Another anti-austerity protest in Spain. Photograph: Guillem Valle/Corbis

Austerity mania is sweeping Europe. François Hollande's socialist government in France will become the latest to tighten its belt when it announces €30bn (£25bn) of spending cuts and tax increases on Friday. This follows Spain's decision to take around €40bn out of its budget with the aim of hitting deficit reduction targets agreed with Brussels.

Meanwhile, negotiations continue in Athens between Greece and the so-called troika (the International Monetary Fund, the European Central Bank and the European Union) over a fresh package of spending cuts and tax increases now estimated at €13.5bn.

All this is happening at a time when the eurozone economy is already going backwards. France announced zero growth in the second quarter – extending its period of stagnation to nine months. Spain's central bank warned earlier this week that the economy was currently contracting sharply, while Greece is already in the midst of a 1930s-style depression.

The austerity programmes come with pledges of economic reforms. Put simply, the idea is that too many eurozone countries have been feather-bedded for too long and now need a chill blast of reality to wake them up. Budget retrenchment will ensure that countries live within their means while deregulation, privatisation and more flexible labour markets will make them leaner and fitter. Before too long a revitalised Europe will be punching above its weight in the global economy.

All of which is total moonshine.

Not one of the objectives set by Hollande, Mariano Rajoy in Spain or Antonis Samaras in Greece is likely to be met. The first goal is that budget deficits will come down rapidly as a result of austerity. All the evidence so far is that targets will be missed because demand will be sucked out of already pitifully weak economies, with the effects magnified because so many countries are acting in the same way simultaneously.

A second fallacy is that the financial markets will be impressed by this self-flagellation. In the short-term that may be the case, but once the rotten economic data – for growth, unemployment and the public finances – starts to roll in, investors will take fright at the combination of bombed-out economies and rising debt-to-GDP ratios.

Finally, there is the misguided notion that voters will stoically accept all this pain, seeing it as a price worth paying for the restoration of national solvency and to ensure the future of the eurozone. In the fantasy world inhabited by European policymakers, the future is brighter, richer, more harmonious.

The general strike in Greece, the demonstrations in Madrid, the pressure for autonomy in Catalonia and the likely negative reaction in France to Hollande's budget, paint a rather different picture.

In the real world, the insistence on pain, pain and yet more pain means permanent recession, toppled governments and growing hostility to the European Union. If it eventually leads to the breakup of the single currency because voters decide they have had enough, those running the show (sic) will have only themselves to blame.

In all the dozens of summits and meetings held over the past couple of years about how to keep the euro show on the road, one subject has been notably absent. Amid all their talk of haircuts (on debt values) and tranches (of loans), European leaders have barely talked about the people who are bearing the brunt, first of the crisis and then of the throat-clearing that passes for firefighting in Brussels. This is not accidental. The euro project has relied upon draining the politics out of the inherently political: the very existence of a 17-nation economic union without a common treasury is testimony to that.

Especially amid austerity, however, it is impossible to ignore the politics. More than 200,000 demonstrators took to the streets of Athens on Wednesday. Thousands besieged parliament in Madrid on Tuesday. Last week more than half a million people marched in cities across Portugal to protest against cuts in social security. This is a pan-southern-European pushback against austerity, while the package is still being negotiated. The political strains are causing old regional fissures to re-emerge. One fifth of the population of Catalonia, 1.5 million people, marched last week in what can only be interpreted as a surge of separatist sentiment. For them it is not just the contract with Brussels and Frankfurt that needs to be renegotiated, but the contract with Madrid – in other words, the constitution. With regional elections coming up on 25 November, this is not something Madrid can ignore. Initially they wanted to collect their own taxes, which they would share with Madrid. When that was rejected, the price of peace escalated. Popular outrage over Catalan money going elsewhere, amid health and education cuts, is fuelling demands that the money stays put.

On Thursday the prime minister, Mariano Rajoy, unveils an austerity budget which is meant to pre-empt Brussels' conditions. When Spain is finally forced to ask for a bailout, it can say that the conditions demanded are the ones that it is already enacting. But this will only rub more salt into the wounds at home. With his absolute majority, Mr Rajoy was meant to be the leader who could deliver the austerity necessary to secure a future national bailout. That no longer looks certain, which is why Spanish bond yields went soaring yesterday. This in turn will hasten the outcome both Madrid and Brussels have been stalling on.

The Greeks and the Spaniards are committed Europhiles. No one has forgotten the history of coups and dictatorships from which membership of the EU served as a release. The EU has not stopped being the future. But its funds can no longer be called structural. Destructural funds are nearer the mark for millions of ordinary citizens. And everyone in the EU will pay the price.

A protester in Madrid this week. Photograph: Andrea Comas/Reuters

Cull the Lib Dems. No more apologies. Ask the Queen what she thinks. Or elect badgers, as they will be just as useful. Make Andrew Mitchell minister for truth! I may be a pleb – mirabile dictu! – but I know a distraction when I see one. Domestic politics enters conference season and we all have to pretend it matters. What we are actually seeing is the brandishing of powerlessness from our political class, the shrinking of their ability to think differently or even widely.

Gate-gate was amusing for all of five seconds, though I don't mind a bit of swearing myself. That a muppet such as Mitchell looks down on working people hardly struck me as a scoop. Phillip Blond's peculiar suggestion that we start talking about caste instead of class would I suppose make clear who the untouchables really are, and stop the worrying delusion that the majority of people are middle-class. Nick "I am sorry" Clegg and Vince "I told you so" Cable have jostled for power and defined freedom for us. Clegg himself veered between The Thick of It's quiet batpeople and visions of fascism. As you do.

What interested me was his warning that if we do not write our own budgets we could end up like countries that "find their right to self-determination withdrawn by the markets, and new rules imposed by their creditors, without warning or clemency". In other words there is no alternative to cuts. "The markets" are in charge, so why then even have party political conferences?

