Europe could be in worst hour since WW2: Merkel

(Reuters) - German Chancellor Angela Merkel said on Monday that Europe could be living through its toughest hour since World War Two as new leaders in Italy and Greece rushed to form governments and limit the damage from the euro zone debt crisis.

A rally on financial markets sparked by the appointment of respected European technocrats in Rome and Athens soon stalled. Analysts warned that daunting obstacles could hinder the decisive action needed to revive their ailing economies.

Italy had to pay a euro-lifetime record yield of 6.3 percent to sell five-year bonds with investors wary of buying its debt until prime minister-designate Mario Monti can undertake profound economic reforms.

In a first sign of trouble for new Greek Prime Minister Lucas Papademos, the leader of the main conservative party rejected any toughening of austerity and refused to sign a letter sought by European authorities pledging support for a new 130 billion euro bailout.

Merkel put the situation facing the euro zone into stark relief in an attempt to rally her conservative party behind the government at a congress in Leipzig.

"Europe is in one of its toughest, perhaps the toughest hour since World War Two," she told her Christian Democrats (CDU), saying she feared Europe would fail if the euro failed and vowing to do anything to stop this from happening.

In a one-hour address, Merkel called for closer European political union but offered no new ideas for resolving a crisis that has forced bailouts of Greece, Ireland and Portugal, raising fears about the survival of the 17-state currency zone.

European Union governments have until a summit on December 9 to come up with the outlines of a bolder and more convincing strategy, with some form of massive, visible financial backing.

Prospects are uncertain as the German government, the Bundesbank and hardliners in the European Central Bank have blocked key policy options. These include issuing common euro zone bonds, mutualising the euro zone's debt stock, letting the ECB create money to fight the crisis, or having it act as lender of last resort, directly or via the euro zone rescue fund.

Finance Minister Wolfgang Schaeuble told Reuters that Germany wanted Europe to push through changes to the EU's Lisbon Treaty by the end of 2012 that set the foundation for a common fiscal policy in the bloc.

He conceded some non-euro states might oppose that but said they should not prevent the 17 euro zone countries going ahead.

"The most important thing is quick agreement on the structures for a fiscal union," he said.

HIGH DRAMA IN ROME

In weekend drama, Italy's president asked Monti, a former European commissioner, to form a government to reverse a disastrous collapse of market confidence in an economy whose debt burden is too big for the euro bloc to bail out.

Italians sang, danced and drank champagne in the streets to celebrate the resignation of scandal-plagued billionaire Silvio Berlusconi, and an impromptu orchestra near the presidential palace played the Hallelujah chorus from Handel's Messiah.

The ECB has been buying troubled euro zone governments' bonds episodically to try to stabilize markets. But figures released on Monday showed it halved its weekly bond buy at the height of the Italian government crisis last week, suggesting it was no longer willing to help Berlusconi.

After a tumultuous week, when Italy's borrowing costs rose to the kind of levels that saw Ireland and Greece forced to seek international bailouts, initial market reaction was positive on Monday, with both stocks and bond markets lifted.

But in a sign of the fragile state of confidence, the trend was reversed after the Italian bond auction, and the release of figures showing industrial production slumped by 2 percent in the euro zone in September, raising the specter of recession.

Monti held talks with political parties on Monday before separate meetings with trade unions and employers on Tuesday, as he moves to appoint what is expected to be a relatively small cabinet made up of experts from outside parliament.

He went to work after a frenetic weekend in which Italy's parliament approved a package of economic reforms agreed with European leaders, clearing the way for Berlusconi to resign.

"Monti spoke about a significant program with many sacrifices," Francesco Nucara, a lawmaker from one of the myriad tiny parliamentary groups involved in the talks, said after meeting the prime minister-designate.

Monti told a news conference that political parties must understand the depth of the crisis, and that he aimed to serve until scheduled elections in 2013, not just until reforms had been pushed through.

"NO SILVER BULLET"

Global equity markets and the euro slid on doubts the incoming Italian and Greek leaders would take the tough steps needed to resolve the debt crisis.

Mark McCormick, currency strategist at Brown Brothers Harriman in New York, called the national unity governments in Italy and Greece "the necessary policy response to avert a meltdown", but said they were "unlikely to be a silver bullet".

While Italy's problems and the long-drawn-out departure of Berlusconi have pushed the collapse of the much smaller Greek economy backstage, IMF and European leaders will keep Papademos under pressure to implement radical reforms.

Papademos succeeded George Papandreou, whose proposal to hold a referendum on the bailout terms prompted EU leaders to raise the threat of a Greek exit from the currency bloc.

The new premier, who oversaw Greece's entry to the euro zone in 2002, must win a confidence vote on Wednesday before meeting euro zone finance ministers in Brussels on Thursday.

He told parliament at the start of the confidence debate that the policies needed to secure an international bailout had aggravated the recession, but added that Greece had no choice but to remain within the euro zone.

Reforms -- including widening the tax base and fighting rampant tax evasion -- could mitigate the problem, he said.

The Herculean task he faces was illustrated when New Democracy leader Antonis Samaras said he would not vote for new austerity measures. Spending cuts and tax rises agreed with foreign lenders should be changed in favor of economic growth.

"I agree with the goals to cut government spending ... to reduce debt, to erase the deficit, to make structural changes. I do not agree with whatever stunts growth," he told party MPs.

Inspectors for Greece's international lenders, known as the troika, were due to meet Papademos's administration after the confidence vote, but uncertainty grew whether they would come.

DISRUPTIVE DEMONSTRATIONS

Most Greeks hailed Papademos's appointment, but thousands of people angry at more than a year of austerity are expected to rally on Thursday, the anniversary of a 1973 student uprising that helped to bring down a 1967-1974 military junta.

That could complicate talks between the troika and the new cabinet, as the demonstration is expected to shut down central Athens and could be the biggest rally in months of protests that have at times turned violent.

Carlos Martin Ruiz de Gordejuela, spokesman for the European Commission's mission in Greece, said the troika team "may come at the end of the week but nothing is fixed".

Monday's euro zone industrial production figures pointed to a sharp contraction toward the end of the year and the risk of a double-dip recession.

The slide in output at euro zone factories was the biggest since February 2009 -- when the economy was reeling from the worst financial crisis since the 1930s.

"It clearly doesn't bode well for the future," said Francois Cabau, an economist at Barclays Capital. "If we don't see some resolution of the euro zone sovereign debt crisis, business confidence could go even lower."