Can Europe Save the Euro — and Itself?

Why EU leaders are finding it so difficult to contain the debt crisis and prevent the collapse of the single currency.


Tensions in financial markets were on the rise in early March when leaders of the 17 euro countries gathered for a special summit meeting in Brussels to consider new measures to address the bloc’s worsening debt crisis. Doubts about the efficacy of big bailout programs for Greece and Ireland were growing, driving up yields on government bonds of countries on the euro zone’s periphery, and speculation was swirling that Portugal too would soon need a rescue.

As Germany’s Angela Merkel, France’s Nicolas Sarkozy and other leaders sat around a giant oval meeting table at the European Union’s Justus Lipsius Building, John Lipsky, who was overseeing the Greek and Irish programs as the No. 2 official at the International Monetary Fund, appealed to the politicians to take bolder action to contain the crisis and save the euro. “Europe’s problems are manageable, but they have to be managed,” he said. “If they aren’t managed, they will fester. And if they are left to fester, they’ll become unmanageable.”

Over the next nine months, the euro zone leaders would hold seven more summits and countless bilateral meetings, and several of the key participants would caucus at the Group of Twenty summit in Cannes and at a farewell ceremony in Frankfurt for Jean-Claude Trichet, who stepped down in late October as president of the European Central Bank. Those meetings produced a string of initiatives designed to stem the crisis: a pact for the euro to enhance economic policy coordination and competitiveness; a so-called six-pack of measures to tighten the bloc’s rules on deficits and debt; a €78 billion ($104 billion) bailout for Portugal; a revised adjustment program for Greece that offered more money while imposing a 50 percent haircut on private bondholders; a €100 billion-plus recapitalization plan for European banks; and a plan to leverage the EU’s bailout fund, the European Financial Stability Facility, to provide a massive €1 trillion in firepower. Euro zone chiefs even orchestrated the replacement of elected governments in Greece and Italy with technocratic leaders committed to pursuing stringent austerity programs.

The efforts failed to impress financial markets, however. Bond yields climbed to record highs, and contagion spread from the periphery to Spain and Italy. Even Germany received a scare when investors shunned one of its bond auctions at the end of November. So when the leaders reconvened in Brussels in early December, they found themselves confronting a nightmare scenario: the possible breakup of the euro, an event that could plunge Europe into a depression, unravel decades of closer political cooperation in the EU and push the rest of the global economy into recession.

Weeks of frantic bargaining between Berlin and Paris had exposed the basic policy differences between the euro’s two linchpin members — the role of the ECB and the desirability of jointly issuing Eurobonds — even as they edged closer to a compromise. The escalation of the crisis had eroded business confidence, tightened credit conditions and left the euro area on the brink of recession, which would only aggravate the debt problem. On December 5, just three days before the summit opened, Standard & Poor’s put 15 of the 17 euro countries — including France, Germany and the Netherlands — on credit watch for a possible ratings downgrade, saying the bloc’s “defensive and piecemeal measures” had been inadequate to contain the systemic problems in the euro zone. And only hours before the leaders gathered, the European Banking Authority said that as a result of the latest round of stress tests, EU banks would need to raise an additional €114.7 billion in capital to meet new regulatory standards.

As Sarkozy told a gathering of center-right political leaders in Marseille just hours before the summit opened, “Never has the risk of Europe exploding been so big.”

The pressure had a galvanizing effect, at least in the short run. In an all-night negotiating session, European leaders agreed to a fiscal compact designed by the bloc’s largest economy and paymaster, Germany. The plan will enshrine tough new balanced-budget rules in each country’s constitution, subject violators to automatic sanctions and policy remedies from Brussels, and require governments to submit their economic policies to closer European oversight and coordination. The leaders also agreed to accelerate the introduction of a permanent bailout facility, the European Stability Mechanism, and to increase their crisis-fighting firepower by having national central banks lend as much as €200 billion to the IMF, an amount that could be recycled back to troubled countries. EU leaders hoped that move would attract contributions from surplus countries like China that to date have been reluctant to come to Europe’s aid.

