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BERLIN— The symbolism was perfect, even though it was purely accidental. The setting: the German Finance Ministry, a dull gray edifice on Wilhelmstrasse that once served as Luftwaffe chief Hermann Goering’s headquarters. The scene: a discussion with two Finance Ministry officials. The backdrop: a tall window that framed a Greek flag atop that nation’s neighboring consulate, fluttering in the distance against a crisp blue November sky. The euro crisis— which started in Greece in 2010, spread to Ireland, Portugal, and Spain, and now threatens to engulf Italy—seems to loom over nearly all discussions here these days among officials, pundits, and business leaders. 

Early in the crisis, the Germans evinced denial. Later came frustration. Now they telegraph a grim resignation about the economic challenges ahead, including the possible breakup of the 17-nation eurozone. Yet, for the first time, they are also hopeful that Germany, facing the demise of the common currency that Berlin was instrumental in creating, is finally ready to show more leadership.

German Chancellor Angela Merkel has had an epiphany, her close political advisers say. Merkel’s hesitant approach in the beginning of the euro crisis had involved the bare minimum needed to avoid a meltdown, out of fear that anything more would anger the German taxpayers footing the bill. But her late-October confrontations with Greece and Italy—rejecting Greek plans to put economic reforms to a referendum, forcing the Italian prime minister to resign when she realized that further dithering risked catastrophe—have stiffened the chancellor’s spine. “She is determined that she will not be the chancellor who presides over the death of the euro,” said Elmar Brok, a member of the European Parliament from Merkel’s Christian Democratic Party. Philipp Roesler, vice chancellor of Germany and chairman of the Free Democratic Party, agrees. “You will get more clarity” on Merkel’s vision, he said. “The federal government is going to do everything it can to hang on to the euro and to keep it stable.”

German voters approve, and Merkel’s popularity has rebounded. That improvement will give her room to advance a more assertive, forward-leaning German response to Europe’s financial problems, Merkel’s confidants say. And while financial markets may not yet be impressed (the cost of borrowing continues to rise in crisis-plagued countries), Merkel’s newfound fortitude could be good news for the Obama administration. German passivity in the face of turmoil that threatens to undermine both the U.S. economic recovery and the president’s reelection bid has increasingly frustrated the White House.

The first test of Merkel’s resolve to pull Europe out of its downward spiral will come at a summit of E.U. leaders in Brussels next week. The chancellor has signaled that she will push for closer political union in Europe—to give Europe a finance minister and centralized budgetary oversight—and for changes in Europe’s governing treaty (or agreement among like- minded nations) that would automatically trigger tough sanctions on profligate governments. All of this is intended to make Brussels, not Berlin, the enforcer and thus the boogeyman.

Trouble is, Merkel may be missing the point. The chancellor is attempting to nail down long-term reform in indebted countries before acquiescing to short-term relief measures. In strategic terms, this makes sense.

But she is playing a high-stakes poker game, and she does not hold all the cards. Financial- market players are upping the ante daily:

In strategic terms, this makes sense. Financial- market players, however, are upping the ante daily: They want the European Central Bank to act as the eurozone’s lender of last resort, buying government debt to hold down borrowing costs. They want the euro member nations to raise money by issuing euro bonds backed by all governments, most notably Germany (with its AAA bond rating), to reassure buyers that they will be safe. And they want at least a $1.3 trillion bailout fund for countries at risk of defaulting on their debts. If Merkel does not have these three aces up her sleeve, she risks losing the entire pot: the euro, economic growth in Europe for a decade, the Continent’s prominence in world affairs, and her own legacy.

Events are about to test Merkel’s gamble— and the German public’s willingness to prop up the European economy. The next turn in the unfolding crisis may come before Christmas. A bank run looms, as international money managers reduce their exposure before closing their books at the end of the calendar year, driving borrowing costs for Italy above 7 percent—clearly an unsustainable level. Rome may have no alternative but to turn to the International Monetary Fund for several hundred billion dollars in assistance as early as January, observers here speculate. The IMF will not help unless Europe—and especially Germany—participates in any new bailout.

So as the financial contagion spreads across Europe, threatening to infect the United States, Merkel’s team says that she has gotten serious. The question is, serious enough?

