What Draghi got on Thursday, April 25^th was more than just tacit support. He received an explicit green light for a new ambitious program that the ECB is on the verge of launching, perhaps as early as next week but no later than June.

Merkel gave her consent while speaking in front of an audience of representatives from the German savings banks association. For the many observers that are exclusively focused on interest rate cuts as the primary tool capable of injecting life into a faltering European economy, what they heard was alarming. Merkel dismissed the idea that the ECB should lower interest rates. If anything, she believed that rates should even go up for Germany. It sounded like a warning shot across the ECB’s bow.

Nothing could be further from the truth. Pouring cold water on the idea of lowering interest rates was not Merkel’s main argument. More importantly, she stressed that what is currently needed is a way to get cheap credit to those SME’s in the periphery of Europe that are having a hard time accessing funds.

For weeks, Draghi and fellow members of the ECB’s executive board have argued along the exact same lines. They have repeatedly stressed that as long as low interest rates are not successfully transmitted to all of the euro zone’s banks (and this is presently the case), it does not make much sense to be tinkering with them. What is needed, they have argued, is a set of new instruments designed to get credit flowing again.

Based on public and private remarks made by representatives of the European Commission, the European Investment Bank and the ECB in Washington during the recent spring meetings of the International Monetary Fund (IMF) and World Bank, I have concluded that this time the ECB is working on a plan that would involve all three European institutions. Needless to say, no details were offered. And of course, it is difficult, if not impossible, to imagine how the ECB could lend directly to SME’s. Hence, this time it is the EIB, under its head Werner Hoyer, that could play a central role.

The main aim of the new program would be to encourage the securitization of loans made to small and medium sized companies. The central part of the concerted action undertaken by the ECB, the EIB and the EU Commission should be to provide a guarantee for those securities and reduce the risk to banks.

Whatever shape the program might take, the ECB will continue to remind politicians that they are not off the hook and that most of the homework still rests with them. They need to address the underlying structural reform backlog that is hampering a recovery. However, once again Mario Draghi seems prepared to act in a moment of need. We now know that Merkel will give her placet to the new experiment.

On Monday, the German administration felt forced to reassure its citizens that their savings are safe. For months, Germany had made it quite clear that some form of bail in, i.e. private participation of Cypriot depositors in raising the necessary funds, was necessary as part of a deal to rescue Cyprus. Merkel and other creditor countries needed to address their own bailout fatigue. The fact that Cyprus has the reputation of allowing Russian oligarchs to launder their money through Cypriot banks has made things much more complicated. Going after bond-holders did not make much sense. Corporate bonds of Cypriot banks are small in size, with the bonded debt amounting to a mere 1,7 billion euros against some 70 billion euros in deposits. Cyprus needed a country specific solution, one that included bank depositors. More importantly, the deal needed to be credibly sold as such.

But instead of doing just that, the euro zone and the International Monetary Fund (IMF) managed to jeopardize the fragile European stability of the past few months. By forcing Cyprus to raid small bank deposits (those worth 100,000 euros or less), they have triggered renewed turbulence in the financial markets. In fact, this deal has been sold so badly that, on Monday, even the U.S. Treasury felt it had to publicly urge Europeans to find a fair solution. Cyprus is now scrambling to tweak the deal and will first try (and probably fail) to extract better conditions from Europeans. In the meantime, banks in Cyprus remain closed.

There is much blame to go around. However, the main mistake was for Europeans to allow Cyprus to decide on its own how to raise the 5,8 billion euros needed from deposit holders. Contrary to initial reports, Germany and others did not insist on raiding small depositors. How to raise the money was largely left to Cyprus itself. According to many media reports, it was the government of Cyprus that resisted putting a much heavier levy on accounts exceeding 100,000 euros. It did not want to excessively squeeze big depositors (including Russians), for fear of losing them. Europeans made the mistake of not protecting small depositors.

Some have criticized Europe of being too hard with Cyprus, others of not going far enough. But there are also those who think that overall Europeans did the right thing. Everybody seems to agree on the fact, however, that asking small depositors to pay a high price for Cyprus’ rescue was a mistake. Just how bad is not clear yet.