So, crisis averted? Hardly. The latest package lays the foundation for some much-needed improvements to the euro zone’s economic policymaking process, but at best it’s only the first step on a long road toward the kind of fiscal union that could end the crisis and sustain the euro. These arrangements aren’t a quick fix. It will take at least six months to put the new framework in place, assuming euro zone governments carry out what they’ve agreed to, and even longer to prove their effectiveness. Ireland may submit the package to its citizens in a referendum — a dicey prospect considering that Irish voters rejected the EU’s Lisbon Treaty in 2008, forcing a renegotiation.

The new agreement contains nothing to stimulate economic growth in the near term. With its fixation on budget deficits as the source of the crisis, Germany is effectively forcing euro members to make deeper spending cuts and bigger tax increases in the name of fiscal health. The risk is that this collective austerity will aggravate the economic downturn and make Europe’s debt burden worse — a vicious circle that Greece finds itself trapped in at the moment. “They haven’t yet understood that they need to grow,” says Charles Wyplosz, professor of international economics at the Graduate Institute of International and Development Studies, in Geneva.

In the meantime, Europe has urgent funding needs that can’t wait for the political process to play out. In the first half of 2012, euro area governments and agencies need to refinance nearly €750 billion in maturing bonds, according to Deutsche Bank estimates, and EU banks need to raise an additional €400 billion in funding. If investors go on strike, European governments would quickly exhaust the €250 billion spare lending capacity left in their bailout fund. The new IMF financing is unlikely to plug the gap either. Its modest size doesn’t amount to the overwhelming firepower that U.S. President Barack Obama and Treasury Secretary Timothy Geithner have been urging the Europeans to raise.

All of which leaves governments dependent on the ECB, which has bought sovereign bonds reluctantly to prevent a market meltdown but so far refuses bolder intervention to lower governments’ borrowing costs. The central bank’s new president, Mario Draghi, hailed the Brussels deal as “a very good outcome” that would foster more-disciplined economic policies in the euro area, but he indicated that the ECB would focus its resources on providing liquidity to banks, not governments.

“The ECB will continue to buy bonds without being the bazooka the market is looking for,” says Lars Feld, director of the Walter Eucken Institute in Freiburg, Germany, and a member of the German Council of Economic Experts, a government advisory body.

The result is bound to frustrate investors and EU trade partners that had hoped for decisive moves to end the debt crisis. Markets had rallied briefly in advance of the summit on hopes of a grand bargain — acceptance by governments of tight fiscal rules to buttress the euro in the long run, combined with aggressive bond purchases by the ECB to reduce financing costs in the short term — but that optimism gave way to a familiar, anxious reality. Europe continues to muddle along, doing enough to keep the euro show on the road but failing to stem doubts about the currency’s long-term future.

“The outcome was less than markets had hoped for but about what they expected — just enough to contain the ongoing European crisis, but not a clear road map to a solution,” says John Makin, a scholar at the American Enterprise Institute, a Washington think tank.

The euro fell by nearly four cents in the week after the summit, to about $1.30, while government bonds were mixed. Spain sold €6.03 billion of 10-year bonds at a yield of 5.55 percent, while Italy had to pay 6.47 percent to sell €3 billion worth of five-year notes. Fitch Ratings said that a comprehensive solution to the debt crisis was “technically and politically beyond reach.” The agency put six countries — Belgium, Cyprus, Ireland, Italy, Slovenia and Spain — on watch for a possible downgrade and reaffirmed France’s triple-A rating even as it lowered the outlook to negative.

“We all hope there’ll be a big solution to resolve this crisis once and for all,” says Bernhard Speyer, head of banking, financial markets and regulation at Deutsche Bank Research in Frankfurt. But, he adds, “we all know it’s a balance-sheet crisis. It will go on for a decade. There is no quick fix.”

The euro package came at a steep price. British Prime Minister David Cameron declined to endorse the agreement after failing to win an exemption from further EU regulation for the U.K.’s financial services industry. Cameron’s move means that the new fiscal reforms will have to be adopted by an intergovernmental agreement among the 17 euro zone countries plus other willing states, rather than by a treaty amendment involving all 27 European Union members, which Germany had demanded as a demonstration of the bloc’s resolve.