HOW IT PLAYED

The German government’s response to the crisis has been widely criticized as a day late and a euro short. In the spring of 2010, Berlin dragged its feet before consenting to a minor Greek bailout that carried an unsustainable interest rate. At the same time, it reluctantly agreed to the creation of a $600 billion euro- zone bailout fund with so many restrictions that its firepower was much less than intended. Throughout the crisis, Germany initially resisted European Central Bank initiatives to reduce financial-market volatility and increase liquidity. “They are always behind the curve,” complained Henrik Enderlein, associate dean at the Hertie School of Governance in Berlin.

But Merkel’s caution has been the product of political calculus, not miscalculation, said John Kornblum, a former U.S. ambassador to Germany and now an international business consultant here. “They have had a very simple strategy: ‘We can’t get way ahead of our public, our politics, or our courts unless there is a crisis,’ ” he noted. One of Merkel’s close economic advisers explained her style as, “Don’t take big risks. Go step by step. That is how you take people with you.”

That’s also how Merkel has maintained pressure on Greece and other indebted European nations to leverage reforms that they have long resisted. The view from Berlin is that if Germany and others had simply written big checks to cover Portuguese or Spanish shortfalls, those governments would not have cut public spending, raised the retirement age, or taken the other measures needed to get their debts under control.

To her credit, Merkel’s incremental course seems to be working. She has moved the German debate over the proper response to the euro crisis from Bundestag opposition on bailouts 18 months ago to support inside that body today. “She has forced people to go through a reality check, and she has pretty much won the day,” said Thomas Mayer, Deutsche Bank’s chief economist.

That result has helped her with the public, too. After a prolonged decline in popularity earlier this year, marked by electoral setbacks for Merkel’s Christian Democratic Party in several state elections, things have turned around. In early October, only 45 percent of the German public approved of her euro-crisis

management, according to the German television broadcaster ZDF. In November, 56 percent approved.

But Merkel’s critics—an odd mix of liberal and conservative economists and the tabloid press—say that Germany and Europe have paid a stiff price for her tactics. “Popular discontent has risen; intra-European Community tension has grown,” said Gerhard Schick, a Green Party member of the German Bundestag. “Debt levels have risen, and the financial sector is less stable. So we have lost two years.” Reinhard Schlinkert, managing director of Infratest dimap, one of the most respected German polling groups, points out that a majority of Germans don’t understand what’s happening.

The chancellor’s handling of the crisis has frustrated German voters, who resent what they see as Berlin’s creeping rescue of Europe. “There is a growing gap between elite perceptions and voter perceptions,” said Christian Schuette, the commentary editor for the Financial Times Deutschland. “And there is a growing impression that the elite does not know what it is doing.”

Merkel’s critics say that her incremental approach to crisis management lacks principle— a harsh rebuke in the moralistic discourse of German politics. They complain that the chancellor has drawn numerous lines in the sand over the last year and a half, only

to cross every one of them. “If you have someone saying no and then finally saying yes,” observed Enderlein of the Hertie School, “you don’t have credibility.”

Further complicating Merkel’s need to rally public support for bolder initiatives, the shoppers on Berlin’s fashionable Friedrichstrasse or the lunch crowd at popular Café Einstein on Unter den Linden show no concern about the economy. More than half of Germans tell pollsters that the euro crisis has not personally affected them. Unemployment is at its lowest level in two decades. “People have a false sense of security,” said Joerg Rocholl, president of the European School of Management and Technology in Berlin. “They do not realize all the burdens that will come.”

To date, Merkel has confounded the skeptics and outwitted her critics. She has held together her own party and secured the legislative support of the Social Democrats and the Greens, the two major opposition parties, if only because both demand an even stronger German response to the crisis. (The only major resistance has come from the Free Democratic Party, which has long stood for less government involvement in the economy.)

But things will only get harder. Next year, German economic growth is expected to slow to 0.8 percent, down dramatically from 2.9 percent this year, according to the European Commission. “Merkel’s biggest threat isthat 80 percent of the worst part of the euro crisis is yet to come,” Schlinkert said. Peer Steinbrueck, the former German finance minister whom many expect to lead his Social Democratic Party in the 2013 election, is especially worried. “We have to be sensitive that anti-European sentiment could emerge,” he warned.