For opposing views and further analysis on the developing situation in Cyprus:

The Cyprus bank Deal: What it Means, by Jakob Funk Kirkegaard. Originally published by the Peterson Institute for International Economics

Draghi barely mentioned the currency in his prepared remarks in the press conference after the regular meeting of the governing council, merely pointing out that the central bank is monitoring the situation on foreign exchange markets. “We want to see if the appreciation is sustained, and if it alters our assessment of the risk to price stability,” he said. Those words proved to be sufficient to send the euro two cents down versus the dollar. Within minutes of the end of his press conference, the common currency started declining versus all but two of its major counterparts. Draghi had achieved what many politicians in the periphery of Europe would like him to do: weaken the euro.

However, as has been the case with the launch of his bond buying program known as OMT (Outright Monetary Transactions), Draghi had done so without firing one single shot. How did he  do it? And what exactly happened today?

Draghi still has a credibility surplus that allows him to move markets without actually doing anything. On Thursday Feb. 7^th, he once again successfully managed expectations. Markets still very much believe that he is prepared to do whatever it takes to save the euro. They are reluctant to test whether he can actually trigger the huge weapons he has brought on deck.

He walked a very fine line between France (whose President Francois Hollande thinks that the euro should be weakened by intervening on currency markets) and Germany (whose leadership believes nothing should be done, not yet at least). He continues to be a master in monetary diplomacy.

He did not specifically talk about countermeasures he would take should the impression arise that a G20 country had started to manipulate its currency in order to gain a competitive advantage. However, by mentioning the ECB’s inflation target (2%), he hinted at further easing should the euro zone slip into deflationary territory. Draghi did not say however, whether the governing council would merely lower interest rates or even consider following others (FED, Bank of Japan or Bank of England) on their path of quantitative easing.

My guess is that he would like to do none of the above, hoping that words can mitigate the effects of measures undertaken by others (in particular Japan) that are weakening, and will probably continue to weaken, their currencies. So far the euro is still moving within its historic band of fluctuation. But for how long? Draghi today merely acknowledged that the so-called currency war has appeared on his radar screen. But what he intends to do about it if things really heat up is far from clear.

On his first visit to Berlin as French Prime Minister, Jean-Marc Ayrault is slightly more diplomatic, but the essence of his message to Germans is similar: stop lecturing us. The stuttering Franco-German engine is back in the spotlight as mutual frustrations are growing on both sides of the river Rhine. Germans believe that the new French President Francois Hollande is showing unwillingness to reform his country; the French are frustrated by what is perceived as a persistent German attempt to turn the whole continent, including France, into Germany. The debate between austerity and growth is back where it was a few months ago. But the simmering tensions between Germany and France go deeper. Germany and France have to find a new balance. The crisis management of the former French President Nicolas Sarkozy and German Chancellor Angela Merkel clearly did not work to France’s advantage. Merkel has to understand and accept that France is looking for alternatives to reestablish some sort of equilibrium. The recent debate in Germany does not help to strengthen the ties to the new government in Paris. Here it is in a nutshell:

The German political elite seems to think that in order to avoid the wrath of financial markets, France’s economy needs to reduce the size of the public sector, reform the labor market, and create the conditions for small and mid-sized companies to grow. Higher taxes and deep spending cuts are unavoidable. France could quickly become the sick man of Europe if it does not act decisively. In other words, Germany and many economists are suggesting to France to swallow the same bitter medicine that other big European countries such as Italy and Spain are taking to cure themselves from past sins.

President Hollande recognizes that he and his country have a problem. However, he is still struggling to find the right balance, and any outside intrusion makes his job more difficult. So far, France has been rewarded by financial markets not because of its stellar economic performance, but because of its closeness to Germany. Even at the height of the euro crisis, financial markets thought that Germany would stick with France and vice versa, even in the event of a partial breakup. Hence, Paris’ political elite fears that rising tensions between Hollande and Merkel could spook investors and turn them against France. Things could unravel very quickly. Any lectures from Berlin increase the risk for Germany as well as for France.

Here are some of the key points made by participants: The so-called Asia pivot that many Europeans seem to be so worried about is largely a rhetorical tool designed by the U.S. to mask its disengagement from Afghanistan. The focus on Asia and China in particular is nothing new. It occurred long ago and Europeans are looking to Asia as much as Americans do.

It is true that the Obama administration had tried to broaden its horizon in his first term. The President looked for new friends to add to his traditional European allies, but the forum that he hoped would help him to move towards that goal, the G20, failed to deliver. In the end, he has rediscovered it European friends because it is easier to deal with them and because the euro crisis has turned the old continent into a global problem that even jeopardized to thwart his efforts to get reelected. The election is won, but the potentially devastating impact of a worsening euro crisis still exists.

