Germany inched toward a wider ban on naked short selling of stocks and Italy approved austerity measures on Tuesday to contain a euro zone debt crisis that could lead U.S. officials to urge stress tests for European banks.

A draft German finance ministry document called for restrictions on speculative trades that one government source said would be extended to all shares, widening a ban imposed last week that only covered top financial firms, euro government bonds and related credit default swaps.

Berlin's initial move stunned markets though it was seen as largely symbolic because it was isolated -- only Austria followed -- and most of the affected trading takes place in London.

Though experts questioned the efficiency of the policy, it contributed to a climate of uncertainty that undermined the euro, which euro fell to an 8-1/2-year low against the yen and approached a 4-year low versus the dollar.

People are worried the euro zone crisis will spread and derail the global economic recovery, said Carsten Fritsch, an analyst at Commerzbank.

U.S. stocks declined but sharply cut losses late in Tuesday's session. The Dow closed 0.2 percent lower at 10,043.75 points, trading on both sides of the 10,000 mark.

The pan-European stock index fell by as much as 3.4 percent to a nine-month low and the Libor three-month dollar rate rose to the highest level since July as banks became more wary of lending to European institutions after the Spanish government's rescue of a local bank over the weekend.

What's driving the markets so badly at the moment is concern about European banking risk, with a focus on savings banks in Spain after the restructuring of CajaSur, said Bob Parker, vice chairman of asset management at Credit Suisse.

Oil fell below $68 a barrel at one point and gold prices shot above $1,200 an ounce as investors fled riskier assets to the safety of bullion, and the U.S. and Japanese currencies.

BULLARD NOT BEARISH

St. Louis Federal Reserve Bank President James Bullard tried to downplay the risk of contagion, telling Reuters Insider television in London that euro zone guarantees for the region's banking sector would limit the damage globally.

There is some risk that the European crisis will morph into something larger. But as of today, because of bank guarantees, I can't really see it going through into the global banking system, Bullard said.

U.S. Treasury Secretary Timothy Geithner will urge European officials this week to conduct some form of banking system stress tests, CNBC reported, citing an Obama administration official.

The stress tests would differ from those conducted by U.S. regulators in the spring of 2009 because Europe lacks a huge bailout fund like the $700 billion Troubled Asset Relief Program to plug any capital deficiencies found, CNBC said.

Geithner and other Treasury officials routinely argue that the U.S. stress tests helped calm intense market turmoil caused by the financial crisis and helped open the door for private capital to return to the banking sector/

Italy's cabinet on Tuesday approved a multibillion-euro package of budget cuts designed to slash the government's deficit to beneath the EU ceiling of 3/0 percent of GDP by 2012, a government source said.

Details of the measures were not immediately available but a draft of the package obtained by Reuters included a four-year freeze on public sector salaries, and a reduction in state personnel by replacing only one in five of those who leave.

Italy reluctantly joined Greece, Spain and Portugal in trying to slash budget deficits but the downside could be slower economic growth.

There is indeed a risk that, under market pressure, some countries overdo austerity, Olivier Blanchard, chief economist of the International Monetary Fund, said in a newspaper interview. That would be a mistake.

European Economic and Monetary Affairs Commissioner Olli Rehn urged EU governments to combine smart budget cuts with structural reforms such as freeing up labor markets.

A former ECB governing council member, Slovenian European Affairs Minister Mitja Gaspari, said that unless euro zone states with healthier fiscal positions took steps to stimulate growth, the bloc might dip back into recession next year.

The chance of a new (EU) recession is smaller than the chance of things moving for the better but bigger than we thought a few months ago, Gaspari told Reuters.

(Reporting by Reuters bureaux around the world)

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