Italy moved closer to a national unity government on Thursday, with outgoing Prime Minister Silvio Berlusconi reversing a call for early elections, as EU policymakers dithered over an accelerating debt crisis.
Political and economic turmoil in Rome has spurred fears of a possible break-up of the euro zone with borrowing costs for Europe's third biggest economy at unsustainable levels and the 17-nation currency bloc unable to afford a bailout.
Three senior European Central Bank policymakers rebuffed pressure from investors and foreign governments to intervene massively as a lender of last resort on bond markets to shield Italy and Spain from rapidly spreading financial contagion.
We have gone pretty far in what we can do but there is not much more that can be expected from us. It is now up to the governments, ECB governing council member Klaas Knot told the Dutch parliament.
Knot, who is also Dutch central bank chief, said bond-buying only had a temporary effect. The ECB has bought more than 180 billion euros of peripheral euro zone bonds and traders said it was active again in the market on Thursday, but the purchases have failed to lower borrowing costs durably.
Stepping up the scale of bond-buying would eventually force the ECB to start printing money with the risk of stoking inflation, which was why the EU treaty had excluded such action, Knot said.
ECB executive board member Peter Praet said it was not the task of the central bank to intervene when there are fundamental doubts about the sustainability of some countries.
In Brussels, a euro zone official said there were no plans to use the bloc's 440-billion-euro ($600 billion) rescue fund to help Italy, even with a precautionary credit line.
Financial assistance is not in the cards, the official said. A second official said: The ECB will be drawn like every one else by the weight of gravity (to act).
Italian 10-year bond yields steadied at around 7 percent, a level seen as unsustainable in the long term, due to signs that the political deadlock may be easing. Rome paid less to sell 1-year treasury bills than many had feared.
Sources in Berlusconi's conservative PdL party said he was convinced it would be better not to call elections at the moment, an abrupt reversal. The billionaire media magnate has agreed to resign within days after parliament approves long delayed economic reforms demanded by European partners.
PdL parliamentary floor leader Fabrizio Cicchitto said the party was now considering supporting a unity government led by former European Commissioner Mario Monti, a respected economist favored by the center-left opposition.
But Berlusconi's populist coalition partner, the Northern League, said it would not back a Monti government.
In Athens, the president's office said Greek party leaders had finally agreed on Lucas Papademos, a former top European Central Bank official, to form an interim government to pull back Greece from the brink of bankruptcy.
The euro rose from a one-month low and world stocks inched up on hopes that new governments being formed in Italy and Greece could help fend off a euro zone break-up.
SMALLER EURO ZONE DENIED
European governments and the EU's executive Commission tried to quash talk of a possible shrinking of the currency area.
EU sources told Reuters on Wednesday that French and German officials had held informal discussions on a two-speed Europe with a more tightly integrated and possibly smaller euro zone and a looser outer circle.
The discussions among senior policymakers, still in the realms of the theoretical, have focused on how to protect the euro zone from breaking up via tighter common policies which some members may by unable or unwilling to live with.
A German government spokesman stressed on Thursday that Berlin was not pursuing the idea of a smaller euro zone. European Commission President Jose Manuel Barroso issued a stark warning of the dangers of a split in the European Union.
There cannot be peace and prosperity in the North or in the West of Europe, if there is no peace and prosperity in the South or in the East, Barroso said in a speech in Berlin.
German Chancellor Angela Merkel said on Wednesday that Europe's plight was now so unpleasant that deep structural reforms were needed quickly, warning the rest of the world would not wait. That will mean more Europe, not less Europe, she told a conference in Berlin.
She called for changes in EU treaties after French President Nicolas Sarkozy advocated a two-speed Europe in which euro zone countries accelerate and deepen integration while an expanding group outside the currency bloc stays more loosely connected -- a signal that some members may have to quit the euro.
The head of the International Monetary Fund called for political clarity in efforts to tackle Italy's debt crisis, warning that the world could face a lost decade if Europe's problems were not tackled boldly.
Uncertainty around who would succeed Berlusconi was fuelling market volatility, Christine Lagarde said on a visit to China.
No one exactly understands who is going to come out as the leader. That confusion is particularly conducive to volatility, she told a news conference in Beijing. Political clarity is conducive to more stability and my objective from the Fund's point of view is better and more stability.
Even with the exit of a man who came to symbolize scandal and empty promises, it will not be easy for Italy to convince markets it can cut its huge debt, liberalize the labor market, attack tax evasion and boost productivity.
Euro zone finance ministers agreed on Monday on a road map for leveraging the currency bloc's rescue fund to shield larger economies like Italy and Spain from a possible Greek default.
But markets are running faster than policy and there are deep doubts about the efficacy of those complex leveraging plans, and with Italy's debt totaling around 1.9 trillion euros even a larger bailout fund could struggle to cope.
In Greece, a government official said the new coalition government would be sworn in at 1200 GMT after days of bickering between the ruling Socialists and the conservative opposition bickered over jobs and austerity plans.
Papademos, a respected figure in European capitals and on financial markets, will lead a national unity government that must sign up to a 130 billion bailout deal with the euro zone before calling an early election.
Greece will run out of money in just over a month unless it meets the conditions to receive the next tranche of EU/IMF aid.
(Additional reporting by Dina Kyriakidou, Angeliki Koutantou and Lefteris Papadimas in Athens, Emelia Sithole-Matarise, Kirsten Donovan and William James in London, Barry Moody and Alberto Sisto in Rome; Writing by Paul Taylor; Editing by Mike Peacock)