(Reuters) - The new head of the European Central Bank signaled on Thursday it was ready to take stronger action to fight Europe's debt crisis if political leaders agree next week on much tighter budget controls in the 17-nation euro zone.
Speaking a day after the world's major central banks took emergency joint action to provide cheaper dollar funding for starved European banks, Mario Draghi painted a dark picture of the state of the banking system.
A new fiscal compact would be the most important signal from euro area governments for embarking on a path of comprehensive deepening of economic integration. It would also present a clear trajectory for the future evolution of the euro area, thus framing expectations, he told the European Parliament.
Draghi did not spell out what action the ECB might take, but it is under huge political and market pressure to massively step up purchases of euro zone government bonds or lend money to the IMF to support ailing Italy and Spain.
In the short-term, economists expect the central bank to relieve pressure on banks and an economy heading into recession cutting interest rates next week and announcing longer-term cheap liquidity tenders with easier collateral rules. Markets are pricing in a 25 basis point cut to 1.0 percent on December 8 and Draghi said nothing to dissuade them.
In response to lawmakers' comments, he added that the ECB had scope to act within the European Union treaty and the most important thing was to make sure that frozen credit channels started to work again.
Draghi, who faces some of the toughest decisions in the currency's 12-year history after just one month in the job, said the ECB was aware many European banks were in difficulty because of stress on sovereign bonds, tight inter-bank funding markets and scarce collateral.
Downside risks to the economic outlook have increased, he said, noting that the ECB's mandate was to maintain price stability in both directions -- a rare indication that the bank is concerned about deflation risks as well as inflation.
Two years into Europe's debt crisis, investors are fleeing the euro zone bond market, European banks are dumping government debt, south European banks are bleeding deposits and a recession looms, fuelling doubts about the survival of the single currency.
The euro and European stocks were steady after surging on Wednesday after the joint intervention by the U.S. Federal Reserve, the ECB and the central banks of Japan, Britain, Canada and Switzerland.
Safe-haven German bond futures crept up further after Draghi said the ECB's bond-buying program was only temporary and limited but markets were cheered by strong demand at Spanish and French bond auctions on Thursday.
DAYS TO SAVE EURO?
European Union leaders hold a crucial summit on December 9 at which EU paymaster Germany is pressing for an agreement on treaty change to establish coercive powers to veto national budgets in the euro zone that breach agreed rules.
That prompted the chief financial officer of the European Bank for Reconstruction and Development, Manfred Schepers, to tell a Dutch newspaper: There are seven work days left to save Europe.
Berlin wants the European Commission to be empowered to reject national budgets before they go to parliament and to refer serial deficit offenders to the European Court of Justice.
That is highly controversial in France, which is working on joint proposals with Germany to be put to EU partners next week.
President Nicolas Sarkozy was due to outline his vision of euro zone integration in a speech in the southern port city of Toulon later on Thursday (1730 GMT) and German Chancellor Angela Merkel will set out her views to parliament in Berlin on Friday.
Sources close to the negotiations said they had not yet reached agreement on key issues including the role of the EU executive and court, with Paris preferring an intergovernmental approach leaving the final word with elected leaders.
The conservative Sarkozy's main challenger in next year's presidential election, Socialist Francois Hollande, said on Wednesday that as president he would never hand France's budget sovereignty over to European judges.
In Berlin, leaders of Merkel's centre-right coalition agreed on Thursday that Germany's opposition to common euro zone debt issuance was non-negotiable, slamming one door which France and other southern euro zone states have tried to open.
We are not prepared to buy changes to the (EU) treaty in exchange for rules that other European countries want, for example euro bonds, Economics Minister Philipp Roesler of the liberal Free Democrats said after talks with Merkel and Horst Seehofer, leader of the Bavarian Christian Social Union.
With the ECB formally barred by treaty from acting as lender of last resort to the euro zone or directly financing governments, EU officials are working on ways to support states under bond market pressure via the International Monetary Fund.
One idea under active consideration is allowing euro zone national central banks affiliated to the ECB to lend money to the IMF which could provide larger credit lines for Italy and Spain on strictly monitored policy conditions.
In a key policy shift, German Finance Minister Wolfgang Schaeuble said on Wednesday Germany was now open to increasing the IMF's resources through bilateral loans or more special drawing rights, reversing the stance it took at last month's Cannes G20 summit.
That fuelled momentum for a global deal to boost the Fund's resources, although many other major economies want to see the euro zone put more of its own firepower on the line to defeat the debt crisis before they make commitments.
China's vice finance minister said the euro zone had made positive progress by agreeing this week to ramp up the firepower of its rescue fund but Beijing hoped to see more progress at next week's EU summit.
The current crisis, to some extent, is more serious and challenging than the international financial crisis following the fall of Lehman Brothers, Zhu Guangyao told a trade forum.
In Greece, where the euro zone debt crisis began in 2009, schools, hospitals and public transport were paralysed by a one-day general strike in protest at the new national unity government's EU/IMF-imposed austerity budget.
The strike is the first such test for new technocrat Prime Minister Lucas Papademos, who has had little time to celebrate since European finance ministers this week approved an 8 billion euro tranche of aid to prevent Greece from going bankrupt.