(REUTERS) - The European Central Bank spooked financial markets on Thursday by dousing hopes of dramatic crisis-fighting action in the euro area hours before European leaders gathered for what the French president billed as a last chance summit.
ECB President Mario Draghi discouraged expectations that the bank would massively step up buying of government bonds if European Union leaders, gathered in Brussels, agreed on moves towards closer fiscal union.
He said the euro zone's rescue fund should remain the main tool to fight bond market contagion, despite its clear limits, and it was illegal for the ECB or national central banks to lend money to the IMF to buy euro zone bonds, appearing to veto one firefighting option under consideration.
The ECB did take unprecedented action to support Europe's cash-starved banks with three-year liquidity and cut interest rates back to a record low 1.0 percent to counter a forecast recession brought on by widespread austerity measures.
The euro and world shares dived as investors, increasingly convinced that only the ECB has the power to protect the euro zone, focused on what Draghi was cool about rather than the measures he announced.
One step forward, two steps back, said Alan Clarke, UK and euro zone economist at Scotia Capital. The euro zone leaders might as well not bother. Pack their bags, go home, enjoy the weekend and do their Christmas shopping.
French President Nicolas Sarkozy dramatized the danger facing the 17-nation single currency area hours before their eighth crisis summit of the year in a speech to European conservative leaders in the French port city of Marseille.
Never has the risk of Europe exploding been so big, he told leaders including German Chancellor Angela Merkel and the heads of the EU institutions.
The diagnosis is that the euro, which should inspire confidence, is not inspiring this confidence, the French leader said. If there is no deal on Friday, there will be no second chance.
France and Germany used the Marseille meeting to lobby for their plan to amend the European Union treaty to toughen budget discipline, which they want to have ready by March. But several countries are skeptical of full-blown treaty change.
German Chancellor Angela Merkel said she was convinced leaders would find a solution to the euro crisis at the summit.
The euro has lost credibility and this must be won back. We will make clear that we will accept more binding rules, she told reporters on arriving in Brussels, insisting on the need for treaty change to anchor tougher discipline.
The new ECB chief said his remark last week that other elements might follow if euro zone leaders agreed to seal tougher new budget rules had been overinterpreted as hinting the bank could step up bond purchases.
I was surprised by the implicit meaning that was given, Draghi said, without offering an alternative interpretation.
The ECB cut its main rate by a quarter-point and flagged a strong chance of recession next year. Draghi admitted the central bankers had been divided even on that decision.
The intensified financial market tensions are continuing to dampen economic activity in the euro area and the outlook remains subject to high uncertainty and substantial downside risks, he told a news conference.
The plight of Europe's banks was thrown into sharp relief. The European Banking Authority watchdog told them to increase their capital by a total of 114.7 billion euros, significantly more than predicted two months ago.
A Reuters poll of economists found that while 33 out of 57 believe the euro zone will probably survive in its current form, 38 of those questioned expected this week's summit would fail to deliver a decisive solution to the debt crisis.
Euro zone officials said the summit was likely to decide to bring forward the launch date of a permanent bailout fund to 2012 from mid-2013. Before Draghi spoke, one euro zone source said negotiators were close to agreement for their central banks to lend 150 billion euros to the IMF for firefighting.
Draghi ruled out the IMF buying euro zone bonds but that still leaves the option of lending direct to governments as it more customarily does, although Italy for one has insisted it needs no such assistance.
A proposal to give the permanent European Stability Mechanism a banking license with access to ECB funding was off the table due to German opposition.
The EU remains divided over the need for treaty change. Summit chairman Herman Van Rompuy is urging leaders to avoid a laborious full overhaul that could take up to two years and face uncertain ratification. He wants them instead to slip stricter budget enforcement through in a protocol to existing treaties.
This infuriated Merkel and was one reason behind a gloomy briefing by a senior German official on Wednesday, who dampened hopes for a breakthrough and said some leaders and institutions still didn't understand the severity of the crisis.
If all 27 EU states do not support more fiscal union by adapting the existing Lisbon treaty, which took eight years to negotiate, then Sarkozy and Merkel want the 17 euro zone countries to go ahead alone with more integration.
Should it turn out that not all 27 are able to go down this path, then we have to make a treaty change for the 17 euro states, said Luxembourg premier Jean-Claude Juncker, who chairs the grouping of euro zone finance ministers. I don't want this but I don't exclude it.
Swedish Prime Minister Fredrik Reinfeldt, speaking for a non-euro state, said: We want to stick with the 27 concept of course because all of us are members of the European Union and we want to have our influence. We want to keep the European project together.
The Franco-German plan would slap automatic penalties on countries that overshoot deficit targets and make countries anchor a balanced budget rule in their constitutions. The sanctions could be stopped only if three quarters of euro zone countries are against them.
Not all euro zone countries are comfortable with all the French and German proposals, with Finland opposed to their call for majority votes on major policy decisions.
U.S. Treasury Secretary Timothy Geithner, ending a visit to Europe to urge decisive action with talks with new Italian Prime Minister Mario Monti, said it was essential for European leaders to strengthen their financial firewall to give economic reforms a chance to work.
Monti is pushing through economic reforms after the euro zone's third biggest economy found itself sucked to the centre of the debt crisis.
(Additional reporting by Catherine Bremer in Marseille, Leigh Thomas and Brian Love in Paris, Sakari Suoninen in Frankfurt, Jan Strupczewski in Brussels, and Terhi Kinnunen in Helsinki; Writing by Paul Taylor/Mike Peacock; editing by Janet McBride)