This just after we have seen the extraordinary images from Madrid where protesters were shot with rubber bullets. No, we are not Spain. And "Spain is not Uganda", as the Spanish prime minister, Mariano Rajoy, helpfully texted his finance minister recently. Spain is not Greece either, but why do we play down what is not so far away? Two hours away becomes another world.

So we watch protesters bludgeoned and accused of an attempted coup. We see the graffiti – "The End of Fear" – and we surely recognise, even though we are not in the euro, this attempt to slam austerity on to the population for their own good. The Spanish economy is contracting. For months miners have been fighting police with rocket launchers in Asturias. They don't want a revolution, just a living wage. Unemployment is crippling. There are no jobs for more than half of Spanish youth. Ghost villas crumble as the construction industry grinds to a halt, yet Rajoy is expected to make spending cuts of more than €65bn. There is still a middle class in Spain, unlike Greece, able to soak up some of this damage.

But as the government spends a fortune on tear gas, the centre cannot hold. One and a half million Catalans marched for independence. Constitutionally, no one knows how this can happen, but it is spoken about with inevitability. Thus the crisis will tear apart countries as well as families. It will be a tough technocrat who can hold the north and south of Italy together.

These people who hurt in the places where we used to play have been told like us that they overdid it, and now it is payback time. Our government's story that it is all Labour's fault works only if you avoid all foreign news. But how are we to position ourselves? Must we merely accept that politicians have no choice? That punishing the poor is simply pragmatic, so let's not get all hot-headed like these Mediterranean types?

Well, look at Portugal, hardly famed for its crazed radicalism. When Prime Minister Pedro Passos Coelho announced a rise from 11 to 18% in social security payments as part of its €78bn bailout, Portugal saw the biggest demonstrations since ridding itself of dictatorship in 1974. The government has now U-turned in the face of masses of all political persuasions. Their posters were telling: "We are not the children of democracy, we are the parents of the next revolution."

This is the backdrop to which our party leaders will set out the agenda. We will have to accept that there is no alternative and that only the likes of Osborne and Laws understand the complexities of what they will push through.

Globally, another narrative exists: from Occupy, from the 99%, or even the 47% – or even us plebs could roll one out. But nowhere is it represented in the party system. As party leaders congratulate themselves on the tough choices they make, not one will say we are slashing the NHS by precisely the amount the war in Afghanistan costs us. Not one will explain that stopping tax avoidance by the super rich would pay for a functioning welfare system. Instead, we are offered the choice only between who can cut most earnestly and most efficiently.

We do not need to be tear-gassed into submission as we simply keep our eyes shut tight while Athens burns. Again.

The message remains that there is no alternative to austerity, but remember the Paris 1968 slogan: "Those who lack imagination cannot imagine what is lacking." When no alternative can be voiced by our main parties, the deficit is not purely fiscal. It is one of democracy.

A demonstrator protesting against the Spanish government's handling of the economic crisis is surrounded by riot police outside the the parliament building in Madrid Photograph: Sergio Perez/Reuters

Angela Merkel said Germany's highest court had sent a powerful message to the rest of Europe and beyond, after it paved the way for the creation of a €500bn rescue fund to tackle the eurozone's debt crisis.

Markets rallied following the decision by the eight justices of the constitutional court in Karlsruhe to let Germany ratify a treaty to establish the European stability mechanism (ESM). The euro reached a four-month high and European stock markets rose after the court imposed conditions that were less burdensome than German parliamentarians and other ESM supporters had feared.

The ESM can now start up next month and become fully operational by the new year, despite the warnings of analysts who say it will not work. The ruling was considered one of the most important in the court's 61-year history.

A key condition attached to the ruling means that Germany's liabilities will be capped at €190bn. But the fact that the Bundestag and Germany's ESM representative can override the limitation led some observers to say it was a bluff, introduced to assuage the concerns of German taxpayers whose frustration at the prospect of having to bail out indebted southern European countries indefinitely has been on the rise.

A poll before the ruling showed that 54% of Germans wanted the court to block the ESM, amid growing fears that Germany is ceding too many powers to European institutions. The court was petitioned by 37,000 Germans arguing that the ESM was anti-constitutional.

The ruling is a breakthrough for Merkel and allows the go-ahead of the two-pronged approach she favours of both bailouts and budgetary discipline in the form of the ESM and the fiscal pact. She said the decision sent a strong signal of Germany's commitment to Europe, and was positive news for German taxpayers, who she said had been provided with certainty.

"This is a good day for Germany, a good day for Europe," she told the Bundestag. "We haven't yet overcome the crisis, but we have achieved our first steps."

Frank-Walter Steinmeier, leader of the opposition Social Democrats, expressed his relief that the ESM – whose creation had been substantially delayed by the constitutional court's deliberations – could now start to work. "The significance of this decision for the future of Europe cannot be underestimated," he told the Bundestag.

Neil Prothero, of the Economist Intelligence Unit, said the decision would come as a relief to policymakers across the eurozone. "A decision against the ESM would have thrown the region's crisis response strategy into disarray," he said.

But Gunnar Beck, an EU analyst at London's School of Oriental and African Studies, called the decision "a completely absurd judgment from a legal point of view", because it meant Germany's liability was fixed "unless it is decided otherwise, which means there's no limit to it".

He was gloomy about the long-term effects of the decision, predicting that the markets' enthusiasm would not last. "In the short term the market will be booming, but in the long term this means unending horror. Germany is locked in now and it means that if the ECB buys unlimited bonds, Germany's liability is unlimited as well," he said. "Germany is like a bank that has lent too much to its biggest client so that it has to continue lending until the client goes bust".

