History of the Euro Crisis

02.01.2012 11:05

WSJ: On the Secret Committee to Save the Euro, a Dangerous Divide

BRUSSELS—Two months after Lehman Brothers collapsed in the fall of 2008, a small group of European leaders set up a secret task force—one so secret that they dubbed it "the group that doesn't exist."

Its mission: Devise a plan to head off a default by a country in the 16-nation euro zone.

When Greece ran into trouble a year later, the conclave, whose existence has never before been reported, had yet to agree on a strategy. In a prelude to a cantankerous public debate that would later delay Europe's response to the euro-zone debt crisis until the eleventh hour, the task force struggled to surmount broad disagreement over whether and how the euro zone should rescue one of its own. It never found the answer.

A Wall Street Journal investigation, based on dozens of interviews with officials from around the EU, reveals that the divisions that bedeviled the task force pushed the currency union perilously close to collapse. In early May, just hours before Germany and France broke their stalemate and agreed to endorse a trillion-dollar fund to rescue troubled euro-zone members, French Finance Minister Christine Lagarde told her delegation the euro zone was on the verge of breaking apart, according to people familiar with the matter.
The euro zone's near death had stakes for people around the world. A wave of government defaults on Europe's periphery could have triggered a new crisis in the international banking system, with even worse consequences for the global economy than the failure of Lehman.

The dangerous dithering was driven by ideological divisions that continue to paralyze the currency union's search for solutions to its structural flaws. Deep differences on economic policy between Europe's frugal north and laxer south, between Germany and France, and between national governments and central EU institutions hindered an effective early response to the crisis. Only when faced with calamity—the collapse of the euro zone—did leaders put aside their differences and reach a compromise.

Complicating matters: The two most important politicians deciding the fate of the euro often had conflicting agendas—and much at stake personally.
French President Nicolas Sarkozy, known in France as the "hyper-president" for his relentless flurry of new initiatives, faced declining approval ratings as his domestic economic overhaul stalled. The excitable 55-year-old leader saw that Greece's woes could rock the euro zone. Mr. Sarkozy seized on the issue as an opportunity to prove his leadership chops and thus shore up his popularity.

For German Chancellor Angela Merkel, 56, the crisis was the biggest test of her career. A trained physicist known for her cautious, deliberative style, she feared a backlash from German voters and lawmakers, and defeat in Germany's supreme court, if she risked taxpayer money on serial deficit-sinner Greece. Despite pressure from Mr. Sarkozy, she fiercely resisted a quick fix.

When Mr. Sarkozy barreled into one meeting with camera crews and photographers in tow, Ms. Merkel icily ordered the cameras out: "I won't let you do this to me," she said, warning she wouldn't play the part of "the stubborn old bag."
Europe eventually did establish a rescue fund in May. By then the price of calm had soared, requiring a pledge of €750 billion. It defused the panic but hasn't snuffed out the crisis: Unsustainable borrowing still poses huge challenges, especially in Greece and Ireland.

The danger of a government-debt crisis in the euro zone began to preoccupy top European policy makers in October 2008. Hungary, an EU member which doesn't use the euro, found itself unable to sell bonds to jittery investors. The EU, using an existing but little-used program, and the International Monetary Fund and World Bank swiftly propped up Hungary by pledging about €20 billion in loans.

But it soon became apparent that the euro zone had no tools to save one of its own. EU treaties made clear the facility used for Hungary was off limits to euro members. For most EU officials, the IMF was taboo, too: Its loans were fine for poor ex-Communist nations, they felt, but not for developed euro members.

In March 2009, French Treasury official Xavier Musca was preparing to step down as chairman of the Economic and Financial Committee, an influential body of technocrats who manage EU economic policy. He briefed his successor, Thomas Wieser of Austria, on the duties. At the end of a long list, he added one more. "Incidentally," Mr. Musca said, "there's a group that doesn't exist."

The secret task force, coordinated by the committee chairman, had been meeting surreptitiously since November 2008 to craft a plan should a Hungary-style crisis strike a euro nation. Membership was limited to senior policy makers—usually just below ministerial level—from France, Germany, the European Commission, Europe's central bank and the office of Jean-Claude Juncker, the Luxembourg premier who heads an assembly of euro finance ministers.

The task force met in the shadows of the EU's many councils and summits in Brussels, Luxembourg and other capitals, often gathering at 6 a.m. or huddling over sandwiches late at night. Participants kept colleagues in their own governments in the dark, for fear leaks would trigger rampant speculation in financial markets.

Potential crisis candidates were obvious: Portugal, Ireland, Greece and Spain, a group of deeply indebted states derisively tagged with the acronym "PIGS" by bond traders.
A gap quickly opened up between Germany, attached to euro-zone rules it viewed as banning bailouts for profligate countries, and France, which wanted greater freedom for national governments to support each other as they saw fit.

A fault line also developed over whether EU institutions should run any bailout operation. The European Commission, the union's executive branch, pushed for a central role in raising and lending funds—and found an ally in France. Germany, wary of a power grab, was deeply reluctant to put its cash in Brussels' hands.

The German finance ministry feared the commission was trying to establish a precedent for centralized European public borrowing, through EU bonds. That would imply Germany, Europe's strongest creditor, subsidizing other nations. Instead, Germany insisted any aid must come via loans by the individual euro-zone members to a stricken country. That way Berlin, writer of the biggest check, could control the process and force a wayward recipient to reform itself.

The philosophical divide among task-force members persisted for nearly a year. Last October, it ceased to be academic.

That month, Greece's newly elected Socialist government declared the country's 2009 budget deficit was heading for 12.5% of gross domestic product—more than three times the previous government's official forecast.

Stunned investors began to dump Greek bonds. Greece faced daunting debt repayments in spring 2010, and it wasn't at all clear if it would have the money to make them.

By February, it became obvious that the 16-nation euro zone would have to do something to address the Greek bond meltdown. The secret task force of France, Germany and EU bureaucrats opened its doors to the rest of the member countries—except Greece.

A summit of EU leaders had been planned for Feb. 11 to mull Europe's long-term economic goals. Governments insisted publicly that Greece was "not on the agenda." The hope, say aides to several European leaders, was that if Europe didn't upset the markets by talking about the matter, Greece might be able to sell enough bonds to escape trouble.

But Greek bond prices—a key measure of investor confidence—began plunging in the days before the meeting. Luxembourg's Mr. Juncker convened an emergency teleconference of euro-zone finance ministers on the eve of the summit. They agreed on a statement to be read at the summit's conclusion pledging "support" for Greece.

In Berlin's austere chancellery building, Ms. Merkel wasn't happy. Her advisers were telling her that Greece's problems ran deeper than a short-term cash shortage: The country was economically uncompetitive and living beyond its means. Without a deep overhaul, a quick-fix bailout would keep Greece afloat for only a few months, they warned. In addition, Germany's supreme court would strike down a bailout, the advisers warned, unless it was absolutely unavoidable.

Deep in the night, Ms. Merkel called other leaders, including President Sarkozy, and made it clear she would veto any promise of aid for Greece unless Athens took much tougher action to cut its public spending and overhaul its economy.

Mr. Sarkozy replied that Greek Prime Minister George Papandreou was already taking brave action.

"Now it is time for Europe to help," he said.

"The financial markets will say this is not a solution," Ms. Merkel told the French leader.

The next day's summit, on a Thursday, was scheduled for 10:15 a.m. at the Bibliotheque Solvay, a historic library on a Brussels hilltop. Late Wednesday, EU President Herman Van Rompuy of Belgium postponed it by more than two hours. Snowy weather was the official explanation given for the delay.

In reality, Mr. Van Rompuy huddled that morning in his office on the fifth floor of the EU's summit building with a few key leaders—including Ms. Merkel, Mr. Sarkozy and the head of the European Central Bank, Jean-Claude Trichet. Other European leaders were cooling their heels at the library. On currency markets, the euro was gyrating in anticipation of a bold rescue—or a bust.

Mr. Sarkozy pushed the chancellor for a clear public declaration that Europe stood behind Greece. "I cannot buy that," Ms. Merkel responded.

Eventually, Mr. Van Rompuy brokered a compromise, in the form of a nine-word sentence tacked on to a statement aides were scribbling out on a conference table: "The Greek government has not requested any financial support." The language sneaked in a back-door mention of Greece, but it conformed to Ms. Merkel's insistence that the country not be offered any help.

She had won the round.

Other European leaders believed Ms. Merkel was playing for time because of domestic politics. Her center-right coalition faced a crucial regional election on May 9 in North Rhine-Westphalia, Germany's most populous state. Opinion polls showed voters were furious about the prospect of bailing out the profligate Greeks.

"It was clear that the election was playing a big role," says the finance minister of another euro-zone country. Spokesmen for Ms. Merkel strenuously deny that North Rhine-Westphalia influenced her tactics on Greece.

The chancellor struggled to rein in speculation about an imminent bailout one Friday in late February, when the head of Germany's biggest bank, Deutsche Bank Chief Executive Josef Ackermann, mysteriously appeared in Athens for consultations with Greek leaders. Mr. Ackermann had an idea for supplying Greece with up to €30 billion of credit—half from Germany and France, half from major European banks.

In a phone call from Athens that day, Mr. Ackermann pitched the proposal to Ms. Merkel's chief economic adviser, Jens Weidmann. The reply: unacceptable. "You cannot tell the Greeks that this is a German government offer," Mr. Weidmann said, fearing the already-widespread impression that Mr. Ackermann was acting as a go-between.