However, the economic challenges in the U.S. and Europe will have an adverse impact on foreign policies. Charles Kupchan of the Council on Foreign Relations pointed out that he does not expect this alliance to do much in the next four years. According to Dr. Kupchan, these “will be four years of transatlantic retrenchment.” In other words not much activism is to be expected. The weak economy will, according to him, sap all the energy of American and European politicians. He even expressed skepticism about the U.S.’ ability to deal with the fiscal cliff, pointing out that the makeup of the political forces that should deal with that challenge is still the same that caused gridlock before the election.

Overall there was a sense that there will be reluctance on both sides of the Atlantic to look for foreign policy challenges. Of course, all of the conferences participants agreed on the fact that a military intervention could be forced upon the U.S. by Iran. In that case, the rather exhausted alliance could face some severe stress. Teheran and its nuclear program have the capacity to act as an abrupt wake up call.

If therefore appears that the answer to the central question posed at the conference is neither will we thrive together nor wither apart. The answer is in fact that we will likely wither together.

Those who expect the summit to include a Spanish bailout request, a deal to keep Greece afloat, and serious progress towards a banking union could end up being seriously disappointed. Europeans are not close to a breakthrough on any of these three topics. After all, they are also waiting to see what happens on November 6^th, as well as in the following weeks when the U.S. will try to tackle its own fiscal cliff. Nevertheless, this week’s gathering in Brussels is still a serious test. It should at least allow us to better understand how committed European leaders still are in completing the tasks they gave themselves at their ‘historic’ summit meeting in late June. Most importantly it will shed some light on Germany’s true intentions.

Let’s begin with Greece. All the noise coming out of the German government indicates that a ‘Grexit’ is not in the cards − not now, not in the future. “It will not happen that there will be a ‘Staatsbankrott’ in Greece,” German Finance Minister Wolfgang Schaeuble said while touring Asia after the annual World Bank and International Monetary Fund meetings in Japan. He added that speculating on Greece leaving the euro does not make any sense. German Chancellor Angela Merkel’s recent visit to Athens, while largely tailored to meet demands of her domestic audience, carried the same message. However, in order to avoid sudden, unforeseen hick ups, Berlin needs some help from Athens, i.e credible reforms. That is where things get complicated, and that is also why timing events matters. In order to avoid market turbulence before the U.S. election, a decision on Greece will probably be taken later in November. There is just enough time to do that. By its own accounts, the Greek government will run out of cash at the end of that month.

This takes us to Spain. It is not only the government in Madrid that still resists making a bailout request. Spanish Prime Minister Mariano Rajoy’s stubbornness is equal only to Schaeuble’s refusal to expedite the process. Germany is trying to hold off as long as it possibly can, as the Germans are not at all convinced that Spain needs a new bailout.

They believe that Spanish banks’ needs are already taken care of through the 100 billion euro heavy war chest dedicated to that very task. Schaeuble believes that financial markets have not yet understood how much progress Spain has made. When they do, he argues, Madrid will be rewarded and pressure on Spanish sovereign bonds will ease. Unfortunately, the German posture is almost exclusively driven by the need to protect German taxpayers and voters from a new round of financial transfers to the periphery, not by underlying economic realities on the ground. Germany wants to bundle any help to Spain, Greece and Cyprus into one big package in order to confront the German Bundestag only once and not three times. Even Berlin knows that despite some recent competitiveness gains, the Spanish economy is not likely to bounce back anytime soon and will likely need more help. The recession continues to negatively impact tax revenues and is putting additional strains on the Spanish budget. Austerity could indeed become self-defeating. Moreover, if Spain does not request a ‘full macro economic adjustment program’, the European Central Bank’s bond buying program cannot be activated. Financial markets could end up perceiving the Outright Monetary Transactions (OMT) as a giant bluff. We know what that means: a negative reaction by financial markets, pushing yields for Spanish and possibly Italian bonds up dramatically. More importantly, investors could even start questioning the ECB’s credibility.

Stock markets reacted promptly by retreating, as investors seemed to anticipate both a weaker earnings season and heightened volatility in the coming months.

This past week offered enough evidence to support both growing unease and cautious optimism. Let’s focus on the brighter side first.

