Marathon negotiations to overhaul Spain's rigid labor market collapsed on Thursday, leaving a fragile government to impose looser hire-and-fire laws without trade union backing in the troubled euro zone state.
The head of the World Bank earlier cast doubt on Europe's ability to surmount a sovereign debt crisis without restructuring liabilities of heavily indebted countries such as Greece -- a step euro zone leaders are refusing to contemplate.
Bond markets snapped up a new Spanish 3-year benchmark issue, which saw solid demand albeit at a premium, boosting the euro and Spanish stocks.
That and an earlier auction in Portugal showed that fiscally stressed southern euro zone countries -- potentially backed since Monday by 440 billion euros of credit guarantees from euro zone governments -- can still access the credit markets.
In the Netherlands, a virtual dead heat in Wednesday's general election between right-wing Liberals, who advocate stark budget cuts, and the center-left Labor Party, which wants less austerity, raised the prospect of months of policy deadlock.
The Liberals won a fragile one-seat lead, putting them in pole position to form a coalition that must tackle a ballooning budget deficit in the fiscally conservative euro zone country. But negotiations are set to be long and complex, with at least three parties required to form a majority.
In Spain the failure of talks with employers and unions left Prime Minister Jose Luis Rodriguez Zapatero's minority Socialist government seeking allies among regional parties to enact new labor laws without a social consensus at a time when his high-deficit country is already under financial market pressure.
Economists consider labor market reforms, along with bank restructuring and reducing a budget deficit that is above 11 percent of national output, essential to solving Spain's longer-term economic problems after a deep recession.
A top financial source said on Wednesday that smaller Spanish banks were losing access to European credit markets due to concerns that Spain could be heading for a crisis along the lines of Greece, although its public debt is far smaller.
Fellow euro zone weakling Portugal attracted strong demand at a bond auction on Wednesday and ruled out needing to draw on the euro zone rescue package.
Lisbon had to pay a higher yield of 5.225 percent on its 10-year bond, well above May's 4.523 percent, at a time when benchmark German bond yields are at a record low.
Euribor interbank lending rates climbed above the European Central Bank's (ECB) benchmark interest rate for the first time in seven months on Thursday in a sign of persistent reluctance of banks in the euro area to lend to each other.
As expected, the ECB left interest rates at 1 percent on Thursday and the Bank of England also kept rates unchanged.
ZOELLICK CHALLENGES TABOO
World Bank chief Robert Zoellick challenged a European taboo in a speech in Berlin on Wednesday evening by saying a managed restructuring could raise confidence in financial markets if a euro zone country were unable to pay its debts.
The uncertainty about who will pay and how they will pay can exacerbate and spread fears -- sweeping along other countries, or banks, that would otherwise be able to manage given discipline and time, he said.
One needs to consider these issues carefully, case-by-case. If it becomes clear that a particular debtor cannot pay back its borrowings, a managed restructuring, combined with financial support, can create confidence that growth can be restored, Zoellick said according to a prepared text.
European Union governments and the ECB have insisted there is no question of any euro zone country having to reschedule or reduce its debt mountain, including Greece, which received a euro zone/IMF bailout last month.
Greece's debt stands at 120 percent of gross national product and is projected to rise to 145 percent in 2013, while its economy is expected to contract further.
ECB inflation hawk Axel Weber, head of Germany's powerful Bundesbank, said on Wednesday that financial markets' skepticism of the rescue plan for Greece and a wider $1 trillion safety net for the euro zone was incomprehensible.
The euro zone needed to win back lost confidence after its latest bout of support measures, he said, adding that recent austerity measures announced by Spain, Portugal and Greece went in the right direction, even though they were only first steps.
Weber opposed and has continued to criticize the ECB's decision to start buying euro government bonds to support countries having difficulty accessing credit markets.
ECB President Jean-Claude Trichet was expected to face questions about that rift, and about the bank's relatively opaque bond-purchasing program at a news conference (1230 GMT) after the central bank's monthly Governing Council meeting.
A weekly running total published by the ECB on Monday showed bond purchasing slowed to 5.5 billion euros last week. But the bank discloses neither the nationalities of the debt purchased -- presumed by traders to be mostly Greek -- nor the institutions from which it buys bonds in the market.
(Additional reporting by Gilbert Kreijger in Amsterdam, Paul Day in Madrid, Paul Carrel in Berlin, Sergio Goncalves and Andrei Khalip in Portugal; writing by Paul Taylor, editing by Jason Neely, John Stonestreet)