Survey data bear out that concern. Germans, more than other Europeans, see themselves as victims. Seventy-two percent say that forces beyond their control determine success in life, according to the Pew Global Attitudes survey. Such views are on the rise, and things could get ugly if the economy turns sour. “Germans do not accept that they could be at fault,” said Schuette of Financial Times Deutschland. “If we have a recession, people will think it is [foreigners’] fault, that we were betrayed. And we could go ballistic.” The stakes in navigating the eurozone crisis are high.

WHAT LEADERSHIP MEANS

For much of the last year and a half, Merkel’s cautious (seemingly hesitant) style raised questions about whether the East German- born physicist was up to the job of leading Europe’s most powerful nation. Even her mentor, conservative former Chancellor Helmut Kohl, criticized her for “thinking small.” But in the last few months, Merkel’s critics have begun to have faith. Her game of chicken led to meaningful economic changes in Portugal and Spain, with reform likely in Greece and Italy. So far, she has avoided a eurozone meltdown.

The German electoral calendar now gives Merkel breathing room to take more risks. In 2011, the chancellor faced nine major local elections, so she was always judging any eurozone initiative by its domestic political impact. In 2012, only one German state election is scheduled. “Merkel has a window of opportunity,” the Green Party’s Schick observed. “It’s until the middle of next year. After that, every decision will be framed by considerations for the 2013 national elections.”

The challenge is clear. Italy, and increasingly Spain and France, are in the crosshairs of the financial markets. Unlike Greece, they are too big to fail, but they are also too big to save, at least with current policy tools.

So the options are limited. The European Central Bank can print money to buy more national bonds. The European Financial Stability Facility, the eurozone’s bailout fund, can provide more money for troubled economies. And the eurozone countries can raise money and lower interest rates by issuing joint bonds. The details of these options are constantly evolving because the half-life of new ideas is now measured in days, not weeks. Proposals keep getting shot down for one of two reasons: because of fears in Berlin either of boosting inflation or of Germany’s becoming what people term “the paymaster of Europe.”

Inflation concerns arise out of the fact that the U.S. Federal Reserve Board and the Bank of England have both responded to the economic downturn by buying bonds. The European Central Bank is prohibited from purchasing national debt directly, but it has bought such bonds indirectly in an ineffectual attempt to hold down interest rates. Paris, London, and Washington are pushing for the ECB to purchase more Italian and other bonds to bring those governments’ borrowing costs down to sustainable levels.

Merkel, however, has refused, fearing that any increase in the money supply brought on by such bond-buying would spark rising price hikes. (German officials harbor a phobia of hyperinflation dating back to 1923, when prices doubled every two days.) Inflation would also be seen as breaking a solemn promise to oters. In 2001, when the deutsche mark was exchanged for the euro, Berlin vowed that the move would not lead to rising prices or a loss of control over the currency. Given an aging population and a high savings rate, any debasement of the euro would erode German pensioners’ nest eggs, sparking voter fury. “If it comes to choosing between stable money and the euro, the German people will choose stable money,” observed Dorothea Siems, senior economic policy correspondent for Die Welt.

Germans do not widely acknowledge how little inflationary pressure exists today. (The current rate is just 2.5 percent, compared with 3.5 percent in the United States.) But some German officials have begun to push back against anti-inflationary fears. “Even if you have had a bad experience with floods in the past, you need to use water if your house is on fire,” former Deputy German Finance Minister Thomas Mirow told the Financial Times Deutschland.

On the paymaster problem, Germans know they have the richest economy in Europe. If more money is lent to indebted countries, it will have to come out of Germans’ pockets. ECB board member Juergen Stark speaks for many Germans when he says, “Being the lender of last resort is not our job.” Germans are also aggrieved that they bore the $1.9 trillion cost of German unification in the 1990s largely on their own.

Nevertheless, the ECB is working on various plans to increase the pot of available bailout money over German opposition. And, on this issue, the Social Democrats have split with Merkel. “The [bailout fund] is not big enough,” Steinbrueck said. “You have to tell voters the truth—that Germany has to pay and that it is in Germany’s self-interest.”

