German Chancellor Angela Merkel sought to quash talk of an imminent Greek default or exit from the euro zone, but confusion over whether she would issue a joint statement on Greece with French President Sarkozy sent markets gyrating up and then down.
Confidence in the 17-nation currency area was further dented when Italy was forced to pay the highest interest rates since joining the euro in 1999 to sell 5-year bonds.
"I think there is a possibility, if the wrong steps are taken, that the system goes off the rails," Sergio Marchionne, the CEO of Italian carmaker Fiat, told reporters in Frankfurt when asked if the euro's survival was at risk.
Merkel said in a radio interview that Europe was doing everything in its power to avoid a Greek default and urged politicians in her own coalition to weigh their words carefully to avoid creating turmoil on financial markets.
Her economy minister said earlier this week that there should be no taboos in stabilizing the euro, including an orderly bankruptcy of Greece. And lawmakers from her coalition have said in recent days that Greece may have to leave the euro zone -- a move Citigroup's chief economist warned would lead to "financial and economic disaster."
"As soon as Greece has exited, we expect the markets will focus on the country or countries most likely to exit next from the euro area," Willem Buiter said in a note published on Tuesday.
Merkel, in an interview with RBB inforadio, said Europe would use all the tools at its disposal to prevent a Greek default and warned that an exit from the bloc would immediately lead to "domino effects."
"We face a completely new challenge, one that has no historic precedent," she said. "We want our currency to succeed. Germany is absolutely committed to this currency."
BERLIN-PARIS CONFUSION
Merkel and French President Nicolas Sarkozy conferred by telephone on the crisis at the start of the week, and senior French sources told Reuters they planned to issue a joint statement on Greece, sending the euro and Greek bank stocks higher.
Less than an hour later, a spokesman for Sarkozy changed course and denied a statement was planned, sending markets into reverse. German officials told Reuters the government in Berlin had seen no need for a statement, as Merkel and Sarkozy are due to hold a call with Greek Prime Minister George Papandreou on Wednesday.
The mixed signals reinforced the sense in the markets that European countries are unable to unite behind a common approach to the crisis.
Merkel faces intense pressure at home to resist new steps to shore up weak euro zone countries after agreeing to bailouts of Greece, Ireland and Portugal over the past 15 months.
But concern is growing abroad that Europe's piecemeal approach could backfire, with grave consequences for the global economy.
U.S. President Barack Obama told Spanish journalists in a group interview published on Tuesday that euro zone leaders needed to show markets they were taking responsibility for the debt crisis. Weakness in the global economy would persist so long as it is not resolved, he said.
In a measure of the alarm in Washington, Treasury Secretary Timothy Geithner will take the unprecedented step of attending a meeting of EU finance ministers in Poland on Friday. It will be his second trip to Europe in a week after he met his main EU counterparts at a G7 meeting last weekend.
Obama said that while Greece is the immediate concern, an even bigger problem is what may happen should markets keep attacking the larger economies of Spain and Italy.
"In the end the big countries in Europe, the leaders in Europe must meet and take a decision on how to coordinate monetary integration with more effective co-ordinated fiscal policy," the news agency EFE quoted him as saying.
Geithner is likely to urge euro zone finance ministers on Friday to speed up ratification of changes to their bailout fund and consider boosting its size, an EU source said.
ITALY YIELDS SOAR
Markets have already priced in the near certainty of a Greek debt default. Credit default swap prices suggest a 90 percent probability of default in the next five years, according to CDS pricing data provider Markit.
International inspectors are due to return to Athens on Monday to review deficit-cutting steps before deciding on the next tranche of aid.
Greece has said it only has a few weeks' cash and needs the 8 billion euro tranche in October to pay salaries and pensions.
Pressure on Italy mounted on Tuesday at a bond auction that showed the limits of European Central Bank efforts to hold down Rome's borrowing costs by buying government bonds in return for austerity measures to cut its budget deficit.
The five-year bond yield hit a euro lifetime high of 5.60 percent despite ECB purchases in the secondary market that led to the resignation of the central bank's German chief economist, Juergen Stark, last Friday.
"Markets want to see decisive action and they want to see someone in control of the situation," said Marc Ostwald, an analyst at Monument Securities in London.
"Nothing that we've had, be it at a domestic level in Italy, be it at a pan-euro zone level, or above all from Germany, indicates that anyone really is getting to grips with presenting euro zone policy with one voice," he said.
A Financial Times report that Rome had asked China to buy "significant" quantities of its bonds in recent talks provided little support.
A Treasury spokesman said Italian Economy Minister Giulio Tremonti met Chinese officials last week including the head of its sovereign wealth fund. But an Italian ministerial source told Reuters that the talks had centered on possible Chinese investments in Italy's industrial sector, not its bonds.
Chinese leaders have repeatedly offered verbal support to Greece, Portugal and Spain but encouraging words have not so far been matched by spectacular action.
Obama's comments suggested that Washington is trying to nudge European governments toward closer fiscal union or a bigger bailout fund to recapitalize teetering banks but European politics, especially in Germany, make that difficult.
The German Constitutional Court last week appeared to rule out issuing common euro zone bonds unless Berlin amended its Basic Law and the EU adopted a new treaty.
Merkel suggested the way forward should involve sharper punishment for states that violate the bloc's budget discipline rules, which have been repeatedly breached in the last decade, including by central euro zone powers Germany and France.
"Until now, for example, if countries violate the Stability and Growth Pact they cannot be taken before the European Court of Justice," she said.
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