The European Central Bank spooked financial markets Thursday by dousing hopes of dramatic crisis-fighting action in the euro area shortly before European leaders began what the French president billed 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, meeting in Brussels, agreed on moves toward closer fiscal union.
A six-page draft agreement handed to the 27 leaders as they began their two-day summit called for a new fiscal compact with much tougher enforcement of budget rules in the euro zone, and a permanent rescue fund brought forward to mid-2012 and armed with a banking license.
But as soon as the draft text leaked, a senior German official rejected key measures including letting the euro zone's future rescue fund, the European Stability Mechanism, operate as a bank borrowing from the ECB, and a long-term goal of issuing common euro zone bonds.
Draghi said the bloc's existing bailout facility should remain the main tool to fight bond market contagion, despite its clear limits. It was illegal for the ECB or national central banks to lend money to the IMF to buy euro zone bonds, he said, 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 briefly rallied on news of the draft summit conclusions, only to fall back on the German rejection. Investors are increasingly convinced only the ECB has the power to protect the euro zone, and were disappointed by Draghi's caution on bond-buying.
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 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.
Merkel said on arrival in Brussels: The euro has lost credibility and this must be won back. We will make clear that we will accept more binding rules. She insisted there must be 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 also thrown into sharp relief. The European Banking Authority 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.
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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 operations.
Although he ruled out the IMF buying euro zone bonds, that left the option of lending directly to governments as it more customarily does, although Italy for one has insisted it needs no such assistance.
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 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.
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.
However, he said there was no support in Sweden for treaty change as of now.
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.
General government budgets shall in principle be balanced. Member states may incur deficits only to take into account the budgetary impact of the economic cycle or in case of exceptional economic circumstances, the draft summit conclusions said. The structural deficit limit would be 0.5 percent of GDP.
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.
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 center 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)