How ECB Chief Outflanked German Foe in Fight for Euro

The ECB's shift to create money to purchase struggling countries' debt without limit was dependent on Mario Draghi's cultivations of links with German political leaders to outmaneuver Bundesbank President Jens Weidmann says WSJ's Brian Blackstone. Photo: Getty Images

As Mario Draghi watched euro-zone markets disintegrate in late July, he scribbled two sentences into the margin of an otherwise routine speech for London investors, changing the course of the three-year-old euro crisis.

"Within our mandate, the ECB is ready to do whatever it takes to preserve the euro," the European Central Bank president jotted. "And believe me, it will be enough."

The ECB had long resisted using its most powerful tool—its printing press—to save struggling European governments from the debt crisis. The Bundesbank, Germany's influential central bank, warned of dark consequences if the ECB tried that. Now Mr. Draghi, the ECB's Italian chief, was signaling that it would defy its biggest shareholder.

Investors' loss of confidence in the very survival of the euro convinced him there was no other option. Lenders were turning away from Spain and Italy, where a government insolvency could destroy the dream of European unity and rock the global economy.

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Bundesbank President Jens Weidmann, defending its anti-inflation rigor, opposed new ECB bond buying.

By agreeing to create money to purchase struggling countries' debt without limit, the ECB has ushered in the decisive phase of Europe's battle to save the euro. If the ECB's resort to the printing press fails to stabilize markets and buy time for crisis-hit countries to recover, nothing else will, economists say.

Even if it works, the ECB will emerge a fundamentally different institution, having abandoned major planks of the economic orthodoxy that shaped its charter and first decade. A more activist central bank, while welcomed in most European countries, is already confronting deep skepticism in Germany, where fears are growing that it is sowing the seeds of inflation.

A loss of German support for the euro would call the currency's viability into question anew. The controversy over the ECB shows how the euro crisis is fueling tension among European nations. While many Germans fear a takeover of the currency union by Mediterranean countries, many southern Europeans feel that German obstinacy is prolonging the crisis.

This account of the ECB's momentous shift, based on interviews with numerous officials familiar with the events and with central players' thinking, shows how the cautious Mr. Draghi changed his mind about the bank's role and cultivated German political leaders to outmaneuver Bundesbank President Jens Weidmann, in a tactical struggle to redefine Europe's strategy against the crisis.

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Mr. Weidmann, sitting in his vast Bundesbank office with panoramic views of the Frankfurt skyline, was taken aback. Mr. Draghi soon called him from London to explain his remarks, arguing that markets had been betting on the breakup of the euro and that was unacceptable.The battle lines were drawn immediately after Mr. Draghi's London speech on July 26.

Mr. Weidmann countered that investors were betting against Italy and Spain because of flaws in their economies that only national politicians could fix. ECB bond buying would just take the heat off them.

"This is a political problem that in my view needs a political solution," Mr. Weidmann told the Italian, according to people familiar with the conversation.

For Mr. Weidmann, the ECB's gambit betrayed its founding principles, which were rooted in the traditions of the Bundesbank and the lessons of Europe's postwar history. Though only 44 years old, Mr. Weidmann views himself as a defender of the German bank's legacy, against some nations' laxer monetary mores.

As a boy in the late 1970s, he learned the difference between the German mark and Europe's softer currencies during family vacations. On the mountainous Gargano peninsula in Italy's rustic southeast, he was struck by locals' use of gettoni, or tokens, in pay phones—because the value of lira coins was falling so fast that phone booths couldn't keep pace.

By his late teens, Mr. Weidmann said recently, he had "inhaled" the Bundesbank view: Central banks exist to defend a currency against politicians' cravings for easy money.

Germany's obsession with price stability is often said to stem from 1920s hyperinflation under the Weimar Republic. But for modern Germany's economic elite, it is rooted in a more recent experience: the postwar success of West Germany.

In Germans' collective memory, the Bundesbank's refusal to make politicians' life easy by printing money was critical. Though the Bundesbank briefly bought German bonds amid a recession in 1975, it soon stopped, and West Germany emerged with less inflation, debt and unemployment than most other Western countries. "Not all Germans believe in God, but all believe in the Bundesbank," former European Commission President Jacques Delors once said.

During the troubled 1970s, Mr. Draghi was a doctoral student at the Massachusetts Institute of Technology, pondering why Italy was turning from a fast-growing economy into a financial mess.

When central banks buy bonds in large quantities, they pay for them with newly created money. Mr. Draghi concluded that Rome's habit of force-feeding its central bank with public debt was debasing the lira.

