The European Central Bank is thinking the unthinkable to save the euro, including resuming its controversial bond-buying programme and possibly even pursuing quantitative easing- in effect printing money.
Bold action is probably at least five weeks away, insiders say, though some more clues may come when the ECB reveals its latest interest rate decision on Thursday.
Several other pieces have to fall into place before the ECB will act decisively, insiders say. These include a request for assistance from Spain, which Madrid is still resisting, a decision by eurozone leaders to let their bailout fund buy bonds at auction, and a German court ruling on the legality of the eurozone's permanent rescue fund, due on 12 September.
Above all, ECB President Mario Draghi must overcome the resistance of Germany's powerful central bank, the guardian of monetary orthodoxy, glowering from the other side of Frankfurt.
Draghi raised expectations last Thursday that the ECB would resume buying sovereign bonds as Spanish and Italian borrowing costs vaulted towards levels that could force the eurozone's third and fourth largest economies out of the credit markets.
"Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough," he told a pre-Olympic investment conference in London.
Draghi made it clear he believes the ECB can legitimately intervene in bond markets to curb the high interest rates investors are demanding for buying Spanish and Italian debt rather than safe-haven German Bunds. "To the extent that the size of the sovereign premia hamper the functioning of the monetary policy transmission channels, they come within our mandate," he said.
His remarks surprised some colleagues on the ECB's policy-setting Governing Council, who had not been consulted, central bank sources said.
The counterblast from the Bundesbank came within 24 hours.
The once mighty German monetary authority, now an affiliate and the biggest shareholder in the ECB, declared its opposition to reviving the dormant bond-buying programme, arguing that it would remove market pressure on heavily indebted governments to pursue austere budget policies and economic reforms.
"The mechanism of bond purchases is problematic because it sets the wrong incentives," a spokesman for Bundesbank President Jens Weidmann said.
The Bundesbank has also consistently opposed other ideas-such as giving the eurozone's rescue fund a banking licence and letting it borrow from the central bank to fight fire in the bond markets-on the grounds that they breach a European Union treaty prohibiting monetary financing of governments.
Draghi and Weidmann will have a chance to thrash out their differences when they meet before Thursday's monthly meeting of the Governing Council. The outcome of this struggle between the ECB and the German parent on which it was modelled may determine whether the euro survives.
This account of the tug-of-war among Europe's central bankers is based on numerous conversations with ECB and national central bank policymakers, European Union officials and private bankers privy to ECB policy debates, who spoke on condition of anonymity because of the acute sensitivity of the subject.
The ECB has already cut interest rates to a record low 0.75 percent, bought 211.5 billion euros-worth of troubled eurozone governments' bonds and loosened its collateral rules so it now accepts all kinds of paper from mortgage-backed securities to car loans as surety for funds.
Short-term options for further action include a deeper cut in rates and a further easing of collateral rules. But both are seen as having limited benefits and plenty of drawbacks.
The main idea under consideration is re-activating the bond-buying programme for Spain and Italy in tandem with the eurozone's rescue funds. Supporting Spain would entail a negotiated agreement stipulating fiscal targets and economic reform conditions and international monitoring of them, several sources in the Eurosystem of central banks said.
To save Spanish Prime Minister Mariano Rajoy's face, such a programme might be less exacting than the EU/IMF bailouts imposed on Greece, Ireland and Portugal.
The ECB might also make a third drop of long-term cheap loans to eurozone banks after lending them 1 trillion euros in three-year, low-rate funds earlier this year. But much of that money has so far ended up parked back in the ECB's vaults rather than being lent to other banks or to the "real economy".
Some central bankers believe a depreciation of the euro's exchange rate could ease the problems of peripheral countries such as Portugal and Italy, which compete with China in sectors such as textiles, shoes and furniture.
The euro has slipped from around $1.50 to just above $1.20 since the sovereign debt crisis erupted in early 2010, but any deliberate move by the ECB to weaken the exchange rate would be likely to anger the US Federal Reserve and the Bank of Japan.