The court had been under huge pressure not to torpedo the ESM, amid fears that it would cause the destruction of the euro and have a chaotic effect on the global economy. Andreas Vosskuhle, the court's president, said the economic and political consequences of delaying the law's introduction were "almost impossible to calculate reliably".

Despite repeated claims of the court's independence, there have been strong suggestions of at least one high-level meeting between the government and the court, reports about which led to speculation that the two bodies might have worked closely on a face-saving solution.

A little light relief amid the gravitas was offered by a slip of the tongue by Vosskuhle, who called the petitions to block the ESM "justified" before changing it to "unjustified" after being corrected by a colleague, as peals of laughter filled the courtroom.

Bank power balance

The EU executive has unveiled new laws empowering the European Central Bank to police 6,000 banks in the eurozone, a step towards a more centralised federation in response to almost three years of the bloc's currency crisis.

The aim, accompanied by decisions on direct eurozone recapitalisation of struggling banks, is to establish a far more robust supervisory and regulatory regime over the banks and to break the pernicious links between weak sovereigns and vulnerable banks feeding Europe's debt crisis.

While broadly welcomed by all of the EU including Britain, which will take no part in the new regime, the detail of the draft legislation will be hugely contested by EU governments between now and the end of the year, with London and Berlin squaring off as opposite poles in the argument.

Signalling the new draft represented just the start of months of wrestling over the outcome, a British diplomat said: "A banking union for the euro area must also respect the integrity of the single market for the whole of the European Union, and we'll ensure the agreement on it does that."

Germany strongly resists planned supervision of all 6,000 banks, seeking to minimise the ECB's remit to just 20-odd "systemic" banks, the biggest in the eurozone, which would include only two German institutions. Berlin is also reluctant to rush into using eurozone bailout funds for direct bank recapitalisation.

Berlin, the first to call for the "banking union" and to insist that the supervisory powers be vested in the ECB in Frankfurt, appear to be keen on the policing of eurozone banks as long as few as possible German banks are controlled.

The British, remaining outside the new regime, are worried about the impact of the new system on non-euro members, on the European single market, and on the City of London, disputing complicated new proposed voting arrangements they fear could leave them defenceless against moves to penalise London-based banks while making it harder to force action against eurozone banks.

For the ECB to gain the sweeping new powers,including that to grant and withdraw banking licenses in the eurozone, all 27 EU governments must agree, giving the UK a veto if they fail to force concessions.

The ECB's supervisory role is to be phased in, according to the plan, kicking off next January with extensive intrusive powers of scrutiny over weak banks already being bailed out, notably in Spain, extending to the 20-30 systemic banks by the middle of next year, and then putting all 6,000 banks under ECB policing by the beginning of 2014.

The draft law concerns solely supervisory powers. The plan is to then expand the regime over a few years to include a common eurozone resolution authority and funds for winding up or restructuring failing banks as well as common deposit guarantee schemes for eurozone savers.

Both elements are also contested by Berlin which is wary of being made co-liable for the costs of other countries' banking failures and savings guarantees. While the new ECB regime will apply to all of the eurozone, non-euro countries can also come under the system without gaining voting rights in the new ECB supervisory board. Of the non-euro countries, Poland is the keenest to join but is also arguing for better terms.

While Michel Barnier, the single market commissioner in charge, sounded optimistic on Wednesday that several non-euro countries would join the new supervisory system, senior officials expect it to start with only the 17 single currency countries.

The trickiest part of the new system concerns relations between the ECB authority representing the 17 and the London-based European Banking Authority which groups national supervisors and coordinates between them.

The Germans are scathing about the performance of the EBA, the ECB in Frankfurt sees it as a rival, while the British are worried that the role of the EBA is actually being strengthened and could damage UK interests.

Ian Traynor in Brussels

The euro crisis reflects the failure of a dead-end policy. The German government lacks the courage to move beyond a status quo that has become untenable. This is why, despite extensive rescue programmes and countless crisis summits, the situation of the eurozone has steadily deteriorated over the last two years. In the wake of its economic crash, Greece faces the prospect of leaving the eurozone, which would have incalculable knock-on effects for the other member countries. Italy, Spain and Portugal are all in the grip of a severe recession, which is driving up unemployment.

The economic downturn in these problem countries is making the fragile situation of the banks even more precarious, and the growing uncertainty about the future of monetary union is undermining the confidence of investors, who are increasingly reluctant to buy bonds issued by the problem countries. Rising interest rates for government bonds, coupled with the steadily deteriorating economic situation, are hampering the processes of consolidation – which were never going to be easy in the first place.

This self-reinforcing destabilisation is largely the product of ad hoc crisis management strategies, which have barely begun to address the challenge of consolidating the European institutions. The fact that the attempts to deal with the crisis over the years have been characterised by a hand-to-mouth incrementalism that has only made things worse serves to highlight the lack of political creativity.

However, the justification for taking a major step forward on European integration does not derive solely from the current eurozone crisis, but also from the need to curb the evil practices of the shadowy parallel universe that the investment banks and hedge funds have built up alongside the real economy of goods and services. This requires our politicians to get a grip and take control again.

The measures needed to bring back proper regulation are obvious enough. But they are not being applied, firstly because an implementation of these measures at a national, state level would have counterproductive consequences, and secondly because the regulatory agenda that emerged from the first London G20 summit in 2008 would require globally coordinated action, which for the present is rendered impossible by the political fragmentation of the international community.

A major economic power like the EU, or failing that the eurozone, could become a standard-bearer for the way forward here. Only a significant consolidation of European integration can sustain a common currency without the need for a neverending series of bailouts, which in the long term would strain the solidarity of the European national populations in the eurozone on both sides – donor countries and recipients – to breaking point. This means, however, that a transfer of sovereignty to European institutions is unavoidable in order to impose effective fiscal discipline and guarantee a stable financial system. At the same time we need closer coordination of financial, economic and social policies in the member countries, with the aim of correcting the structural imbalances within the common currency area.

