Following an unproductive meeting of European finance chiefs in Cyprus last week, a market rally triggered by Draghi's debt-buying plan has run out of steam. Spanish and Italian bonds have surrendered some of their recent gains.

Spanish 10-year yields reached a euro-era record 7.75 percent on July 25, before Draghi pledged a day later to do “whatever it takes” to safeguard the monetary union. Since then, they have fallen below 6 percent, while those of Italy have dropped more than a percentage point toward 5 percent. The euro has gained 7 percent against the dollar since the start of August.

“Politicians tend to act for their own good and that of their countries rather than the greater good of Europe,” said Jacques Cailloux, chief European economist at Nomura International Plc in London. “That's an unfortunate case and if it continues the markets will test the sovereigns again.”

Unresolved is whether Spanish Prime Minister Mariano Rajoy will trigger the ECB's aid-for-austerity deal and if Greek leader Antonis Samaras keep his constituents, coalition partners and benefactors onside enough to keep aid cash flowing.

Looming is the vulnerability of Italy and the fragility of unelected Premier Mario Monti's coalition as Cyprus negotiates the fifth bailout after Greece, Ireland, Portugal and Spain's financial system.

Outside the danger zone, German Chancellor Angela Merkel must rally her bailout-allergic electorate and French President Francois Hollande needs to recast his growth-model. Meantime, European policy makers are struggling to meet a self-imposed deadline of the start of 2013 to get a bank-supervisory regime up and running. Merkel and Hollande are scheduled to meet Sept. 22 Ludwigsburg, near Stuttgart.

Crisis aside, they all share the urgency of finding an economic elixir. Unemployment is at a record 11.3 percent in the euro bloc and as high as 25 percent in Spain. The region is bound for its second recession in three years.

“The region has to get down to the messy business of implementation, and is likely to throw up problems along the way,” said Alex White, an economist at JPMorgan Chase & Co. in London.

Europe's powers are, for now, enjoying a moment of calm after the ECB revived bond buying, Germany's constitutional court blessed the ESM, an election in the Netherlands passed without an anti-euro spasm and Greece's prospects for help stayed intact despite budget backsliding.

“Europe is stabilized,” Austrian Finance Minister Maria Fekter says. French Finance Minister Pierre Moscovici sees “light at the end of the tunnel.”

The lesson of the turmoil is nevertheless that pride has always come before a fall. Leaders declared a turning point six months ago before hitting reverse as Spain's banks wobbled and support for Greek anti-bailout parties forced two elections there in a six-week span. In 2011, officials cheered the results of a July summit and headed on vacation only to find their pact in pieces before they returned.

The respite in markets won't “last long” if Spain doesn't seek assistance, ECB Governing Council member Luc Coene said Sept. 17. “Spreads will rise again, and then Spain will be somewhat forced to come back on its decision and submit to the conditionality program,” he said.

Rajoy's Delay

Delay is the order of the day in Madrid. Rajoy, in power for 10 months after winning the biggest parliamentary majority in almost three decades, is balancing the need for aid with the potential for political and economic fallout.

He has already reneged on promises not to cut firing costs or unemployment benefits, raise taxes and scrap a tax break on mortgages. The leader of Catalonia, which accounts for 20 percent of the country's economy, raised the specter of secession even as he clings to a financial lifeline from Madrid.

“An imminent application for external assistance by the government is unlikely,” said Antonio Barroso, an analyst at the Eurasia Group in London. “Rajoy's priority is to limit the number of conditions attached to another rescue package and thereby limit the negative political spillover from accepting additional external aid.”

Rajoy is first trying to pacify markets by promising to detail new reform measures by the end of this month, including a possible increase in the retirement age, shift toward consumption taxes and deregulation of closed professions. If that's not enough, he will have to decide on the size of a bailout, with Germany advising against a full rescue given he has already secured 100 billion euros for banks.

The more Spain digs in its heels, the more Germany may seek harsher terms, said Andrew Benito, an economist at Goldman Sachs Group Inc. While Germany's top court backed the ESM and Merkel endorsed Draghi's Outright Monetary Transactions over the resistance of Bundesbank President Jens Weidmann, her public is less sympathetic.

Their views — reflected in an ARD-DeutschlandTrend poll that showed just 13 percent supported ECB bond-buying — will count increasingly as Merkel gears up for re-election next year.

“The more the Spanish administration indulges domestic political interests and is perceived to be taking undue advantage of external support, the more explicit conditionality is likely to be demanded,” said Benito. “This would add to existing tensions.”

The risk of German antagonism could leave the ECB in a tight spot if a bailed-out country then falls short of what's demanded. The Washington-based Institute of International Finance, which represents more than 450 financial companies, this week warned of a “cliff effect” in which termination of support prompts an “abrupt” market correction.

In another squabble that could delay a lasting solution, Germany is pushing back against the timetable for greater banking oversight, urging caution when assigning new duties to the ECB. European Union leaders want a single supervisor by the start of next year to break the negative feedback loop between sovereign and banking debt.

That spat foreshadows a deeper divide as the bloc's leaders turn to closer cooperation on budget issues. “We've made little progress on fiscal union, and that will be the next focus,” said Joachim Fels, chief economist at Morgan Stanley in London.

If Spain does hit the aid button, attention would shift to Rome where officials so far deny the need for help even as an austerity-driven recession deepens. Monti is now overhauling the labor market by easing the rules on firing workers during difficult economic times without the risk of a court ordering their reinstatement. Support for the government fell to a low of 17 percent, a poll by Rome-based IPR Marketing showed Sept. 17.

The need to quell a “contagion effect” will likely leave Italy under pressure from governments and investors to sign up for help if Spain does, said Tobias Blattner, director of European economic research at Daiwa Capital Markets in London.

Europe's original problem child, Greece's three-way coalition government is still trying to win aid blocked since June. It has yet to to agree on a full package of 11.5 billion euros of savings in the next two years.

“You want to be sure if something happens to Greece, you want Spain and Italy under the umbrella,” Blattner told Mark Barton on Bloomberg Television's “Countdown.”

Greek Verdict

While late homework has typically meant punishment, Greece is winning some respite and may get easier terms as Europe's chiefs try to cement the market rally and keep from reheating the euro-exit trade. A verdict on the country's fiscal plans will now wait until October when European leaders next gather.

Even if the next chunk of a 240 billion-euro package is released there remains a funding gap unlikely to be cut by fiscal measures amid a fifth year of recession, says Erik Nielsen, chief global economist at UniCredit SpA in London.

“My bottom line is that Greece will remain in limbo, drip-fed by Europe and the IMF during the next six to 12 months, and that crunch time is more likely to start next year,” said Nielsen.

Longer-term, Jennifer McKeown of London-based Capital Economics Ltd. warns it's too soon to “sound the all clear.” Europe may still find its financial firewall too small and while bond-buying deals with the symptoms of the euro's ills it doesn't tackle unsustainable debts and how to cut them without deflating economies, she said.

“Our long held view that a limited euro-zone break up will commence in the coming months is unaltered,” said McKeown.

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