A posse of cameras met Mr. Ackermann when he emerged from the Greek parliament building. "I'm regularly in Greece because I love Greece and the beautiful weather," a grinning Mr. Ackermann said, before disappearing into his armored Mercedes-Benz.

By mid-March, Greek Premier Papandreou was clamoring openly for Europe to reassure markets by putting money on the table. Ms. Merkel went on German public radio that month and said Greece didn't need aid. An upcoming EU summit should focus on other issues—and other European leaders shouldn't stir up "false expectations," she said.

But behind the scenes, Ms. Merkel was starting to take over the contingency planning.

There was one thing the secret task force had agreed on: Europe, not the IMF, would handle any bailout. The German finance ministry felt the same. Involving the Washington-based fund in a bailout of Greece would be an admission of European weakness, Finance Minister Wolfgang Schäuble said publicly. Mr. Sarkozy, Mr. Juncker and ECB chief Trichet all shared that view strongly.

Ms. Merkel, however, overruled them all. Her advisers were telling her that aid to Greece could be sold to her skeptical countrymen only as part of a wrenching IMF program of economic adjustment for Greece. IMF-inflicted pain would also deter other indebted euro-zone countries from seeking aid.

The disagreement came to a head before the broader EU's regular spring summit in Brussels on March 25.

That afternoon, before all 27 leaders gathered, Ms. Merkel met Mr. Sarkozy in one of the many spartan meeting rooms in the EU's warren-like headquarters. The chancellor agreed to announce that the euro zone would rescue Greece if it faced default—but only as a last resort, once Greece had exhausted its access to capital markets. Also, the IMF must be part of any loan package, and the IMF—not the European Commission—should draw up Greece's program of overhauls, she said.

Mr. Sarkozy protested against involving the IMF, whose biggest shareholder is the U.S. government. Europe cannot let "the Americans" decide who gets credit in Europe, he said.

Ms. Merkel put her foot down, insisting that only the IMF had the necessary experience. Mr. Sarkozy, recognizing that Germany's financial muscle was essential for any bailout, reluctantly gave way.

On April 11, with the crisis of investor confidence spreading from Greek government bonds to the country's banking system, the EU finally put money on the table. As Germany wanted, the €30 billion for the first year would come in the form of 15 separate government-to-government loans, while the IMF would lend another €15 billion. Officials hoped the sum, enough to cover Greece's borrowing needs for less than a year, would be enough to calm markets.

It wasn't.

— David Gauthier-Villars

Currency Union Teetering, 'Mr. Euro' Is Forced to Act

LISBON—On May 6, top officials of the European Central Bank were sitting down to dinner with their spouses in the elegant Emperor's Room of the Palacio da Bacalhoa, a 15th-century estate and winery south of the Portuguese capital, when stocks in New York began a terrifying slide.
The bankers' BlackBerrys lit up with frantic notes. The euro was swooning. The Dow Jones Industrial Average had plummeted 1,000 points in the "Flash Crash."

Jean-Claude Trichet, the ECB's president, feared that a fiscal mess in tiny Greece, which had consumed Europe for months, was now touching off another global financial crisis.

It was perhaps the worst of many stomach-churning moments that spring for Mr. Trichet, an urbane 67-year-old Frenchman known as "Mr. Euro" for devoting much of his 40-year career to building the common currency. It now seemed possible the panic could derail his life's work.

This account of how he and other European leaders cobbled an uneasy pact to keep the euro zone from unraveling—a patch-up that continues to show signs of strain—was based on interviews with dozens of officials across the continent.

Mr. Trichet, a child of World War II, shares his generation's intense pride in Europe's postwar achievements. He likes to show visitors to his Frankfurt office the colorful 17th-century map of Europe on his wall, to illustrate how far the Continent has come from the political fragmentation of the past.

But he is also acutely aware of the currency union's flawed construction: Despite having a single currency and central bank, national economic policies are poorly aligned. And the euro zone lacks a central authority with the power to keep national governments from spending beyond their means.
Now, profligate spending had imperiled the euro, and Mr. Euro was left holding the bag.

As bond investors dumped Greece's debt in the spring and financial turmoil threatened to engulf other euro-zone nations, Mr. Trichet had grown increasingly frustrated that governments hadn't heeded his warnings over the years about the perils of excessive borrowing.

That night in the winery, Mr. Trichet was stuck with two unappealing options. The ECB, using its authority to create euros, could buy the bonds private investors were shunning. That would buoy the weak governments and appease several countries, particularly France, clamoring for the ECB to take a leading role in a rescue. But it could also shatter the bank's hard-won credibility as an institution that doesn't bow to political pressure—a credibility vital to the euro's success.

The second option: Do nothing, preserve his principles, and risk watching the currency union fall apart.

Over the next three days, Mr. Trichet sought a way out of his bind by pushing Europe's leaders to overcome disunity and act. His quest ran into the euro zone's biggest political flaw: There was nobody in charge.

By the time the ECB chiefs met in Lisbon, the euro zone was in danger of coming unglued. Two weeks earlier, Greek Prime Minister George Papandreou had gone on national television from the remote Mediterranean island of Kastelorizo to publicly ask Europe for help. After much debate, European leaders and the International Monetary Fund had agreed to lend €110 billion over three years, expanding an earlier offer of €45 billion.

But even that generous sum was too late to stop the financial-market rout. Investor panic spread along the Mediterranean, infecting banks and government bonds in Spain and Portugal. Fears of default pushed Greek bond yields over 10%, a ruinous rate of interest that would make it nearly impossible for Athens to repair its finances.
Mr. Trichet was reluctant to get involved. Earlier that day, after the ECB's monthly policy meeting, he was blunt when asked by reporters whether the bank would step in and buy debt: "We did not discuss this option," he said.

What the world didn't know: They discussed it after dinner.

With markets quaking, Mr. Trichet convened an informal conclave of the ECB's governing council in the palace's tiled wine cellar. Surrounded by bottles of the estate's Bordeaux-blend red, they debated the idea of bond purchases for about 45 minutes. The strategy split the bankers. German officials equated bond-buying with "printing money," which they argued could stoke inflation. The step was so controversial that ECB watchers dubbed it "the nuclear option."
Despite German reservations, a clear majority in the wine cellar were prepared to go ahead. But to preserve an air of independence, they postponed a formal decision until they had seen euro-zone governments adopt tough measures of their own.

ECB officials had hoped Mr. Trichet's public rejection of the nuclear option would spur governments to do just that. Now, with the Dow plunging and markets signaling a deep sell-off in Europe the next day, central bankers feared Mr. Trichet's comments might have contributed to the general panic. (It wasn't clear yet that technical glitches at the New York Stock Exchange bore part of the blame.)

The board members, resolved to play their cards close to the vest, made no public statements after the wine-cellar meeting.

The next day, a Friday, euro-zone leaders were due in Brussels for a quick meeting to approve the Greek package. Events were overtaking them: Lending between European banks was freezing up; investors were fleeing weaker euro nations' bonds.

French President Nicolas Sarkozy arrived early at the Brussels summit and held a series of one-on-one meetings with other euro-zone leaders, urging them to back his plan: With the crisis widening beyond Greece, the leaders should announce a massive rescue fund that same day, big enough to save any euro-zone nation from default.

The Sarkozy plan was short on details. But the force of his pitch—and his entourage of photographers and camera crews—steamrolled most of his peers. Next he swept into a meeting room where German Chancellor Angela Merkel waited. Mr. Sarkozy pressed her for a decision, declaring: "This is the moment of truth."

Ms. Merkel had accepted the need for action but knew she faced a fight in Germany to justify ever-bigger taxpayer checks for struggling euro members. She asked Mr. Sarkozy for details on how the bailout would work. Receiving vague answers, she refused to back his plan.

Mr. Trichet, also at the Brussels summit, had brought a warning: The crisis was about to claim another victim—Portugal—and governments needed to act, now. He shocked leaders by passing around a chart that showed Portugal's bonds tracking Greece's nosedive.

Mr. Trichet's appeal, delivered with customary sangfroid, led to a quarrel with his volatile fellow Frenchman, Mr. Sarkozy. The French president repeatedly pressed the ECB chief to commit to aggressive intervention in bond markets. Mr. Trichet, unwilling to show his hand, replied that the ECB didn't take orders.

As the two argued, say people present, the normally genteel central banker raised his voice with Mr. Sarkozy. Ms. Merkel calmed Mr. Trichet down by telling Mr. Sarkozy pointedly that Germany supported the ECB's independence.

Facing another Franco-German stalemate, EU President Herman Van Rompuy brokered a late-night compromise: Leaders would declare the coming of a broad European "stabilization fund," which finance ministers would flesh out over the weekend. A full announcement Sunday evening would aim to wow financial markets when they opened Monday.

The next afternoon, Ms. Merkel and Mr. Sarkozy spoke by phone. He was expecting German foot-dragging. She stunned him with a proposal: a euro-zone rescue fund of €500 billion. If Germany was going to support such a fund, it should be a blow-out that would convince markets, she had decided.

But the chancellor said she was concerned about encouraging profligacy, and worried that Germany's supreme court might strike down the fund. So she proposed tough conditions: Rescue loans would require unanimous approval by euro-zone governments. The IMF must be involved. The facility should be temporary. And there could be no collective European bonds.
Mr. Sarkozy and the European Commission in Brussels had other ideas. At 2:45 p.m. the next day, Sunday, May 9, the 27 commissioners signed off on a draft pact. The main points: A majority vote by euro members would suffice to make money available. The commission would raise all of the funds by selling collective EU bonds. The rescue facility would exist indefinitely. An IMF role wasn't foreseen.

