Debt Contagion Threat Splits EU Leaders Seeking Rules to Stem Euro Crisis

European Union divisions widened over how to contain the debt contagion that threatens the euro, limiting a summit that began today to an agreement on a crisis- management mechanism that takes effect in 2013.

German Chancellor Angela Merkel balked at boosting or making more flexible use of the EU’s 750 billion-euro ($1 trillion) emergency fund, as leaders neared an accord on the tool to contain future debt shocks and the European Central Bank armed itself with more capital.

Strife among Merkel, the ECB, Luxembourg Prime Minister Jean-Claude Juncker, and the German domestic opposition intensified on the eve of the Brussels summit, marring confidence in Europe’s handling of the fiscal woes that forced Greece and Ireland to fall back on financial handouts.

“There is a situation of European gridlock again with Germany blocking actions to make progress,” said Nick Kounis, chief euro-region economist at ABN Amro NV in Amsterdam and a former U.K. Treasury official. “There is a high risk of the crisis re-escalating and maybe now it’s the quiet before the storm in markets.”

Most European bonds fell today. The extra yield that investors demand to hold Spanish 10-year bonds over German counterparts rose 2 basis points to 244, one day after Moody’s Investors Service warned about a possible credit downgrade. A Spanish bond auction raised 2.4 billion euros, less than the maximum target. The euro fell 0.2 percent to $1.3187.

‘Last Resort’

EU governments are close to agreeing on a two-sentence amendment to the bloc’s Lisbon Treaty foreseeing a “mechanism to safeguard the stability of the euro area as a whole” with financial aid for distressed governments “subject to strict conditionality,” according to a draft text.

Germany has failed to get a reference to possible costs to bondholders enshrined in the treaty and is virtually alone in pushing for the amendment to say that any financial assistance will only be offered as a “last resort,” EU officials said yesterday.

The summit started at 5 p.m. Brussels time with EU President Herman Van Rompuy likely to announce interim results in the late evening after dinner and a round of talks. The gathering is slated to end around 1 p.m. tomorrow.

Last overhauled a year ago, the treaty is the EU’s equivalent of a constitution, binding on EU institutions in Brussels and on national governments’ handling of European affairs. All 27 countries, including the 11 outside the euro region, would need to ratify the amendment.

British Condition

Britain, the largest of the non-euro states and with a soaring deficit of its own, will back a future aid facility as long as it doesn’t have to pay in, Prime Minister David Cameron said.

“We do need a new mechanism to help the euro zone sort out its problems and its issues -- that’s important for Britain,” Cameron said in Brussels. “But we do need to make sure that Britain is not liable to spend money under that mechanism.”

German insistence on cutting bond values when countries get into trouble in the future triggered the latest phase in the debt crisis, culminating in an 85 billion-euro support package for Ireland on Nov. 28.

Merkel laid out a nine-point set of demands that don’t need to be embedded in the treaty, which won backing from euro finance ministers last month. In a retreat for Germany, the plan foresees only “case by case” writedowns for bondholders in accord with International Monetary Fund practices.

‘Decisive Signal’

Today’s summit should send a “clear and decisive signal for Europe,” Merkel told reporters in Brussels. Setting up a permanent mechanism “is a huge step of solidarity among the euro countries.”

Away from the constitutional debate, Finnish Prime Minister Mari Kiviniemi took issue with German objections to adding flexibility to the 440 billion-euro European Financial Stability Facility, the main component of the rescue funds.

“We are not ready to increase the size of the EFSF,” Kiviniemi told Bloomberg Television. “But we are able to consider making that vehicle a bit more flexible.”

Merkel continued to hold out against calls by ECB President Jean-Claude Trichet to put more money into the aid fund. The ECB has bought 72 billion euros of weaker countries’ debt since May under a policy without unanimous support on the bank’s council.

ECB Capital

A “back-of-the-envelope calculation” indicates the ECB may lose money on the emergency purchases, David Owen, chief European economist at Jefferies International Ltd. in London, said yesterday. The ECB today tapped national central banks for an extra 5 billion euros, almost doubling its capital to 10.76 billion euros.

Driven by a German public outcry against aiding fiscally reckless countries, Merkel also ruled out retooling the support facility to buy troubled governments’ bonds and opposed further entwining Europe’s economies by consenting to joint borrowing.

Luxembourg’s Juncker, the promoter of the joint bond-sale proposal, said it won’t go anywhere at the summit. Joint borrowing “would be a good thing even though we won’t come to a conclusion on this at the meeting,” Juncker told InfoRadio Berlin-Brandenburg.

Joining forces to borrow could cost German taxpayers an extra 13.4 billion euros in interest payments annually by harming Germany’s credit rating, the Munich-based Ifo economic research institute said on Nov. 23.

German opposition leaders seized on the debate over the bonds to criticize Merkel. Joint borrowing in the “medium term” could be the kernel of a more integrated European economy, former Finance Minister Peer Steinbrueck and former Foreign Minister Frank-Walter Steinmeier wrote in yesterday’s Financial Times.

“Our leaders face a choice: extend the crisis by stumbling through, or regain momentum to end it,” the two Social Democrats wrote. “Much will depend on the German chancellor.”

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