Germany stepped up its fight against speculators with a ban on some financial trades on Wednesday, triggering big market falls and wrong footing European governments that said they were not consulted.
Berlin's unilateral action suggested Europe remained unable to form a united front in addressing its debt crisis. It worried investors by increasing uncertainty over market regulation in the region.
Chancellor Angela Merkel told German lawmakers European Union leaders had to ensure markets could not extort the state as she described steps to curb short selling of German bank shares and euro zone government bonds.
Merkel's decision appeared to shatter a consensus on cautious regulatory reform which had been building within the EU and across the globe.
Analysts saw the move as a political gesture to placate German public opinion after her party lost a regional election this month.
It again suggests that the Germans are no closer to understanding that the markets are not the problem here. The markets are right to be uncertain about the sustainability of the euro zone in its current form, said Simon Tilford, chief economist At the Center for European Reform.
What is specific to Germany is a readiness to make unilateral announcements on things that would only be doable if they were done collectively...It's pretty populist stuff.
Some analysts speculated Germany's ban might be an attempt to reduce market volatility before further negative developments in the euro zone debt crisis -- conceivably even a restructuring of Greek debt.
SECRETS AND RUMOURS
After the euro zone and the International Monetary Fund devised a 110 billion euro ($135 billion) bailout of Greece this month, governments are likely to do their utmost to avoid a restructuring and give time for Greek austerity steps to work.
But this prospect did little to reassure jittery markets on Monday. If there is a secret here, it can't possibly be a positive one, Rabobank said in a research note.
The euro hit a fresh four-year low against the dollar, but later rebounded, notching its best one-day gain in a year against the greenback on speculation European monetary officials might do more to support it.
Talk of potential meetings or action by the European Central Bank pushed the euro higher from its lowest level since April 2006.
PRESSURE ON MERKEL
Germany banned naked short-selling of shares in its 10 top financial institutions, naked short sales of euro zone government bonds, and naked transactions in credit default swaps (CDS), which are used to insure against debt defaults.
In naked short-selling, a trader sells an instrument short, betting its price will fall, without first borrowing the instrument or ensuring it can be borrowed, as would be done in a conventional short sale. Naked trade in CDS does not hedge an underlying asset.
Germany's financial regulator, Bafin, said the ban was due to the extraordinary volatility in government bonds in the euro zone. Massive short-selling could have endangered the stability of the financial system, it said.
Merkel has been under huge pressure from within her conservative party to act. The Greek bailout and a $1 trillion safety net for vulnerable euro zone states, to which Berlin is a major contributor, are deeply unpopular with German voters.
The German parliament is due to vote on the safety net on Friday and the opposition Social Democrats have conditioned their support on pledges to impose a tax on financial markets.
The room for maneuver that Mrs Merkel has is not as big as many people think, said Gerd Langguth, a political scientist at Bonn University and a Merkel biographer.
Many analysts doubt Germany's unilateral ban will have much impact on restricting trade in financial markets which stretch across national borders.
Jean-Pierre Jouyet, head of French markets regulator AMF, told Reuters Berlin's action could actually weaken the euro: It will not be in danger as long as there is an orderly governance and therefore any confusion will help more to weaken the euro than to strengthen it.
A clearly irritated Christine Lagarde, the French economy minister, said Paris had no intention of following suit: It seems to me that one ought to at least seek the advice of the other member states concerned by this measure.
EU finance ministers will discuss the German ban Friday, said EU President Herman van Rompuy, who is to chair meetings on toughening EU budget rules and improving economic governance.
In the United States, where the bulk of credit default swap trading is done, stocks slipped on uncertainty about implications of the ban.
U.S. Treasury Secretary Tim Geithner told CNBC television the history of trading restrictions was not good.
Tightening the euro zone's fiscal rules, to prevent countries from running up huge debts, could help restore investor confidence in the euro over the long term.
In her speech to lawmakers, Merkel demanded tough action against notorious deficit sinners in the euro zone, such as loss of voting rights, to create an incentive for budget rigor.
Above all, what's necessary is to develop a process for an orderly state insolvency, she said, though she did not refer to any country by name.
A German government document showed Wednesday Berlin would press these proposals at Friday's meeting of EU finance ministers. The controversy over its financial regulatory initiative could make agreement more difficult.
In the United States' regulatory reform debate was a setback for the Obama administration. Senate Democrats failed to muster enough support Wednesday to end debate on the biggest overhaul of financial regulation since the 1930s, delaying a vote on passage.
Analysts still expect the legislation eventually to pass. More debate on amendments was likely, with banks on alert for changes that could threaten their profits.
(Additional reporting by Holger Hansen and Andreas Rinke in Berlin, Jan Dahinten in Singapore; Writing by Jon Boyle; Editing by Mike Peacock and Andrew Torchia)