International lenders told Greece on Monday it must shrink its public sector and improve tax collection to avoid running out of money within weeks as investors spooked by political setbacks in Europe dumped risky euro zone assets.

Greece is near an agreement to continue receiving bailout funds, a Greek finance ministry official said after a conference call with lenders, though some work still needs to be done.

U.S. stocks staged a late comeback on the news of the possible deal.

Finance Minister Evangelos Venizelos held what Greece termed productive and substantive talks by telephone with senior officials of the European Union and International Monetary Fund after promising as much austerity as necessary to win a vital next installment of aid.

Before the talks, which will resume on Tuesday evening after meetings of experts through the day, the IMF representative in Greece spelled out steps Athens must take to secure the 8 billion euro loan payment it needs to pay salaries and pensions next month.

The ball is in the Greek court. Implementation is of the essence, Bob Traa told an economic conference.

Additional savings measures were required to cut the public deficit to a sustainable level and reduce the public sector's claim on resources -- code for axing jobs and cutting pay and pensions -- while improving tax collection rather than adding further taxes, Traa said.

Venizelos said the country would do what was necessary to get more rescue funds, but would not allow itself to be made a scapegoat by euro zone policymakers who had failed to deal with the region's debt woes.

European stocks and the euro fell sharply on fears of a Greek default, compounded by the failure of EU finance ministers to agree new steps to resolve Europe's debt crisis at weekend talks, and another regional election defeat for German Chancellor Angela Merkel.

In a sign of mounting stress, yields on Italian and Spanish bonds rose further above 5 percent despite six weeks of European Central Bank buying in an effort to stabilize them. The cost of insuring peripheral debt against default also rose.

There will be additional volatility in the global financial markets heading into the end of the month as the pressure to get Greece and others to enact their reforms will be white-hot intense, said Andrew Busch, global currency strategist at BMO Capital Markets in Chicago.

The euro zone debt crisis is now dominating the thoughts of policymakers worldwide with the United States, in particular, pushing for more dramatic action from Europe's leaders.

A new and larger risk looms. The drop in markets and confidence could prompt slippage in developing countries' investment and a pull back by their consumers too, World Bank chief Robert Zoellick said ahead of G20 talks and an IMF/World Bank meeting in Washington later in the week.

Without its next loan tranche, Athens says it will run out of cash in mid-October, leaving it unable to cover state salaries and pensions and pay its bills.

A default would pose the risk of contagion to larger euro zone economies such as Italy and hammer European banks with heavy exposure to Greece.

The finance ministry said no cabinet meeting was scheduled after the telephone call with international lenders or on Tuesday.

Prime Minister George Papandreou canceled a planned trip to Washington and the United Nations at the last minute and returned home in response to the crisis.

A senior Greek government official told Reuters the EU/IMF inspectors expect a new property tax unveiled last week to yield just half the two billion euros targeted this year.

Greek media published a list of 15 austerity measures it said the troika was demanding the Socialist government implement to receive the next tranche of aid.

They included firing another 20,000 state workers, cutting or freezing state salaries and pensions, increasing heating oil tax, shutting down loss-making state organizations, cutting health spending and speeding up privatizations.

The European Commission said it was not asking Athens to adopt any additional austerity steps on top of what had already been agreed in the Greek reform program.

What is on the table is full compliance with the agreed targets, Commission spokesman Amadeu Altafaj said in Brussels.

PUBLIC SUPPORT LACKING

The IMF's Traa acknowledged that the IMF/EU bailout program lacked public support and said there was plenty of goodwill to give Greece more time for its adjustment program in a weaker than expected economy.

He said the economy was set to contract by 5.5 percent this year and 2.5 percent in 2012.

Asked whether Greece would get the next loan tranche, finance minister Venizelos told Reuters: Yes, of course.

Even if it does, many economists and investors believe Athens will have to default on its debt mountain -- more than 150 percent of gross national product -- perhaps within months.

Former IMF managing-director Dominique Strauss-Kahn joined this chorus on Sunday, saying in a French TV interview that Greece's debt must be reduced, and government and private creditors should take losses now rather than playing for time.

(EU) governments are not solving things, they are kicking the problem down the road, and the snowball is growing and making the problem bigger and bigger, he told TF1 television.

Uncertainty over Greece was compounded by another political shock in Germany at the weekend.

The sixth regional election defeat this year for Merkel's center-right coalition on Sunday raised questions about the stability of her government and her ability to push through more euro zone rescue measures.

Her Free Democratic (FDP) junior coalition partners crashed out of the Berlin regional assembly with just 1.8 percent of the vote, raising pressure from some party activists to take a more Euroskeptical line.

The Berlin regional vote appeared to leave the cautious Merkel with less room for maneuver to take bold action in defense of the euro.

Leaders of both the Bavarian Christian Social Union (CSU) and the FDP have raised the prospect of Greece defaulting and possibly having to leave the 17-nation single currency area, ignoring rebukes from the chancellor for alarming markets.

Merkel said on Monday it would send a disastrous political message if euro zone members could be thrown out of the bloc because they faced difficulties. Instead, she advocated tougher rules to force euro states to obey budget discipline.

German lawmakers are due to vote on September 29 on reforms agreed by euro zone leaders in July to allow the European Financial Stability Facility to buy government bonds in the secondary market, give states precautionary loans and lend to recapitalize banks.

Merkel insisted she would win the vote. We intend to pass it of course with our own parliamentary majority ... I am confident this will be the case, she said.

In another illustration of the pressures on her, German central bank chief Jens Weidmann told parliament that planned measures to beef up the euro zone's rescue fund would not encourage countries to put their budgets in order.

U.S. Treasury Secretary Timothy Geithner pressed euro zone finance ministers apparently in vain at a meeting in Wroclaw, Poland, to take stronger action to stop the sovereign debt crisis spreading.

One of his predecessors, Lawrence Summers, said in a Reuters column that all nations should pressure Europe to go beyond grudging incrementalism to recapitalize banks, and revive economic growth.

(Additional reporting by Brian Rohan in Berlin, Catherine Bremer in Paris, William James and Natsuko Waki in London, Harry Papachristou in Athens, Kristina Cooke in New York; Writing by Paul Taylor; editing by Janet McBride/Mike Peacock and Kenneth Barry)