Italy and Greece backsliding shakes euro zone

A demonstrator holds a flare in front of Milan's Stock Exchange Palace September 6, 2011.

BERLIN (Reuters) - Europe's drive to halt its crippling two-year debt crisis looked increasingly at risk on Tuesday amid doubts about the will in Italy and Greece to push through austerity demanded by their partners, and hardening opposition to further aid in the bloc's paymaster Germany.

Against a backdrop of nationwide strikes, the government of embattled Italian Prime Minister Silvio Berlusconi scrambled to secure parliamentary backing for a reform package, floating new tax rises and budget measures having dropped others last week.

The government said it would raise value added tax and introduce a constitutional balanced budget amendment as part of a revised austerity plan. Its credibility has taken a hammering in financial markets because of the chaotic way it has been handled.

Meanwhile fiscal backsliding in Athens has put a new aid payment from the country's international lenders in danger and prompted lawmakers in German Chancellor Angela Merkel's party to call for Greece's ejection from the 17-nation currency area.

Just six weeks after euro zone leaders came together in Brussels to agree new anti-crisis measures -- including a second bailout for Greece and new powers for the bloc's rescue fund -- their strategy looks to be unravelling.

In southern Europe, public resistance to new austerity measures is on the rise, while in the north public anger at a series of taxpayer funded bailouts is building to a crescendo.

"Once you say to Italy we will not allow you to fail, they then have the upper hand," said David Mackie, an economist at J.P. Morgan in London. "There has been a moral hazard issue with Greece for some time. Now we have one in Italy too."

Italian bonds edged higher a day after a sharp sell-off, with traders citing intervention by the European Central Bank. On Monday, incoming ECB chief Mario Draghi said the bank could not be counted on to buy up the bonds of weak euro zone members indefinitely, in what was widely seen as a warning to his native Italy.

ECB WARNING

The ECB agreed last month to buy Italian and Spanish debt on the open market to prevent an upward spiral in their borrowing costs that could tear Europe's 12-year old single currency apart.

But it did so only after receiving new reform pledges from Rome. Berlusconi's divided coalition government has since tinkered with those reforms, fuelling fears of policy disarray in the euro zone's third biggest economy.

The ECB is counting on European governments to step in and assume the role of bond-buyer of last resort once their rescue mechanism, the European Financial Stability Facility (EFSF), receives new powers.

But for that to happen, national parliaments need to approve the changes to the mechanism -- a major hurdle in member states where aid to euro zone stragglers is increasingly unpopular.

In Germany, Merkel's own position may be at risk if enough of her conservative allies vote against a stronger EFSF in a Bundestag vote scheduled for September 29.

In preliminary internal party votes held late on Monday, 25 lawmakers from Germany's ruling coalition refused to back a draft law on the measure, raising questions about whether she can deliver a parliamentary majority without help from the opposition.

If she fails, she would come under pressure to dissolve parliament and call early elections, a step that still seems unlikely for now.

At a meeting with her party on Monday, Merkel was pressed repeatedly on whether it wouldn't be preferable to push Greece out of the euro zone. She warned against it, saying such a step might set off a dangerous "domino-effect."

Senior officials from the EU, IMF and ECB suspended talks on a new aid payment for Athens on Friday amid a dispute over Greece's failure to meet its deficit targets. The inspectors blame the shortfall on delays in the Greek reform drive.

Greece has floated the idea of speeding up payments under a second international bailout to cover a higher-than-expected deficit, although it has made no formal request and any such change would be unlikely, an official close to EU and IMF negotiators told Reuters on Tuesday.

A separate row is simmering over Finland's demands that Greece provide it with collateral in exchange for loans in a second bail-out package. German Finance Minister Wolfgang Schaeuble was to meet his counterparts from Finland and the Netherlands later on Tuesday to try to break the impasse.

Getting private sector banks on board for the second Greek package is also proving difficult. Greece has asked European financial institutions to disclose how they will participate in a bond swap under which private creditors are expected to take losses of 21 percent on their holdings of Greek debt.

But Charles Dallara, head of the Institute of International Finance which has helped coordinate the swap, said on Tuesday that there were "challenges" to the deal.

The euro zone's woes dominated a major banking conference taking place in Frankfurt, where UniCredit (CRDI.MI) CEO Federico Ghizzoni urged European leaders to decide whether they wanted the euro or were prepared to "give it up."

GERMAN LAWMAKERS REBEL

Merkel faces intense pressure from some other countries in Europe to agree to joint euro zone bonds as a way of solving the crisis, but has repeatedly ruled out such a step, arguing it would push up Berlin's borrowing costs and reduce incentives for countries like Greece and Italy to get their finances in shape.

Schaeuble said in a speech in parliament that euro bonds would be "a perfect case of misconceived solidarity."

"The euro would lose its credibility as a stable currency," he said.

Still, with the crisis deepening two years after it first erupted in Athens, Germany may soon face a choice between agreeing to some of the more radical measures it has resisted or allowing the bloc to splinter apart, in what would be a humiliating setback for Europe after more than half a century of ever-closer integration.

"It is possible that markets develop in such a way over the coming weeks that policymakers are forced to do something they don't want to do, like a much more aggressive pooling of fiscal liabilities" said Mackie of J.P. Morgan. "If market pressure builds to such an extent, I think they won't let the euro fail."

(Writing by Noah Barkin; additional reporting by Stephen Brown, Sarah Marsh and Annika Breidthardt in Berlin, Ed Taylor and Jonathan Gould in Frankfurt, James Mackenzie in Rome, Editing by Stephen Nisbet)