In her Berlin office, an irritated Ms. Merkel saw France's handwriting all over the commission's draft. Germany would have to overturn much of it before the night was out.

The effort began badly.

German Finance Minister Wolfgang Schäuble, bound to a wheelchair since being shot by a would-be assassin 20 years ago, had suffered health complications all spring. On arrival in Brussels, he suffered a severe allergic reaction to his medication. An ambulance whisked him to a nearby hospital.

At 3:45 p.m., Mr. Schäuble's deputy, Jörg Asmussen—a civil servant without the authority to sign off on €500 billion—told the other finance ministers Mr. Schäuble wasn't coming back.

The ministers looked "horrified," according to one participant, knowing that without Germany's financial muscle, the meeting would come to nothing. Christine Lagarde, France's cool-headed 54-year-old finance minister, feared Europe was heading for failure.

Said one member of Ms. Lagarde's entourage: "When la merde hits the fan, it comes like fighter planes: in a squadron."

In Berlin, Ms. Merkel turned to the cabinet member she most trusted to be tough enough to impose German demands: Interior Minister Thomas de Maizière, formerly the chancellor's chief of staff. There was just one problem: Mr. de Maizière was hiking deep in rural Germany. An emergency military transport had to shuttle him to Brussels.

While his colleagues waited, a senior commission official, debating with the German delegation, tried to persuade Mr. Asmussen to let Brussels run the stabilization fund.

"Why don't you let us handle this," he said.

"Because we do not trust you," Mr. Asmussen replied.
Mr. de Maizière arrived in Brussels at 8:30 p.m., leaving only a few hours to reach a deal before markets opened in Asia. He set out Germany's hard line. In addition to overturning all the commission's main points, other countries would have to agree to beef up the euro zone's fiscal rules. And Spain and Portugal, which markets saw as potentially the next Greece, would have to adopt fresh austerity measures.

Spanish Finance Minister Elena Salgado, the meeting's chairwoman, balked. "This meeting hasn't been convened to discuss any specific country," she said.

While several ministers from northern Europe turned up the pressure on Spain, Mr. de Maizière pushed through many of Germany's points.

But there remained the impasse that had existed ever since the early secret planning for crisis: Should the bulk of aid come centrally from EU institutions, or take the form of bilateral loans from governments?

Mr. de Maizière said Germany's supreme court would annul any deal raising debt with EU bonds.

Other countries objected to bilateral loans. Italy, with huge public debts, said it would struggle to borrow enough from bond markets. Tiny Malta said its share of a loan—insignificant to saving Europe—would wreck its finances.

As the talks stretched deep into the night, the ministers were left without anything to eat. The EU's catering staff is a skeleton crew on Sundays, so the finance ministers shared the rubbery cellophane-wrapped sandwiches laid out for journalists. For refreshment, they received small glasses with an inch or two of beer.
The ministers sat around an oval table, their aides in rows of desks behind them. Banks of interpreters stood at the ready, but the ministers spoke in English to keep the meeting moving. BlackBerrys and cellphones began to die. Jean-Claude Juncker, the Luxembourg premier, puffed through one cigarette after another despite the smoking ban in EU buildings.

At 10 minutes to midnight, with trading set to start in Sydney, Ms. Lagarde said the meeting should extend its deadline to 2 a.m., to beat the opening of markets in Tokyo. "Nothing against the Australians, but they aren't that important," she said.

With a Dutch official acting as intermediary between the testy French and Germans, the ministers finally reached a compromise. The first €60 billion in the bailout fund would come from commission borrowing. But the bulk would come from a specially invented entity, registered as a financial company in Luxembourg and with a three-year life. It would lend money to crisis-hit governments, raising funds by selling bonds whose repayment would be guaranteed, portion by portion, by euro-zone governments.

The formula spared Italy and others from having to raise funds themselves, but also capped EU institutions' right to borrow on behalf of member states, a concession to Berlin.

With minutes to spare before Tokyo opened, all sides accepted a new draft statement. "Hallelujah," said Ms. Lagarde.

The elation was short-lived. The deal allowed the ECB to press ahead with its bond-buying plan, and the package of EU measures has helped quell the panic. But four months later, the root causes of the Greek crisis remain: There is no central authority to even coordinate national tax-and-spending policies.

In the past month, financial markets have turned their sights on Ireland and Portugal. Doubts remain over the solvency of banks on Europe's stricken fringe. That leaves them dependent on Mr. Trichet's largesse, in the form of "temporary" lending facilities introduced by the ECB when the crisis first hit.

Despite Mr. Trichet's assurances that the bond-buying program is a stop-gap, it not only continues but has also increased in recent weeks—with no end in sight.

—David Gauthier-Villars contributed to this article.

As Ireland Flails, Europe Lurches Across the Rubicon

EAUVILLE, France—On Oct. 18, Angela Merkel and Nicolas Sarkozy took a sunset stroll on the beach of this chic casino resort. Five months earlier, Europe had committed more than $100 billion to rescue Greece. Now the Continent's debt crisis was moving on to Ireland, and the German leader worried Berlin would have to foot the bill for this and future bailouts.
"Angela, I'm going to help you," the French president said, before they set out for the boardwalk. The air chilled, so Mr. Sarkozy ordered an aide to fetch Ms. Merkel's coat. The lights of the palatial casino flickered in the distance.

The two leaders had a risky plan: The Deauville pact, sealed that evening, called for investors holding bonds in insolvent euro-zone nations to shoulder losses on them, starting in 2013. That would instill discipline in profligate countries, but also implied that a Western European nation might default on its debts. That hadn't happened in half a century, and the mere suggestion would shake markets, Mr. Sarkozy's own advisers had warned.

It also risked enraging the European Central Bank. For months, ECB President Jean-Claude Trichet, 68, had tried to rebuild investors' shattered confidence in the euro zone he had spent his career shaping. The central bank was almost single-handedly keeping Ireland and its tattered banks afloat. That task would be made more onerous by Ms. Merkel and Mr. Sarkozy's pact, which risked undermining the currency union itself.
This Wall Street Journal account—based on dozens of interviews with European officials—shows how the Deauville deal set off a chain of events that ultimately has led the leaders of the 16-nation euro zone to stumble into an even closer union.

As markets swooned in the wake of the pact, the ECB came down hard on Ireland. It threatened to cut off emergency lending to Dublin, and leaned heavily on the Irish central bank chief to pressure his nation to accept a bailout that would stanch the crisis, the Journal account reveals.

The agreement had the unforeseen effect of forcing Europe to take steps toward increased economic and political cooperation. In the past few weeks, European governments have created a permanent bailout fund to deal with crisis-hit countries. They have also debated raising money collectively through common European bonds, which could create a bond market akin to that for U.S. Treasurys.
Since the European community was established in 1957, its leaders have labored to forge an economic union that could compete on the global stage and, more important, ensure the Continent never plunged back into the world wars of the 20th century. Their crowning achievement was the creation of a common currency in 1999.

Ever since, economists have warned that monetary union, without a parallel authority to regulate taxes and spending, was destined to fail because there was no way to enforce the fiscal discipline essential to a currency's health. Now, as Europe's year of crisis grinds to a close, the Continent's leaders are contemplating what many long resisted: a United States of Europe.

"The crisis has shown that the process of European nation-building is necessary," says Italian Economy Minister Giulio Tremonti. "It will take time, but it's not possible to set the clock back."

The changes are far from the "quantum leap" in tightening the bloc's fiscal rules that Mr. Trichet urged governments to make earlier this year, to be sure. And governments could lapse back into complacency if markets calm down. Their resolve is likely to be tested amid rising concerns over the soundness of two more countries in the euro zone: Portugal and Spain.

After bailing out Greece in May, EU leaders tried to end the debt crisis by creating a trillion-dollar rescue fund to reassure markets that Europe could take care of its own. For a time, the plan worked.

Over the summer, the euro strengthened against the dollar. In July and August, Mr. Trichet urged governments to cut their deficits more forcefully and punish violators of the zone's deficit rules. But as the markets settled, the will to reform weakened. By the fall, a storm was forming over Ireland.
Greece's crisis stemmed from its public finances. Ireland was a casualty of its banks. They had lent to property developers in a real-estate bubble unmatched in Western Europe. After it burst in 2007, investors stopped trusting Irish banks. In a gamble that would come back to haunt it, Dublin had guaranteed in 2008 it would make depositors and investors whole if the banks failed. As bank losses grew, the government had to pump billions of euros to keep them afloat.

By summer, Ireland was in a vicious cycle: The more the banks lost, the more money Dublin had to give them, putting greater strain on state finances. The more state finances were stretched, the less trustworthy was Ireland's guarantee of the banks' obligations. The ECB, which provides financing for the euro-zone's commercial banks, stepped in, giving Irish banks quick loans in return for collateral.

By summer's end, the ECB had lent Irish banks €60 billion—more than a third of Ireland's annual economic output. In August and September, spooked depositors and investors pulled their money, and the banks grew even more desperate for cash.

Beyond the banks, Mr. Trichet was worried about the Irish government itself. Since May, the ECB had been buying the bonds of troubled euro-zone countries, so it held a lot of Irish government debt. ECB officials nudged Dublin to make bigger budget cuts. At a meeting of finance ministers on Sept. 7 in Brussels, Mr. Trichet told Irish finance minister Brian Lenihan that he had "fiscal appetite"—that is, he was hungry to see Ireland improve its finances.

