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Europe's leaders in last-ditch effort to avert crisis

Jean-Paul Pelissier / Reuters

Buddy can you spare a euro? France's President Nicolas Sarkozy, speaking at the Conservative European People's Party (EPP) congress in Marseille, warns that Europe's economy is facing huge risks.

As Europe's leaders gather for what some believe may be their last chance to preserve the continent's  monetary union, European central bankers slashed interest rates Thursday to ease a credit crunch that has sparked a euro zone recession.

Despite talk of bold new measures to tighten controls over members' spending and debt, though, there appears to be little chance that the eighth crisis summit this year, set to begin in Brussels late Thursday, will resolve the deep political divisions that have brought Europe to the brink of financial collapse. 

Just hours before leaders of the 17 nations joined by a common currency convene the summit, French President Nicolas Sarkozy echoed what many observers have been saying in the weeks leading up to the meeting.

"Never has the risk of Europe exploding been so big," he told a gathering of European Union leaders. "The diagnosis is that the euro, which should inspire confidence, is not inspiring this confidence. If there is no deal on Friday, there will be no second chance."

The current quandary has been building for more than a year, as have fears that one or more Europe’s most heavily debt-laden governments will default. Despite three bailouts, a cobbled patchwork of backstop funds, and multiple failed summits and proposed solutions, the crisis continues to envelop the European financial system and economy.

Investors are demanding ever–higher interest rates on government bonds to offset the risk they wont get their money back. European bankers are having a harder time raising capital, even as regulators have ordered them to build up bigger cash reserves. That’s made it harder, and more costly, for European businesses and consumers to borrow money.

The European Central Bank tried to douse the flames Thursday by cutting interest rates a quarter point to a record low one percent. But at a news conference following the rate cut announcement, ECB President Mario Draghi dashed hopes that the move signaled the opening round of a wider effort to to ease rising market pressure on interest rates with massive bond purchases.

Draghi's comments sent financial markets lower and further eroded confidence that Friday’s meeting will generate a meaningful solution to the crisis.

"One step forward, two steps back," said Alan Clarke, U.K. and euro zone economist at Scotia Capital. "The euro zone leaders might as well not bother. Pack their bags, go home, enjoy the weekend and do their Christmas shopping."

The latest plan being floated by Sarkozy and German Chancellor Angela Merkel would create a mechanism for automatic penalties on countries that don’t meet budget deficit targets. Euro zone countries would also be forced to include a balanced budget requirement in their constitutions.

Even if the 17 leaders agree to such a plan on Friday, it remains to be seen whether voters in member countries will go along.

Proposals for tough budget-balancing measures have been warmly received by investors. But they have generated violent protests in countries such as Greece that have enacted them. Deep spending cuts have also accelerated the euro zone's economic contraction. 

No matter what measures those leaders agree to, they will have little long-term impact without popular support.

“Because of the bumps in the road that will inevitably occur along the way, it will be too easy for politicians down the road, when it's not Merkel or Sarkozy, to blame it on the people who agreed to it at the time,” said  Steve Crawford, an investment banker with Centerview Partners. “I think some democratic process needs to occur because of the consequences that are likely to happen down the road.”

That process will take time, something many investors believe Europe has run out of. 

European voters, meanwhile, remain deeply divided over how to get the continent back on a sound financial footing. French voters are loathe to dilute their national independence by turning over control of budgetary decisions to a central European agency with the veto power over spending decisions. With a presidential election looming, Sarkozy faces rivals who are warning voters that he wants to sacrifice French sovereignty to unelected EU officials.

German voters, on the other hand, are opposed to any measure that would divert their taxes to the cause of bailing out weaker, free-spending countries. Merkel has also steadfastly opposed calls for the ECB to print euros to underwrite massive bond purchases; that’s largely due to the German public’s deep-seated fears of a recurrence of hyperinflation that sank the Weimar Republic in the 1920s. 

The Fast Money traders take a look at Mario Draghi's comments impacting stocks today and await former MF Global CEO Jon Corzine's testimony.

Consumer and business confidence has been sapped by the crisis, tipping the euro zone into a mild recession that threatens to deepen the longer leaders fail to arrive at a solution.

The ECB’s official forecast calls for euro zone gross domestic product to shrink by as much as a full percentage point next year. Some private forecasters, including IHS Global Insight’s chief European economist Howard Archer, think that assessment may not be pessimistic enough.

The ECB's rate cut follows a concerted move on Nov. 30 by central banks areound the world to supply the global capital markets with more cash and avert a wider credit crunch. The Federal Reserve has been working to put out the fire with a series of so-called “swap lines” that supply the ECB with dollars, which it then lends to European banks in exchange for dollar-denominated bonds. As other sources of dollar funding have dried up, European bankers have leaned heavily on those swaps, borrowing $50 billion this week. That’s up from $500 million in November.

Bond rating agency Standard & Poor's put more pressure on European leaders to solve the debt crisis by threatening to downgrade its risk assessment for all 17 countries that use the euro.  The warning Wednesday includes the European Union itself, along with large euro zone banks.