Eurozone Crackup Feared as Italy Teeters

The continuing political and economic crisis in Italy spurred fears of a split in the Eurozone Thursday, with borrowing costs for its third-biggest economy at unsustainable levels and the bloc unable to afford a bailout.

European Union sources told Reuters that French and German officials had held discussions on a two-tier Europe with a smaller, more tightly integrated Eurozone and a looser outer circle.

The discussions among senior policymakers, still in the realms of the theoretical, have focused on how to protect the Eurozone from breaking up via tighter common policies which some members may by unable or unwilling to live with.

A German government spokesman said Thursday that Berlin wasn't pursuing the idea of a smaller Eurozone.

Asian shares fell more than three percent after similar falls on Wall Street and in Europe as investors took fright at the accelerating sovereign debt crisis and at buck-passing among European leaders and institutions.

The risk premium on all southern European government bonds over safe-haven German Bunds continued to rise at the opening Thursday ahead of an Italian treasury bill sale seen as a major test of the country's ability to fund itself.

As the crisis accelerated, European Commission President Jose Manuel Barroso issued a stark warning of the dangers of a split in the European Union.

There cannot be peace and prosperity in the North or in the West of Europe, if there is no peace and prosperity in the South or in the East, Barroso said in a speech in Berlin.

The European Central Bank's hardline chief economist told governments not to expect the bank to rescue them with unlimited funds, despite its efforts to stabilize runaway bond markets.

We are not the lender of last resort, and I do not advise European governments to ask the ECB to become lender of last resort, Juergen Stark, who will quit his post in protest at continued bond-buying, told a conference in Frankfurt.

This will mean that the ECB immediately will lose its independence.

It wasn't clear to what extent he spoke for new ECB President Mario Draghi, but the central bank has so far opposed any role in helping to leverage the Eurozone's rescue fund.

The ECB, the only effective bulwark against market attacks, intervened to buy Italian bonds in large amounts Wednesday and was back in the fray Thursday, but Italy's 10-year bond yields have shot above seven percent, a level widely deemed unsustainable.

One Eurozone official said the bloc wasn't making any plans to bail out Italy, which is deemed too big to save, with the 440-billion-euro European Financial Stability Facility.

Financial assistance is not in the cards, the official said, adding that the bloc wasn't even considering extending a precautionary credit line to Rome.

A second official said: The ECB will be drawn like every one else by the weight of gravity (to act).

MORE EUROPE?

German Chancellor Angela Merkel said Wednesday that Europe's plight was now so unpleasant that deep structural reforms were needed quickly, warning the rest of the world wouldn't wait. That will mean more Europe, not less Europe, she told a conference in Berlin.

She called for changes in EU treaties after French President Nicolas Sarkozy advocated a two-speed Europe in which Eurozone countries accelerate and deepen integration while an expanding group outside the currency bloc stays more loosely connected -- a signal that some members may have to quit the euro.

With Italy replacing Greece at the center of the crisis, politicians in outgoing Prime Minister Silvio Berlusconi's party appeared to be having second thoughts about his insistence on elections instead of an interim government.

Having lost his majority in a parliamentary vote, Berlusconi confirmed he would resign after implementing economic reforms demanded by the EU, and said Italy must then hold an election in which he wouldn't stand.

But Fabrizio Cicchitto, parliamentary floor leader of Berlusconi's PDL party, said the group was now considering supporting a unity government led by former European Commissioner Mario Monti as well as the option of early elections.

The head of the International Monetary Fund called for political clarity in efforts to tackle Italy's debt crisis, warning that the world could face a lost decade if Europe's problems were not tackled boldly.

Uncertainty around who would succeed Berlusconi was fuelling market volatility, Christine Lagarde said on a visit to China.

No one exactly understands who is going to come out as the leader. That confusion is particularly conducive to volatility, she told a news conference in Beijing.

Political clarity is conducive to more stability and my objective from the fund's point of view is better and more stability.

An early election would probably not happen until February, leaving a three-month policy vacuum in which markets could create havoc.

Even with the exit of a man who came to symbolize scandal and empty promises, it won't be easy for Italy to convince markets it can cut its huge debt, liberalize the labor market, attack tax evasion and boost productivity.

Eurozone finance ministers agreed on Monday on a road map for leveraging the 17-nation currency bloc's rescue fund to shield larger economies like Italy and Spain from a possible Greek default.

But markets are running faster than policy and there are serious doubts about the efficacy of those complex plans, and with Italy's debt totaling around 1.9 trillion euros even a larger bailout fund could struggle to cope.

Many outside Europe are calling on the ECB to take a more active role as other major central banks do in acting as lender of last resort. German opposition to that remains implacable, seeing it as a threat to the central bank's independence.

In Greece, political leaders resumed their search for a national unity government as the country headed toward an economic abyss, with former ECB vice-president Lucas Papademos re-emerging as favorite to head an interim coalition Cabinet.

Papademos made his demands for both major parties to back a new bailout package, which includes austerity measures that are likely to prove highly unpopular, amid warnings that Europe is running out of patience with Greece and may cut a financial lifeline that the party leaders seem to take for granted.

Outgoing Prime Minister George Papandreou and opposition leaders met President Karolas Papoulias for a fourth day of talks on a crisis coalition that must secure financial aid before Greece runs out of money in just over a month.

(Additional reporting by Dina Kyriakidou and Lefteris Papadimas in Athens, Emelia Sithole-Matarise, Kirsten Donovan and William James in London; Writing by Paul Taylor; Editing by Mike Peacock)