Ireland's fate was on the line, but the 51-year-old Mr. Lenihan was waging a personal battle as well. Stricken with pancreatic cancer, he was undergoing rounds of chemotherapy and seemed increasingly despondent, friends say. He doubted that anything he did to improve Ireland's finances would satisfy bond markets.

While Mr. Lenihan cast about for ways to slim Ireland's budget, the crisis worsened. By Sept. 24, Irish banks' borrowings from the ECB had reached €83 billion. Frantic, Irish banks turned to a little-used emergency lending program run by national central banks, which are effectively appendages of the ECB. Ireland's central bank doled out €7 billion to Irish banks this way, accepting low-quality collateral. For example, Anglo Irish Bank offered a government IOU as collateral, thus converting a promise into instant cash.
"Financial gymnastics," one Irish banker called it.

On Sept. 30, Mr. Lenihan announced that Ireland would funnel billions more taxpayer cash into the banks. He promised a new deficit-cutting plan.

When Mr. Lenihan got on a conference call with hundreds of investors to sell the plan the next day, he was drowned out by a deluge of derision. Callers heckled him and shouted, "Short Ireland!"

Mr. Lenihan denied European officials were pushing Ireland to take the EU's emergency bailout funds. "We will paddle our own canoe," he said.

The Irish banks kept sliding. By mid-October, the ECB and euro-zone governments knew they had a second bailout candidate.
That put German Chancellor Merkel in a tight spot. The 56-year-old trained physicist, known for her tough negotiating style and cool demeanor, faced mounting pressure at home to limit how much Germans would spend to save their neighbors. As Europe's largest economy, Germany had borne the largest share of the Greek rescue. The chancellor now wanted fines on countries with excessive deficits to be automatic, rather than subject to a vote by fellow euro governments—a practice that had, she believed, let deficit sinners escape punishment.

To make any forceful change in EU rules, Ms. Merkel knew she needed France on board. Among the euro's 16 members, only Finland and the Netherlands supported her. The ECB also was pushing for automatic penalties. France led the majority that rejected automatic sanctions. It wanted to keep any penalties under the control of national leaders.

On Oct. 18, finance ministers met in Luxembourg to try to resolve the impasse. Only two—the French and German officials—knew the real deal was being brokered miles away, in Deauville.

When Ms. Merkel arrived at the Hotel Royal, Mr. Sarkozy embraced the German chancellor and led her into a small salon with views of the English Channel. France's hyperkinetic 55-year-old president relished the global spotlight. At home, though, protests against his plan to raise the retirement age were peaking, and strikers had crimped the nation's gasoline supply. The two leaders knew that the European project risked failure unless they overcame their longstanding differences on how to resolve the crisis.

Ms. Merkel immediately made one thing clear: Germany could not accept an extension beyond 2013 of the trillion-dollar safety net Europe had created after Greece's bailout, as some euro-zone countries were requesting.
Ms. Merkel proposed a compromise. Germany would drop its demand for automatic sanctions, but in exchange, the chancellor wanted France to support an idea her advisers had worked on for months: In the future, if a euro-zone country needed a bailout, its bondholders would have to accept a reduction on what they were owed, known as a "haircut."

Mr. Sarkozy knew Ms. Merkel was in a fix at home. If he rejected the haircuts, Germany might refuse even temporary help for ailing states.

"The question was: What happens if the Germans turn their back on Europe?" a French official said. "Nobody wanted to go there."

The Deauville pact struck by Ms. Merkel and Mr. Sarkozy hit Luxembourg like a bomb. Jörg Asmussen, Germany's deputy finance minister, printed out an email just after 5 p.m. outlining the proposal and passed it around to finance ministers. Not only had France and Germany decided that private creditors would have to worry about losing their money, but they had also cut a deal behind everyone's back.

"You're going to destroy the euro," Mr. Trichet shouted, in French, to the French delegation, according to people present.

Euro-zone government bonds had long been considered one of the world's safest investments: There was thought to be little risk a member state would default. But now, European leaders were about to enshrine in their laws the possibility of just such a default. That, the ECB knew, risked undercutting the bond market on which members of the monetary union depended.

When Europe's leaders gathered for a pre-summit dinner 10 days later, Mr. Trichet was still angry.

"You don't realize how serious the situation is," he told Mr. Sarkozy.

"Maybe you're talking to bankers," Mr. Sarkozy snapped back. "We are responsible to citizens."

Despite the fracas Mr. Sarkozy and Ms. Merkel had caused, other countries caved to the zone's two dominant powers. In a move toward fiscal unity, EU leaders agreed to authorize a permanent rescue fund and impose losses on creditors in some cases.

Markets revolted. Investors dumped the bonds of Ireland and other weak euro-zone countries, accelerating a sell-off that started after the Deauville meeting. Shut out of debt markets, Ireland faced the prospect of default.

Mr. Trichet was furious: The governments had shattered investor confidence, leaving the ECB to clean up the mess.

Dublin wasn't doing enough to save itself. It had made significant 2010 budget cuts. Yet ECB officials felt that unless Ireland promised impressive cuts for 2011 and beyond, markets would keep worrying—forcing the ECB to keep lending to Irish banks. In their view, a euro-zone bailout of Ireland would give Dublin enough cash to fix the banking sector without going bust itself.

On Nov. 9, Olli Rehn, the European Union's economy commissioner, relayed a stern warning from Mr. Trichet to Irish politicians. "The degree of exposure of the ECB to the Irish banks is unsustainable," Mr. Rehn told a group of officials over coffee and croissants at the EU's Dublin office.

The politicians were shaken. Mr. Trichet had been propping up Ireland's banks for months with emergency loans. Translated from banker-speak, the warning was clear: Mr. Trichet was threatening to cut Ireland off.

Over the next two weeks, the ECB played hardball. Behind closed doors, it threatened to shut off cash it was providing the banks, and scotched a plan to salvage the weakest lender, Anglo Irish Bank.

Irish officials insisted publicly that a bailout wasn't on the table: Political leaders feared a voter backlash at the loss of sovereignty a bailout would entail. But on Sunday, Nov. 14, Mr. Lenihan quietly dispatched a team to Brussels to hold preliminary talks in case a rescue was needed.

Two days later, euro-zone finance ministers gathered in Brussels. They urged Mr. Lenihan to accept the money and stop the market panic from spreading. "You have to do it tonight," Mr. Trichet told Mr. Lenihan.

Ireland still tried to resist. Then, on Nov. 18, at their monthly meeting on the 36th floor of the ECB headquarters, Europe's central bankers delivered an ultimatum to their Irish counterpart, Patrick Honohan: The ECB would disallow use of the Irish central bank's emergency loan program unless Ireland took the bailout.

That weekend, Ireland formally asked for the money.

In the days that followed, the ECB lobbied hard behind the scenes to water down the Deauville pact, arguing that it would lock Europe's weakest governments out of capital markets.

On Nov. 28, finance ministers approved a €67.5 billion rescue deal for Ireland. They also presented the details of the permanent bailout fund first unveiled a month earlier.

But Ms. Merkel, frightened by the uncertainty that her deal with Mr. Sarkozy had unleashed, agreed to a partial compromise. Instead of taking the hard line envisioned by the Deauville pact, the leaders agreed to restrict the use of haircuts: In most circumstances a country unable to borrow from bond markets would simply get a bailout. Only if the country were formally deemed insolvent by all other euro-zone members would bondholders face losses.

Still, the impact of the permanent bailout fund was undeniable: All the euro-zone countries now will become partly responsible for their free-spending brethren. That could prod the countries to head off fiscal irresponsibility by involving themselves more deeply in each other's tax and spending policies.

The agreements had left a loose end: Portugal. Lisbon is widely seen as next in line for a bailout, because of its gaping budget deficit and chronically weak economic growth.

Several participants at the Nov. 28 finance ministers' meeting pushed Lisbon to apply for aid, say people familiar with the matter, but the Portuguese finance minister refused. He has said repeatedly that his country doesn't need outside help.

Market fears about Portugal and neighboring Spain continue to haunt Europe's leaders. This month, the bonds of Italy and Belgium—two indebted countries previously spared from panic—have come under selling pressure. There are signs this pressure is pushing governments to venture further toward a united Europe.

The finance ministers of Italy and Luxembourg this month proposed raising money for European countries collectively, through common European bonds. France and Germany are still opposed to such E-bonds, but others in Europe are willing to discuss them.

Next year, the debate over Europe's future will continue. The pull of national sovereignty will face the push of coordination. If a closer union fails, some European leaders argue, the euro could unravel with dire consequences.

"The euro is our common destiny, and Europe is our common future," Ms. Merkel told the German parliament this month.

—Marcus Walker and Adam Mitchell contributed to this article.

In Euro's Hour of Need, Aide Gets 'Madame Non' to Say Yes

BERLIN—As Europe's debt crisis threatened to spiral out of control, German Chancellor Angela Merkel boarded a Luftwaffe jet on Nov. 10 with her finance minister, Wolfgang Schäuble, for an overnight flight to a global summit in South Korea.
Ireland was on the verge of following Greece into a financial bailout. Portugal appeared close behind, and financial-market panic was infecting Spain. Investors, spooked by German foot-dragging as the crisis unfolded, doubted Berlin's willingness to keep writing checks to rescue its neighbors.

