By Barry Moody and Andreas Rinke
ROME/BERLIN (Reuters) - Italian borrowing costs reached breaking point on Wednesday after Prime Minister Silvio Berlusconi's insistence on elections instead of an interim government threatened prolonged instability and kindled fears of a split in the euro zone.
European Commission President Jose Manuel Barroso issued a stern warning of the dangers of splitting the zone, rocked by an escalating debt crisis. EU sources told Reuters French and German officials had held discussions on just such a move.
"There cannot be peace and prosperity in the North or in the West of Europe, if there is no peace and prosperity in the South or in the East," Barroso said.
Italian 10-year bond yields shot above the 7 percent level that is widely deemed unsustainable, reflecting an evaporation of investor confidence and prompting German Chancellor Angela Merkel to issue a call to arms.
Merkel said Europe's plight was now so "unpleasant" that deep structural reforms were needed quickly, warning the rest of the world would not wait. "That will mean more Europe, not less Europe," she told a conference in Berlin.
She called for changes in EU treaties after French President Nicolas Sarkozy advocated a two-speed Europe in which euro zone countries accelerate and deepen integration while an expanding group outside the currency bloc stays more loosely connected -- a signal that some members may have to quit the euro.
"It is time for a breakthrough to a new Europe," Merkel said. "A community that says, regardless of what happens in the rest of the world, that it can never again change its ground rules, that community simply can't survive."
The European Central Bank, the only effective bulwark against market attacks, intervened to buy Italian bonds in large amounts but remained reluctant to go further.
Italy has replaced Greece at the center of the crisis and is on the cusp of needing a bailout that Europe cannot afford.
"Financial assistance is not in the cards," one euro zone official said, adding that the bloc was not even considering extending a precautionary credit line to Rome.
Having lost his majority in a parliamentary vote, Berlusconi confirmed he would resign after implementing economic reforms demanded by the European Union, and said Italy must then hold an election in which he would not stand.
He opposed any form of transitional or unity government -- which the opposition and many in the markets favor -- and said polls were not likely until February, leaving a three-month policy vacuum in which markets could create havoc.
Italian President Giorgio Napolitano said there was no doubt about the resignation of Berlusconi once economic reforms were implemented by parliament within days.
"Therefore, within a short time either a new government will be formed...or parliament will be dissolved to immediately begin an electoral campaign," Napolitano said.
Even with the exit of a man who came to symbolize scandal and empty promises, it will not be easy for Italy to convince markets it can cut its huge debt, liberalize the labor market, attack tax evasion and boost productivity.
Worries that the debt crisis could be infiltrating the core of the euro zone were reflected in the spread of 10-year French government bonds over their German equivalent blowing out to a euro era high around 140 basis points.
FRUSTRATION
Policymakers outside the euro area kept up pressure for more decisive action to stop the crisis spreading.
Christine Lagarde, head of the International Monetary Fund, told a financial forum in Beijing that Europe's debt crisis risked plunging the global economy into a Japan-style "lost decade."
"If we do not act boldly and if we do not act together, the economy around the world runs the risk of downward spiral of uncertainty, financial instability and potential collapse of global demand."
Berlusconi has reluctantly conceded that the IMF can oversee Italian reform efforts.
Euro zone finance ministers agreed on Monday on a road map for leveraging the 17-nation currency bloc's 440-billion-euro ($600 billion) rescue fund to shield larger economies like Italy and Spain from a possible Greek default.
But there are doubts about the efficacy of those complex plans, and with Italy's debt totaling around 1.9 trillion euros even a larger bailout fund could struggle to cope.
Lagarde said she was hopeful the technical details on boosting the European Financial Stability Fund (EFSF) to around 1 trillion euros would be ready by December.
Many outside Europe are calling on the ECB to take a more active role as other major central banks do in acting as lender of last resort. German opposition to that remains implacable, seeing it as a threat to the central bank's independence.
"The ECB will be drawn like everyone else by the weight of gravity (to act)," one euro zone official said.
"CORE" ZONE DISCUSSED
EU sources told Reuters German and French officials had discussed plans for a radical overhaul of the European Union that would involve establishing a more integrated and potentially smaller euro zone.
The discussions among policymakers in Paris, Berlin and Brussels raise the possibility of one or more countries leaving the zone, while the core pushes to deeper economic integration.
In a speech in Berlin, Barroso said Germany's gross domestic product could contract by 3 percent if the 17-member zone shrank and its economy would shed a million jobs.
"What is more, it would jeopardize the future prosperity of the next generation," he said.
Barroso said any push toward deeper integration should not come at the price of new divisions among EU member states.
GREEK DRAMA
With the markets' fire turned firmly on Italy, Greece's struggle to find a new prime minister became something of a sideshow, but one which demonstrated the difficulty in taking decisive action anywhere within the euro zone.
Greek Prime Minister George Papandreou said he was stepping down without saying who would succeed him as the nation heads toward bankruptcy, but party sources said leaders had agreed it would be the speaker of parliament.
Parties from left and right settled on veteran socialist Filippos Petsalnikos, barring-last minute snags, the sources said, turning to their own political class after ditching a plan to recruit a former top European Central Bank official.
The socialist and conservative parties had wanted former ECB vice-president Lucas Papademos to lead a government of national unity but he appears to have made demands about his level of influence which they could not swallow.
(Additional reporting by Dina Kyriakidou and Lefteris Papadimas in Athens, Emelia Sithole-Matarise, Kirsten Donovan and William James in London; Writing by Mike Peacock; Editing by Janet McBride and Andrew Roche)
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