Mr. Draghi became one of Italy's most effective public officials in the 1990s, spearheading efforts to tame the budget deficit and qualify for euro membership. After a stint at Goldman Sachs, he became head of the Banca d'Italia in January 2006 at the age of 58.

Two weeks later, Germany's new chancellor, Angela Merkel, hired Mr. Weidmann, then a 37-year-old star analyst at the Bundesbank, to be her chief economics adviser. Mr. Weidmann became her most important aide during the global financial crisis and the euro-zone storm that followed.

In early 2011, Bundesbank President Axel Weber resigned after protesting a more limited ECB move to buy struggling euro nations' bonds. Mr. Weidmann got his job.

With Mr. Weber out of the picture, Mr. Draghi became the front-runner for next ECB president—to the dismay of many Germans.

"Please not this Italian," wailed the tabloid Bild. "Mamma mia, for Italians, inflation is a way of life, like tomato sauce with pasta!"

Yet Mr. Draghi's credentials were strong. He presented himself to German media as a believer in the Bundesbank's anti-inflation orthodoxy, calling Germany "a model" for the rest of the continent. It worked. Ms. Merkel swung behind him. Bild declared him "rather German, even really Prussian."

The crisis, however, was taking a turn that would test Mr. Draghi's adherence to the German playbook.

By mid-2011 investors were fleeing Italian and Spanish bonds. Influential economists argued for a rethink of the ECB's role, saying what worked for Germany under the mark didn't necessarily work in a multinational currency union. They said only the ECB could prevent runs on countries, by promising to support their bonds, just as central banks backstop banks.

The ECB's Governing Council debated the argument that summer. Many of the national central-bank heads were sympathetic to it. Not Mr. Weidmann. Did central-bank officials know better than investors what a fair bond yield on governments' debt was, he asked. And was 7% really a calamity, or just unpleasant for finance ministers?

Afraid of a German backlash, the ECB bought Italian and Spanish bonds only halfheartedly, stressing that the buying was "limited" and "temporary." Bond investors weren't reassured. And then Italy, which had promised economic overhauls, reneged. The ECB, shaken by the experience, let struggling countries' borrowing costs rise again.

Mr. Draghi had stayed quiet during the debates. When he took over as president in November, he dashed hopes of more decisive bond buying. Instead, he launched a program to support banks with cheap loans.

The move brought a brief calm to bond markets. In early March, Mr. Draghi shelved what was left of the bond-buying program, after concluding it was ineffective. Mr. Weidmann thought he had won the argument.

The unraveling of euro-zone financial markets this summer forced Mr. Draghi to rethink.

Northern Europe's savings were steering clear of southern Europe's borrowers. So despite a wave of policy overhauls by new national leaders, Italian and Spanish borrowing costs were rising, to unsustainable levels. As they rose, so did borrowing costs for the countries' small businesses, and they were gasping for affordable credit.

Political turmoil in Greece raised the odds of a euro exit that many feared would trigger bank runs across Europe's south. Companies around Europe made preparations for a breakup of the euro. Investors were increasingly pricing in catastrophe.

Mr. Draghi and allies on the ECB's executive board, especially Benoit Coeuré of France and J?rg Asmussen of Germany, decided they needed a contingency plan. In late June, they and a few staff members began working in secret on a new bond-buying plan, one without the flaws of the previous effort.

This time, the ECB would help a government only if it signed on to strict policy conditions. Then, the bank would intervene without limit.

Mr. Draghi knew he would face blowback in Germany. A chorus of media, lawmakers and economists there would accuse him of risking inflation, exceeding the ECB's mandate and violating European treaties. He needed support from the highest level in Berlin.

Over months of calls and discreet visits to the chancellery, he had been building up a relationship of trust with Ms. Merkel and her veteran finance minister, Wolfgang Sch?uble. Mr. Draghi kept them informed of how his thinking was evolving.

Both Ms. Merkel and Mr. Sch?uble were dubious of bond buying. They worried it might not work, and might remove the pressure on Italy and Spain to shrink deficits and ease rigid labor rules. But they also knew that euro-zone governments' bailout funds were too small and cumbersome to save Italy and Spain in case of a full-blown market run. Only the ECB could intervene quickly and massively.

For weeks, Mr. Draghi watched euro-breakup fears building in the 30 to 40 financial indicators he studied daily. When he arrived in London on July 24, Spanish and Italian bond yields were spiking.