The escalation of the crisis shows that the strategy previously pushed through by the German government in Europe is based on a false diagnosis. The current crisis is not a crisis of the euro. The euro has shown itself to be a stable currency. Nor is the current crisis a debt crisis specific to Europe. Compared with the US and Japan, the EU – and within the EU the eurozone – has the lowest level of debt of all three economic regions. The crisis is a crisis of refinancing affecting individual countries within the eurozone, and is primarily due to an inadequate institutional underpinning of the common currency.

The deepening of the crisis makes it clear that the solutions tried so far have all been found wanting. So the fear is that monetary union in its present form cannot survive much longer without a fundamental change of strategy. The starting point for a change of direction in our thinking is a clear diagnosis of the causes of the crisis.

The German government seems to assume that the problems have basically been caused by a lack of fiscal discipline at the national level, and that the solution is primarily to be sought in a rigorous policy of spending cuts by individual countries. At the institutional level the Germans want this approach to be underpinned by stricter fiscal rules in the first instance, supplemented by bailout funds that are quantitatively limited and subject to conditions – thereby forcing the countries concerned to adopt policies of extreme austerity, which have weakened their economies and driven up unemployment.

In actual fact the problem countries have so far failed to limit their refinancing costs to a manageable level, despite extensive structural reforms and a policy of spending cuts that are unusually severe by international standards. The events of the last few months point to one conclusion: that the German government's diagnosis and therapy have been too one-dimensional in conception from the beginning. The crisis has not come about just because individual countries have behaved badly, but is due in large measure to systemic problems. These cannot be solved by greater efforts at the national level; they require a systemic answer.

The current instability of the financial markets is driven by the risk that an individual country might become insolvent, and that risk can only be eliminated, or at least limited, by collective guarantees for government bonds issued within the eurozone. There are concerns that this could create disincentives, and these should be taken very seriously. The only way to allay these concerns is to ensure that collective guarantees are combined with strict collective control over national budgets. This means, however, that the degree of fiscal control necessary to underpin collective guarantees is no longer achievable within the context of national sovereignty via contractually agreed rules.

There are only two coherent strategies for dealing with the current crisis: a return to national currencies across the EU, which would expose each individual country to the unpredictable fluctuations of highly speculative foreign exchange markets, or the institutional underpinning of a collective fiscal, economic and social policy within the eurozone, with the further aim of restoring to policymakers their lost capacity for action in the face of market imperatives at a transnational level. And looking beyond the current crisis, the promise of a "social Europe" also depends upon this.

Only a politically united core Europe offers any hope of reversing the process – already far advanced – of transforming a citizens' democracy built on the idea of the social state into a sham democracy governed by market principles. For this reason alone – because it leads on to this broader perspective – the second option deserves preference over the first.

If we wish to avoid both a return to monetary nationalism and a permanent euro crisis, then we need to do now what we failed to do at the time of the euro's launch: we need to begin the process of moving towards political union, beginning with the core Europe of the 17 EMU member countries.

We believe that we should be entirely open about this process. It is simply not possible to retain the common currency without also espousing the idea of collective responsibility and redressing the institutional deficit in the eurozone. The proposal by the Council of Economic Experts to set up a collective debt redemption fund has been rejected by the German government, but its appeal lies precisely in the fact that it puts an end to the illusion of continuing national sovereignty by openly establishing the principle of collective responsibility. It would, however, make more sense to mutualise eurozone debt within the Maastricht criteria – so up to the 60% threshold, rather than above that level.

As long as European governments fail to state clearly what they are really doing, they will continue to undermine the already weak democratic foundations of the European Union. The battle cry of the American war of independence – "No taxation without representation" – has a new and unexpected resonance today: once we create scope in the eurozone for policies that result in redistributive effects across national boundaries, European legislators who represent the people (directly through the European parliament and indirectly through the European Council) must be able to decide and vote on these policies. Otherwise we would be violating the principle that the legislator who decides how public money is to be spent is one and the same as the democratically elected legislator who raises taxes to fund this spending.

Nevertheless the historical memory of a unification of the German Reich that was forced upon many parts of the country for dynastic reasons should serve as a warning to us. The financial markets must not now be pandered to with complicated and untransparent structures, while governments meekly accept the imposition on their peoples of a centralised executive power that takes on a life of its own above their heads. Before it comes to that, the people themselves must have their say. As the representative of the biggest donor country in the European Council, the federal republic should take the initiative and table a resolution for summoning a constitutional convention.

This is the only way to bridge the unavoidable time gap between the immediate economic measures that are due to be put in place, but which can still be revoked in the meantime, and the retrospective legitimation that may be required. If the results of the referenda are positive, the peoples of Europe could regain, at a European level, the sovereignty that was stolen from them by "the markets" a long time ago.

The strategy of treaty change is designed to bring about the establishment of a politically unified core European currency area, which other EU countries – in particular Poland – would be allowed to join. This calls for clear thinking about the political make-up of a supranational democracy that would allow collective government without assuming the form of a federal state.

The European federal state is the wrong model, demanding more solidarity than the historically autonomous European nations are willing to contemplate. The consolidation of the institutions that is now required could be guided by the principle that a democratic core Europe should represent the totality of citizens from the EMU member states, but each individual citizen in his or her twin capacity as a directly participating citizen of the reformed union on the one hand, and an indirectly participating member of one of the participating European nations on the other.

