The European Central Bank acted to soften a looming recession and avert a credit crunch by cutting interest rates and offering banks long-term funds on Thursday, as EU leaders prepared for a summit that could determine the fate of the euro zone.
The ECB cut its main rate by a quarter-point to a record low 1.0 percent with anxiety over the worsening sovereign debt crisis drowning out concern about above-target inflation.
ECB President Mario Draghi also announced unprecedented action to support Europe's cash-starved banks with three-year liquidity tenders and easier collateral rules.
"The intensified financial market tensions are continuing to dampen economic activity in the euro area and the outlook remains subject to high uncertainty and substantial downside risks," he said in a gloomy assessment.
Draghi has signalled the ECB may act more aggressively to support government bonds if Friday's EU summit agrees to move towards fiscal union in the euro area.
French President Nicolas Sarkozy dramatised the danger facing the 17-nation single currency area hours before their eighth crisis summit of the year in a speech to European conservative leaders in the French port city of Marseille.
"Never has the risk of Europe exploding been so big," he told leaders including German Chancellor Angela Merkel and the heads of the EU institutions.
"The diagnosis is that the euro, which should inspire confidence, is not inspiring this confidence. The diagnosis is that we have a few weeks to decide, because time is working against us," the French leader said.
"If there is no deal on Friday, there will be no second chance."
European Commission President Jose Manuel Barroso used words reminiscent of the late U.S. President John F. Kennedy to appeal to EU leaders to put aside sharp differences and support their common currency.
"What I expect from all heads of governments is that they don't come saying what they cannot do but what they will do for Europe. All the world is watching us and what the world expects from us is not more national problems but European solutions."
France and Germany used the Marseille meeting to lobby for their plan to amend the European Union treaty to toughen budget discipline, which they want to have ready by March. But several countries are sceptical.
The often contradictory views were illustrated by two comments that came within a few hours of one another. France's Europe minister said the fate of the euro was at stake.
"What that means ... is that the euro can explode and Europe come apart. That would be a catastrophe not only for Europe and France but for the world," Jean Leonetti told Canal+ television.
The chairman of euro area finance ministers said the 17-nation currency was not at risk.
Euro gains
The euro gained on currency markets after the ECB decision but European shares pared gains in thin trading with investors sidelined by uncertainty over the summit outcome.
A Reuters poll of economists found that while 33 out of 57 believe the euro zone will probably survive in its current form, 38 of those questioned expect this week's summit will fail to deliver a decisive solution to the debt crisis.
CNBC's Simon Hobbs has the story on ECB's Mario Draghi's call to add more non-standard measures.
U.S. Treasury Secretary Timothy Geithner, winding up a visit to Europe to urge decisive action, said the world could be encouraged by the euro zone's progress in the last few weeks.
It was essential for European leaders to strengthen their financial firewall to give economic reforms a chance to work, he said after talks with new Italian Prime Minister Mario Monti in Milan. Monti is pushing through economic reforms after the euro zone's third biggest economy found itself sucked to the centre of the debt crisis.
Ratings agency Standard & Poor's has ramped up pressure by threatening a mass downgrade of euro-zone sovereign ratings.
It extended that threat on Wednesday to include the European Union itself, which has had a top-notch AAA rating since the mid-1970s, and large euro-zone banks.
In one glimmer of positive news for stressed euro zone countries, two big financial clearing houses cut the cost of using Italian bonds to raise funds following some easing in the country's bond yields.
In moves to strengthen the euro zone's financial firewall, euro zone officials said the summit was likely to decide to bring forward the launch date of a permanent bailout fund to 2012 from mid-2013 and were close to agreement for their central banks to lend 150 billion euros to the IMF for firefighting.
However, a proposal to give the permanent European Stability Mechanism the right to act like a bank with access to ECB funding was "off the table" due to German opposition, one euro zone source said amid preparatory negotiations.
The EU remains divided over the need for treaty change. Summit chairman Herman Van Rompuy is urging leaders to avoid a laborious full overhaul that could take up to two years and face uncertain ratification. He wants them instead to slip stricter budget enforcement through in a protocol to existing treaties.
This infuriated Merkel and was one reason behind a gloomy briefing by a senior German official on Wednesday, who dampened hopes for a breakthrough and said some leaders and institutions still didn't understand the severity of the crisis.
If all 27 EU states do not support more fiscal union by adapting the existing Lisbon treaty, which took eight years to negotiate, then Sarkozy and Merkel want the 17 euro zone countries to go ahead alone with more integration.
Swedish Prime Minister Fredrik Reinfeldt, speaking for a non-euro state, said: "We respect that the euro zone wants their own meetings and take part of the responsibility on their own ... But we want to stick with the 27 concept of course because all of us are members of the European Union and we want to have our influence. We want to keep the European project together."
Sarkozy and Merkel are both due to hold bilateral meetings later with incoming Spanish Prime Minister Mariano Rajoy before they head to Brussels.
"We need more binding and more ambitious rules and commitments for the euro area member states," Sarkozy and Merkel wrote in a letter to European Council President Van Rompuy, who has made his own proposals for tackling the crisis.
The Franco-German plan would slap automatic penalties on countries that overshoot deficit targets and make countries anchor a balanced budget rule in their constitutions. The sanctions could be stopped only if three quarters of euro zone countries are against them.
Not all euro zone countries are comfortable with all the French and German proposals, with Finland opposed to their call for majority votes on major policy decisions.
With financial market doubts hanging over the euro zone's temporary EFSF financial rescue fund, many economists say that the most effective way of getting a grip on the crisis would be for the ECB to buy euro zone government bonds more aggressively.
But an ECB source said any action on that front would have to await the outcome of Friday's EU summit.
Copyright 2011 Thomson Reuters.
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