused of deepening Europe's crisis by resisting a quick aid package for Greece. She blames the crisis on a lack of fiscal discipline on Europe's periphery and wants a radical strengthening of EU budget rules as well as changes to the Lisbon Treaty to prevent such profligacy from ever happening again.

In the other corner are France and its hyperactive President Nicolas Sarkozy. He sees the crisis as an opportunity to usher in the euro zone-wide economic government Paris has long sought. In this Europe, the bloc's leaders, not its central bankers and finance ministers, would set economic policy.

The euro zone's struggle with the markets could well determine the fate of the ambitious common currency project. Europe's internal fight will shape the future of the continent itself. The euro is Europe; Europe is peace on this continent, Sarkozy told journalists in early May, the flags of the euro zone's 16 members behind him. We cannot allow what previous generations have built to be undone. That's what is at stake.

HIDDEN FLAWS

As 2009 drew to a close, Europe's common currency appeared to have weathered the worst global financial crisis since the Great Depression with barely a scratch. Countries outside the euro area, from Iceland to Ukraine, had seen their economies collapse, but most of those within the zone were basking in the glow of their 11-year-old currency and hailing it as an anchor of stability. The euro had shot above $1.50, approaching a record high against the dollar, which appeared to be in a state of terminal decline.

For much of the 2000s, it seemed that markets had effectively mutualized the risk of euro zone debt by treating all government bonds as equal. Spreads between German bunds and the debt of countries such as Greece, Italy and Belgium were minuscule, even though the latter states had debt-to-GDP ratios of close to 100 percent -- far above the 60 percent ceiling prescribed by the Maastricht Treaty.

The first clear sign of trouble came in October, when a newly elected Greek government shocked financial markets and its euro zone partners by announcing a huge upward revision of its budget deficit forecast. After years of barely distinguishing between the debt of different euro zone countries, investors could suddenly see the massive fiscal divergences within the bloc.

Markets turned on the euro and began demanding higher interest rates to buy the debt of struggling southern European countries -- first Greece and then Portugal and Spain. It was like something gathering pace, rolling down a hill, and then falling off the edge of a cliff, said a currency trader in London.

In crucial ways, the euro zone has always been a defective system. From the beginning, monetary union had more to do with political accommodation than fiscal integration. Yes, there were strict rules governing a member state's deficit and debt levels. But even Germany, long a stickler for fiscal discipline, had successfully pushed for a loosening of the rules after it repeatedly breached them in the early 2000s.

The bloc's flaws had been hidden by a decade of growth, itself fueled by low credit and, in places such as Spain and Ireland, a real estate bubble.

Now the shock of the global financial crisis and the economic downturn had exposed those flaws for all to see. In hindsight, the real surprise is not that investors began to charge a risk premium to hold the bonds of high-deficit countries from late 2008, but that it took them a full decade to notice that Greece was not Germany.

TEUTONIC ORDERS

Can the euro zone fix those flaws and win back the confidence of the markets? The answer depends to a large extent on whether Berlin and Paris can agree on a way forward. France and Germany have always been the engines of monetary union, but their visions of how the euro zone should function were very different, even before the bloc's founding.

Germany's most recent thinking was laid out in a May 19 memorandum drawn up by Schaeuble's finance ministry. In the nine-point document, sent to European governments, Berlin called for quicker and harsher sanctions for countries that fail to keep their deficits in check, including denying violators access to EU structural funding and suspending their right to vote on matters of bloc-wide importance.

Berlin also wants a procedure for orderly state insolvencies to be an integral part of any fix for this and future crises. Economists such as Deutsche Bank's Thomas Mayer say that is code for a managed Greek default within the euro zone -- a scenario that many consider inevitable at some point, despite the 750 billion euro rescue package. Greece's public debt is forecast to climb above 130 percent of Gross Domestic Product this year and its budget deficit could exceed 9 percent. Portugal's debt is projected to top 85 percent of output with a deficit of more than 7 percent. The pressure to make creditors share the pain with taxpayers in those countries may become overwhelming.

Another possible solution to the euro zone's flaws might be to mutualize the bloc's debt. Jean-Claude Juncker, chairman of the group of euro zone finance ministers, proposed such a scheme in late 2008. A common bond, he said, should cover the first 40 percent of overall euro zone sovereign debt and come guaranteed by the whole euro area. Anything above that level would be junior debt, and more costly for governments to issue nationally. That would encourage governments to reduce their debt levels toward a manageable 40 percent.

Germany, though, has nixed the idea, arguing that it would raise the borrowing costs of virtuous nations while rewarding Europe's spendthrifts by giving them lower borrowing costs.

To ensure all of Berlin's proposed reforms are written in stone, Merkel wants to amend the Lisbon Treaty, a process that could take years if its initial ratification by all 27 member states is anything to go by.

European Commission President Jose Manuel Barroso has called the Germans naive for thinking they can change the treaty without others seeking to unpick the parts they dislike. But Merkel insists the changes are necessary to ensure the German public -- staunchly opposed to aid for Greece and fearful it will open the door to more bailouts -- does not turn against the European project.

Germany also worries that its own Constitutional Court would not tolerate a second case like Greece. The threat of a court veto directly shaped Merkel's tough stance on aid for Athens and her negotiating position on the euro zone rescue mechanism. Merkel and her circle of advisers were beside themselves when French Europe Minister Pierre Lellouche told the Financial Times late last month that the rescue scheme violated EU law -- a comment they feared the court in Karlsruhe might seize on to justify blocking the mechanism.