Ms. Merkel had emerged early in the crisis as Europe's taskmaster and defender of Germany's purse—the "Madame Non" of the euro zone. Mr. Schäuble, the elder statesman of the German cabinet and an unapologetic Europhile, spent much of the 10-hour flight encouraging Ms. Merkel to change her tune. She realized Germany needed to do more. The nation, he argued, had to help others in order to help itself.

"We must not always talk about what we don't want," the 68-year-old veteran politician told Ms. Merkel and her advisers. "We must say why the euro is in Germany's interest."
This account of Germany's transformation from a reluctant rescuer into a leader in fighting the fire, based on interviews with more than 20 European policy makers, reveals the critical backstage role played by a politician who was nearly written off last year because of his failing health. Germany's strategic shift has ushered in a new phase in Europe's battle to quell its debt crisis. The danger is far from over, but financial markets are now more confident that Germany will do what it takes to save the euro.

Mr. Schäuble sold Ms. Merkel on a plan that came to be known as the "grand bargain." It contained a carrot and a stick: Germany would increase its financial commitments to Europe's rescue funds, but only if the 17 members of the euro zone agreed on a common economic strategy and more fiscal rigor.

"We will have a more convincing position if we move in both directions," Mr. Schäuble told her during the flight. "We need stricter rules for all, but we must also offer the instruments to fight contagion—in our own interest."

Although other euro-zone nations pushed back hard against the strict rules Germany proposed, in the end they struck a deal. Portugal's request for a bailout last week is the first big test of whether the deal has worked. Lisbon, whose stagnant economy and high debt scared away lenders, is expected to get a roughly €80 billion ($116 billion) rescue package by May, predicated on tough economic reforms.
The Portugal news didn't send markets into a panic, a striking contrast to the turmoil that accompanied prior bailouts. Crucially, Spain's borrowing costs have remained at elevated but stable levels this year. European leaders believe they are closer to containing the crisis than at any time since it began in Greece in late 2009.

"The dominant country, Germany, has realized that it is in Germany's interest to address the crisis in the euro," says Jacques Delors, a Frenchman who as head of the European Commission in the 1980s and '90s was one of the fathers of the euro.

Trouble could flare again if Spain's economy deteriorates. Debt woes are still ravaging Greece and Ireland, for whom Europe has yet to map a convincing route to recovery. Exposure to the weakest countries' debts remains a headache for banks in Europe's core economies.

And while European leaders have reached agreement, many of their voters remain hostile to more aid for other euro members. Finland's election on Sunday could produce a government that rejects the deal to expand the bailout fund—forcing other euro members back to the drawing board.

Mr. Schäuble sees defending the euro as Germany's historic duty, part of its calling to anchor peace and prosperity in Europe after being given what he calls a "second chance" following World War II. He recently called European integration "the best thing that German politics has achieved in the last 60 years."

A conservative from the Black Forest, Mr. Schäuble is one of Europe's last senior politicians from the generation of Helmut Kohl and François Mitterrand that created the modern European Union. He was first elected to parliament in 1972, and has held a string of cabinet posts since 1984. In 1990, a mentally ill assailant shot him at an election rally, leaving him in wheelchair, paralyzed from the chest down.
His pro-European convictions grew partly from his roots near Germany's southwestern border with France, which made him a lifelong Francophile. But his dedication to European unity also comes from his longtime political patron, the former chancellor Mr. Kohl, who strove to unite Europe at the same time as he reunified Germany 20 years ago.

Last year, Mr. Schäuble's political career seemed nearly over. Medical complications forced him into the hospital repeatedly, and he missed crucial EU meetings as the euro-zone crisis mounted. Mr. Schäuble offered to resign more than once. Ms. Merkel stood by him.

When his health stabilized last fall, he thrust himself into the crisis, pushing back against the negative view of Europe taking root in Germany. Many German lawmakers and commentators saw other euro members as idle mendicants grasping for Germany's hard-earned money.

"Schäuble is drunk on Europe. He doesn't fight for national interests," says Frank Schäffler, a lawmaker from Germany's pro-business Free Democratic Party, and a leading opponent of bailing out more euro members.

Mr. Schäuble told a German newspaper last month that protecting the legacy of European integration is a central reason why he feels he has to continue in government.

Ms. Merkel had long argued that rescue loans would only take the pressure off indebted nations to tackle their problems, and that assistance should only be a last resort. Last May, she approved aid for Greece and the creation of a bailout facility—but only did so as the currency union itself threatened to unravel.

But by the time the chancellor boarded the flight to Korea last November, she was rethinking her approach. She realized that euro-zone members hadn't yet done enough to stem the crisis, but she was concerned about how a greater German financial commitment would fly with lawmakers and the electorate, according to people familiar with the debate that night.
Ms. Merkel and her finance minister agreed to a plan: Germany would push to beef up existing EU proposals—for a permanent rescue fund and tighter supervision of national budgets—with new measures to erase market doubts about the euro.

Mr. Schäuble wanted to boost the lending capacity of the temporary bailout fund to €440 billion, from around €250 billion. Doing so would signal that the fund was big enough to save Spain, widely seen as the euro's decisive battlefield, if needed.

They also agreed that Germany's move needed to be conditional on other countries' reforming their economies to boost growth. Berlin had long believed that weaker euro members would never escape their debts unless they became more productive.

The plan would have to be sold in three stages: to Germany's ruling coalition, to France, and to the rest of the euro zone.

German lawmakers didn't want the euro rescue effort to become a bottomless pit for taxpayers. Lawmakers from the Free Democratic Party, in particular, feared Mr. Schäuble was building a kind of über-welfare state, turning the EU into a "transfer union" in which Germans work hard and more profligate nations take their money.

Ms. Merkel lobbied lawmakers intensively, insisting that action was necessary to restore calm to financial markets.

Next, Ms. Merkel wanted France on her side. Often, when the two countries have agreed on something, the rest of Europe has followed.

The two nations' cabinets met on Dec. 10 in the German town of Freiburg, Mr. Schäuble's birthplace. Ms. Merkel told President Nicolas Sarkozy that she had softened to France's longtime desire for closer coordination of economic policy among leaders in the euro zone. But she wanted something in return: Euro members should agree on a list of concrete overhauls that would be listed in a formal pact. Germany dubbed it a "pact for competitiveness."

"OK, let's do it," Mr. Sarkozy said, according to people present.

Ms. Merkel stepped up her rhetoric in defense of the euro. Instead of threatening to expel miscreant euro members, as she did earlier in 2010, she declared repeatedly that the euro was Europe, and neither would be allowed to fail. "Germany will do everything to defend the euro," she said after the Freiburg meeting. Added Mr. Sarkozy: "Our determination is total, both in Germany and France."

The hardest part, it turned out, was selling the plan to other euro members.

In Germany's view, other euro members had to agree first to the pact for competitiveness and stricter EU supervision of their budgets. Only then would Germany offer more generous financial aid for euro nations in need.

The European Commission, the EU's Brussels-based executive arm, had long wanted a bigger bailout fund. But the commission and most euro nations wanted to reduce restrictions on tapping the funds. The EU's main bailout fund, which expires in 2013, can only lend to a government locked out of bond markets and facing default, and only in return for a painful program of budget cuts. Germany wanted to keep it that way.

Top civil servants from European finance ministries fought it out at a series of secret meetings in Brussels. Many officials argued that countries should be able to get a "precautionary credit line" with few strings attached. German representatives said such easy money was out of the question. Only Finland was clearly on Germany's side.

Italy and Luxembourg wanted to replace the bulk of national borrowing with collective euro-zone bonds. Greece wanted others to lend it money so it could buy back its own bonds at fire-sale prices, shrinking its debts.

European Central Bank President Jean-Claude Trichet wanted the bailout fund to buy already issued government bonds to stabilize the market. That change would rid the bank of its controversial and risky bond-buying program, handing over such activity to euro members.

As the demands multiplied, some EU officials began referring to the grand bargain as "the American pizza," because so many toppings were being added.

Germany wasn't pleased. "All these options were just ways to get at Germany's wallet," says a senior German official.

Germany's demands for the rest of Europe became clear when drafts of its pact for competitiveness leaked in January. The text required euro-zone countries to take immediate actions that included raising retirement ages, scrapping inflation-linked wages and amending constitutions to outlaw big budget deficits. Failure to deliver could lead to sanctions, the text suggested.

Unease about German domination of Europe grew. Germany was accused of meddling in such national issues as the age at which citizens get their pensions. "La inspectora is coming," Spain's press announced before Ms. Merkel visited Madrid in early February.

Ms. Merkel turned saleswoman. In the run-up to a critical EU summit on Feb. 4, she phoned or visited the other 26 EU leaders. The consultations seemed to go well. German officials grew confident—falsely, it turned out—that all euro members were on board.

Deep fissures opened at lunchtime on the summit's first day, when 25 of Europe's leaders were left waiting for Ms. Merkel and Mr. Sarkozy. As their colleagues stared at empty plates, the French and German leaders held a press conference to present their proposal, which they made sound like a fait accompli.

"The aim, in my view, must be that within a year, we can point to very concrete steps that show we mean it and we take this pact seriously," Ms. Merkel said.

"Mesdames et messieurs, I don't need to tell you that I fully and wholly underscore and share what the chancellor just said," added Mr. Sarkozy.

"Let's go to work!" concluded Ms. Merkel.

The two got a frosty reception in the dining room, say officials who were present. Other heads of government still hadn't seen the German text of the pact—they had only read about it in the press. Some leaders saw it as a Franco-German attempt to railroad them. Others objected to specific demands they had read about.

