European leaders struggled to reconcile austerity with growth on Monday at a summit due to approve a permanent rescue fund for the euro zone and put finishing touches to a German-driven pact for stricter budget discipline.
Officially, the half-day summit was meant to focus mainly 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 about Greece's unresolved debt restructuring negotiations with private bondholders, may sour efforts to send a more optimistic message that Europe is getting on top of its debt crisis.
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.
And 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 savings 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 that 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.
Despite the rhetoric on growth, debate over strengthening the euro zone's financial defenses and lowering Greece's debt burden are likely to dominate the talks.
Negotiations between the Greek government and private bondholders over the restructuring of 200 billion euros of Greek debt made progress over the weekend, but were not concluded before the summit began.
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 between Greece and its private bondholders, EU leaders cannot move forward with a second, 130 billion euro rescue program for Athens, which they originally agreed to at a summit last October.
Germany caused outrage in Greece by proposing last week 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 idea won cautious backing from the Dutch and Swedish prime ministers.
"We need to have things in place for monitoring that they are really doing what they are promising," Swedish Prime Minister Frederik Reinfeldt told reporters on arrival.
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."
Permanent rescue fund
The leaders were to sign a treaty creating the European Stability Mechanism (ESM), a 500-billion-euro permanent bailout fund that is due to become operational in July, a year earlier than first planned.
But there was a last-minute hitch over the terms of a 'fiscal compact treaty' tightening budget rules when four central European states demanded that countries planning to join the euro 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 - including from Italy's Monti, IMF chief Christine Lagarde and U.S. Treasury Secretary Timothy Geithner - to combine the resources of the two funds to create a
super-firewall of 750 billion euros ($1 trillion).
The International Monetary Fund says if Europe puts up more of its own money, that will convince others to contribute more resources to the IMF, boosting its crisis-fighting abilities and improving market sentiment.
But 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.
However, they were unlikely to resolve a decade-old battle over creating a single European patent which would reduce the high cost of registering inventions and protecting intellectual property. Firms currently have to register patents in each of the 27 member states. The streamlining has long been stymied by disputes over language and the location of an EU patent court.