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BRUSSELS (Reuters) - Chancellor Angela Merkel cemented her political ascendancy in Europe Monday when 25 out of 27 EU states agreed to a German-inspired pact for stricter budget discipline, even as they struggled to rekindle growth from the ashes of austerity.
Only Britain and the Czech Republic refused to sign a fiscal compact in March that will impose quasi-automatic sanctions on countries that breach European Union budget deficit limits and will enshrine balanced budget rules in national law.
The accord was eagerly greeted by the European Central Bank which has long pressed euro zone governments to put their houses in order.
"It is the first step toward a fiscal union. It certainly will strengthen confidence in the euro area," ECB President Mario Draghi said.
Officially, the half-day summit focused on a strategy to revive 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 differences over the limits of austerity, and Greece's unfinished debt restructuring negotiations, hampered efforts to convey a more optimistic message that Europe is getting on top of its debt crisis.
Merkel told a news conference the agreements on the fiscal pact and a permanent rescue fund for the euro zone were a "small but fine step on the path to restoring confidence."
French President Nicolas Sarkozy said he expected a deal on reducing Greece's debt to private bondholders within days and he believed independent European institutions - a clear reference to the ECB - would help meet a funding gap.
Greek Prime Minister Lucas Papademos said he hoped to reach a deal both with private creditors over restructuring 200 billion euros of debt and on conditions tied to a second bailout by its international lenders by the end of the week.
"Significant progress has been made in talks about private sector involvement ... We are seeking to conclude negotiations with the troika by the end of the week," Papademos told reporters after he and his finance minister met the heads of EU institutions.
Until there is a deal, EU leaders cannot move forward with a second, 130-billion-euro rescue program for Athens, which they originally pledged at a summit last October. Without it, Athens faces default in March when huge bond repayments fall due.
The EU leaders also agreed that a 500-billion-euro European Stability Mechanism will enter into force in July, a year earlier than planned, to back heavily indebted states.
Europe is already under pressure from the United States, China, the International Monetary Fund and some of its own members to increase the size of the financial firewall, but Merkel has refused to consider the issue before March.
Many economists doubt the wisdom of so severely restricting deficit spending, and EU diplomats say the fiscal compact was mostly a political gesture to calm German voters angry at repeated euro zone bailouts and to restore market confidence.
"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.
There was no repetition of last month's confrontation between British Prime Minister David Cameron and Sarkozy when Cameron vetoed efforts to amend the EU treaty to tighten euro zone budget discipline.
But the British and French leaders sniped at each other at separate news conferences while professing mutual respect.
Cameron told reporters: "Our national interest is that these countries get on and sort out the mess that is the euro."
German Chancellor Angela Merkel said that although Cameron had shown no sign of relenting in his opposition to treaty change, the new pact could be easily slotted into EU law at a later date and she expected it would be within five years.
Financial markets fretted over the lack of tangible progress in the Greek debt talks and gloom about Europe's economic outlook. The risk premium on southern European government bonds rose while the euro and stocks fell.
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.
France halved its 2012 growth forecast to a mere 0.5 percent in a potentially ominous sign for Sarkozy's troubled bid for re-election in May. But the president said Paris could achieve its deficit reduction target without further savings.
Italy, rushing through sweeping economic reforms under new Prime Minister Mario Monti, was rewarded with a significant fall in its borrowing costs at an auction of 10- and 5-year bonds, despite two-notch downgrades of its credit rating by Standard & Poor's and Fitch this month.
But Portugal's slide toward 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 several years.
The yield spread on 10-year Portuguese bonds over safe haven German Bunds topped 15 percentage points for the first time in the euro era.
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 to combine the resources of the two funds to create a super-firewall of 750 billion euros ($1 trillion).
The IMF says if Europe puts up more of its own money, that will convince others to give more resources to the IMF, boosting its crisis-fighting abilities and improving market sentiment.
Germany has so far resisted such a step.
Merkel has said she will not discuss the issue of the ESM/EFSF's ceiling until the next EU summit in March. Meanwhile, 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.
The EU will consider how to deploy 82 billion euros of unspent funds from the EU's 2007-2013 budget in an attempt to boost growth and employment. Some will be recycled toward job creation, especially among the young.
But with no new public money available for a stimulus, the leaders focused mainly on promoting structural reforms such as loosening labor market regulation, cutting red tape for business and promoting innovation.
($1 = 0.7615 euros)
Additional reporting by Julien Toyer, Harry Papachristou, John O'Donnell, Matt Falloon and Robin Emmott in Brussels, Marius Zaharia, William James and Jeremy Gaunt in London, Axel Bugge in Lisbon; Writing by Paul Taylor, editing by Mike Peacock.