By Francesco Guarascio and Robin Emmott BRUSSELS (Reuters) - France and Italy renewed their commitment to reform their economies on Friday in the hope of winning more time to bring their public finances in order but the ECB's president warned more needed to be done to avoid "a relapse into recession".
After the bloc's revival came to a halt in the second quarter, France and Italy want to shift course away from the spending cuts that marked the bloc's response to the 2009-2012 crisis. Germany says debt discipline must continue.
Seated around a large oval table in the EU summit's red marble building, European Central Bank President Mario Draghi told euro zone leaders over lunch that more needed to be done.
"We avoided the collapse of the euro with a joint effort. Now our focus should be to act jointly again to avoid a relapse into a recession," Draghi said, according to his spokesman, who quoted from his speech. "Hope is not a strategy."
He said a coherent strategy for economic growth had to involve "concrete and credible" structural reforms.
Laying out a four-pronged strategy, Draghi emphasized that monetary policy was only one part of an economic revival plan, with the others being reforms, sound public finances and healing the bloc's sick banks.
But despite Draghi's firm words, the summit underscored how the euro zone has few quick fixes for near record unemployment, leaving it in search of billions of euros for spending that Berlin wants to see come from the private sector.
Merkel said no country with a national debt greater than its economic output should be borrowing more, diplomats said.
According to people in the room, Merkel said record low interest rates gave the euro zone "room to breathe" and that a mix of private investment, fiscal discipline and openness to fast-growing Asian economies was the way forward.
POTENTIAL GROWTH
Merkel also said a proposed free-trade deal with the United States, which is increasingly unpopular in Europe, was crucial.
But such measures could take years to bear fruit, while the euro zone's poor performance is becoming a wider concern, with the United States and the International Monetary Fund worrying that the bloc that makes up a fifth of the world economy is a drag on global prosperity.
The debate is complicated by EU rules that seek to keep country's public finances in order and Germany's promise to balance its books next year for the first time since 1969.
The European Union's top economic official renewed calls on Berlin to act, saying that without investment the future was bleak for Europe's biggest economy, even if it is stronger than most.
"All euro area countries have shortages in potential growth, including Germany," said Jyrki Katainen, the European Commissioner who will become the bloc's growth tsar from November, tasked with bringing down near record unemployment and raising investment.
"Germany's potential growth is currently 1.5 (percent). This is far too low," he told reporters.
"RAPID DEATH"
Diplomats say the euro zone may be moving towards a bargain where France and Italy, the second and third biggest euro zone economies, make new commitments to reform in return for more spending room in their budgets.
At the summit, French President Francois Hollande said Europe should not give the impression that there were "good and bad students" and promised in principle to meet EU budget rules, diplomats said.
Italian Prime Minister Matteo Renzi is proposing tax cuts to get households spending again, as his country is suffering its third recession since 2008.
But Dutch Premier Mark Rutte, a Merkel ally, said no investors will put their money into the euro zone if public finances are out of control, warning against the risk of what he described as "rapid death" for the currency area.
Jeroen Dijsselbloem, the Dutch finance minister who chairs the meetings of euro zone finance ministers, said structural economic reforms were key.
"Paris and in Rome are quite ambitious in terms of reforms and modernizing their societies, the government and the economy," Dijsselbloem said. "I think that's crucial."
The European Commission, which acts as a budget policeman, has until next Wednesday to reject any 2015 budgets with France's in the spotlight after it said it would fail to meet EU debt limits until 2017.
Any changes made by Paris and Rome are likely to be small, officials say.
"We need to look at each case separately, keeping in view the Stability and Growth Pact rules and the need to maintain a responsible fiscal policy," said Lithuanian President Dalia Grybauskaite, whose country joins the euro zone next year.
"Austerity needs to be in place, and in parallel we need to invest," she said.
Such declarations on budget discipline could provide cover for the ECB to do more to fend off the deflation that would make it even harder for the euro zone to bring down its debts.
Many investors want to see the ECB launch a U.S.-style quantitative easing program that could act as a proxy for government stimulus. But Draghi faces stiff resistance, notably from Germany.
(Additional reporting by Paul Taylor and Philip Blenkinsop; Editing by Mike Peacock and Alastair Macdonald)