It’s unclear whether that legal distinction will affect how the new fiscal rules are implemented. Germany wants the European Commission to vet country budgets and the EU’s Court of Justice to judge on any violations of the compact, but Cameron insists that EU institutions work for all 27 member states and shouldn’t police side deals. The dispute risks a split between the euro area and the U.K., home to the financial market that will ultimately decide the euro’s fate. Although British clashes with Europe are as constant as the tides, this marked the first time that the U.K. had rejected a major EU initiative. Former prime minister John Major signed the Maastricht Treaty in 1992 after negotiating the right to stay out of the single currency. The mood today in Cameron’s Conservative Party is more euro-skeptical than ever, with several dozen members of Parliament agitating for a referendum on the U.K.’s membership in the EU. Suddenly, a British exit from the union, like a Greek exit from the euro, is no longer a taboo subject.

The discord leaves some EU observers doubtful that the leaders can overcome their divisions and save the euro. “The European structure is dysfunctional,” says John Kornblum, former U.S. ambassador to Germany and Berlin-based senior counselor at law firm Noerr. “They’ve mastered the art of endless compromise without any substance to it. They’ve been at this for 18 months. They haven’t shown any sense of vision, and I don’t think they will.”

The current state of affairs is a far cry from the “ever-closer union” that European leaders pledged to forge in the Treaty of Rome more than 60 years ago. Indeed, it’s no small irony that the euro, which was seen as the crowning achievement of European integration when it was introduced in 1999, could be its unmaking. For that very reason, many seasoned European observers still believe that EU leaders will ultimately do what is necessary to save the single currency. As Dominique Moïsi, special adviser at the French Institute of International Relations, in Paris puts it, “What’s at stake is simply the survival of Europe — nothing less, nothing more.”

Consider the economic consequences. A breakup of monetary union would have a far greater impact on financial markets and the global economy than the failure of Lehman Brothers Holdings did three years ago. Such an event would almost certainly involve the default of countries, widespread bank failures and the possible collapse of Europe’s payments system because of contract uncertainty. “Given that modern economies subsist on credit and contracts, it should be clear that undoing EMU under most scenarios is the economic equivalent of mutually assured destruction,” John Normand and Arindam Sandilya, foreign exchange strategists at J.P. Morgan Securities, said in a recent research note to clients. “If EMU breakup were a very likely event, then so would be a European depression, a global recession and possibly a global depression.”

Mark Cliffe, global head of financial market research at ING Group in London, reckons that a breakup would cause output across the euro zone to plunge by more than 12 percent over two years, an impact more than twice as great as the hit Europe suffered after Lehman’s failure, and would drive unemployment above 14 percent.

The political fallout in Europe would be equally great. Countries exiting the euro would impose capital controls and possibly border controls to prevent people from taking money out. Competitive devaluations among new national currencies would provoke a clamor to impose tariffs or suspend European competition rules. Europe’s single market, the greatest engine of growth and prosperity that the bloc has ever devised, would likely come crashing down. “If the euro breaks up, then there is a big risk that Europe breaks up,” says Guy Verhofstadt, the former Belgian prime minister who now leads the Alliance of Liberals and Democrats for Europe in the European Parliament.

How did a seemingly containable debt crisis in Greece, a state that accounts for just 2 percent of the euro zone economy, metastasize in the space of two years into an existential crisis affecting the world’s largest economic bloc? To a large extent, it was baked into the design.

The Delors Report, the blueprint for the single currency that was drafted in 1989 by a group of central bankers and academics led by former European Commission president Jacques Delors, warned of the risk that monetary union could foster economic imbalances by creating a giant capital market and enabling governments to borrow beyond their means. But leaders decided the currency would complete the single market and that risks could be managed.

After the fall of the Berlin Wall late that year, European leaders seized on the single currency as the project that would bind a newly unified Germany to its EU partners. Initially, the Maastricht negotiators discussed the creation of an economic and political union; this might have given the currency a stronger governmental foundation, but neither the leaders nor their citizens had an appetite for building a United States of Europe. So the currency was hoisted on a shaky patchwork of EU intergovernmental and communal institutions. Europe would become the euro.

