BRUSSELS (Reuters) - European Union leaders argued on Thursday over the right balance between budget austerity and reviving lost growth at the first summit for two years in which the euro zone debt crisis did not eclipse all else.
After their finance ministers gave provisional approval to a second bailout for Greece, and a flood of cheap European Central Bank funds calmed bond markets, the 27 leaders used the breathing space to focus on structural economic reforms and other ways to combat record unemployment.
They also agreed to give Serbia candidate status for EU membership and reappointed former Belgian Prime Minister Herman Van Rompuy for a second 2-1/2-year term as president of the European Council, adding the role of chairing new twice-yearly summits of the 17-member euro zone.
Leaders of 25 of the 27 countries will sign a German-driven fiscal compact treaty on Friday to enforce EU deficit-cutting and debt reduction rules more strictly.
But without a return to growth several European countries risk entering the same spiral of depression as Greece.
"For too long, our crisis management has erred too far towards austerity," European Parliament President Martin Schulz, a German Social Democrat, told the leaders bluntly.
British Prime Minister David Cameron told reporters that Europe faced a growth crisis as well as a debt crisis.
Diplomats said Cameron won support from Italy's Mario Monti and Dutch Prime Minister Mark Rutte when he complained that a draft summit statement paid insufficient attention to a call by 12 EU leaders for more market deregulation to unleash economic dynamism.
But European Commission Jose Manuel Barroso said the real problem lay with countries' failure to implement agreed reforms. Diplomats cited a dispute between Britain, France and Germany that is holding up a long-delayed agreement on a single European patent that would cut business innovation costs.
German Chancellor Angela Merkel, the driving force behind strict austerity policies, said the ECB's massive cash injection to banks had bought Europe's politicians precious time to work on improving competitiveness, growth and employment.
"We absolutely must make use of this time, otherwise we will find that the world does not trust us," she said.
Unemployment in the 17-nation euro zone hit a euro-era record 10.7 percent in January, data out on Thursday showed, and the euro zone's manufacturing sector contracted for the seventh month running in February.
While jobless totals in economic powerhouse Germany continue to decline, the unemployment rate in Spain rose to 23.3 percent, with one young person in two out of work.
"Despite the euphoria in the banking sector following the ECB's loan programme, the real economy remains very depressed and the key factor is the unemployment rate, both socially and because of the damage to growth," said Steen Jakobsen, an economist at Saxobank.
Spain has made itself a test case of whether Europe is willing to ease its drive for balanced budgets to allow more scope for the growth that is essential to pay down public debt, but was given no slack on Thursday.
Madrid reported this week its 2011 deficit hit 8.5 percent of gross domestic product, far above the 6 percent target agreed with Brussels. That means it would have to cut the equivalent of four percentage points of GDP to meet this year's target of 4.4 percent, while the economy is forecast to contract by 1 percent.
Prime Minister Mariano Rajoy's new government is pleading for more realistic revised targets, posing a dilemma for the European Commission, which is trying to restore the credibility of rules flouted in the past not only by Greece but also by Germany and France, the bloc's two biggest economies.
Barroso told a news conference there had been no discussion of giving any country more flexibility on deficit reduction. Finnish Prime Minister Jyrki Katainen, a north European deficit hawk, said it would be "completely wrong" to give countries more room to meet their fiscal targets.
Spanish Economy Minister Luis De Guindos said he did not expect any leeway until May, but a government source said Madrid would present a 2012 spending limit on Friday based on a deficit target of around 5.3 to 5.5 percent, defying the Commission.
At Merkel's insistence, the issue of increasing the size of the currency bloc's rescue fund was not on the agenda, but Van Rompuy said finance ministers would review the adequacy of the financial firewall by the end of March.
Merkel faces strong public hostility to further bailouts and a backbench revolt in her centre-right coalition that could make it hard to win parliamentary support for a bigger bailout fund.
German officials say that with bond market tensions easing, there is no immediate need to combine the existing temporary rescue fund with a planned permanent 500-billion-euro European Stability Mechanism to build a bigger firewall.
Major economies in the Group of 20 told the Europeans last weekend they would not give the International Monetary Fund more money to combat the fallout from the euro zone crisis unless Europe first increased its own warchest.
A day after the ECB pumped 530 billion euros of cheap, three-year liquidity into European banks, yields on Italian 10-year bonds fell below 5 percent for the first time since last August. Spanish yields also dropped and safe-haven German Bund futures slid in a sign of investors' returning risk appetite.
ECB President Mario Draghi said Europe was on a fragile path to recovery and in a much healthier position than three months ago. But it must persevere with budget consolidation, he said.
The industry body which determines when bondholders are entitled to cash in credit insurance said recent preparations for a debt restructuring do not so far constitute a "credit event" triggering a credit default swaps payout.
The decision by the International Swaps and Derivatives Association cheered EU officials who have been keen to avoid such a potentially disruptive event. But market participants said they still expected Athens' action to trigger a CDS payout if Greece uses legal powers to coerce bondholders who do not voluntarily accept a bond swap.
Economists say the ECB's massive money creation buys time for the euro zone but will not solve the bloc's problems, which require a return to competitiveness and growth in peripheral member states and a rebalancing between the strong and weak.
Additional reporting by Robin Emmott, Jan Strupczewski, John O'Donnell, David Brunnstrom, Andreas Rinke and Julien Toyer in Brussels; writing by Paul Taylor, editing by Mike Peacock