ROME/ATHENS (Reuters) - Italy moved closer to a national unity government on Thursday, following Greece's lead in seeking a respected veteran technocrat to pilot painful economic reforms in an effort to avert a euro zone bond market meltdown.
After five days of chaotic haggling, former European Central Bank vice-president Lucas Papademos was appointed to head an interim crisis cabinet charged with saving Greece from default, bankruptcy and an exit from the euro zone.
In Rome, former European Commissioner Mario Monti emerged as favorite to replace Italian Prime Minister Silvio Berlusconi within days and lead an emergency government that would implement long delayed reforms of pensions, labor markets and business regulation.
A political source said Monti, 68, would meet President Giorgio Napolitano and lower house speaker Gianfranco Fini on Thursday night.
Italy's political and economic turmoil has spurred fears of a possible break-up of the euro zone with borrowing costs for Europe's third biggest economy at unsustainable levels and the 17-nation currency bloc unable to afford a bailout.
German Chancellor Angela Merkel, Europe's main paymaster, called for broad political support for reforms in Greece and said Italy was on the road to winning back confidence, but political clarity was still needed.
She dismissed talk of a possible shrinking of the currency area, saying: "We only have one goal, that is to bring about a stabilization of the euro zone in its current form."
European Union officials continued to dither and pass the buck on how best to fight the worsening sovereign debt crisis.
Three senior ECB policymakers rebuffed pressure from investors and world leaders to intervene massively as a lender of last resort on bond markets to shield Italy and Spain from rapidly spreading financial contagion.
"We have gone pretty far in what we can do but there is not much more that can be expected from us. It is now up to the governments," ECB governing council member Klaas Knot told the Dutch parliament.
Knot, the Dutch central bank chief, said bond-buying only had a temporary effect. The ECB has bought more than 180 billion euros of peripheral euro zone bonds and traders said it was active in the market again on Thursday, but the purchases have failed to lower borrowing costs durably.
Stepping up the scale of bond-buying would eventually force the ECB to start printing money with the risk of stoking inflation, which was why the EU treaty had excluded such action, Knot said.
ECB executive board member Peter Praet said it was not the task of the central bank to intervene "when there are fundamental doubts about the sustainability of some countries." Outgoing ECB chief economist Juergen Stark earlier rejected calls for the ECB to act as lender of last resort like the U.S. Federal Reserve or the Bank of England.
In Brussels, a euro zone official said there were no plans to use the bloc's 440-billion-euro ($600 billion) rescue fund to help Italy, even with a precautionary credit line.
"Financial assistance is not in the cards," the official said. A second official said: "The ECB will be drawn like every one else by the weight of gravity (to act).
The euro rose from a one-month low on hopes that new governments being formed in Italy and Greece could help fend off a euro zone break-up.
Italian 10-year bond yields fell back below the red line of 7 percent from 7.6 percent on Wednesday, a level seen as unsustainable in the long term, amid signs that the political deadlock was easing. Rome paid less to sell 1-year treasury bills than many had feared.
President Giorgio Napolitano asked Monti, a respected economist whom he appointed a senator for life on Wednesday, to stay in Rome over the weekend and drop out of a conference he was due to chair in The Hague as moves to form a new government accelerated.
Political sources said the timetable imposed by the head of state, whose role is usually ceremonial, could see a broad-based Monti government as early as Sunday night or Monday.
Sources in Berlusconi's conservative PdL party said he was now convinced it would be better not to call elections at the moment, an abrupt reversal. The billionaire media magnate has agreed to depart as soon as parliament approves economic reforms demanded by European partners.
Berlusconi's populist coalition partner, the Northern League, said it would not support a Monti government.
Monti, 68, has made no public statement and it is unclear what conditions he might set for taking office.
In Athens, Papademos said after agreeing to head a crisis coalition: "The Greek economy is facing huge problems despite the efforts undertaken.
"The choices we will make will be decisive for the Greek people. The path will not be easy but I am convinced the problems will be resolved faster and at a smaller cost if there is unity, understanding and prudence."
His government may serve barely 100 days. No official date was set for early elections but Papademos said the parties had agreed on an indicative date of February 19.
SMALLER EURO ZONE DENIED
Merkel, French officials and the EU's executive Commission all tried to quash talk of a possible shrinking of the euro area, although they raised the possibility last week that Greece might have to leave the single currency.
EU sources told Reuters that French and German officials had held informal discussions on a two-speed Europe with a more tightly integrated and possibly smaller euro zone and a looser outer circle.
European Commission President Jose Manuel Barroso issued a stark warning of the dangers of a split in the European Union.
"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 in a speech in Berlin.
Merkel has called for changes in EU treaties and French President Nicolas Sarkozy advocated a two-speed Europe with a deeply integrated euro zone at its core and an expanding but looser group outside the currency bloc.
The head of the International Monetary Fund said uncertainty around who would succeed Berlusconi was fuelling market turmoil.
"That confusion is particularly conducive to volatility," Christine Lagarde told a news conference in Beijing. "Political clarity is conducive to more stability and my objective from the Fund's point of view is better and more stability."
A senior G20 source said ideas of convening an emergency meeting of finance ministers of the world's leading economies to discuss support measures for the euro zone before the French presidency ends at the end of the year had fizzled out. They would meet next in Mexico in February.
Euro zone finance ministers agreed on Monday on a road map for leveraging the currency bloc's rescue fund to shield larger economies like Italy and Spain from a possible Greek default.
But markets are running faster than policy and there are deep doubts about the efficacy of those complex leveraging plans, and with Italy's debt totaling around 1.9 trillion euros even a larger bailout fund could struggle to cope.
(Additional reporting by Dina Kyriakidou, Angeliki Koutantou and Lefteris Papadimas in Athens, Emelia Sithole-Matarise, Kirsten Donovan and William James in London, Barry Moody and Alberto Sisto in Rome; Writing by Paul Taylor; Editing by Mike Peacock)