The European Commission's chief accused Germany on Monday of making naive proposals to combat the euro zone debt crisis, while financial markets took fright after Spain bailed out a small savings bank.

The International Monetary Fund also called on Madrid to make major economic reforms, saying it faced severe problems including a dysfunctional labor market.

With Europe's leaders still divided over how to safeguard the euro project, Commission President Jose Manuel Barroso took a swipe at German Chancellor Angela Merkel's assertion that changes to the EU treaty were unavoidable.

We will not propose treaty modifications even though we are open to good ideas, he told a German newspaper.

It would also be naive to think one can reform the treaty only in areas Germany considers important, he said in an interview with the Frankfurter Allgemeine Zeitung.

European Union leaders agreed a $1 trillion safety net for the euro currency earlier this month after Merkel dropped her long-standing opposition. This prevented the debt crisis which began in Greece for spreading to other euro zone countries with big budget deficits and debt loads, such as Spain and Portugal.

But Merkel, facing anger at home that Germany would fund the bulk of any bailout, has said the agreement merely bought some time, and Europe had to deal with governments which threatened the currency bloc by breaking the EU's budget and debt rules.

Barroso suggested any attempt at rewriting the EU treaty would open a Pandora's box of conflicting demands.

Berlin wants to strengthen enforcement of EU budget rules with stiffer penalties such as withdrawal of some EU funding and the voting rights of countries that are rampant violators.

There are already procedures by which states with excessive deficits do not vote. Under constitutional law it would be nearly impossible to do more, in my view, said Barroso.

SEEKING LEADERSHIP

Financial markets seeking firm leadership from Europe in overcoming its economic problems have not taken such public bickering well. But on Monday a local problem with a small Spanish bank caused jitters across markets globally.

The euro fell about 1.5 percent, stocks see-sawed and bank-to-bank funding costs rose after the Spanish central bank took over savings bank CajaSur on Saturday.

Gold prices rose more than 1 percent as investors moved into a traditional retreat during uncertain times.

People are going into safety. Things are not going to change overnight, said George Goncalves, head of U.S. interest rate strategy with Nomura Securities International in New York.

Europe ought to be in relatively good shape, with the falling euro helping its exporters to sell into regions which are growing more strongly such as the United States and Asia.

But analysts said there was still no confidence that euro zone governments could solve the problem.

Strong global growth, an expansionary monetary stance and a falling euro would normally point to solid euro-area growth. But the deterioration in credit markets represents an important challenge to a fragile euro-area recovery, said Darren Williams, senior European economist at Alliance Bernstein.

A BAD TIME FOR SPAIN

CajaSur's rescue came at a bad time for the Spanish government, which last week announced a 15 billion euro austerity package to repair public finances.

Analysts said the stability of Spain's financial system was not at risk. Foreign investors could be reading the CajaSur intervention as a signal that further bank bailouts could be on the cards and are extrapolating the savings banks' situation to the rest of the system ... But there is no foundation for this, Renta 4 bank analyst Nuria Alvarez said.

The IMF was less sanguine, saying Spain must make far-reaching, comprehensive reforms.

The challenges are severe: a dysfunctional labor market, the deflating property bubble, a large fiscal deficit, heavy private sector and external indebtedness, anemic productivity growth, weak competitiveness, and a banking sector with pockets of weakness, the IMF said in a report.

Spain faces the threat of a general strike over the austerity measures and unions are still trying to agree labor market reforms to reduce its unemployment rate from 20 percent, the highest in the euro zone.

Italy, which is also carrying a huge debt burden, is acting to combat its problems. An austerity budget which the cabinet is due to approve on Tuesday cuts public sector hiring and pay, temporarily delays retirement for some state workers and reduces funds to local government, according to a draft.

(Additional reporting Gavin Jones in Rome, Walter Brandimarte in New York, Ian Chua in London, Paul Day in Madrid; editing by Myra MacDonald)

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