Skeptics, including such prominent economists as Harvard University’s Martin Feldstein, warned that the euro would never work. Europe, they contended, lacked the labor mobility and automatic transfers of a federal tax code that made the U.S. an optimal currency area and managed economic and financial tensions between Rust Belt states like Michigan and fast-growing states like Texas.

Europe’s response was to impose strict fiscal constraints on countries joining monetary union, in the belief that they couldn’t get into trouble if they didn’t overspend. At Germany’s insistence, the EU in 1997 adopted a Stability and Growth Pact requiring countries to keep their deficits below 3 percent of GDP or face the threat of fines. The debate at that time would be familiar to students of recent events, with then–German Chancellor Helmut Kohl and his Finance minister, Theo Waigel, insisting on strict fiscal limits and quasiautomatic sanctions while then–French President Jacques Chirac argued that political leaders should have the leeway to adjust or ignore the rules depending on economic conditions.

Germany won the battle, but Chirac’s instincts would prove astute. When the economic slowdown of the early 2000s caused France’s and Germany’s deficits to rise above 3 percent, then-Chancellor Gerhard Schröder teamed up with Chirac to prevent EU authorities from sanctioning the two countries under the excessive-deficit procedure. Memories of those events leave many analysts skeptical that the EU’s new fiscal compact will have real teeth.

“For those of us of a certain age, the fiscal language looks to be copied and pasted from the original Stability and Growth Pact, with a few bells and whistles added to imply that ‘this time we mean it,’?” says Steven Englander, head of Group of Ten currency strategy at Citigroup in New York.

The launch of the euro in 1999 unleashed a financial bonanza. Yields across the euro zone tumbled to within basis points of the benchmark lows set by Germany, providing a windfall to governments in Lisbon, Madrid and Rome, and big profits for investors who had bet on convergence. Markets shed their caution, just as Delors had predicted, and decided that credit risk and current-account balances no longer mattered in Euroland.

Ironically, one of the early worries about monetary union was that it had locked Germany into an uncompetitive situation. The country was still struggling to digest the costs of unification, it had entered the euro at a strong exchange rate, and the ECB’s single interest rate was influenced more by the euro zone’s fast-growing, higher-inflation periphery than by the sluggish German economy. The Schröder government responded by tightening the government’s belt and negotiating a landmark accord on wage restraint between business and labor. Those policies revived Germany as an export powerhouse, while the free-spending periphery rapidly lost competitiveness. The comparison is stark. Although unit labor costs are nearly 5 percent lower in Germany today than in 2000, they have risen by roughly 10 percent in Portugal, 15 percent in Spain, nearly 20 percent in Greece and close to 25 percent in Ireland and Italy.

Greece took full advantage of the market’s exuberance and the euro’s weak governance. Athens joined the euro in 2001 thanks to fiddled budget figures and played cat and mouse with EU authorities for years to mask the true state of its finances. Greece was able to borrow at rates just 30 basis points above German Bunds’ as recently as 2008, and the government enjoyed a solid investment-grade rating of A or A– as late as December 2009, even though its debt was 113 percent of GDP and rising. The crisis only erupted in December 2009 when George Papandreou, the newly elected Socialist prime minister, announced that Greece had been concealing its budget problems and that the deficit would be nearly double the 6.7 percent claimed by his conservative predecessor. (The final figure would turn out to be 15.8 percent.)

The EU’s response to Greece set a pattern that has played out repeatedly in the past two years. It hesitated at first, reflecting anger over Greek behavior (“it was an error” to let Athens join the euro, an exasperated Sarkozy told French television in October) and German reluctance to foot the bill for its profligate partners. But with spreads rising and the ECB and IMF warning that the future of the euro was at stake, in May 2010, Merkel acquiesced to a €110 billion EU-IMF bailout program that promised to fund Athens for three years in return for a sweeping package of spending cuts, serious tax enforcement, labor market reforms and privatizations.

