By James Mackenzie and Ilona Wissenbach
Just 24 hours before European Union leaders are due to adopt a plan to reduce Greece's debt burden, fortify European banks to withstand bond losses, and scale up the euro zone rescue fund to prevent market contagion, all eyes were on Rome.
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Prime Minister Silvio Berlusconi's faction-ridden cabinet failed to agree at an emergency session late Monday on raising the retirement age, one of the key economic reforms demanded by Italy's EU partners as a condition for supporting its bonds.
Berlusconi responded defiantly to public pressure from French President Nicolas Sarkozy and German Chancellor Angela Merkel at an EU meeting on Sunday, saying in a statement that no one could teach Italy lessons.
The European Commission said it was not about humiliating Italy, but about ensuring that a member state meets its commitments on budget discipline and economic coordination.
"It's not about challenging sovereignty, it's not about lecturing, it's not about humiliating," said the Commission spokesman on economic issues, Amadeu Altafaj.
"We have 27 democratically elected governments, which have agreed on reinforcing surveillance and on having a higher degree of coordination of their economic policies. It makes sense. It's one of the main lessons of the crisis."
With Berlusconi's Northern League coalition partners opposed to raising the retirement age to 67 from 65, there was growing talk that a government crisis could lead to an early parliamentary election. Northern League leader Umberto Bossi told reporters the center-right cabinet was at risk over the EU reform demands.
"The situation is difficult, very dangerous. This is a dramatic moment," Bossi said.
As the coalition parties held separate meetings, President Giorgio Napolitano said in a statement Italy must do everything to reduce the risk to government bonds by making its commitment to cut public debt more credible and boosting growth.
The euro zone's number three economy is at the center of the storm, despite European Central Bank intervention to buy its bonds, because it needs to issue some 600 billion euros in bonds in the next three years to refinance maturing debt.
Italy has the euro zone's largest sovereign bond market, with public debt of 1.8 trillion euros, 120 percent of GDP.
Italy was not the only unresolved item on the summit agenda and Bank of England governor Mervyn King voiced skepticism from outside the euro zone as to whether the currency area's leaders would be able to find solutions.
"Even on July 21 there was a package which they held out as being the solution to it. The underlying problems hadn't changed at all and they won't change," King told the House of Commons treasury committee.
"The aim of the measures to be introduced over the next few days is to create a year or possibly two years' breathing space. The underlying problems still have to be resolved."
GAME OF CHICKEN
Tough negotiations were continuing between euro zone governments and Greece's private bondholders over the scale of a write-down they will have to accept on Greek debt holdings.
Governments are demanding that banks and insurers accept a 60 percent "haircut" as part of a second rescue package to make Athens' debt mountain, set to reach 160 percent of economic output this year, more sustainable.
Bank negotiators have offered a 40 percent write-down and warned that forcing them into deeper losses would amount to a forced default with what banks say will be devastating consequences for the European financial system.
EU diplomats said the outcome of the game of chicken between governments and banks was uncertain, but some forecast a last-minute deal on a 50 percent write-down.
Greek Prime Minister George Papandreou said: "I hope that tomorrow we will come to decisions, this is our partners' will.
"Tomorrow we want to put an end, turn a page, in order for the country to move forward."
Many uncertainties remain also over complex options to increase the firepower of the 440-billion-euro ($600 billion) European Financial Stability Facility so it can prevent contagion spreading from Greece to Italy and Spain.
A working paper circulated to German lawmakers on Monday set out two options that might be used separately or in tandem to provide partial insurance on new Italian and Spanish bonds and to attract foreign sovereign and private investors via a special purpose investment vehicle (SPIV).
The German parliament has insisted on holding a vote on Wednesday to give Merkel a mandate just before she leaves for the euro zone summit.
Her Free Democratic junior coalition partners, who have dabbled in Euroscepticism, said the plan, which could leverage the EFSF up to more than 1 trillion euros, was acceptable. Finance Minister Wolfgang Schaeuble was to present the plan to parliament's budget committee on Tuesday.
Financial markets held their breath with trading volatile pending the outcome of Wednesday night's summit, due to start with a short meeting of the full 27-nation European Union at 1600 GMT, followed by a lengthier session of the 17 euro zone members.
The euro and European shares were steady, but in a sign of bond market nerves, Spain's short-term borrowing costs jumped to their highest since 2008 at an auction of three- and six-month bills on Tuesday.
Even if the leaders agree on the leverage plan for the EFSF, the arrangements could take several weeks to put in place and euro zone leaders are counting heavily on the European Central Bank to go on buying Italian and Spanish bonds.
Draft conclusions for Wednesday's summit, obtained by Reuters, show leaders want to include a line urging the ECB to continue "non-standard measures in the current exceptional financial market environment", a reference to buying bonds in the secondary market.
But Merkel opposed any such wording.
Outgoing ECB President Jean-Claude Trichet, who retires next week, had signaled that the central bank was looking to exit from the deeply controversial bond-buying policy once the EFSF gained its new powers to intervene on bond markets.
EU officials say they are counting on his successor, Mario Draghi of Italy, to continue the purchases as long as is necessary to stabilize the bond markets.
Diplomats said France and the European Commission wanted a line in Wednesday's euro zone summit statement welcoming the ECB's willingness to continue supporting states in difficulty -- a formula that would respect the bank's cherished independence.
(For an Interactive timeline on Eurozone debt crisis in the last year please click on http://link.reuters.com/rev89r )
(Additional reporting by Paolo Biondi and Roberto Landucci in Rome, Andreas Rinke in Berlin, Luke Baker in Brussels, David Milliken and Emilia Sithole-Matarise in London; Writing by Paul Taylor; editing by Janet McBride)