It is not out of the question that the federal constitutional court will seize the initiative from the political parties and announce a plebiscite to amend the constitution. That would mean that the parties could no longer avoid taking a position on the choice of options that has been kept in the dark until now. A joint initiative backed by the SPD, CDU and Greens to set up a constitutional convention, the results of which could be voted on at the same time as the plebiscite on the constitution (but not before the end of the next parliamentary term), would not then be an unrealistic prospect. This would be the first time that Germany has conducted a public debate of this kind, in which opinions are formed and decisions taken about the different political options for Europe's future: and we believe there is a good chance that in the course of this debate an alliance of political parties would be able to persuade a majority of the electorate of the advantages of a political union.

The four-year crisis has brought all kinds of issues to the fore and focused the attention of national publics on European questions as never before. One result has been the awakening of an awareness of the need to regulate the financial markets and correct the structural imbalances within the eurozone. For the first time in the history of capitalism a crisis triggered by the most advanced sector, the banks, could only be resolved by governments getting their citizens, in their capacity as taxpayers, to stump up for the losses incurred. At this point a barrier between systemic processes and real-life processes was broken down. The citizens are rightly outraged.

The widespread feeling of injustice derives from the fact that faceless market processes have assumed a directly political dimension in the popular perception. This feeling is combined with a sense of rage, suppressed or otherwise, at one's own impotence. To counteract this we need a new politics of self-empowerment.

A discussion about the purpose and aim of the unification process would present an opportunity to broaden the focus of public debate, which has hitherto been confined to economic issues. The awareness that global political power is shifting from the west to the east, and the sense that our relationship with the US is changing, combine to present the synergetic benefits of European unification in a new light. In the postcolonial world the role of Europe has changed, and not just with reference to the dubious reputation of former imperial powers, to say nothing of the Holocaust. Future projections backed by statistical data indicate that Europe is headed for further change, destined to become a continent of shrinking population numbers, declining economic importance and dwindling political significance. The people of Europe must learn that they can only preserve their welfare-state model of society and the diversity of their nation-state cultures by joining forces and working together. They must pool their resources – if they want to exert any kind of influence on the international political agenda and the solution of global problems. To abandon European unification now would be to quit the world stage for good.

• Translated by Allan Blunden. The German version of this article appeared in Frankfurter Allgemeine Zeitung.

Luxembourg prime minister and Eurogroup president Jean-Claude Juncker Photograph: Jean-Christophe Verhaegen/Getty

Good morning, and welcome to our rolling coverage of Europe's financial crisis.

When the full story of the eurozone crisis is written, this *might* go down as one of the more important weeks. With the August holidays looming, speculation that world leaders and central bankers may take decisive action in the next few days is building towards a crescendo.

Mario Draghi, head of the European Central Bank, started the ball rolling last Thursday with his pledge to do everything (within his mandate) to protect the euro. Now Eurogroup head Jean-Claude Juncker has taken up the torch, declaring last night that the eurozone has reached a "decisive point", and that leaders have no time to lose.

Juncker pledged that:

What measures we will take, we will decide in the coming days.

Angela Merkel and Mario Monti echoed Draghi's sentiments over the weekend. After speaking by phone, the two leaders announced they had "agreed that Germany and Italy will do everything to protect the eurozone" in a phone conversation on Sunday.

So, that's the talk out of the way. Now for the action? That could come on Thursday, when the ECB (and the Bank of England) both hold their monthly monetary policy meetings. Draghi has set the bar of expectation pretty high – now he has to deliver something.

What could that be? A mere interest rate cut wouldn't be the "game-changer" that many are calling for. But anything more significant move faces opposition. An official "peg" on peripheral bond yields would be opposed by Germany, while the ECB itself has been unwilling to grant the European Stability Facility a banking license.

The trouble could start if Draghi et al can't deliver on the expectations they've now set....

Mario Draghi said the eurozone was much stronger than people acknowledged. Photograph: Mario Vedder/AP

Mario Draghi, president of the European Central Bank, said on Thursday the euro was "irreversible" and promised to do everything within his power to save it.

Speaking at the UK government's Global Investment Conference in London, Draghi said: "Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough."

The news sent the euro up 1% against the dollar, to $1.2315, and it also gained against other major currencies. Spanish and Italian borrowing costs eased, after Draghi appeared to signal that the ECB was prepared to act to calm the bond markets.

"If government borrowing premia hurt monetary policy transmission, they are in our mandate," he said.

The yield on Spanish 10-year debt dipped to a whisker above 7%, at 7.009%, while Italian 10-year yields fell to 6.1%.

Draghi said the eurozone was much stronger than people acknowledged and progress over the last six months had been remarkable. "The last summit was a real success as it was the first time that all the leaders of 27 countries, including the UK, said the only way out of this crisis is to have more Europe. This means that much more of what is national sovereignty is going to be exercised at supranational level."

Draghi was sharing the stage with Sir Mervyn King, governor of the Bank of England, who took the opportunity to deflect blame for the financial crisis from the banking sector. "Of course there was bad behaviour," he said. "But this was a crisis which emanated from major mistakes in macroeconomic policy around the world, and fundamentally the inability to successfully co-ordinate macroeconomic policy so that globally you wouldn't get the imbalances, the capital flows, that created the difficulties in the banking system."

The day kicks off two weeks of investment summits aimed at attracting more foreign investment into the UK and promoting British business. Based in Lancaster House, the summit is taking place within earshot of the beach volleyball at Horse Guards Parade and aims to take advantage of the influx of foreign dignitaries for the Games.

The event offers some respite for trade minister Lord Green, who is under pressure because of his role as chief executive and then chairman at HSBC when the bank laundered money for Mexican drug barons and possibly even terrorists.

Green welcomed delegates to the conference and exchanged a warm handshake with King, among others. Green was promoting the UK as a great place to do business, alongside Lord Sassoon, commercial secretary to the Treasury, in a change to the schedule. He had been due to share the podium with Stuart Gulliver, current chief executive of HSBC, but Gulliver withdrew from the conference after the money laundering revelations.