The plan was supposed to reduce Greece’s deficit to a modest 2.6 percent of GDP by 2014, enable the country to return to the capital markets and restore competitiveness and growth. It has failed on all counts, however. The Greek economy has fallen more sharply than the IMF forecast because of the austerity measures and capital flight. Output is now expected to contract by more than 15 percent between 2009 and 2012, and the unemployment rate has rocketed to 17.5 percent. The combination of a weaker economy and foot-dragging by the Papandreou government in the face of massive street protests has caused the deficit to overshoot the plan’s targets. The EU forecasts that the deficit will hit 8.9 percent of GDP in 2011 and that Greece’s debt will reach an astonishing 198 percent of GDP in 2012.

Similarly bleak numbers persuaded euro zone leaders to accept what the market had long believed: Greece was insolvent. In July 2011, EU leaders agreed to a revised program that extended maturities and lowered interest rates on the country’s bailout loans. Even more important, they negotiated a so-called private sector involvement that imposed a 20 percent haircut on Greece’s bondholders, something the ECB had lobbied against vigorously. The deal avoided a technical default — and the triggering of Greek credit default swaps — by characterizing the haircut as voluntary, but it set a momentous precedent all the same.

Three months later, with Greece’s position continuing to deteriorate and the opposition assailing his budget cuts, Papandreou stunned his EU colleagues on the eve of yet another summit by calling for a referendum on the country’s austerity program. Incensed, Merkel and Sarkozy told Papandreou bluntly that any referendum would effectively be on Greece’s continued participation in the euro. They then proceeded to revise the Greek bailout program to increase the haircut on private bondholders to 50 percent.

That October 26 summit meeting, another session intended to restore confidence, instead poured fuel on the flames of the crisis. Raising the haircut to 50 percent made a mockery of the notion that the reduction was voluntary and sent a clear signal to investors to unload the bonds of countries like Italy and Spain lest the EU impose write-downs on those too. Meanwhile, the suggestion by Merkel and Sarkozy that Greece might have to leave the euro shattered a taboo. The EU had always insisted that monetary union was irreversible, and the Maastricht Treaty contains no provision for a country to exit. With their brinksmanship, however, EU leaders had shattered any aura of permanence around the euro. “It’s like virginity,” says one senior EU official. “Once you lose it, it’s hard to get it back.”

Prompted by the adverse market reaction, euro zone leaders agreed in December to put away the hair clippers. Greece was a “unique and exceptional” case, they said. All future euro government bonds would contain standard, IMF-approved collective action clauses under which terms may be renegotiated in a crisis, but there would be no more forced write-downs. Putting the breakup genie back in the bottle will be difficult. For now, betting on a euro collapse is a fixture of the European financial scene, with all the volatility that entails. Willem Buiter, chief economist at Citigroup in London, estimates the chances of a Greek exit at about 20 percent and a full euro breakup at about 5 percent. Eric Chaney, chief economist at AXA in Paris, says the market was pricing the odds of a euro breakup at slightly more than 50 percent in early December, when yields on Italian bonds spiked above 7 percent, a level most economists deem unsustainable. “It’s not yet too late, but it’s a very, very close call on whether the policymakers have lost control,” says Chaney.

Still, euro zone leaders continue to pursue a largely unchanged game plan for dealing with the crisis. Ireland and Portugal are following the same kind of austerity and structural reform programs as Greece. Ireland is the closest thing to a success story so far. The government succeeded in privatizing Bank of Ireland, one of the lenders whose excesses caused the country’s crisis, over the summer, and the economy started growing again modestly in 2011 at a pace of just over 1 percent. Still, output remains more than 10 percent below the precrisis peak, unemployment has climbed above 14 percent, and the national debt is on track to hit 120 percent in 2013. Prime Minister Enda Kenny makes no secret that he wants to win debt relief of some kind from his EU partners.