Europe’s third policy option is to issue euro bonds, which would be backed by the full faith and credit of all eurozone governments, but which would effectively be backstopped by Berlin, the most credit-worthy government. Germans fear that offering such guarantees would raise their own cost of borrowing. It would, but even if interest rates doubled, Germans would still be paying less than they did in 2008.

The European Commission has proposed several bond alternatives. One would replace all national-government bond issues in the eurozone with euro bonds. Another would replace only some of them. The German Council of Economic Experts, which advises the government, has proposed its own partial sharing of sovereign debt. Merkel has rejected all such proposals. “There is no way it will work,” she said in a speech in late November, because, in the end, someone will be responsible for all that new debt—and Merkel fears it would be her taxpayers.

The German Constitution only complicates things. Its integrity is jealously guarded here (another constraining legacy of Germany’s traumatic past). Any effort that appears to run roughshod over the constitution would frighten the public. The Constitutional Court ruled recently that future German participation in eurozone bailouts must first gain Bundestag approval. Moreover, the court has temporarily banned Bundestag efforts to streamline this decision-making process, foreshadowing delays in German rescue efforts. The only way to change this would be to amend the constitution. “For Merkel,” said Enderlein, “it would amount to political suicide.”

So, in the short run, Merkel is pursuing changes in the eurozone’s founding treaty— which promises to be a protracted process— or, barring that, an intergovernmental agreement among the major European economies. She wants to give Brussels new powers to force budgetary discipline on member governments. This is music to the ears of her constituents, who crave assurance that profligate governments will not waste German cash. More than half of Germans (54 percent) think that the European Union should have greater authority over member states’ economic and budgetary policies, according to the 2011 Transatlantic Trends survey by the German Marshall Fund of the United States.

BUT CAN SHE DO IT?

Merkel’s resolve to save the euro faces an uphill climb, weighed down by German public opinion, constitutional constraints, and, most important, fickle and impatient financial markets. “If Italy plays by the rules,” Enderlein said, “then things stabilize. But if you get Italy wrong, then it’s a total disaster.”

That realization has given rise to discussion here about a breakup of the eurozone. In late November, Moody’s advised its clients: “The probability of multiple defaults by euro- area countries is no longer negligible. A series of defaults would also significantly increase the likelihood of one or more members not simply defaulting, but also leaving the euro area.” Hans-Olaf Henkel, the former president of the Federation of German Industries, has proposed that Germany, Austria, Finland, and the Netherlands leave the eurozone and create a new currency, what some call a northern euro.

The Merkel government—and the German business and political establishment—have rejected this heresy. “A northern euro would appreciate to the moon,” said Steinbrueck, damaging German exports and the nation’s economic health. But in Schlinkert’s surveys, 46 percent of Germans say they wish they had kept the deutsche mark. The electorate is divided over whether Germany should hold a referendum to keep the euro as the country’s currency. “A serious breakup of the euro would be the Armageddon scenario,” said the Financial Times Deutschland’s Schuette. “But I don’t think the German public believes the Armageddon scenario. And if they do, they underestimate the consequences.”

After months of cautious moves in response to the euro crisis, during which she has been criticized by some as weak and praised by others for keeping the pressure on debtor nations, Merkel is ready to provide the kind of leadership that can come only from the German chancellor, insiders say. It would go beyond reforming the eurozone treaty. Closer oversight of national budgets, sanctions for running deficits, and more-centralized fiscal policy are necessary but not sufficient cures for Europe’s ills. The European Central Bank needs to act as a lender of last resort. Europe needs a bailout fund that is large enough to intimidate financial speculators. And indebted countries need to be able to raise money at lower interest rates through the issuance of euro bonds. Although none of this will be popular in Germany, Merkel now has the time on the political calendar, the revived political support, and, according to aides, the determination to do what is needed to save the euro—and, by extension, Europe’s future.

There is, however, no evidence yet of such decisiveness. And time is not on Merkel’s side. With the fate of Europe’s economy, and that of the United States’, hanging in the balance, the White House can only hope she finds the backbone to act.

Bruce Stokes is a contributing editor at National Journal and a senior fellow for economics at the German Marshall Fund of the United States.