The euro zone creaked under the weight of record unemployment at the end of 2011 while jobless rates in Germany fell to historic lows, putting the onus firmly on Europe's top economy to take the lead in steering the struggling region back to recovery.

Joblessness in Italy rose to its highest since current records began in 2004, underlining the divergent fortunes of nations at the region's core and its periphery.

The data came a day after Europe's leaders met at a summit to try to shift the economic debate from fighting a deepening debt crisis to reviving growth.

German Chancellor Angela Merkel put her stamp firmly on the continent at the summit when 25 out of 27 EU states agreed to a German-inspired pact for stricter budget discipline.

Ticking both the growth and austerity boxes is tough. It means steering a policy course that promotes stimulus to revive a regional economy teetering on the edge of recession while also pursuing tough cutbacks to keep at bay market players harrying the weaker links in the euro zone debt chain.

As its economy becomes ever more dominant in the region, Germany faces mounting pressure to front the unenviable task of squaring that policy circle, and end an acute balance of payments crisis in the region.

Germany is showing that there is life and fun after austerity, Holger Schmieding, economist at Berenberg Bank in London, said, referring to the German jobs data.

But hopes that traditionally export-focused Germany has much leeway to persuade its citizens to buy more goods and services from other parts of Europe may be misplaced, and the more urgent task would appear to be restoring market faith in the euro zone.

The key for the near-term outlook is not for government spending, it is for the return of (market) confidence, Schmieding said.

In that respect, Germany - along with the European Central Bank - could be a bit more generous. I would like them both to sign up to a stronger safety net for Italy, Schmieding said.

Jobless rates in Italy and Spain, both struggling to persuade markets they can manage their debts against the backdrop of stagnating economies, have risen to multi-year highs.

Joblessness in Italy rose to 8.9 percent, its highest since current records began in 2004, the country's statistics institute said on Tuesday - a figure dwarfed by the 17-year high of 22.85 percent with which Spain ended the year.

German unemployment, by contrast, fell a tenth of a percentage point in January from December to 6.7 percent.

BALANCE OF PAYMENTS

Germany's economy has revived strongly since the crisis of 2008/9, while many of its euro zone peers have stagnated.

Its rebound has been driven in large part by exports, with domestic demand growing at a slower rate, meaning outflows of goods and services between it and its euro zone partners have been heavily weighted in Berlin's favor.

Reversing those flows - or at least ironing out the imbalances - would boost the region's weaker economies.

But getting this done, perhaps by allowing more stores to open on Sundays to boost consumer spending, would have a limited effect.

Germany is also not immune to the currency global slowdown.

Its economy is now at risk of contacting in at least one quarter this year, so German employers also need to be wary of granting inflation-busting pay awards such as the 6.5 percent sought by the IG Metall union for its 3.3 million electronics and metal industry workers.

Across the bloc as a whole, meanwhile, concerns about the outlook for the euro zone seem to have dampened the traditional pre-Christmas shopping spree in the region's top two economies, data showed on Tuesday.

In France, consumer spending unexpectedly dropped by 0.7 percent in December in a sign consumers are tightening their purse strings as uncertainties over jobs and economic growth weigh.

What's obvious is that we've got a real stagnation in consumer spending which raises questions about France's economic model which is based largely on dynamic consumption, Gilles Moec, economist at Deutsche Bank, said.

Data suggested a similar problem in Germany, where retail sales unexpectedly fell 1.4 percent.

GERMANY LEADS

But economists said anecdotal evidence as well as recent consumer surveys suggest German demand remains buoyant and the figure would be revised up.

As long as the labor market is doing well, consumption will be strong, Commerzbank's Ulrike Rondorf said.

That is a lesson Europe's weaker nations may learn by following Germany's lead.

Back in 2005, Germany's jobless rate soared to above 12 percent, while Spain's fell to below 8.5 percent.

Since then, Berlin has implemented root-and-branch labor reforms, matching work hours more closely to demand and introducing job sharing and encouraging part-time work.

By the end of 2011 that picture had dramatically reversed, with Germany falling to a post-reunification low and Spain clocking off the year at 22.85 percent, its highest jobless rate in 17 years.

Germany, in putting into place reforms, has showed that there is a way to prevent this rise in unemployment, Etienne de Callatay, economist at Bank Degroof in Brussels, said.

... If we want to fight against unemployment you need to follow the German example.

Spain's government will unveil major labor reforms later this month, but even if they are far-reaching, the country's central bank only expects jobless rates to fall in the medium term.

Growth will only come from a return of core Europe to where it was before July of last year, when concerns about peripheral nations' ability to service their debts triggered a bout of market contagion, Berenberg Bank's Schmieding said.

(Reporting by Sarah Marsh, Brian Rohan, Robin Emmott and Vicky Buffery. Editing by Jeremy Gaunt.)

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