Other countries in the speculators’ crosshairs have also begun to take stronger measures. Silvio Berlusconi, who only weeks before had insisted that Italy wasn’t in crisis because the restaurants were full, resigned in November to make way for a technocratic government led by Mario Monti, president of Milan’s Bocconi University and former European commissioner. In December, Monti introduced a €30 billion package of spending and pension cuts and tax increases that aims to balance Italy’s budget in 2013. With the economy flatlining and rates on Italian ten-year bonds standing at about 6.5 percent, many economists doubt he will achieve that goal.

In Spain former prime minister José Luis Zapatero cut spending and passed landmark labor reforms in 2011 that reduce the high cost of firing workers, which economists believe discourages companies from hiring. Mariano Rajoy, due to succeed Zapatero in mid-December after his conservative Partido Popular routed the Socialists in November elections, promises to step up the pace of austerity and accelerate the restructuring of the country’s troubled banking sector.

EU officials are frustrated that such measures haven’t eased the turmoil in financial markets and brought down interest rates. “The reforms that have been undertaken in a certain number of countries go far beyond what has been undertaken in some other countries, like the U.S. or U.K.,” says Yves Mersch, governor of the Banque centrale du Luxembourg and the longest-serving member of the ECB’s governing council. “Sooner or later this will be reflected in the fundamentals.”

The markets, however, are focusing at least as much on the denominator — growth — as they are on the numerator — deficits. Greece’s debt burden is soaring because the economy is shrinking faster than the government can retrench. Many investors fear the same fate could trap other countries. Economists have been lowering their growth outlooks because of the impact of austerity measures and financial turmoil. Economists at Goldman Sachs Group predict euro area output will drop by 0.8 percent in 2012; Citigroup’s Buiter is forecasting a decline of 1.2 percent.

Many economists regard as misguided Europe’s focus on deficits as the main cause of the crisis. Yes, Greece borrowed wildly, and Italy has failed for decades to get its debt under control, but Ireland and Spain were paragons of fiscal virtue before the crisis. Ireland ran a budget surplus, on average, between 1992 and 2007, while Spain had a modest debt-to-GDP ratio of 40 percent in 2008. What broke the budgets in both countries were massive real estate busts that crashed the economies and forced the governments to bail out imprudent lenders.

“What we’ve learned from this crisis is that some countries can be undisciplined and run into trouble, and some countries can be very disciplined and run into trouble,” says Jean Pisani-Ferry, the French economist who heads the Bruegel think tank in Brussels. “How are we going to solve the problems of the Spains of tomorrow?”

The EU is stepping up its surveillance of euro zone economies and putting more emphasis on things like current-account imbalances and unit labor costs as sources of potential trouble. But the new fiscal compact endorsed in Brussels keeps the main focus squarely on deficits.

The compact will require euro area members to put a so-called debt brake in their constitutions, limiting structural budget deficits — that is, deficits adjusted for the economic cycle — to 0.5 percent of GDP. The rule is modeled on a German brake adopted in the past decade that sets a deficit ceiling of 0.35 percent. Countries that violate the rule will face as-yet-unspecified “automatic consequences” and be put on structural reform programs agreed upon with their euro partners and the European Commission. All countries will have to submit their annual budgets for approval by the commission, which can order changes. Countries with debts of more than 60 percent of GDP — most of the 17 euro members — need to reduce that excess debt by 5 percent a year.

The new framework faces several hurdles. Euro area leaders need to draft a treaty spelling out the detailed rules, which they aim to do by March 2012. Then national parliaments have to ratify the deal; in some cases, like Ireland’s, that may involve risky referendums. Under the most optimistic scenario, the compact will be in place sometime in the summer of 2012. “With some luck, it may well be remembered as the summit when Europe took its first step towards a fiscal union,” Joachim Fels, chief economist at Morgan Stanley, wrote in a note to clients.

For many Europeans, however, the outlines of that fiscal union are incomplete. Countries are being told to accept tough fiscal discipline at a time when the economy is sagging and social discontent is on the rise. It’s unclear whether countries that accept the bargain will have access to the capital markets. Italy and Spain together will need to borrow at a rate of €10 billion a week in 2012 and 2013.

