Europe’s new Iron Lady

There are few better ways to gauge Germany’s unique place in history, past and present, than to take a spin in one of its latest engineering marvels up a street named for the founding father of Communism, where Soviet tanks shot dead dozens of unarmed protesters in 1953. Sixty years later, both Germany’s era of Nazi dictatorship and the Cold War that followed are fading from consciousness. Berlin is now the pulsating heart of Germany and home to the single most critical person in resolving Europe’s economic crisis: German Chancellor Angela Merkel.

Merkel could scarcely have imagined that role for herself in 2005 when she moved into her seventh-floor office in the postmodern Chancellery building on the Rhine. Then the unemployment rate topped 12% and the country was still reeling from the staggering cost of reuniting East and West Germany, which occurred in 1990, a year after the Berlin Wall fell. Now Germany is Europe’s biggest and strongest economy, and its 5.4% unemployment rate is the lowest in 19 years. Merkel’s initial job of stabilizing the country has given way to a far more epic task: deciding how to bail out Europe’s debt-ridden economies, or whether they merit bailing out at all.

Because of its solvency and huge size, Germany is almost alone among the 28 EU countries in its ability to rescue nations like Italy, Spain, Greece, Portugal, Ireland, and Cyprus, whose public debt and outsize deficits have led to hundreds of thousands of layoffs and have threatened to ravage cherished social benefits. Thrust into the crisis in 2010, when Greece appeared close to all-out bankruptcy, Merkel has continually weighed the cost of expensive bailouts against the danger that the euro could collapse as a currency. She has chosen to act, crafting rescue packages worth billions of euros, with the biggest contributions shouldered by Germany, in order to stave off the collapse of EU’s weakest economies and shore up the euro itself.

In the process, Merkel, 59, has effectively become Europe’s preeminent leader, as well as widely popular among German voters, who look set to hand her a third term in office in national elections on Sept. 22. Henry Kissinger famously once said he did not know whom to call when he wanted to call Europe. Today few wonder. The evening that François Hollande was sworn in as French President in May last year, he flew to Berlin to meet Merkel, not waiting to unpack his bags in the Élysée Palace. When Chinese Premier Li Keqiang took his first official trip to Europe in May, Merkel was the only EU leader he visited. And after the G-8 summit in Northern Ireland in late June, President Obama flew directly to Berlin to huddle with Merkel. Asked in June by the German magazine Der Spiegel whether she ever felt powerless, Merkel said, “That is not a feeling I normally have,” before adding, “I have to be patient and convince others to go along with me.”

Like a latter-day Margaret Thatcher, Merkel has exhibited an iron will in pushing for reform. With German money the deciding factor, Merkel has wrested tough concessions from governments, arguing that European leaders need to overhaul labor regulations and restructure their public finances by balancing their budgets. While that message has brought her applause at home — her approval ratings exceed 60% — it has not gone down well elsewhere. On the streets of Athens, some protesters have depicted Merkel as a Nazi imposing her will on hapless Greeks.

Merkel has shrugged off the attacks. Instead, she has pushed through Europe’s new $650 billion European Stability Mechanism fund, which launched last September with Germany as the single largest contributor. Against opposition from some German bankers, she has also backed the idea of a new EU banking union. Beginning next year, it will (in theory) place oversight of European financial institutions in the hands of the European Central Bank — which just happens to be based in Frankfurt. And in March, Merkel drove a “bail-in” deal for Cyprus, forcing big depositors in the island’s banks to accept heavy losses on their savings as a condition for saving the island from economic collapse.

Although Merkel insists that no EU member should abandon the euro — not even tiny Cyprus — she makes it clear that each EU country needs to cut spending and balance its budget. In essence, Merkel is asking EU leaders to behave like the stereotypical modest-living German; in other words, a bit like herself. Germans charge much less to credit cards (if they have them at all) compared with their British and French counterparts, and most are renters, not homeowners. After the subprime meltdown in 2008, Merkel remarked that the financial industry “should simply have asked a Swabian housewife,” referring to a region in southwestern Germany. “She would have told us her worldly wisdom: In the long run, you cannot live beyond your means.”

