The United States raised pressure on euro zone leaders to take decisive action to solve the region's debt crisis, notably by lowering troubled members' borrowing costs, on the eve of a crucial European Central Bank meeting.
US Treasury Secretary Timothy Geithner said the euro zone must take steps including "bringing down interest rates in the countries that are reforming and making sure those banking systems can provide the credit those economies need".
He made the comments in an interview with Bloomberg Television broadcast today, a day after he flew to Germany to meet finance minister Wolfgang Schauble and ECB president Mario Draghi.
Italy and Spain, the euro zone's fourth and third largest economies, could lose access to credit markets as the risk premium investors demand to hold their bonds rather than safe-haven German debt has spiralled to levels considered unsustainable in the long term.
But German vice-chancellor Philipp Roesler rejected pressure for the ECB to step in and cap the borrowing costs of troubled euro zone countries, saying the central bank should stick to fighting inflation and not ease the market incentive to reform.
"If you take away the interest rate pressure on individual states, you also take away the pressure on them to reform," Roesler, economy minister and leader of the Free Democrats, junior partners in Chancellor Angela Merkel's centre-right coalition, told reporters in Berlin.
He also reaffirmed Germany's opposition to letting the euro zone's rescue fund borrow from the central bank to buy government bonds, calling it "the road to an inflation union".
Mr Draghi last week said that the central bank would do whatever it takes to preserve the euro, stirring speculation it might take more radical steps when the ECB's policy-setting governing council holds its monthly meeting tomorrow.
Mr Geithner said Mr Schauble and Mr Draghi had walked him through plans they were putting in place to try to solve the crisis, but he cautioned against expecting immediate action.
"What you know, from what Europe has said, that they are committed to doing what's necessary to hold the Europe Union together," said Mr Geithner. "I absolutely believe they have the means to do it."
Mr Geithner said past financial crisis showed that the longer it took to address the issues, the more they cost.
"I believe they understand that. That's why they've signalled they are prepared to move further. Now again, this is going to take time," he added.
Market expectations of a major ECB move this week have faded after a spike following Draghi's comments, with European shares slipping and a rally in Spanish and Italian bonds petering out.
But those traders and investors who expect action tomorrow would sell the euro and European shares and drive up Spanish and Italian bond yields if the ECB did nothing.
Nick Parsons, head of markets strategy at nabCapital in London, predicts the euro could fall a couple of US cents from current levels, while bond market analysts expect Spanish yields to reach new euro-era highs if the ECB does not act.
Italian prime minister Mario Monti, touring Europe to press for action to bring down Rome's borrowing costs, made his pitch to euro zone hardliner Finland today, saying Italy did not need an assistance programme but it might in future need "a breathing break" from high interest rates.
"The basic idea is that Italy does not seem to need special aid right now, especially not to save its economy," Mr Monti was quoted as saying by Finnish daily Helsingin Sanomat on the day he was due to meet Prime Minister Jyrki Katainen.
He added that it was frustrating that reforms his government has carried out are not reflected in interest rates. The euro area financial crisis has sent the group's third largest economy's borrowing costs spiralling.
Central bank sources have told Reuters that intervention could be at least five weeks away because Mr Draghi's comments had not been agreed in advance with the governing council, and other elements must first fall into place.
The sources said the ECB could revive its mothballed sovereign bond-buying programme in tandem with the euro zone's rescue funds, but Spain would first have to request assistance, which it has resisted so far.
Euro zone leaders would have to agree to the rescue funds buying up government bonds, and the German Constitutional Court would have to uphold the legality of the region's permanent rescue fund in a ruling due on September 12th.
The leaders have spent the past week issuing statements promising to take whatever steps are necessary to rescue the currency, but none has raised expectations as high as Draghi, who heads the only federal European institution able to act swiftly and decisively.
However, the ECB is divided with Germany's influential Bundesbank opposed to reviving government bonds or giving the euro zone rescue fund a banking licence so it can borrow from the central bank to buy unlimited quantities of bonds.
Mr Draghi met Bundesbank chief Jens Weidmann privately earlier this week to try to reconcile differences on what action the bank might take. Neither bank would comment on the meeting.
The Bundesbank released a June 29th interview for an in-house publication in which Mr Weidmann said governments expected too much from the central bank, and what they wanted did not always make economic sense.
"Politicians overestimate the central bank's capacity and place too many demands of it," he said.
"Whether it's about interest rates or any sort of special measures, in the end it always comes down to the same thing: trying to rope the central bank into meeting fiscal policy objectives."
Mr Weidmann said the Bundesbank would continue to defend its positions firmly "so that the (European) monetary union remains a stability union".
With the economy slowing and inflation under control, other options on the ECB's radar screen include a possible further cut in interest rates and a further loosening of rules on the collateral it will accept to lend funds to banks.
Unemployment in the euro zone in June hit its highest level since the single currency was born, at 11.2 per cent, while data released yesterday showed capital fleeing Spanish banks at a growing rate.
Reuters
