Germany's top court handed the country's parliament a greater say over euro zone bailouts on Wednesday, in a closely-watched ruling that could hamper Berlin's ability to act swiftly to counter a debt crisis that has plagued the currency bloc for two years.
The Constitutional Court in the southern city of Karlsruhe rejected, as expected, a series of lawsuits aimed at blocking German participation in emergency loan packages. Chancellor Angela Merkel hailed that decision as validation of her much-criticized euro zone policy.
But the court also said her government must get approval from parliament's budget committee before granting such aid and appeared to rule out more radical solutions floated by Germany's European partners for solving the crisis, such as joint euro zone bonds.
This was a very tight decision. But it should not be mistakenly interpreted as a constitutional blank check authorizing further rescue measures, the chief judge Andreas Vosskuhle told plaintiffs, government officials and members of parliament in the courtroom.
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, an economist at ING.
Doubts about the willingness of countries like Italy and Greece to push through the austerity measures demanded by their partners have darkened the political mood in Germany and other northern European members of the 17-nation currency bloc.
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 drive that markets, and more importantly the European Central Bank which has stepped in to buy Italian bonds and avert the need for 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 Europe's rescue mechanism, the European Financial Stability Facility (EFSF), said Greece's IMF/EU programme 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, in a speech to parliament following the court ruling, said a radical change in attitude was needed to resolve the 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.
Jeered by opposition parties during her address, Merkel faces intense pressure from members of her coalition to resist steps like joint euro zone bonds that might reassures markets, but would also penalize Germany and reduce incentives for peripheral countries to take tough austerity steps.
In its ruling, the court also appeared to rule out such steps, saying parliament was forbidden from setting up permanent legal mechanisms resulting in the assumption of liabilities based on the voluntary decisions of other states.
Frustration with Greece's inability to meet fiscal targets set out for it by the EU, IMF and ECB has grown particularly acute over the past week and German politicians are now openly talking about the country 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, head of the Bavarian Christian Social Union (CSU), 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.
(Additional reporting by Annika Breidthardt and Jan Strupczewski; Writing by Mike Peacock; Editing by Hugh Lawson)