Germany's top court handed its country's parliament a greater say over euro zone bailouts, potentially hampering Berlin's ability to act decisively against a debt crisis which Chancellor Angela Merkel said needed a fundamental rethink to solve.
The Constitutional Court rejected a series of lawsuits aimed at blocking the participation of Europe's biggest economy in emergency loan packages but said the government must get approval from parliament's budget committee before granting such aid.
This was a very tight decision. But it should not be mistakenly interpreted as a constitutional blank check authorizing further rescue measures, the judge told plaintiffs, government officials and members of parliament in the courtroom in Karlsruhe.
The euro briefly rose against the dollar in response.
Today's ruling should bring some relief to financial markets as a total chaos scenario has been avoided, but it should not lead to euphoria, said Carsten Brzeski at ING.
The ruling confirms our view that the German piecemeal approach on the debt crisis is not likely to change but eventually the German parliament will vote in favor of a second Greek bailout package and the beefed-up EFSF (euro zone rescue fund).
With Germany's ability to act quickly constrained, the euro zone's most indebted nations scrambled to convince investors of their commitment to tackle their debt problems.
Doubts about the will of Italy and Greece to push through the austerity demanded by their partners have darkened the political mood in Europe and triggered renewed pressure in bond markets.
Italy's center-right government promised on Tuesday to hike value-added tax as it bowed to market pressure for more action on its swollen debt and ignored mass street protests and strikes against its austerity measures.
But such has been the chaos surrounding its austerity process that markets, and more importantly the European Central Bank which has stepped in to buy Italian bonds and prevent it needing a bailout, are unlikely to be convinced yet.
Meanwhile fiscal backsliding in Athens has put a new aid payment from the country's international lenders in danger and prompted lawmakers in Merkel's party to call for Greece's ejection from the 17-nation currency area.
Greece's finance minister pledged to speed up delayed privatizations and structural reforms, following the suspension of talks with its lenders.
But the head of the European Financial Stability Facility (EFSF) said Greece's IMF/EU program was not working, it would not be able to return to markets as planned and its citizens may have to accept a decline in living standards.
The objective (of EU/IMF aid) is clear, it is to buy time. This is now working in Ireland and Portugal but it is not yet working in Greece, EFSF head Klaus Regling said.
Merkel said a radical change in attitude was needed to resolve the two-year crisis.
I'm convinced that this crisis, if a great crisis of the western world is to be avoided, cannot be fought with a 'carry on' attitude. We need a fundamental rethink, Merkel said.
We must make it very clear to people that the current problem, namely of excessive debt built up over decades, cannot be solved in one blow, with things like euro bonds or debt restructurings that will suddenly make everything okay. No, this will be a long, hard path, but one that is right for the future of Europe, she told parliament.
The leader of Germany's Christian Social Union, one of three parties in Merkel's ruling coalition, was quoted as saying he could not rule out Greece leaving the euro zone.
I do not think that can be ruled out but I'm counting on the success of the path that has been taken with aid and consolidation efforts, Horst Seehofer, CSU chairman and Bavaria state premier, told Bild newspaper.
A confidence vote will be called which should see the Italian package passed in the Senate later on Wednesday, offering some reassurance ahead of Thursday's meeting of the ECB governing council, which has been pushing Rome for action.
Rome said it would raise value added tax and introduce a constitutional balanced budget amendment as part of a revised plan. But its credibility has taken a hammering in financial markets because of the haphazard way it has been handled.
In southern Europe, public resistance to new austerity measures is on the rise, while in the north public anger at a series of taxpayer-funded bailouts is building to a crescendo.
If Italy goes, then the whole thing falls apart, Nobel Prize-winning economist Paul Krugman told Reuters in the Russian city of Yaroslavl.
The ECB is counting on euro zone governments to step in and assume the role of bond-buyer of last resort once the EFSF receives new powers agreed by euro zone leaders in July.
But national parliaments need to approve the changes, a major hurdle in member states where aid to euro zone stragglers is increasingly unpopular.
A euro zone official said a deal giving new powers to the bailout fund would be ratified by all euro zone countries by the end of September -- a timeframe that had been put in doubt when a government coalition member in Slovakia said its parliament would not vote until December at the earliest.
An arcane argument over a Finnish demand for collateral from Greece in return for new loan guarantees may also not be resolved until the end of September because of its legal complexity, euro zone officials said.
Merkel's own job may also be at risk if enough of her conservative allies vote against a stronger EFSF in a parliamentary vote scheduled for September 29.
Ireland's finance minister said rapid ratification of the EFSF's powers was essential but that the fund was still too small at 440 billion euros.
What's going on now are negotiations on how to retrofit the measures to protect the currency and a lot of progress has been made, but there's a lot more to be done, Michael Noonan said.
(Additional reporting by Annika Breidthardt and Jan Strupczewski; Writing by Mike Peacock; Editing by Hugh Lawson)