* ECB liquidity flood buys policymakers time
* Spain is test case for application of fiscal rules
* Unemployment at euro-era record, growth strategy in focus
* Merkel says improving competitiveness is key (Adds Merkel, De Guindos, ISDA decision)
By Paul Taylor and Jan Strupczewski
BRUSSELS, March 1 (Reuters) - European Union leaders wrestled on Thursday with the balance between budget austerity and reviving lost growth at the first summit for two years in which the euro zone debt crisis did not eclipse all else.
With a second bailout for Greece almost in place and a flood of cheap European Central Bank funds calming bond markets, the 27 leaders have a breathing space to focus on structural economic reforms and other ways to combat record unemployment.
Leaders of 25 countries will sign a German-driven fiscal compact treaty on Friday to enforce EU deficit-cutting and debt reduction rules more strictly.
But without a return to growth several European countries risk entering the same spiral of depression as Greece.
"We need to improve our competitiveness. Only if Europe manages that will we have a future in which we are able to shrink our budget deficits and safeguard our wealth and jobs in Europe," German Chancellor Angela Merkel told reporters.
The head of EU employers' lobby BusinessEurope warned Europe's leaders that domestic demand remains depressed and expansion plans have been undermined by political uncertainty.
"We must not allow an acute crisis to become a chronic story of low growth," Philippe de Buck said.
Unemployment in the 17-nation euro zone hit a euro-era record 10.7 percent in January, data out on Thursday showed, and the euro zone's manufacturing sector contracted for the seventh month running in February.
While jobless totals in economic powerhouse Germany continue to decline, the unemployment rate in Spain rose to 23.3 percent, with one young person in two out of work.
"Despite the euphoria in the banking sector following the ECB's loan programme, the real economy remains very depressed and the key factor is the unemployment rate, both socially and because of the damage to growth," said Steen Jakobsen, an economist at Saxobank.
Spain is emerging as the test case of whether Europe is willing to ease its drive for balanced budgets to allow more scope for the growth that is essential to work down public debt.
Madrid reported this week its 2011 deficit hit 8.5 percent of gross domestic product, far above the 6 percent target agreed with Brussels. That means it would have to cut the equivalent of four percentage points of GDP to meet this year's target of 4.4 percent, while the economy is forecast to contract by 1 percent.
Prime Minister Mariano Rajoy's new government is privately pleading for more realistic revised targets, posing a dilemma for the European Commission, which is trying to restore the credibility of rules flouted in the past not only by Greece but also by Germany and France, the bloc's two biggest economies.
"Spain is going to meet all its commitments in terms of budget adjustments taking into account the fact that the situation has changed," Economy Minister Luis de Guindos said.
"The previous government had agreed to reduce the deficit to 4.4 percent based on growth of 2.3 percent, which is not the case today," he told reporters.
No decision on Spain is expected at the summit, but the debate is sure to loom large in the corridors, as will international pressure for the euro zone to boost its financial firewall to prevent the debt crisis engulfing other countries.
At Merkel's insistence, the issue of increasing the size of the currency bloc's rescue fund was not on the agenda either, but her partners will be looking for assurances that Berlin is ready to move on the issue later this month.
Merkel faces strong public hostility to further bailouts and a backbench revolt in her centre-right coalition that could make it hard to win parliamentary support for a bigger bailout fund.
German officials say that with bond market tensions easing, there is no immediate need to combine the existing temporary rescue fund with a planned permanent 500-billion-euro European Stability Mechanism to build a bigger firewall.
Major economies in the Group of 20 told the Europeans last weekend they would not give the International Monetary Fund more money to combat the fallout from the euro zone crisis unless Europe first increased its own warchest.
A day after the ECB pumped another 530 billion euros of cheap, three-year liquidity into European banks, yields on Italian 10-year bonds fell below 5 percent for the first time since last August. Spanish bond yields also dropped, while safe-haven German Bund futures slid in a sign of returning risk appetite among investors.
In another boost for euro zone leaders, the industry body responsible for determining when bondholders are entitled to cash in credit insurance ruled on Thursday that Greece's recent preparations for a debt restructuring do not constitute a "credit event" triggering a credit default swaps payout.
But while the decision by the International Swaps and Derivatives Association cheered EU officials who have been keen to avoid such a potentially disruptive event, it angered the world's biggest bond fund manager, California-based PIMCO.
PIMCO's co-founder and chief investment officer Bill Gross said ISDA's decision set a dangerous precedent.
It could yet change if Greece uses a legal device next week to force recalcitrant creditors to sign up to a bond exchange.
Economists say the ECB's massive money creation buys time for the euro zone but will not solve the bloc's problems, which require a return to competitiveness and growth in peripheral member states and a rebalancing between the strong and weak.
The fiscal compact treaty which Merkel demanded as a condition for further financial assistance to countries in trouble faces two uncertainties.
Ireland announced this week it would put the matter to a referendum in a country suffering from a steep economic decline and under an EU/IMF bailout programme.
Perhaps the bigger uncertainty lies in France, where opposition Socialist presidential candidate Francois Hollande has vowed to renegotiate the treaty to add measures to promote growth if, as opinion polls suggest, he defeats conservative President Nicolas Sarkozy in a May runoff.
European Council President Herman Van Rompuy urged EU leaders in a letter to focus on practical implementation of economic reforms to boost their growth potential.
Van Rompuy said in a paper prepared for the summit that those countries under market scrutiny must pursue fiscal consolidation in earnest, but others should use their budgetary room for manoeuvre to boost demand to fight economic stagnation. (Additional reporting by Robin Emmott, Luke Baker and Julien Toyer in Brussels. Writing by Paul Taylor, editing by Mike Peacock)