Yet for all Merkel’s preaching about belt tightening and reform, it remains to be seen whether she can change Europe. Are the bailouts simply papering over systemic problems? In large part the answer to that question splits along left-right political lines, with conservatives pushing continued spending cuts and liberals believing that those cuts will only worsen the situation. But many increasingly question whether Merkel’s austerity policies will do more harm than good. And leaders of the countries receiving German money have begun to bristle over strict budget-cutting targets. When new Italian Prime Minister Enrico Letta flew to Berlin to meet with Merkel on April 30, he told reporters, “How and where we find resources is a domestic matter. I don’t owe explanations to anyone.”

As the debate rages over which direction to take out of the eurocrisis Merkel has stuck to her position, drawing criticism from some economists, who accuse her of having little long-term vision for Europe. “What we see is her trying to steer the boat through the fog, watching that it doesn’t crash on the banks,” says Carsten Brzeski, senior economist in Brussels for ING. With the EU staggering from crisis to crisis, her resolve will continue to be tested.

Thus far, however , Merkel’s steadfast strategy has worked. And as the Chancellor readied her election campaign, her Christian Democratic Party was the clear front-runner, with its rivals badly trailing. Yet voters could turn cold toward Merkel if, for example, Germany itself confronts an economic downturn. “There’s deep discontent with the government’s euro rescue policies,” says Bernd Lucke, an economist who co-founded the euro-skeptic party Alternative for Germany earlier this year. The party argues for debt-ridden EU countries to exit the eurozone, and maybe the EU itself. “There are hundreds of millions of euros going to countries that have no way to pay them back,” he says.

Despite Germany’s low unemployment, there are signs of possible trouble ahead. The biggest worry is Germany’s shrinking, aging population — it has Europe’s lowest birthrate — which economists cite as a financial time bomb. Persuading German women to have more children has become an urgent task for Merkel, who herself is married (to a publicity-shy chemistry researcher named Joachim Sauer) but childless and whom many Germans have nicknamed Mutti, or “Mom.” The first German census results in 20 years, released in May, included a shocker: The country had 1.5 million fewer people than had been assumed. Demographers fear that the population could shrink much more, from about 80 million now to below 70 million by 2060.

Then come Germany’s other indicators. German GDP has risen a total of only about 1.5% since the global crisis hit in 2008, compared with 3% in the U.S. for that period. Economists point to Germany’s heavy dependence on exports as one reason. German executives rightly boast of the country’s strong manufacturing industry, which is the envy of many world leaders, including Obama, who has praised Germany’s investment in technology. But with relatively low wages in Germany itself, wealthier consumers abroad are required to keep German industry healthy. Nearly 50% of superbly engineered German audio equipment, cars, and heavy machinery head to other EU countries, making it even more urgent for Merkel to keep those economies afloat. Yet after years of recession, many Europeans are too strapped to buy new BMWs and high-priced Bosch appliances.

In fact, some economists believe that Merkel’s strong clout within Europe is less a measure of Germany’s economic strength than of the weak state of the rest of the continent. “The irony of the eurocrisis is that it has massively increased the power of Germany, but the country has bad problems itself,” says Simon Tilford, chief economist for the Center for European Reform, a research organization in London. “Within Europe she is the top dog, absolutely, at the moment,” Tilford says. Yet when Merkel appears among major non-European heads of state — for example, at the G-8 meetings — he argues, “she is just the leader of a country with terrible demographics and stagnant growth.”

Considering Merkel ‘s beginnings, it is astonishing that she is a leader at all, let alone Europe’s “top dog” on whom Obama pinned the U.S. Presidential Medal of Freedom in the White House Rose Garden in 2011. (The Chancellor declined to speak to Fortune for this story.) One morning in late May, I drove an hour east out of Berlin, past the glassy office buildings and the sprawling suburbs, until the road gave way to a single lane that cut through trees and fields. About 40 miles outside the capital I arrived in Templin, in what was the heart of Communist East Germany before the Berlin Wall came down in 1989, ending the Cold War and leading to the collapse of the Soviet Union. Today about 17,000 people live in the sleepy, provincial town, which sits amid lakes and forests and provides a quick getaway for Berliners wanting to escape urban stress. Welcome to Merkel’s hometown.