For most euro zone countries, the solution to the funding problem lies in a shift from national debt issuance to some common form of Eurobond. The liability for these bonds would most likely be joint and several, which would make the zone’s collective debt of about 88 percent of GDP sustainable. By contrast, the EFSF bailout fund is backed by pro rata guarantees from member states. As more countries fall into trouble, fewer countries are left to shoulder the increasing financial burden. Ultimately, even Germany could be dragged down by the debts of its neighbors.

In November the European Commission issued a green paper with proposals for three different types of “stability bonds” — a name chosen to appeal to German ears. The plan would “make the euro-area financial system more resilient to future shocks” by giving countries more-secure access to the capital markets and reducing or eliminating the need for costly bailout schemes.

The German Council of Economic Experts has put forward a competing plan for what it calls redemption bonds. Under this plan, modeled on the scheme used by Alexander Hamilton to pay off the Revolutionary War debts of the original 13 U.S. states, euro zone members would pool their debts in excess of 60 percent of GDP into a redemption fund, which they would finance jointly and commit to paying off in 20 to 25 years. The plan would “give countries some breathing space” to balance deficit reduction efforts with pro-growth reforms, says the council’s Feld. It also would leave each country responsible for its debts up to the 60 percent level, easing German fears that the euro zone could turn into a transfer union, with Berlin paying the tab for its partners.

For Belgium’s Verhofstadt, some form of Eurobonds is the only solution. “A monetary union with discipline but no solidarity is not sustainable,” he says. “Europe is at a crossroads. If you want to save the euro, you have to jump into a federal union.”

The German government has resisted the Eurobond idea, but Merkel has moderated her opposition subtly, from “not ever” a few months ago to “not now” more recently. As one senior EU official puts it, Eurobonds are “the final gift” that Berlin can offer its euro partners, and Merkel doesn’t want to extend it until she’s sure that countries have embraced Germany’s stability culture of low deficits and low inflation.

“At the end of the process, when we have a full-fledged stability union, we might consider new forms of common debt management, but not at the beginning,” says Jörg Asmussen, the German deputy Finance minister who will go to Frankfurt in January to take a seat on the ECB’s executive board.

That leaves the euro area in a bind. Members have committed to a fiscal framework that could resolve the bloc’s debt problems in the long run, but in the meantime, they need money — lots of it. The ECB, just like the Federal Reserve in the U.S., is the only entity with the unlimited capacity to buy debt and prevent countries from defaulting.

The central bank has been intervening in the bond market since May 2010, when it agreed to buy Greek debt as part of that country’s rescue. The ECB expanded its role significantly in October 2011, when it began buying Italian and Spanish bonds to contain a spike in yields, even though those countries hadn’t adopted an IMF adjustment program. Altogether the central bank has bought more than €200 billion of government bonds to date. But the ECB has failed to stem the market panic because it has made its purchases reluctantly, with no open-ended commitment.

The bank is loath to do anything that smacks of monetizing government debt, which is illegal under the Maastricht Treaty. As one central banker puts it, the ECB doesn’t want to become “a bridge to nowhere,” keeping the euro afloat with no clear framework for resolving the bloc’s underlying debt problems.

So the game of recent weeks, which looks set to continue into 2012, has been for euro zone governments to commit to tighter fiscal discipline in hopes of persuading the ECB to act. Draghi so far is keeping his cards close to his vest, welcoming the agreement on the fiscal compact at the December summit but signaling no change in the central bank’s bond-purchasing strategy.

Luxembourg’s Mersch is equally coy. “The ECB has in the past shown that it is able to react rapidly and also to react in an innovative way if need was there,” he says. “But we are guided by our statutes, our treaty, our objectives.”

EU officials and many market participants are betting that Draghi will eventually open the ECB’s purse strings. Having been created to manage the euro, the bank will not want to preside over its demise.

“We are convinced that when push comes to shove, he will do what needs to be done,” says one senior EU official. “But he has to have the political room to do so. He will go over the head of the Bundesbank if he’s sure Berlin will keep its mouth shut.”

So the high-wire act among governments, the ECB and financial markets seems likely to drag on for many more months to come, with the future of the euro — and Europe — hanging in the balance. No one can afford a misstep.