Though Sarkozy's office apologized for Lellouche's remarks, heads are still shaking in Berlin. The knowledge in Paris about how German politics works is surprisingly limited, said one bitter German official.

GALLIC IRRITATION

France, too, is frustrated. Its officials believe Germany has failed to grasp the real message of the euro zone crisis -- that a currency union cannot work without deeper political cooperation on a range of economic issues. Paris has made clear that it regards Germany's massive trade surplus, swollen by years of wage restraint and weak domestic consumption, as one of the causes of the Greek crisis.

Sarkozy would like to see an economic government for the currency area, with regular summits of the 16 national leaders and a dedicated secretariat to oversee the coordination of economic policy and address imbalances in competitiveness. The crisis has shown that Europe's current system has reached its limit, a French government official told Reuters. We cannot have one country where everything is directed toward productivity gains and competitiveness and others that put the focus on consumption and social protection. Either we come closer to each other, or we will have a political crisis on our hands, on top of an economic and financial crisis.

So far, Merkel doesn't appear to be listening. Last week, her government unveiled an 80 billion euro austerity package designed to bring down Germany's deficit -- precisely the kind of consumption-dampening policy program Paris has been warning Berlin against. Little wonder that a dinner in Berlin between Merkel and Sarkozy to discuss euro area economic governance was abruptly postponed hours after the austerity package was launched. It makes sense to delay a meeting when you feel it will not yield results and in this case, there would not have been any results, the French official said.

Relations were already under strain after Germany's surprise announcement last month of a unilateral ban on naked short selling of financial instruments. The move, which came just hours after EU finance ministers had discussed how they could better align policy, caught Berlin's partners by surprise, and reinforced the perception in Paris and elsewhere that Merkel has little time for coordination, especially when it conflicts with her domestic priorities.

Despite these squabbles, Merkel and Sarkozy know they need each other. Both leaders have shown they can compromise on difficult issues -- whether in steering Europe's response to the financial crisis, agreeing a common stance on climate change or dealing with thorny management issues at the Franco-German aerospace giant EADS.

In a show of solidarity and a rebuke to Britain last week, the pair sent a joint letter to the European Commission urging it to push for an extension of Germany's naked short-selling ban across the 27-nation bloc. Officials also say the two countries are working toward a grand bargain of the kind that past leaders like Helmut Kohl and Francois Mitterrand reached before Europe's monetary union was born. France's agreement to a German replacing Jean-Claude Trichet as the next head of the European Central Bank in 2011 could be a part of such a deal, officials in France say.

And while they may not always agree on the future of the euro zone, there is one issue on which France and Germany have common purpose: limiting the power of the European Commission.

The Lisbon Treaty was supposed to herald a more streamlined Brussels and a newly muscular Commission. So far, it hasn't worked out that way. Berlin and Paris have both pinned partial blame for Greece's meltdown on the failure of the Commission to police the EU's budget rules, and see no reason to reward Brussels with additional powers. Both French and German proposals would give more power to member states or independent bodies such as the European Central Bank, rather than the EU executive. One senior Brussels official said that if the Germans get their way, the Commission will end up as Mrs Merkel's doormat.

Commission President Barroso seems determined to resist the Franco-German push, and has argued that there is no need for a radical overhaul of rules or the creation of new institutions. Respect for European budget rules cannot be enhanced by reducing the credibility of community institutions and the community method, Barroso told a Brussels press conference on June 2.

A WAY FORWARD

Much is still uncertain. Washington continues to press Europe to embrace bolder solutions than most euro zone governments are willing to contemplate. U.S. Treasury Secretary Geithner has urged European regulators to conduct rigorous stress tests of each bank and publish the results. Such a move, he says, will restore market confidence and avoid a Japan-style decade of economic stagnation with zombie banks. World Bank president Robert Zoellick, a former top U.S. official, wants Europe to consider an orderly restructuring of the debts of its most troubled countries and institutions.

Other questions need to be answered. Even if Berlin and Paris agree on stronger economic governance, what should the bloc do about the debt mountains of the most highly indebted countries? How should it resolve the liabilities of banks that hold most of that debt and other bad loans? And how will the political and financial situation in places such as Spain add to Europe's woes in the coming months?

On a cool day in early February, Merkel stood next to Sarkozy at the Elysee Palace and broke a long-standing national taboo. Germany, she said, might be able to support a form of economic government as long as it included all 27 EU countries rather than the 16 euro zone nations that France envisions. To get what we want we will have to make compromises, a senior German government official acknowledged.

The key will be finding a deal that both France and Germany can sell at home. In the ever-flexible world of EU politics, that may not be as hard as it looks. Take the 750 billion euro deal last month. Sarkozy claimed it was 95 percent French, while Merkel told her team Germany had won all its main demands. If worried Germans can be convinced that fiscal discipline has been restored, and restive French can believe that political will has regained primacy over the markets, perhaps a way forward can be found. It would help, too, if the solution to Europe's current mess worked.

(Additional reporting by Julien Toyer, Ilona Wissenbach, Jan Strupczewski and David Brunnstrom in Brussels, Krista Hughes in Frankfurt and George Matlock and Naomi Tajitsu in London; Editing by Simon Robinson)

Germany Iceland Portugal Ukraine