In Merkel’s day, the town was sealed off from the West. Young Angela’s sole link to the other side of the wall (from where her father, a Lutheran minister, had moved the family when she was a baby) were the care packages her aunt sent from West Germany. One contained a cherished pair of denim jeans for her niece, but Angela was banned from wearing them to school: Western clothing was frowned upon. Her childhood acquaintances remember a girl who was smart and bookish, with just a handful of close friends. “She was quiet, almost invisible,” says Carola Mock, a pediatrician in Templin, who attended school with Merkel.

Politics was taught in the classroom under portraits of Lenin and Marx, and children dutifully learned about the evils of Western capitalism. Merkel became a star student of Russian, which she still speaks well, and was a member of the Communist youth organization. “We even had the Pioneers salute,” Hans-Ulrich Beeskow, Merkel’s math teacher at middle school, tells me as he walks me around Merkel’s childhood haunts. “I would shout to the class, ‘Are you ready?’ and they would shout back, ‘Always ready!’ ” he says, throwing up his arms in demonstration.

Little could have readied Merkel for the November night in 1989 when thousands of young Germans breached the Berlin Wall, dooming Communist rule in Eastern Europe forever. Merkel, then 35, was working as a researcher at the state-run Academy of Sciences in East Berlin, having earned a doctorate in physical chemistry. Measured and cautious and buried in her work, she did not join the throngs of young Germans partying atop the smashed wall. Instead, the night of the revolution Merkel went to the gym and took her regular sauna. A few days later she traveled to Poland to address a scientific conference, to the astonishment of her hosts, who wondered why she was not participating in the events in Berlin.

Those who knew Merkel at the time describe her as having almost stumbled into politics by happenstance. “I think one of the motivations to get into politics was to avoid unemployment,” says Beeskow. “The Academy of Sciences dissolved with reunification. She was out of a job.” East Germany’s first and only democratic government hired Merkel as its spokeswoman, and she began traveling to meetings in West Germany, where she got to know officials and journalists and positioned herself to join the unified government. “She was like an exotic creature,” says Georg Streiter, a journalist at that time, who is now deputy government spokesman, recalling a dinner he and his colleagues shared with her soon after the wall fell, where they peppered her with questions about life in Communist East Germany.

When Germany reunited in 1990, Helmut Köhl, who was Chancellor for 16 years, recruited Merkel, first as his women’s minister and later as environment minister. “He needed people from the East, and he needed women,” says Andreas Fritzenkötter, who was Köhl’s spokesman at the time. Merkel had emerged from a hermetic world where any flash of Western sympathy had drawn scrutiny from the Stasi, the East German secret police.

She was a soft-spoken woman with an unadorned appearance, and from the start was forced to assert her views in the testosterone-heavy world of politics. (Recently she told editors of the German women’s magazine Brigitte that what she most envied about men was “the ability to chop wood and talk in a deep voice.”) “She paid no attention to her appearance, and even today does not,” says Fritzenkötter, who recalls watching her mentor Köhl upbraid her, as an inexperienced politician, during a cabinet meeting. “When I met her in 1989, it was difficult to see that she would become a prominent leader,” he says. “But she was like a sponge for information.”

There is one lesson for which Merkel has had no teacher, however: how to fix Europe. In Brussels one morning in May, I watched Merkel work the chamber in the EU’s headquarters, where all the heads of state were gathering for a daylong summit. The agenda was scattershot: tax reform and renewable energy. But for Merkel, the real business was ensuring that no EU economy was about to spin out of control, taking her chances for reelection with it.

As she milled about, chatting with other leaders, she was not only the most important leader in the room but also the consummate political survivor, having seen enraged voters throw out so many other leaders in punishment for their crisis management, among them British Prime Minister Gordon Brown, French President Nicolas Sarkozy, and Italian Prime Minister Silvio Berlusconi.

With the German economy still humming along, at least for now, Merkel is not likely to suffer the same fate this fall. But the pressure on the German leader remains intense. When a journalist recently asked Merkel where, after years of the eurocrisis, she experiences true silence, she replied, “Alone in my office.” She hopes to be back in that quiet room after September’s elections, crafting the next rescue plan for the EU’s troubled economies and proving that her approach can work both for Germany and for Europe.

This story is from the August 12, 2013 issue of Fortune.