The pact was "like a yeti," exclaimed Czech Prime Minister Petr Necas: "Everybody is talking about it, but nobody has seen it." Polish premier Donald Tusk went further, calling the proposal "a humiliation."

Even Germany's allies in the euro zone balked. The Dutch and Belgian leaders, Mark Rutte and Yves Leterme, said their electorates had no desire to take orders from Ms. Merkel. Belgium and Luxembourg defended their nations' practice of indexing wages to inflation, which Ms. Merkel wanted to abolish. Austrian Chancellor Werner Faymann balked at raising his country's retirement age. Italy's Silvio Berlusconi complained about having to cut the national debt.

In all, around 19 countries raised objections, Mr. Leterme told reporters afterwards, describing the summit as "surreal." The meeting ended without agreement.

Germany had little choice but to water down its proposal. By late March, it had become the "Euro Plus Pact," a set of broad promises by euro members and some other EU states to foster competitiveness, employment and fiscal virtue, but with each nation choosing its own means of meeting the goals.

In the end, Mr. Schäuble's grand bargain was only a partial success.

Germany committed to open its coffers further for the European cause, but in return it won promises of uncertain value. Many observers say the deal didn't go far enough, and still leaves major questions unanswered, such as how to restore the solvency of Greece and Ireland.

"Now, the situation is better than it was one year ago," says Mr. Delors, the former European Commission president. "But more must be done to strengthen the condition of the euro."

—David Gauthier-Villars and Alessandra Galloni contributed to this article.

Dithering at the Top Turned EU Crisis to Global Threat

At a closed-door meeting in Washington on April 14, Europe's effort to contain its debt crisis began to unravel.

Inside the French ambassador's 19-bedroom mansion, finance ministers and central bankers from the world's largest economies heard Dominique Strauss-Kahn, then-head of the International Monetary Fund, deliver an ultimatum.
Greece, the country that triggered the euro-zone debt crisis, would need a much bigger bailout than planned, Mr. Strauss-Kahn said. Unless Europe coughed up extra cash, the IMF, which a year earlier had agreed to share the burden with European countries, wouldn't release any more aid for Athens.

The warning prompted a split among the euro zone's representatives over who should pay to save Greece from the biggest sovereign bankruptcy in history. European taxpayers alone? Or should the banks that had lent Greece too much during the global credit bubble also suffer?

The IMF didn't mind how Europe proceeded, as long as there was clarity by summer. "We need a decision," said Mr. Strauss-Kahn.

It was to be Europe's fateful spring. A Wall Street Journal investigation, based on more than two dozen interviews with euro-zone policy makers, revealed how the currency union floundered in indecision—failing to address either the immediate concerns of investors or the fundamental weaknesses undermining the euro. The consequence was that a crisis in a few small economies turned into a threat to the survival of Europe's common currency and a menace to the global economy.
In April, after a year of drama and bailouts, the euro zone seemed to have contained the immediate crisis to Greece and other small countries. Crucially, euro-zone economies such as Spain and Italy had avoided the panicked flight of capital. They were still able to borrow money at affordable rates in the bond market.

But by July, the rift among euro-zone leaders over who should bear the burden of Greece's debt had prompted investors to shun all financially fragile euro nations. Like a wildfire, the spreading uncertainty threatened to engulf the whole of Europe's indebted south, to outstrip the resources of its richer north and to burn down the symbol of Europe's dream of unity, its single currency.

Now, as the bloc's leaders rush to forge a closer political union, the lesson of that period looms large. Investor trust in public debt is part of the foundation on which all nation-states depend. And in Europe's common currency—a unique experiment with the livelihoods of 330 million people—nations will win or lose that trust together.

The dispute at the Washington meeting divided two of the Continent's grand old men, both of them born in 1942 and both among the fathers of the euro.

Wolfgang Schäuble, Germany's ascetic and irascible finance minister, understood the IMF's ultimatum. The euro zone would have to draw up a second bailout package for Greece by summer, just a year after a loan deal for €110 billion, or $140 billion.

But this time, Mr. Schäuble said, "We cannot just buy out the private investors" with taxpayer money. That would reward reckless lending, he said, and it would never get through an increasingly impatient German parliament. Greece's bondholders would be required to lend more money, Mr. Schäuble proposed, rather than take payment for their bonds at maturity.
Jean-Claude Trichet, the urbane French head of the European Central Bank, warned against forcing bondholders to put in more money, which would effectively delay repayment. "This is not a good way to go in a monetary union," Mr. Trichet said. "Investors would avoid all euro-area bonds."

Mr. Trichet, in the twilight of a 36-year career as a finance official, feared that if Greece didn't honor its bond debts on time, the implicit trust that kept credit flowing to many weak euro-zone governments would shatter. More countries and their banks would lose access to capital markets, in a chain reaction with incalculable consequences.

The April meeting ended inconclusively.

Meanwhile, the cost for fixing Greece was rising. The Athens government's budget deficit was stuck at a stubbornly high level.
Italian and Spanish borrowing costs were still affordable and stable. The yield on Spain's 10-year bonds hovered around 5.3%; on Italy's, around 4.6%.

The debate over making bondholders contribute to the new funding package for Greece—known as private-sector involvement, or PSI—divided euro-zone countries.

Germany had allies. In the Netherlands and Finland, new governments had promised voters they wouldn't pay for problems in less-frugal Mediterranean countries. Breaking those promises would risk rebellions in parliament.

But France joined the ECB in resisting burden-sharing by bondholders. France's banks had lent more heavily than Germany's to Greece and other indebted euro nations, and France fretted about a Lehman Brothers-style banking-system meltdown. Italian officials also feared that a precedent for losses in Greece would scare investors away from Italy's bonds.

Three weeks after the Washington gathering, on Friday, May 6, panic erupted. German news weekly Der Spiegel reported that Greece was thinking of leaving the euro zone, with policy makers heading to a secret meeting that night in Luxembourg.

The report was half-right. There was a meeting, but Greece was staying put.

Inside a country chateau, top euro-zone officials told Greece's finance minister they expected deeper austerity and faster reforms in return for a new aid package.

Then Mr. Schäuble said he wanted to discuss how bondholder burden-sharing would work. The usually smooth-mannered Mr. Trichet lost his patience. "I want to put my position on the record," he said: "I don't agree with private-sector involvement, so I won't take part in a discussion about the practicalities." He stormed out.

Mr. Trichet's assent was vital. If the ECB were to stop accepting Greek bonds as collateral for its lending to banks on the grounds that the bonds were in default, then Greece's banks, which were stuffed full of their government's bonds, would quickly run out of cash and collapse. That would radically drive up the cost of a rescue.

In Greece, a new wave of mass strikes and demonstrations was starting. Protesters, angry about Europe's imposition of extra spending cuts and tax hikes, clashed with police in front of the Athens parliament in the biggest and most violent protests in a year.

Spanish and Italian bond prices remained stable. But Europe was at a dangerous impasse over Greece.

Many euro-zone governments hoped Mr. Strauss-Kahn could find a way to relax the IMF's summer deadline. The IMF chief was due to discuss the matter with German Chancellor Angela Merkel in Berlin on May 15, and with euro-zone finance ministers in Brussels the next day.

Mr. Strauss-Kahn couldn't attend. Police in New York pulled him off his Paris-bound flight and charged him with sexually assaulting a hotel chambermaid. (The charges were later dropped, and prosecutors said they doubted the maid's reliability.) An aide phoned Ms. Merkel at her central-Berlin home that Saturday and told her the news. The astonished chancellor responded with a German idiom that translates roughly as: "You couldn't make this up."

The IMF sent a lower-ranking official to Brussels in his place who had no latitude to deviate from the IMF's deadline.

In Athens, meanwhile, a tent city of the "Indignant" protest movement—a groundswell of anger at the country's impoverishment—sprang up outside parliament. Spain's bond prices began to wobble as investors worried that other countries might also face debt restructuring.

On June 1, Mr. Schäuble's deputy, Jörg Asmussen, presented a German plan at a meeting of finance officials in Vienna, at the Hofburg palace of the former Habsburg emperors. It involved pressuring Greece's bondholders to swap their Greek debt for new IOUs that would come due far in the future. That would cut the amount of European taxpayer funding Greece would need.

After a meal in a palace banquet hall, the officials quarreled into the wee hours.

For the ECB, Mr. Trichet's deputy Vitor Constâncio, of Portugal, denounced the German plan as "dangerous." Credit-rating agencies would declare Greece to be in default on some of its debts—a so-called selective default. In that case, Mr. Constâncio warned, the ECB would refuse to accept Greek government bonds as collateral, dealing a death blow to Greek banks. France, Italy and Spain all supported Mr. Constâncio.

Germany's Mr. Asmussen shot back with a threat of his own. Europe needed Germany's money to fund a new program of Greek loans. "Without private-sector involvement," he said, "there will be no program."

Greece was descending into chaos. Embattled premier George Papandreou's slender majority in parliament was fraying. On June 15, a swelling demonstration in Athens's central square veered out of control.

Alone in his office, Mr. Papandreou phoned the parliamentary opposition leader and offered to make way for a national-unity government. Talks broke down, and the Greek government limped on badly wounded.

Even Ms. Merkel had some doubts about her finance ministry's hard-line insistence that Greece's bondholders take a loss. On June 17, she discussed a softer plan with French President Nicolas Sarkozy: a gentleman's agreement under which Greek bonds would be honored but the bondholders would volunteer to buy new ones.