Bold options such as accepting losses on ECB holdings of Greek government bonds, and the ultimate "Big Bazooka" of buying up masses of bonds from all eurozone countries, are also on the central bankers' radar screen, the sources said.
The latter would emulate the US Federal Reserve and the Bank of England policy known in central bank jargon as quantitative easing, and to ordinary citizens as printing money.
Since the onset of the global financial crisis in 2008, the Fed has tripled the size of its balance sheet and the Bank of England's has more than quadrupled; but the ECB's has expanded less than threefold, mostly through long-term lending to banks.
When the ECB did buy Greek, Portuguese, Irish, Spanish and Italian bonds, a programme suspended since March, it insisted that for each extra euro created, a euro was withdrawn from circulation by taking in interest-bearing deposits from banks. This is called sterilisation, intended to prevent inflation.
The most radical option for the ECB would be to create money to buy debt across the euro zone without sterilising the purchases. Insiders say that if such an operation bought debt from all euro zone countries, the ECB could avoid accusations of financing individual governments.
A risk of deflation could give the ECB cover to embark on QE, and some policymakers think that in extremis the Bundesbank could go along with such a policy, so long as it did not involve buying government bonds.
With inflation falling fast towards the ECB's target of below but close to 2 percent, growth slowing sharply in northern Europe and recession deepening in the south, the central bank has unusual scope to move.
By buying assets other than sovereign debt, such as bank and corporate bonds, the ECB could still pump money into the system while circumventing the "monetary financing" taboo. One option would be for the ECB to allow the eurozone's national central banks to do the bond-buying and carry the risk.
Yet some central bankers worry about whether QE would achieve the desired result of durably reducing sovereign bond spreads and reviving inter-bank lending.
The ECB used to be known for an iron grip on its communications policy. Board members and national central bankers were assigned key messages to deliver, and massaging market expectations was one of the great skills of Draghi's predecessor, Frenchman Jean-Claude Trichet.
That discipline began to fray in the 2008 financial crisis, when then Bundesbank chief Axel Weber opposed any interest rate cut below 1 percent. It weakened further in May 2010 when Weber openly dissented from the ECB's decision to start buying Greek bonds, arguing that it could be inflationary in the long term.
Weber and former ECB chief economist Juergen Stark both resigned in opposition to the bond-buying programme, fuelling German public suspicion of the ECB, which was seen as having strayed from its German orthodox monetary roots.
Insiders say Draghi, who encourages debate, intentionally runs a less rigidly controlled ship than Trichet did.
However, several fellow central bankers were furious when Austria's Ewald Nowotny last week floated the idea of giving the euro zone's future permanent rescue fund a banking licence, so it could tank up on cheap ECB liquidity. A legal opinion previously sought by the ECB had concluded that such a move would breach the treaty ban on monetary financing of governments, insiders said.
Nowotny's friends said he wanted to stir up debate and hinted Draghi was privately sympathetic to his view. Critics say he just muddied the waters and enraged the Bundesbank.
Within the Eurosystem, officials are puzzling over what will work. Merely reactivating the ECB's bond buying programme, even in tandem with bond-buying by the eurozone's rescue funds, may be too small a bazooka to deter speculators from betting against Spain or Italy, two central bankers said.
"Hedge funds aren't stupid. They can count. They know how much is really available from the rescue funds, how much the central bank has bought so far, and what the political constraints are on doing more," one eurozone source said.
Even when ECB bond-buying was in full flow last year, the ECB's Governing Council limited purchases to roughly 20 billion euros a week, partly at the Bundesbank's behest, insiders say.
The experience remains seared into central bankers' memory after a debacle with Italy. Within days of making commitments to deficit cuts and economic reforms to convince the ECB to step in, then Italian Prime Minister Silvio Berlusconi went back on his promises and treated them as a joke.
"They felt cheated and they don't want to have that happen a second time," a senior financial source in the euro zone system said.
So barring a dramatic deterioration, ECB action may have to wait until conditions in the markets get still worse, Greece gets closer to the brink, and the euro zone, in the words of one Brussels crisis manager, "explores the edge of the abyss".