The ECB's plan wasn't yet ready. Mr. Draghi hadn't informed national central-bank chiefs. But, fearing a summer of chaos, he decided to vow publicly to do "whatever it takes."

Markets rejoiced at his July 26 speech. He knew the German backlash would begin the next day.

That evening, he phoned Mr. Sch?uble, who was vacationing on the sandy North Sea island of Sylt, and asked him to help publicly defend the ECB from German media fury.

Mr. Sch?uble, the German government's strongest believer in the euro and European unity, agreed, overriding finance-ministry officials who advised him not to comment on decisions of the central bank.

Mr. Draghi also called French President Fran?ois Hollande and asked him to lobby Ms. Merkel for a joint Franco-German declaration of support. The chancellor, who was on a hiking vacation in the Alps, told Mr. Hollande she was comfortable with Mr. Draghi's move but wary of making a public statement on ECB matters. The two leaders' aides negotiated a wording.

The next morning, the Bundesbank launched its expected counteroffensive to Mr. Draghi's speech, attacking bond-buying as "problematic" and "not the most sensible" way to tackle the crisis.

But at lunchtime, Mr. Sch?uble issued a statement welcoming Mr. Draghi's promise to preserve the euro. Soon afterward, Ms. Merkel and Mr. Hollande declared their determination to do "everything" to defend the euro and called on "European institutions" as well as national governments to do their duty.

Berlin had broken with the Bundesbank. Mr. Draghi had the cover he wanted.

On Aug. 1, a day before the ECB's Governing Council met to approve Mr. Draghi's plan, the Bundesbank website published an in-house interview with Mr. Weidmann in which he argued that his institution deserved special influence inside the ECB. "We are the largest and most important central bank in the Eurosystem and we have a greater say than many other central banks," he said.

But Mr. Weidmann lacked allies on the ECB's Governing Council. Over a dinner at ECB headquarters on Aug. 1, the council members drew up a plan for bond buying. There was one big proviso: Before the ECB would buy their bonds, governments must ask other European countries for credit from the euro-zone bailout funds. That meant agreeing to policy conditions and intrusive monitoring.

At the next day's council meeting, Mr. Weidmann asked Mr. Draghi to make clear at a news conference that substantial differences remained within the ECB over bond buying.

Instead, Mr. Draghi said only Mr. Weidmann had reservations. That broke the ECB's tradition of not naming individual opponents of policy moves.

The German, watching on TV inside the Bundesbank's imposing headquarters, was annoyed. Had the Governing Council held a formal vote, he wouldn't have been alone, he felt. Mr. Draghi was going out of his way to isolate him.

But Mr. Weidmann also felt freer to criticize.

"Revolt of the Bundesbank," declared the cover of Der Spiegel, Germany's leading news magazine, later that month. In the interview inside, Mr. Weidmann warned that the ECB must focus "solely" on inflation, like the Bundesbank, or risk repeating the 1970s mistakes of the Banca d'Italia.

German media overwhelmingly sided with the Bundesbank. Bild claimed that Ms. Merkel had had to pressure Mr. Weidmann not to resign in protest. The Bundesbank denied the report, but many at the ECB believe the Bundesbank planted it to whip up anger in Germany.

Ms. Merkel, in further public statements, said the ECB was acting within its mandate.

Mr. Draghi pressed ahead. Investors were now convinced the ECB was serious. This time, Bundesbank hostility wouldn't hold it back.

The Bundesbank attacked again. It said Mr. Weidmann regarded bond purchases as "tantamount to financing governments by printing bank notes."

The statement exasperated other ECB governors, who felt the German was being extreme in his dissent while offering no alternative. In a rare rebuke of the hallowed Bundesbank by a German politician, Mr. Sch?uble suggested in a newspaper interview that Mr. Weidmann was harming public trust in the ECB and should pipe down.

Mr. Weidmann isn't finished. Last month, in a speech in Frankfurt, he recruited the quintessential classic of German literature, Goethe's "Faust," as an ally against the ECB.

In Faust Part II, Mr. Weidmann noted, the devil Mephisto tempts the Emperor into printing money to pay for public spending:

Such paper notes, instead of pearls and gold,

Are practical, you know how much you hold;

No need to be a trader or a vendor,

To lust for love and wine you can surrender.

In the play, Mr. Weidmann observed, a heady boom gives way to the collapse of the currency.

The markets, however, are listening to Mr. Draghi.

Write to Brian Blackstone at [e-mail] and Marcus Walker atmarcus.walker@