The euro zone is out of the emergency ward, but it may face a chronic debilitating illness rather than a rapid convalescence.

The challenges confronting Europe now are to avoid complacency, rekindle economic growth while cutting debt and prevent national politics pulling the currency area apart.

Last week's European Union summit was the first in two years that was not totally dominated by fire-fighting in the currency bloc's sovereign debt crisis. The relief was audible.

This was not - and that is an innovation - a meeting focused on crisis management, European Commission President Jose Manuel Barroso said. It was a meeting focused on growth.

Three events have changed the mood and calmed financial markets that appeared late last year to be betting on a breakup of Europe's 13-year-old single currency.

European leaders have signed a German-driven fiscal compact treaty giving sharper teeth to their oft disregarded budget discipline rules, and key states such as Italy and Spain are implementing tough spending cuts and pension and labor reforms.

Greece has averted a catastrophic default, at least for now, securing a second international bailout and a deal with private creditors to reduce its debt mountain to more manageable levels.

Above all, two massive injections of cheap, long-term funds by the European Central Bank have prevented an incipient credit crunch that could have triggered bank collapses, bank runs or a bond market inferno forcing Italy or Spain to the wall.

ECB President Mario Draghi is the hero of the hour for finding a way to act as a lender of last resort to banks without breaching an EU treaty prohibition on financing governments directly.

It's not 100 percent guaranteed, but I think we are coming out of this crisis, said French President Nicolas Sarkozy, eager to give voters in next month's presidential election the impression that the worst is behind them.

Such self-congratulation prompted Draghi to warn EU leaders behind closed doors that the crisis was far from over and that the ECB had now done its bit.

Participants quoted him as saying the bank's action had only bought them some time to repair public finances, make credible reforms and revive growth. If Europe did not use the respite to reform, there would be very bad consequences.

FIREWALL

In the next few weeks, EU countries will have to decide how to strengthen their financial firewall, and whether to sanction Spain for flouting agreed deficit reduction targets or allow it more time to revive growth.

German Chancellor Angela Merkel faces a crucial decision by the end of March on whether to allow the euro zone to combine its current temporary and future permanent bailout funds to provide a bigger warchest in case of emergency.

The world's major economies, notably the United States and China, are pressing Europe to put up more money for its own defenses as a condition for raising the International Monetary Fund's resources to combat fallout from the euro zone crisis.

Faced with public hostility and a growing revolt against bailouts in her centre-right coalition, Merkel may be tempted to say there is no need for a bigger rescue fund, which would require tricky parliamentary approval.

German officials say lowering government bond yields too far would only reduce pressure on countries to reform.

If Merkel were to say Nein, and the IMF were to be denied extra funding in April, market tensions could quickly return.

The bond market is euphoric due to Draghi's massive dose of morphine, but it has been anaesthetized, not cured. The pain could return, for example with another round of credit rating agency downgrades of euro zone sovereigns.

Another complacency risk is that countries such as France, whose borrowing costs have fallen, ease up on austerity measures in an election year. Italy's political parties are already watering down some of the radical liberalizing reforms proposed by Prime Minister Mario Monti's government of technocrats.

Other political pitfalls lurk in Ireland, which has a track record of voting No to EU treaties and is putting the fiscal compact to a referendum, and in Greece, which is heading for a general election amid public fury over harsh austerity imposed by its international lenders.

The political will to steward years more of economic hardship there is anything but certain.

SPANISH TEST

Above all, there is the contradiction between the need to cut debt and foster growth, without which debt is more likely to rise than fall.

Spain is a test case with Madrid seeking more time to reduce its deficit, which hit a far-above-forecast 8.5 percent of gross domestic product last year.

The European Commission and Europe's northern deficit hawks are determined to uphold the credibility of the new system while Madrid is desperate to avoid plunging the country into a Greek-style spiral of depression through more drastic budget cuts.

With unemployment above 23 percent and one young person in two out of work, Spain faces possible social unrest - a risk that also stalks Portugal, mired in economic gloom.

A widening gap between more dynamic northern economies and shrinking southern ones is bound to fuel political tension with a lost generation facing mass unemployment in several states.

Another uncertainty factor is France, which may well elect a Socialist president in May committed to renegotiating the fiscal compact to make it more growth-friendly. This may be mostly about political symbolism, but the potential for a clash with Germany is real if Francois Hollande defeats Sarkozy.

The politics of euro zone bailouts could become more fraught in Berlin, where Merkel's Bavarian sister party and her ailing Free Democratic partners are flirting with Euroscepticism ahead of elections in 2013.

If Greece were to fall behind on its bailout program again, the pressure to cut off aid and let it default and leave the euro zone could become overwhelming in Germany, Finland and the Netherlands - the euro zone's last AAA-rated states.

Despite those risks, it's hard to blame European leaders for feeling some satisfaction after two years of crisis management that drew such widespread criticism as too little and too late.

It is not a sin to be a little more optimistic, said a senior EU official who has been in the thick of all 18 summits since the outbreak of the crisis in early 2010. We are nearing in some way a turning point in the euro zone crisis.

But if the euro is sailing into calmer waters, there are still plenty of concealed rocks just below the surface.

There is a strong possibility that the crisis is moving from a very hot phase into a cold phase. Does that mean it is over? Not at all. There are still lots of dangers, said Janis Emmanouilidis, senior fellow at the European Policy Centre think-tank.

(Additional reporting by Luke Baker; Writing by Paul Taylor, editing by Mike Peacock)

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