Spain's regional woes are expected to weigh on financial markets this week after a second local government in three days asked for state aid, increasing fears that the eurozone's fourth largest economy will be forced to seek a full-blown rescue.

On Sunday Murcia became the latest region to admit it needed central government help, after European finance ministers waved through a €100bn (£77.8bn) recapitalisation of Spanish banks on Friday. Several other regions are expected to follow, with Catalonia reportedly unable to pay the interest on €48bn of borrowings.

Murcia's president, Ramón Luis Valcárcel, said he expected the south-eastern region to ask for up to €300m from Madrid as it struggled to refinance debt and cover its deficit.

"Don't imagine they are going to simply make a present of the money," he said, warning that Spain's prime minister, Mariano Rajoy, would impose strict conditions.

Murcia joins the far larger region of Valencia – which flagged up a cash shortage on Friday – on the list of regional governments that have said they will tap an €18bn liquidity fund set up by the central government just 10 days ago.

Several others among Spain's 17 semi-autonomous regions are expected to follow. They include the two biggest regions, Catalonia and Andalucia, as well as central Castilla La Mancha.

Valencia's announcement that it would seek money from the fund, which an increasingly desperate Spanish government has had to partially finance with a loan from the state-owned lottery company, helped send the country's sovereign bond yields soaring on Friday.

New government GDP projections also pushed up yields by forecasting that the Spanish economy would not grow before 2014. Ten-year bond yields rose to a new euro-era record of 7.25% on Friday, a rate widely seen as unsustainable and pushing the country closer to a bailout from the European Union and the International Monetary Fund.

Markets also reacted sharply to the news. On Friday, the Madrid stock market suffered its biggest one-day fall for two years, while markets in London, Paris and Frankfurt also slipped, with the FTSE 100 falling 1% to 5651.

The coming wave of regional bailouts may add further pressure to Spain's bond yields as they threaten to spiral out of control and drive Spain towards a full rescue.

Rajoy's ministers have urged the European Central Bank (ECB) to buy the country's bonds in order to relieve pressure, but ECB president Mario Draghi told Le Monde on Sunday that it had no plans to buy Spanish sovereign debt. He also insisted that the eurozone was "absolutely not" in danger of breaking up.

"We see analysts imagining the scenario of a eurozone blow-up. They don't recognise the political capital that our leaders have invested in this union and Europeans' support. The euro is irreversible," he told the French newspaper.

"All movement towards financial, budgetary and political union is, for me, inevitable and will lead to the creation of new supranational bodies."

Spain's regional bailouts come as senior figures in Catalonia and Murcia admit they will have trouble meeting the 1.5% deficit target they have been set this year by central government.

"There are reasons to doubt how we will be able to reduce the deficit from 4.4% to 1.5% this year," Valcárcel admitted.

Senior figures in Catalonia have also privately admitted that, although they are making every effort to meet the 1.5% target, the region will also struggle to make it. Strict regional deficit targets are a major part of Spain's strategy as it tries to meet the national deficit target it has been set by Brussels, which wants Spain's overall deficit down from last year's 8.9% of GDP to 6.3%.

Last year's high deficit was mainly due to regional governments which, despite demands from central government that they cut back, increased their joint overspend. They run health, education and social services – accounting for 37% of public spending.

Rajoy has introduced tough new laws and designed the liquidity fund in a way that allows it, if necessary, to take direct financial control of regions that fail to curb their deficits – imitating the control Brussels now exerts over southern European economies.

Artur Mas, the nationalist president of the independent-minded Catalonia region, has warned that full intervention would be unacceptable and has threatened to call regional elections if that happens.

"All regional governments run the risk of being intervened by central government, given that, if you do not meet the deficit target, the state will force you to take measures – that is intervention," Valcárcel explained.

Refinancing regional debt does not add to Spain's overall debt, but covering regional deficits does.

There were fresh protests at the weekend as several hundred demonstrators travelled to Madrid from many parts of Spain to protest over the country's near 25% unemployment rate, as well as the stinging austerity measures introduced by the government in a bid to avoid an international financial bailout. Protesters, many of whom were unemployed, carried banners saying "No cuts" and "United, that's enough".

As well as on Spain, markets' eyes will be on the Greek government and banks this week, analysts at Capital Economics note, following the news that the ECB will stop accepting Greek bonds as collateral for its refinancing operations pending a review by the troika.

"Greek banks can still use these bonds to access funds from the Greek National Bank's emergency liquidity assistance," said Jennifer McKeown at Capital Economics. "But such loans are more costly and this development will clearly add to the already intense pressure on the Greek banking system."

The Greek prime minister, Antonis Samaras, said on Sunday that Greece was now in a "Great Depression" similar to the American one in the 1930s. His comments, made to former US president Bill Clinton, who visited Greece as part of a delegation of Greek-American businessmen, came two days before a team of Greece's international lenders arrive in Athens to push for further austerity cuts.

Germany's economy minister, Philipp Rösler, questioned whether Greece could fulfill the conditions for receiving further international aid and said that the idea of the country leaving the euro had "lost its horror."

A Valencian (R) and a Spanish flag. Spain's heavily indebted eastern region of Valencia said on Friday it would apply to Madrid for financial help, spooking markets and complicating central government efforts to stave off a full-blown bailout. Photograph: Heino Kalis/REUTERS

Spain dragged the eurozone closer to the edge of collapse despite winning the backing of finance ministers from the single currency's major economies for a €100bn (£77.8bn) bank rescue fund.

Concerns that Madrid is running out of options to bring down the debts of its ailing banks and bankrupt regions sent the country's borrowing costs soaring above 7.2% – a rate seen as unsustainable for a country that cannot devalue its own currency and is suffering a lengthy double-dip recession.

The bank bailout had been supposed to push down the country's borrowing rates, but the country's problems continue to mount. On Friday the region of Valencia was forced to turn to the Spanish central government for cash help.

