The new head of the European Central Bank signalled on Thursday it stood ready to act more aggressively to fight Europe's debt crisis if political leaders agree next week on much tighter budget controls in the 17-nation euro zone.
In France, President Nicolas Sarkozy called for a new treaty incorporating tougher budget discipline, a European Monetary Fund to support countries in difficulty and decisions in the euro area taken by majority vote instead of unanimity.
Addressing supporters in the port city of Toulon, Sarkozy said he and German Chancellor Angela Merkel would meet next Monday to outline joint proposals to put to a Dec.9 EU summit, seen as make-or-break for the 12-year-old single currency.
Let us not hide it, Europe may be swept away by the crisis if it doesn't get a grip, if it doesn't change," Sarkozy said, warning that a collapse of the euro would make France's debt unmanageable and wipe out people's savings.
We don't have the right to let such a disaster happen."
ECB President Mario Draghi painted a dark picture of the state of Europe's banking system, speaking a day after the world's major central banks took emergency joint action to provide cheaper dollar funding for starved European banks.
"A new fiscal compact would be the most important signal from euro area governments for embarking on a path of comprehensive deepening of economic integration. It would also present a clear trajectory for the future evolution of the euro area, thus framing expectations," he told the European Parliament.
Draghi did not spell out what action the ECB might take, saying only a commitment by political leaders to stricter budget discipline and binding their economies more closely is definitely the most important element to start restoring credibility. Other elements might follow, but the sequencing matters."
In the short-term, economists expect the central bank to relieve pressure on banks and an economy heading into recession by cutting interest rates next week and announcing longer-term cheap liquidity tenders with easier collateral rules. Markets are pricing in a 25 basis point cut to 1.0 percent on Dec. 8.
Draghi, who faces some of the toughest decisions in the currency's 12-year history after just one month in the job, said the ECB was aware many European banks were in difficulty because of stress on sovereign bonds, tight inter-bank funding markets and scarce collateral.
Downside risks to the economic outlook have increased," he said, noting that the ECB's mandate was to maintain price stability "in both directions" -- a rare indication that the bank is concerned about deflation risks as well as inflation.
Sarkozy voiced similar sentiments in words designed to reassure voters anxious about handing more power to Brussels. He called for an intergovernmental" Europe and made no mention of the stronger role for the European Commission or the European Court of Justice sought by Berlin.
"Sovereignty can only be exercised with others. Europe doesn't mean less sovereignty but more sovereignty because it gives us a greater capacity to act," Sarkozy declared.
His Socialist opponents in next year's presidential election denounced an "austerity treaty" imposed by Germany.
Merkel is due to outline her own vision in an address to parliament in Berlin on Friday. Aides said the leaders conferred by telephone to ensure that their speeches, while different in tone, would not be incompatible.
Sarkozy avoided calling directly for massive ECB action to buy bonds of troubled euro zone states or cut interest rates. But he said: "Naturally the European Central Bank has a decisive role to play ... I am convinced that faced with the risk of deflation with threatens Europe the central bank will act."
Two years into Europe's debt crisis, investors are fleeing the euro zone bond market, European banks are dumping government debt, south European banks are bleeding deposits and a recession looms, fuelling doubts about the survival of the single currency.
The euro and European stocks extended gains after surging on Wednesday upon the joint dollar liquidity move by the U.S. Federal Reserve, the ECB and the central banks of Japan, Britain, Canada and Switzerland.
Markets were cheered by strong demand at Spanish and French bond auctions on Thursday. France's 10-year bond spread over safe haven German Bunds fell below 100 basis points for the first time since Oct. 28 after peaking above 200 bps in mid-November.
A group representing many of the world's top private banks added its voice to the calls for action from the ECB. "The crucial role of the ECB in ensuring normal liquidity conditions in the Euro Area sovereign and financial debt markets cannot be overstated," the Institute of International Finance's market monitoring group said in a statement.
NO MORE LOSSES?
EU paymaster Germany is pressing for limited treaty changes to establish coercive powers to veto national budgets in the euro zone that breach agreed rules.
Berlin wants the European Commission to be empowered to reject national budgets before they go to parliament and to refer serial deficit offenders to the European Court of Justice.
Sources close to the negotiations said Germany and France had yet to agree on key issues including the role of the EU executive and court, with Paris preferring an intergovernmental approach leaving the final word with elected leaders.
In another apparent difference, Sarkozy called for a guarantee that savers would face no further losses on European sovereign bonds, and that writedowns for private creditors of Greece would be a one-time exception.
Berlin and its north European allies have so far insisted that private investors must accept the risk of a so-called haircut" on government bonds issued from 2013.
The conservative Sarkozy's main challenger in next year's presidential election, Socialist Francois Hollande, said on Wednesday that as president he would never hand France's budget sovereignty over to European judges.
German Finance Minister Wolfgang Schaeuble said he would propose at the summit that EU states set aside sovereign debt of over 60 percent of gross domestic product -- the EU treaty limit -- in special funds to be paid off over 20 years with national revenues.
Leaders of Merkel's centre-right coalition agreed that Germany's opposition to common euro zone debt issuance was non-negotiable, slamming one door which France and other southern euro zone states have tried to open.
With the ECB barred by treaty from acting as lender of last resort to the euro zone or directly financing governments, EU officials are working on ways to support states under bond market pressure, possibly via the International Monetary Fund.
One idea under active consideration is allowing euro zone national central banks affiliated to the ECB to lend money to the IMF which could provide larger credit lines for Italy and Spain on strictly monitored policy conditions.
In Greece, where the euro zone debt crisis began in 2009, schools, hospitals and public transport were paralysed by a one-day general strike in protest at the new national unity government's EU/IMF-imposed starvation" budget.
The strike is the first such test for new technocrat Prime Minister Lucas Papademos, who has had little time to celebrate since European finance ministers this week approved an 8 billion euro tranche of aid to prevent Greece from going bankrupt.
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