BRUSSELS (Reuters) ? European leaders struggled to reconcile austerity with growth on Monday at a summit that approved a permanent rescue fund for the euro zone and was trying to put finishing touches to a German-driven pact for stricter budget discipline.
Officially, the half-day 27-nation summit was meant to focus on ways to revive growth and create jobs at a time when governments across Europe are having to cut public spending and raise taxes to tackle mountains of debt.
But disputes over the limits of austerity, and Greece's unfinished debt restructuring negotiations with private bondholders, hampered efforts to send a more optimistic message that Europe is getting on top of its debt crisis.
Leaders agreed that a 500-billion-euro European Stability Mechanism will enter into force in July, a year earlier than planned, to back heavily indebted states. But Europe is already under pressure from the United States, China, the International Monetary Fund and some of its own members to increase the size of the financial firewall.
The risk premium on southern European government bonds rose while the euro and stocks fell on concerns about a lack of tangible progress in the Greek debt talks and gloom about Europe's economic outlook.
Highlighting those fears, Spain's economy contracted in the last quarter of 2011 for the first time in two years and looks set to slip into a long recession.
France halved its 2012 growth forecast to a mere 0.5 percent in another potentially ominous sign for President Nicolas Sarkozy's troubled bid for re-election in May. Prime Minister Francois Fillon said the cut would not entail further budget saving measures.
Conservative Spanish Prime Minister Mariano Rajoy, attending his first EU summit, said Madrid was clearly not going to meet its target of 2.3 percent growth this year. That has raised big doubts about whether it can cut its budget deficit from around 8 percent of economic output in 2011 to 4.4 percent by the end of this year as promised.
European Commission President Jose Manuel Barroso hinted Brussels may ease Spain's near-unattainable 2012 deficit target after it updates EU growth forecasts on February 23.
Italy, rushing through sweeping economic reforms under new Prime Minister Mario Monti, was rewarded with a significant fall in its borrowing costs at an auction of 10- and 5-year bonds, despite double-notch downgrades of its credit rating by Standard & Poor's and Fitch this month.
But Portugal's slide towards becoming the next Greece - needing a second bailout to avoid chaotic bankruptcy - gathered pace as banks raised the cost of insuring government bonds against default and insisted the money be paid up front instead of over several years.
The yield spread on 10-year Portuguese bonds over safe haven German Bunds topped 15 percentage points for the first time in the euro era. It cost a record 3.9 million euros ($5.12 million) to insure 10 million euros of Portuguese debt.
OUTLAWING KEYNES?
With Britain standing aloof, most of the other 26 EU leaders were set to approve a fiscal pact to write balanced budget rules into their national law, despite economists' doubts about the wisdom of effectively outlawing deficit spending.
"To write into law a Germanic view of how one should run an economy and that essentially makes Keynesianism illegal is not something we would do," a British official said.
European Parliament President Martin Schulz told the leaders the new fiscal treaty was unnecessary and unbalanced, because it failed to combine budget rigor with necessary investment in public works to create jobs.
The 17th summit in two years as the EU battles to resolve its sovereign debt problems was called to shift the narrative away from politically unpopular austerity and towards growth.
Negotiations between Greece and private bondholders over restructuring 200 billion euros of debt made progress over the weekend, but were not concluded before the summit.
A Greek official said Prime Minister Lucas Papademos would give the summit a brief report on the situation and meet German Chancellor Angela Merkel on the sidelines.
Until there is a deal, EU leaders cannot move forward with a second, 130-billion-euro rescue program for Athens, which they originally pledged at a summit last October.
Germany caused outrage in Greece by proposing that a European commissar take control of Greek public finances to ensure it meets fiscal targets. Greek Finance Minister Evangelos Venizelos said that to make his country choose between national dignity and financial assistance ignored the lessons of history.
The German call won cautious backing from the Dutch and Swedish prime ministers. But Merkel played down the idea of placing Greece under stewardship, saying: "We are having a debate that we shouldn't be having. This is about how Europe can be supportive so Greece can comply, so there are targets."
FISCAL COMPACT
There was a last-minute hitch over the terms of a 'fiscal compact treaty' tightening euro zone budget rules when four central European states demanded that countries planning to join the single currency be allowed to attend all euro zone summits.
The prime ministers of Poland, the Czech Republic, Hungary and Slovakia agreed to seek an amendment to the text as a condition for joining the pact, a Hungarian spokesman said.
The ESM was meant to replace the European Financial Stability Facility, a temporary fund that has been used to bail out Ireland and Portugal. But pressure is mounting to combine the resources of the two funds to create a super-firewall of 750 billion euros ($1 trillion).
The IMF says if Europe puts up more of its own money, that will convince others to give more resources to the IMF, boosting its crisis-fighting abilities and improving market sentiment.
Germany has so far resisted such a step.
Merkel has said she will not discuss the issue of the ESM/EFSF's ceiling until the next EU summit in March. Meanwhile, financial markets will continue to worry that there may not be sufficient rescue funds available to help the likes of Italy and Spain if they run into renewed debt funding problems.
"There are certainly signals that Germany is willing to consider it and it is rather geared towards March from the German side," a senior euro zone official said.
The sticking point is German public opinion which is tired of bailing out the euro zone's financially less prudent.
The summit was expected to announce that up to 20 billion euros of unspent funds from the EU's 2007-2013 budget will be recycled towards job creation, especially among the young, and will commit to freeing up bank lending to small- and medium-sized companies.
But with no new public money available for a stimulus, leaders focused mainly on promoting structural reforms such as loosening labor market regulation, cutting red tape for business and promoting innovation.
($1 = 0.7615 euros)
(Additional reporting by Julien Toyer, Harry Papachristou and Robin Emmott in Brussels, Marius Zaharia, William James, Chris Wickham and Jeremy Gaunt in London,; Roberta Cowan in Amsterdam,; Writing by Paul Taylor; Editing by Mike Peacock/Elizabeth Piper/Janet McBride)
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