That move, together with a downgrade of Spanish bonds to junk status by the credit ratings agency Egan Jones, saw the Madrid stock market suffer its biggest one day fall for two years.

Markets in London, Paris and Frankfurt followed suit with the FTSE 100 falling 1% to 5651. The euro crashed to historic lows against several currencies. Against the pound it fell to 77.72 pence, marking its lowest since the aftermath of the Lehman Brothers collapse in October 2008.

The prospect of Spain standing near the exit to the eurozone with Greece and Portugal had seemed outlandish only a few weeks ago, after eurozone leaders agreed to press ahead with more co-operation and a rescue for Madrid that targeted its banks.

Stock markets climbed and solvency fears eased after the summit, which many saw as provided a lengthy breathing space for politicians to work out a broader rescue package. But the shortcomings of the agreement have once again undermined renewed confidence in the eurozone and sent the bond yields of several countries higher, including Spain and Italy.

Comments by German officials added to the febrile atmosphere with hardliners questioning the eurozone's ability to carry on while southern European countries wrestled with major reforms and public spending cuts.

The Spanish government said a predicted rise in GDP next year of 0.4% had proved optimistic, and the economy would suffer another year of recession. The new forecast that the economy will contract by 0.5% shocked analysts, who said a raft of austerity measures would delay a recovery for several years.

Mariano Rajoy, the leader of Spain's right-wing government, has pushed through €65bn (£50.6bn) of spending cuts and tax rises to meet deficit targets set by Brussels, which are widely blamed for pushing the economy back into recession for another year.

Shortly before the bank bailout was agreed by eurozone ministers on Friday, the Valencia regional government admitted it could no longer fund itself on the markets and requested what is, in effect, a bailout by the Spanish government. Regional governments deliver the key parts of the welfare state, including health, education and social services.

Eastern Valencia said it was asking for central government help as it could not refinance loans that must be paid off this year. Regional vice president José Ciscar did not say how much was needed. "Like other regions, Valencia is suffering the consequences of liquidity restrictions in the markets," he said.

It will become the first of Spain's 17 semi-autonomous regions to tap a new, week-old €18bn (£14bn) fund designed to provide them with liquidity. The fund is part-financed with a loan from the state-owned lottery company.

Valencia, which has long been run by Rajoy's PP, is emblematic of Spain's current crisis. A property crash has hit both regional government income and the region's banks, with its three main banks having to be rescued. Local politicians, meanwhile, have a growing reputation for corruption and frivolous spending.

Valencia mopped up a quarter of the €17bn (£13.2bn) of extra money made available by central government in April to pay a backlog of regional government bills.

Just as Rajoy's government refuses to call the European rescue fund money a bailout, so Valencia's government insisted its request for special funding should not be described as one. "Valencia is signing up to a financing mechanism which other regions will also need in the coming days, without any further measures," Ciscar said.

Last year the regions not only failed to meet government-set deficit reduction targets, but actually increased their joint deficit. Rajoy's government has passed legislation allowing it to take direct control of the finances of regions that stray too far off target.

Analysts believe most regions will miss this year's 1.5 percent deficit target. The government last week asked at least eight of them to revise their 2012 budgets, threatening to take over the finances of some of them.

Analysts at Capital Economics said Spain had suffered a debilitating exodus of funds from its banks and a sharp detioration in its own funding position. As the reliance of the Spanish government on its own banks for funding grows (while the banks themselves are relying on the ECB), so the likelihood of Spain requiring a full-blown sovereign bailout grows too.

European leaders pleaded for calm after signing the final agreement to lend Spain €100bn of funds to underpin its banks.

European Central Bank executive Benoît Cœuré said at a conference in Mexico that it was startling to see international investors fearful of getting their money back from members of the single currency.

However, he said the fundamental measures of economic success were stronger in the eurozone than other developed areas. The eurozone's annual deficit in 2012, he pointed out, is expected to be 3% compared to 8% in the US, and 10% in Japan. He said the eurozone's total public sector debt will reach 90% at the end of the year compared to 106% in the US and 235% in Japan.But his comments were largely ignored as Mariano Rajoy's right wing government went back into crisis mode.

The hope is that markets will reward austerity – but markets will be more pragmatic if austerity weakens economic growth. Photograph: Andy Mueller/Reuters

Like an inmate on death row, the euro has received another last-minute stay of execution. It will survive a little longer. The markets are celebrating, as they have after each of the four previous "euro crisis" summits – until they come to understand that the fundamental problems have yet to be addressed.

There was good news in this summit: Europe's leaders have finally understood that the bootstrap operation by which Europe lends money to the banks to save the sovereigns, and to the sovereigns to save the banks, will not work. Likewise, they now recognise that bailout loans that give the new lender seniority over other creditors worsen the position of private investors, who will simply demand even higher interest rates.

It is deeply troubling that it took Europe's leaders so long to see something so obvious (and evident more than a decade and a half ago in the east Asia crisis). But what is missing from the agreement is even more significant than what is there. A year ago, European leaders acknowledged that Greece could not recover without growth, and that growth could not be achieved by austerity alone. Yet little was done.

What is now proposed is recapitalisation of the European Investment Bank, part of a growth package of some $150bn (£95bn). But politicians are good at repackaging, and, by some accounts, the new money is a small fraction of that amount, and even that will not get into the system immediately. In short: the remedies – far too little and too late – are based on a misdiagnosis of the problem and flawed economics.

The hope is that markets will reward virtue, which is defined as austerity. But markets are more pragmatic. If, as is almost surely the case, austerity weakens economic growth, and thus undermines the capacity to service debt, interest rates will not fall. In fact, investment will decline – a vicious downward spiral on which Greece and Spain have already embarked.