Mr. Schäuble pushed back. The veteran conservative politician was Berlin's biggest supporter of the European dream, but he was also the keeper of Germany's purse. He was determined to make banks share the burden with German taxpayers, and he didn't trust them to keep a gentleman's agreement.

When finance ministers met again on June 20, Mr. Schäuble pushed harder. Greece's bondholders should be told not merely to accept a delay in repayment, he said, but also to forgive some Greek debt—a so-called haircut.

As Greece's economy moved toward free fall, its debts were soaring beyond the country's ability to pay, the Germans and their northern allies argued. Mr. Trichet and the southern countries resisted. Talks dragged on for hours. The ministers knew they couldn't leave without some agreement.

They tried to please everyone: Greece would get more aid. Bondholder losses would be substantial, to placate the Germans, Dutch and Finns. But as the ECB insisted, they would avoid pushing Greece into selective default.

Investors knew you couldn't have it both ways. As the threat of a Greek debt restructuring sank in, Southern Europe's bond markets grew volatile. Spain's 10-year bond yield rose above 5.6%. Italy's reached 4.9%.

Greece's parliament debated the extra austerity measures that Europe demanded. Central Athens erupted in violent protests. Anarchist youths tore up chunks of paving stone and threw them at riot police, who fired back with tear gas and stun grenades. Café parasols burned.

Europe hadn't resolved how to keep Greece afloat. The IMF—whose demand for a decision had set off the whole argument—softened its ultimatum. IMF officials said they were satisfied that Europe would sort out some kind of new bailout, and wired Greece its summer aid payment on July 8.

It wasn't enough to calm markets. Spain's bond yield hit 6.3%. Italy's rose to over 5.8%. Such borrowing costs, if sustained, would make it hard for both countries to rein in their debts.

The selloff in bond markets forced leaders to call an emergency summit for July 21.

Determined not to let the summit pass without an agreement, Ms. Merkel invited the French president, who objected to the German push for bondholder losses, to Berlin. The pair and their advisers met for dinner in the German chancellery the night before the meeting.

Few of them had time to touch the duck breast and vegetables on their plates as they searched for a compromise. Finally, Mr. Sarkozy said he would accept the private-sector involvement—if Ms. Merkel dropped her resistance to giving the euro-zone bailout fund broad new powers to buy debt of weak countries directly and move to protect such countries as Spain and Italy from bond-market contagion. Ms. Merkel agreed.

One more person needed to sign off. Ms. Merkel phoned Mr. Trichet at his Frankfurt office. He took the last Lufthansa flight to Berlin and arrived at the chancellery around 10 p.m.

Reluctantly, Mr. Trichet gave his OK. But he set conditions. Governments would have to insure Greek bonds against default so that the ECB could continue to accept them as collateral. And they would have to make plain that no other euro country but Greece would have its debts restructured.

The trio's deal was both complicated and vague. Their staffs had little time to flesh out details before the next day's summit in Brussels. As leaders trickled into the European Union's boxy headquarters, Ms. Merkel faced a challenge to placate the euro zone's south, which thought private-sector involvement was dangerous, and its north, which thought it didn't go far enough.

When the leaders assembled at the sprawling summit table, Ms. Merkel admitted that the specter of bondholder losses was causing market unrest. But, she said, some Greek debt relief was essential. Without it, the bailout's tough austerity conditions—made tougher by Greece's missing its budget goals—would be seen as unbearable.

"If Greece had met its program parameters in April," she snapped, "that would have helped."

All 17 euro nations had to agree to private-sector involvement. But presented with a calculation that the plan would reduce Greece's debt by only about €19 billion out of more than €350 billion total, Dutch Prime Minister Mark Rutte balked. If it's only €19 billion, he said, "I'm out. I need more."

Finnish premier Jyrki Katainen also complained. His parliament wanted collateral in exchange for more Finnish lending to Greece. "No collateral, no agreement from me," he said.

Mr. Sarkozy was peeved. "All our parliaments can cause problems," he said.

Then it was Slovakia's turn. Prime Minister Iveta Radičová was fighting to keep her coalition together over aid for Greece—a richer country than her own. Adding more powers to the bailout fund "would be suicide," she said.

Greece's Mr. Papandreou pleaded for help. "If we can't solve even Greece, we won't be seen as being able to solve anything else," he said.

Hours later, the leaders had a communiqué. To appease the holdouts, it left key points broad and noncommittal, offering the possibility of collateral to Finland and describing the complex bondholder deal in a few strokes, vague language that would return to haunt the bloc.

Officials struggled to explain the new Greek bailout and the bondholder losses. Amid the confusion, Mr. Rutte dispensed muddled numbers. Bank analysts put out flawed reports.

Investor confidence faltered as it became clear that Europe's compromise achieved the worst of all worlds. Greece would be pushed into a historic default—the first time in nearly 60 years that a developed, Western country wouldn't honor its debts. But the default was so small that Greece was still left with a crushing debt burden.

And then official Europe went on vacation: Ms. Merkel to the Italian Alps, Mr. Sarkozy to the French Riviera.

Bondholders didn't. They went on a rampage.

—Stephen Fidler, David Gauthier-Villars, Sudeep Reddy and Brian Blackstone contributed to this article.

Deepening Crisis Over Euro Pits Leader Against Leader

BERLIN—On a chilly October evening in her austere chancellery, Angela Merkel placed a confidential call to Rome to help save the euro.

Two years after the European debt crisis erupted in little Greece, the unthinkable had happened: Investors were fleeing the government debt of Italy—one of the world's biggest economies. If the selloff couldn't be stopped, Italy would go down, taking with it Europe's shared currency.

Her phone call that night to the 16th-century Quirinale Palace, once a residence of popes, now home to Italy's octogenarian head of state, President Giorgio Napolitano, trod on delicate ground for a German chancellor. Europe's leaders have an unwritten rule not to intervene in one another's domestic politics. But Ms. Merkel was gently prodding Italy to change its prime minister, if the incumbent—Silvio Berlusconi—couldn't change Italy.
Details of Ms. Merkel's diplomatic channel to Rome haven't previously been reported.

Her impatience shows the extent to which Italy's woes undid Europe's strategy to fight the crisis. Until then, Europe had followed a simple formula to preserve the euro: The financially strong would save the weak. But Italy, with nearly €2 trillion, or about $2.6 trillion, in national debt, was simply too big to save.

This Wall Street Journal reconstruction, based on interviews with more than two dozen policy makers, including many leading actors, as well as examinations of key documents, reveals how Germany responded to the dangers in Italy by imposing its power on a divided euro zone. Ms. Merkel, widely criticized for not dealing forcefully with the crisis in its early phase, was at the center of the action, grappling with personal tensions and Byzantine politics among the 17 euro nations.

As well as nudging Mr. Berlusconi off the stage, Ms. Merkel had to smooth out her volatile relationship with France's president, Nicolas Sarkozy. The Franco-German couple eventually overcame many of their differences—and Mr. Berlusconi—only to be blindsided by fresh political chaos in Greece.

Europe's crisis is rooted in deep worries about government debt and economic imbalances inside the euro zone. Those concerns have scared bond investors away from Europe's weaker states, leaving some, like Greece, without access to money with which to refinance or repay their debts. The great danger is that Italy might join them.

Greece and others were small enough to rescue with international bailouts. But an Italian default could severely hurt Europe's, and the world's, financial system, perhaps triggering a worse global slump than the 2008 failure of Lehman Brothers did.
The scramble to shore up investor confidence in Italy led to simmering arguments over how to pay for a financial safety net. Europe's leaders were reluctantly realizing that living with a common currency meant surrendering more of their national independence than they had bargained for.

France and others urged drawing on the virtually unlimited firepower of the European Central Bank. But German strictures and the central bank's own reluctance to bail out governments—for fear of igniting inflation or rewarding profligacy—frustrated that idea.

And while German pressure helped bring about a new, reform-minded government in Italy, today Europe is still fighting to save the euro. The battle ahead looks daunting.

The euro zone, which accounts for nearly 20% of global economic activity, is sliding into recession. France and other countries are struggling to save their credit ratings. And Italy must borrow some €400 billion in 2012.

It's far from clear whether investors are willing to loan such amounts. On Thursday, Italy sold €7 billion in bonds, less than the full amount it had targeted. Investors demanded a yield of nearly 7% on 10-year lending, a painfully high rate.

From the dawn of the crisis in late 2009, Europe's leaders knew they had to avoid a bond-market run on Italy, given its big economy and towering pile of debt. But it was their own handling of Greece that helped spur just such a run. A July 21 decision to restructure Greece's bond debt, which saddled private investors with losses, set a precedent that made many investors wary of lending to any indebted euro members.

Italian politics unnerved the market further. Mr. Berlusconi fell out with his finance minister, Giulio Tremonti, considered a steady hand on Italy's tiller.

"Tremonti thinks he's a genius and everyone else is a cretin," Mr. Berlusconi said in his office, adding that his finance chief was "not a team player," according to a person familiar with the matter. Rumors swirled that Mr. Tremonti might resign, pushing Italy's borrowing costs to a euro-era high. That made it ever tougher for Italy to climb out of its financial hole.

When the market rout worsened on Aug. 3, Mr. Berlusconi gave a defiant speech before parliament declaring that his policies "have been judged adequate by Europe."