The week started with a largely symbolic visit by the German Chancellor to Athens. Officially, no promises were made, but it is clear that Angela Merkel’s message to Greek Prime Minister Antonis Samaras is that Germany will support Greece if Athens undertakes some more decisive steps on the path of reform. In other words, Merkel needs to feed her skeptical electorate with some tangible, albeit limited, results in order to convince her voters that Greece needs to stay in the euro zone and receive either more money or more time to meet its fiscal targets.

Now to the less positive developments. Leading German economists, presenting their economic outlook in Berlin this week, disagreed with the Chancellor. They argued that Greece will not be able to recover without restructuring its debt, now largely held by the official sector. Of course, the German government will not allow this to happen a year before the general election. However, a shift in the debate in Germany from so-called Grexit scenarios to a more sober and realistic assessment of situation is a positive sign.

The leading economic institutes also issued a stark warning about the health of the German economy, now clearly suffering from the economic crisis in the periphery of the continent and in danger of slipping into recession if things deteriorate further. If Merkel takes their advice seriously, she will try to do what she can in order to avoid unsettling financial markets. Renewed uncertainties about Europe could push the German economy into a recession right in the middle of an election year. Merkel must realize that what the fragile European economy needs now is a period of relative calm, not a new existential crisis.

However, the week also offered a cautionary tale about the difficulties of overcoming the deeply seated diffidence within Europe. It was government discord that killed the merger between the two defense and aerospace giants EADS (European Aeronautic Defense and Space Co) and BAE Systems. According to several media reports, it was the Chancellor who informed the French President that there would be no deal. She did not feel that German interests were sufficiently protected by the merger. Despite all the talk of more European integration, national interests trumped the need to forge a strong European company. To be sure, other obstacles played a role as well. But the collapse of the negotiations was a stark reminder of how big the gap can be between the high-flying rhetoric advocating a closer Europe and the parochial realities on the ground. The continent’s politicians still haven’t decided whether they are merely moving towards closer coordination or if they are on a path towards closer integration, whether the goal is a diffident or  rather a more decisive Europe.

However, in Europe, recent statements by Chancellor Angela Merkel suggest that in order to skip a new band of black clouds that are gathering at her autumnal horizon, she is now willing to accelerate the sluggishly paced rescue of the euro zone. That is welcome news. Here is why I believe that Merkel has realized that Europe needs to turn the corner in the next few months.

The German economy is slowing down. Exports have already been hit by the steep recession in big economies such as Spain and Italy. The German business confidence Index has fallen for the fourth consecutive month. German consumer sentiment will inevitably suffer and that could lead to a contraction of the German economy. If Germany slips into recession, it will become much harder for Merkel to sell the rescue of the euro zone domestically. Furthermore, the Chancellor’s credentials as a careful crisis manager could be severely challenged. To her, it has become imperative to keep the euro zone intact. In fact, it seems that Merkel is finally trying to ban all premature talks about a Greek departure from the euro. A new verbal assault against Greece by the Secretary General of the Bavarian sister party of Merkel’s CDU, Alexander Dobrindt, was met by a barrage of scathing criticism from within the government coalition. Over the weekend, in a TV interview, Merkel suggested that everybody should weigh his of her words very carefully when talking of a Greek exit, because the crisis is entering a decisive phase. Other members of her coalition were less polite. There is a palpable sense that Merkel has realized that the debate within her government, rife with daily speculations about a partial break up of the common currency, has created uncertainty among investors and exacerbated the crisis.

The German government is also trying to address the doubts of Bundesbank President Jens Weidmann about a renewed intervention by the European Central Bank (ECB) on bond markets. “We should not underestimate the danger that central bank financing can become addictive like a drug (…) such policy is too close to state financing via the money press for me.” Weidmann told the German weekly “Der Spiegel”. Even more importantly he added, “in democracies, parliaments rather than central banks should decide on such an encompassing mutualization of risk.” In other words, politicians need to address the underlying institutional challenges of the euro zone, rather than rely on bigger and bigger band-aids provided by the ECB. The point that Weidmann is trying to make is that if pooling debt is the answer to the problems of the euro zone, the decision has to be taken by politicians and not through the back door, such as by relying on the ECB. Despite all the talk about a deep rift between Weidmann and the president of the ECB Mario Draghi, these are words than Draghi could have uttered himself.

