European leaders will struggle to reconcile austerity with growth on Monday at a summit due to approve a permanent rescue fund for the euro zone and put finishing touches to a German-driven pact for stricter budget discipline.

Officially, the half-day summit is meant to focus mainly on ways to rekindle growth and create jobs at a time when governments across Europe are having to cut public spending and raise taxes to tackle mountains of debt.

But disputes over the limits of austerity, and about Greece's unresolved debt restructuring negotiations with private bondholders, may sour efforts to send a more optimistic message that Europe is getting on top of its debt crisis.

The risk premium on southern European government bonds rose and stocks were lower on concerns about a lack of tangible progress in the Greek debt talks and gloom about Europe's economic outlook.

Highlighting those fears, Spain's economy contracted in the last quarter of 2011 for the first time in two years and looks set to slip into a long recession.

Italy, rushing through economic reforms under new technocrat Prime Minister Mario Monti, was rewarded with a significant fall in its borrowing costs at an auction of 10- and 5-year bonds on Monday, despite double-notch downgrades of its credit rating by Standard & Poor's and Fitch this month.

But Portugal's slide towards becoming the next Greece - needing a second bailout to avoid chaotic bankruptcy - gathered pace as banks raised the cost of insuring government bonds against default and insisted the money be paid up front instead of over years. On Monday it cost a record 3.9 million euros ($5.12 million) to insure 10 million euros of Portuguese debt.

OUTLAWING KEYNES?

With Britain standing aloof, most of the other 26 EU leaders are set to agree on a fiscal pact to write balanced budget rules into their national law, despite many economists' doubts about the economic wisdom of effectively outlawing deficit spending.

"To write into law a Germanic view of how one should run an economy and that essentially makes Keynesianism illegal is not something we would do," a British official said.

The 17th summit in two years as the EU battles to resolve its sovereign debt problems is meant to shift the narrative away from politically unpopular austerity and towards growth.

The summit is expected to announce that up to 20 billion euros of unspent funds from the EU's 2007-2013 budget will be recycled towards job creation, especially among the young, and will commit to freeing up bank lending to small- and medium-sized companies.

But with no new public money available for a stimulus, leaders will focus mainly on promoting structural reforms such as loosening labour market regulation, cutting red tape for business and promoting innovation.

However, they are unlikely to resolve a decade-old battle over creating a single European patent which would reduce the high cost of registering inventions and protecting intellectual property. Firms currently have to register patents in each of the 27 member states. The streamlining has long been stymied by disputes over language and the location of an EU patent court.

Europe's largest consumer electronics maker, Philips , was the latest in a series of companies to feel the effects of the worsening euro zone economy.

The group swung to a net loss of 160 million euros in the fourth quarter from a profit of 465 million a year earlier as state budget cuts ate into the market for healthcare equipment and declining construction activity dogged its lighting sector.

Philips, which is already cutting 4,500 jobs to revive its bottom line, said the prospects for this year were no brighter.

"We are cautious about 2012 given the uncertainty in the global economy, and Europe in particular," said Chief Executive Frans van Van Houten.

Despite the rhetoric on growth, debate over strengthening the euro zone's financial defences and lowering Greece's debt burden are likely to dominate the talks.

Negotiations between the Greek government and private bondholders over the restructuring of 200 billion euros of Greek debt made progress over the weekend, but are not expected to conclude before the summit begins at 1400 GMT.

Until there is a deal between Greece and its private bondholders, EU leaders cannot move forward with a second, 130 billion euro rescue programme for Athens, which they originally agreed to at a summit last October.

Instead, they will sign a treaty creating the European Stability Mechanism (ESM), a 500-billion-euro permanent bailout fund that is due to become operational in July, a year earlier than first planned. And they are likely to agree the terms of a 'fiscal treaty' tightening budget rules for those that sign up.

 

PERMANENT RESCUE FUND

The ESM was meant to replace the European Financial Stability Facility, a temporary fund that has been used to bail out Ireland and Portugal.

But pressure is mounting - including from Italy's Monti, IMF chief Christine Lagarde and U.S. Treasury Secretary Timothy Geithner - to combine the resources of the two funds to create a super-firewall of 750 billion euros ($1 trillion).

The International Monetary Fund says if Europe puts up more of its own money, that will convince others to contribute more resources to the IMF, boosting its crisis-fighting abilities and improving market sentiment.

But Germany has so far resisted such a step.

Chancellor Angela Merkel has said she will not discuss the issue of the ESM/EFSF's ceiling until leaders meet for their next summit in March. In the meantime, financial markets will continue to worry that there may not be sufficient rescue funds available to help the likes of Italy and Spain if they run into renewed debt funding problems.

"There are certainly signals that Germany is willing to consider it and it is rather geared towards March from the German side," a senior euro zone official said.

The sticking point is German public opinion which is tired of bailing out the euro zone's financially less prudent.