Two days later, the ECB contradicted him in a secret letter. Italy's deficit-cutting plan was "not sufficient," ECB President Jean-Claude Trichet and his anointed successor, Mario Draghi, wrote to Mr. Berlusconi. The letter said Italy needed extensive economic overhaul to boost growth, and it set out detailed demands including greater competition, labor-market deregulation, reduced pension largess, a slimmer bureaucracy and deeper public spending cuts.

The implicit message: These reforms were the conditions for ECB intervention in the bond market.

Rome was furious. Mr. Tremonti would later privately tell a group of European finance ministers that his government had received two threatening letters in August: one from a terrorist group, the other from the ECB. "The one from the ECB was worse," he quipped.

Mr. Berlusconi gave in. On Sunday, Aug. 7, he faxed a letter to the ECB pledging far-reaching reforms and deeper budget cuts.

Mr. Trichet deemed Rome's reply satisfactory, and the next day, the ECB for the first time began buying Italian bonds, calming investors and giving them renewed confidence to buy Italian debt themselves. Rome's borrowing costs declined.
But at home in Italy, Mr. Berlusconi's reforms faced political resistance. He wavered.

Messrs. Trichet and Draghi phoned to press Mr. Berlusconi to honor his promises. European Union President Herman Van Rompuy also called and asked him to take the crisis more seriously. "Otherwise," Mr. Van Rompuy told him, "we are all in trouble."

On Aug. 31, Italian media reported that Mr. Berlusconi had told his advisers he was giving up on pension reform, a key ECB demand.

Investors resumed their flight from Italy. The ECB let Italian bond yields rise again. The episode appeared to confirm the fears of the German faction at the ECB: Politicians would revert to bad behavior if given a reprieve from market pressures.

The crisis had reached a scale that menaced the global economy. The ECB wasn't going to save Italy. Europe's other governments didn't know where else to turn.

The rest of the world was running out of patience. The euro-zone bailout fund—already committed to financing Greece, Ireland and Portugal—had only about €250 billion to spare. If Italy lost the ability to borrow in financial markets, it would burn through that amount in just a few months.

At September's annual meeting of the International Monetary Fund in Washington, D.C., Europe faced intense pressure to act. China and Brazil joined the U.S. in berating Europe for its too-small war chest. Europe was told to "leverage" its bailout fund by borrowing hundreds of billions of euros from the ECB.

Jens Weidmann of Germany's central bank quashed that idea. The bailout fund was an arm of the governments, he said, and lending to governments was against the ECB's charter.
The only options remaining were complicated schemes to offer investors in Italian bonds partial protection through guarantees or a "special-purpose investment vehicle." The problem, officials privately admitted, was that this amounted to financial gymnastics of the kind that banks had indulged in before the 2007 mortgage crash.

On Oct. 19, Mr. Sarkozy sought to break the deadlock. Leaving his wife, the singer and former supermodel Carla Bruni-Sarkozy, in labor at a Paris clinic, he flew to Frankfurt to confront Mr. Trichet over the ECB's reluctance to take bolder action.

Official Europe was gathering at Frankfurt's stately Alte Oper concert hall for a party to honor Mr. Trichet's retirement as ECB head. Mr. Sarkozy hadn't come to celebrate. While the orchestra played Rossini and Mozart, a clique of Europe's most powerful leaders huddled in a side room.

Mr. Sarkozy insisted that only decisive ECB help in government bond markets could save the euro zone. "Everything else is too small," Mr. Sarkozy said. Strains of the "Barber of Seville" overture reached the brown-paneled meeting room.

Mr. Trichet said it isn't the ECB's job to finance governments. His farewell party began turning into a shouting match in French.

Already, he said, the central bank's limited bond-buying had caused a political backlash in Germany, the euro's most powerful nation. "I did a bit, and I was massively criticized in Germany," Mr. Trichet said.

Ms. Merkel, also present, was irritated at the French pressure on the ECB. She thought Mr. Sarkozy, with whom she had a sometimes prickly relationship, was well aware that Germany opposed using the central bank's money-printing press to tackle the crisis.

Ms. Merkel came to Mr. Trichet's defense. "You're a friend of Germany," she said.

News came from Paris that Mr. Sarkozy's wife had given birth to a girl. Ms. Merkel offered restrained congratulations to France's president. The meeting ended without agreement.

A day later, Ms. Merkel made her confidential phone call to Rome. Behind the move was a growing belief in Berlin that euro-zone nations could no longer afford to live however they pleased. Italy's premier, Mr. Berlusconi, mired in legal and sexual scandals and unabashed about his reputation as a libertine, was the temperamental opposite of the sober Ms. Merkel, the daughter of a Lutheran pastor.

Mr. Berlusconi's failure to reanimate Italy's economy endangered Europe. So Ms. Merkel phoned Mr. Napolitano—as Italy's president, the man with authority to name a new prime minister if the incumbent were to lose parliament's support.

Ms. Merkel told the 86-year-old president that Italy's deficit-cutting efforts were "appreciated," but that Europe really wanted to see more aggressive reforms to boost economic growth. She said she was worried Mr. Berlusconi wasn't strong enough to deliver.

Mr. Napolitano said it was "not reassuring" that Mr. Berlusconi had recently survived a parliamentary vote of confidence by just one vote.

Ms. Merkel thanked the president in advance for doing what is "within your powers" to promote reform.

Mr. Napolitano got the message. Days later, he quietly began sounding out Italy's political parties to test the support for a new government if Mr. Berlusconi couldn't satisfy Europe and the markets.

Europe had promised the world it would fix its problems by late October. But Italy was only one of its headaches. While Rome struggled, Greece defied attempts at repair. The Greek bailout deal signed in July now looked far too small. Greece's economy was coming apart.

On Oct. 21, inspectors from the EU and IMF said Greece would now need more than €140 billion in extra euro-zone taxpayer aid through 2020, unless private-sector bondholders forgave 60% of what Greece owed them.

Germany pressed for a deep restructuring of Greek debt. France, fearful that rising bailout costs could jeopardize its own triple-A credit rating, dropped its objections.

Ms. Merkel repaired relations with Mr. Sarkozy at an EU summit on Oct. 23. She gave him a German teddy bear for his baby daughter. The president phoned his wife, Ms. Bruni-Sarkozy, and passed the cellphone to Ms. Merkel, who congratulated France's first lady.

The debate over Greece deepened. The Institute for International Finance, a banking lobby representing many of Greece's biggest creditors, resisted large-scale debt forgiveness for Athens. The banks wanted to make a smaller sacrifice.
Ms. Merkel, on the other hand, wanted banks to forgo 50% of their Greek bond repayments, up from an average 10% under the July accord. Governments would guarantee part of what remained.

Early in Brussels on Oct. 27, at a meeting past midnight, Ms. Merkel and Mr. Sarkozy summoned IIF head Charles Dallara into a room at EU headquarters. "This is the last offer," Ms. Merkel said, handing Mr. Dallara a draft agreement that included the 50% demand.

Her unspoken threat: Banks might get nothing if they spurned it.

Mr. Dallara left the room to phone top bankers. The IIF accepted the deal, and investors expressed relief that Greece wasn't pushed into a full default. Italian bond yields paused their upward march.

But the calm didn't last. Late on Oct. 31, Greek Prime Minister George Papandreou threw a wrench into the works by saying he would call a referendum on the bailout.

Europe was horrified. A "no" vote would sink the bailout and push Greece into the biggest sovereign bankruptcy in history.

Bond markets tanked. Euro-zone leaders summoned Mr. Papandreou to Cannes, France, on Nov. 2, ahead of the Group of 20 summit of world leaders.

Penetrating rain dulled the Riviera resort, which in fairer months welcomes movie stars and oligarchs with a palette of sparkling azure. "The real question" for the referendum, Ms. Merkel told Mr. Papandreou there, "is 'Do you want to be in the euro, or not?'"

A taboo had been broken. For the first time, Europe's leaders were openly suggesting that the euro's weakest members could be cast out.
In Cannes, Spanish Finance Minister Elena Salgado made a bet with her German counterpart, Wolfgang Schäuble, that there would be no Greek referendum. She won the wager, and a bottle of fine wine.

In the end, Mr. Papandreou's own party colleagues rebelled against his idea for a plebiscite. He was forced out of office. The Greek bailout remained in place.

The Cannes conclave turned to Mr. Berlusconi. Italy, Europe's leaders told him, was close to being shut out of bond markets. During lengthy discussions, Mr. Berlusconi fell asleep until aides nudged him awake.

Just days earlier, Mr. Napolitano had released a cryptic statement. He considered it his duty, he said, "to verify the conditions" of Italy's "social and political forces." It was code for speaking more openly with parliament's main groups about forming a new Italian government.

On Nov. 8, Mr. Berlusconi, a dominant figure in Italian politics for 17 years, lost his parliamentary majority. Soon he resigned. Mr. Napolitano, with broad assent in parliament, named the respected economist Mario Monti as Italy's new premier.

As 2011 drew to a close, Ms. Merkel's pressure had helped to install the reform-oriented leaders in southern Europe that she wanted, albeit ones that voters hadn't elected. She and Mr. Sarkozy have also steered the euro zone as a whole toward German-style fiscal rigor aimed at balancing budgets and cutting public debt.

But while Germany touts pan-European austerity as the key to stabilizing the region, investors remain doubtful. Italy's bond yields are still at a worryingly high level. And Europe is still looking for money.

—Brian Blackstone in Frankfurt, David Gauthier-Villars in Paris and Stephen Fidler in Brussels contributed to this article.