The German Chancellor has, of course, more than just one objective. Understandably, she wants to win another term in late 2013 when Germans go to the polls. She is a political animal, after all. At the same time, Merkel is trying to avoid going down in history as the woman who destroyed the euro and Europe. Last but not least, she would like to put her country and the continent (in particular the common currency) on a stronger footing, better equipped for the global challenges Europe and Germany are facing − both morally and economically. In her eyes, economic growth and morality are closely linked, which is why she politely resists the adoption of Anglo-Saxon solutions, such as solving a debt crisis by issuing more debt (which explains why American leverage in this crisis is close to zero).

Sometimes, Merkel’s objectives converge and she comes across as a strong leader on top of her game. In these instances, tactics designed to gain time, or to put it more bluntly, kick the can down the road, seem part of a well thought out strategy, which runs something like this:

-German financial solidarity comes in small doses. Well wrapped in a fog of nuance and complication, these interventions are easier to stomach for German voters, and they keep markets guessing.

-No government in the euro zone, particularly in the periphery, should feel safe from market pressure. Incentives for those governments to rein in spending and push reforms to regain competiveness outweigh inertia.

- Euro zone governments and institutions are pushed together by the crisis. The willingness to give up sovereignty (even in countries such as France or Spain) grows. In this scenario, the euro zone survives and becomes much more German. Merkel’s victory at the general elections in late 2013 is assured.

Unfortunately, with the situation in Spain worsening, her master plan is now in jeopardy. The botched attempt by European officials to calm markets with a bold announcement (recapitalizing Spanish banks with 100 billion Euros) fell flat when it became clear that no details had been worked out. Creditors feared they would eventually loose some or all of their money. It was a brutal wake up call. Merkel should now realize that the same market forces that she has tried to deploy as a tool to keep up the pressure on peripheral countries can also very quickly disrupt her overall strategy.

When her different goals threaten to pull her in opposite directions, the price for Merkel and Germany grows dramatically. It might include:

I beg to differ. This meeting was never meant to come up with concrete solutions. Greece has not voted yet, Irish voters still need to decide whether the fiscal compact will be ratified, and Francois Hollande himself is still in campaign mode by getting ready for national assembly elections due in mid June. More importantly, a few positive, yet overlooked elements did indeed emerge during the gathering of European leaders.

Herman von Rompuy, the president of the European Council was given the task of sketching out concrete steps towards closer integration of the euro area, so called “building blocks”. They should be put on the table at the next summit at the end of June. One part of his task is to explore if a cross border deposit insurance could help to stabilize the banking sector, and in particular to avoid a panic driven bank run should Greece leave the euro. A deposit insurance would not only protect most of the euro zone from a destabilizing Greek contagion, it would in effect open the door to a truly integrated European banking system − something Germany and others had resisted vehemently in the wake of the Lehman Brothers collapse in September 2008. The European Central Bank is a strong advocate for a centralized bank resolution.

As to Eurobonds, they are on the way, but with a different nametag. Hollande has never defined what Eurobonds should look like. Merkel has done it for him. What Merkel is rejecting is the idea of mutualizing ALL Eurozone debt. In Merkel’s definition, Eurobonds amount to a full insurance policy that would only benefit profligate euro zone countries. Such a scheme would encourage moral hazard and would never pass the German smell test. According to her, this type of Eurobond could only be introduced if more sovereignty was transferred from member states to central European authorities and a true fiscal union emerged. Whether Hollande and other Eurobond advocates, such as Italian Prime minister Mario Monti, would completely disagree with Merkel on this point is an open question. Probably not. But there are many types of Eurobonds. Ultimately what Italy, Spain and France want more than anything else is not to pool all debt, but to drive interest rates down to a sustainable level and to avoid falling into a debt trap. What they need is a partial insurance policy. That is something Germany’s governing coalition is much more open to. In effect, leading German economists have already submitted a detailed proposal that would more or less work like this: all debt in excess of 60 % of GDP (the famous limit set up in the Maastricht treaty) could be pooled into a Eurozone debt redemption fund that could be paid down over 20 to 25 years. To service this debt the pool would issue common bonds. Interest rates would come down to a more sustainable level and the huge debt stock of euro zone countries, including Germany’s, would gradually shrink. Of course, in order to finance the rest of their debt, member countries would need to continue to issue their own bonds. In order to avoid excessive market pressure member states would have a strong incentive to keep their deficits under control. This solution is gaining traction in Germany, because it addresses both the practical problem of reducing the debt stock and the moral hazard. It reflects the German willingness to show solidarity but only in exchange for good behavior.