Germany seems surprised by this. Like medieval blood-letters, the country's leaders refuse to see that the medicine does not work, and insist on more of it – until the patient finally dies.

Eurobonds and a solidarity fund could promote growth and stabilise the interest rates faced by governments in crisis. Lower interest rates, for example, would free up money so that even countries with tight budget constraints could spend more on growth-enhancing investments.

Matters are worse in the banking sector. Each country's banking system is backed by its own government; if the government's ability to support the banks erodes, so will confidence in the banks. Even well-managed banking systems would face problems in an economic downturn of Greek and Spanish magnitude; with the collapse of Spain's real-estate bubble, its banks are even more at risk.

In their enthusiasm for creating a "single market", European leaders did not recognise that governments provide an implicit subsidy to their banking systems. It is confidence that if trouble arises the government will support the banks that gives confidence in the banks; and, when some governments are in a much stronger position than others, the implicit subsidy is larger for those countries.

In the absence of a level playing field, why shouldn't money flee the weaker countries, going to the financial institutions in the stronger? Indeed, it is remarkable that there has not been more capital flight. Europe's leaders did not recognise this rising danger, which could easily be averted by a common guarantee, which would simultaneously correct the market distortion arising from the differential implicit subsidy.

The euro was flawed from the outset, but it was clear that the consequences would become apparent only in a crisis. Politically and economically, it came with the best intentions. The single-market principle was supposed to promote the efficient allocation of capital and labor.

But details matter. Tax competition means that capital may go not to where its social return is highest, but to where it can find the best deal. The implicit subsidy to banks means that German banks have an advantage over those of other countries. Workers may leave Ireland or Greece not because their productivity there is lower, but because, by leaving, they can escape the debt burden incurred by their parents. The European Central Bank's mandate is to ensure price stability, but inflation is far from Europe's most important macroeconomic problem today.

Germany worries that, without strict supervision of banks and budgets, it will be left holding the bag for its more profligate neighbours. But that misses the key point: Spain, Ireland, and many other distressed countries ran budget surpluses before the crisis. The downturn caused the deficits, not the other way around.

If these countries made a mistake, it was only that, like Germany today, they were overly credulous about markets, so they (like the US and so many others) allowed an asset bubble to grow unchecked. If sound policies are implemented and better institutions established – which does not mean only more austerity and better supervision of banks, budgets and deficits – and growth is restored, these countries will be able to meet their debt obligations, and there will be no need to call upon the guarantees. Moreover, Germany is on the hook in either case: if the euro or the economies on the periphery collapse, the costs to Germany will be high.

Europe has great strengths. Its weaknesses today mainly reflect flawed policies and institutional arrangements. These can be changed, but only if their fundamental weaknesses are recognised – a task that is far more important than structural reforms within the individual countries. While structural problems have weakened competitiveness and GDP growth in particular countries, they did not bring about the crisis, and addressing them will not resolve it.

Europe's temporising approach to the crisis cannot work indefinitely. It is not just confidence in Europe's periphery that is waning. The survival of the euro itself is being put in doubt.

Copyright: Project Syndicate, 2012

European leaders have pulled back from the brink of disastrous failure in their attempts to rescue the euro, throwing a lifeline to the weakest links in the eurozone by agreeing to shore up struggling banks directly, remove disadvantages for private creditors and move quickly towards a new supervisory regime for banks.

David Cameron said on Friday: "The countries of the eurozone did take some important steps forward last night. There's still important work to do."

Amid bad-tempered talks that continued through the night, Italy and Spain stunned the Germans by blocking progress on an overall deal at a two-day EU summit in Brussels until they obtained guarantees that the eurozone would act to cut the soaring costs of their borrowing.

The tough negotiations were deadlocked for hours, prompting the departure from the summit after midnight of the 10 non-euro countries, including Britain, leaving the eurozone leaders to fight it out.

After 14 hours of wrangling, they emerged with a three-point statement rewriting the rules for the eurozone's new bailout regime in a way likely to soften the draconian terms that have accompanied the rescue programmes for Greece, Portugal, and Ireland over the past two years.

The leaders said a new eurozone banking supervisory system should be established by the end of the year. Once it is operational, the eurozone's new permanent bailout fund, the European Stability Mechanism, would be able to recapitalise failing banks directly, without the loans going via governments as at present and adding to national debt burdens. The shift had been demanded particularly by Mariano Rajoy, the prime minister of Spain.

The new supervisory system is likely to come under the authority of the European Central Bank. Under plans being mooted, the new banking regime is to entail pooling eurozone liability for guaranteeing savers' deposits and a common resolution fund for winding up bad banks. But the statement mentioned neither of these two points, which are controversial in Germany, which is reluctant to accept responsibility for the conduct of other countries.

The statement added that in drawing up the terms for up to €100bn (£80bn) for Spanish banks, private creditors would enjoy the same status as the bailout fund in the event of a debt rescheduling. Previously the fund enjoyed "seniority" over private investors.

Herman Van Rompuy, the European Council president who chaired the fractious summit, described the agreement as a breakthrough.

"We are opening possibilities for countries that are well-behaving to make use of financial stability instruments in order to reassure markets and get again some stability around some of the sovereign bonds of our member states," he said.

Eurozone finance ministers are to flesh out the details of the agreement in 10 days' time. It looked as though the shift towards direct help for struggling banks would help Spain but also lead to an improvement in Ireland's bailout terms. The deadlock imposed by Mario Monti, the Italian prime minister, and Rajoy had threatened to wreck ambitions for a "big leap forward" towards political union. The two leaders decided to block endorsement of an EU "growth pact" until it was clear whether the two-day summit would cough up financial aid.

Monti denied Italy intended to request a bailout. All the evidence pointed to a bad-tempered summit. There were also rows about the location of a new European patents court, with Germany, France and Britain at odds over where the institution should be based. With the fate of the currency said to be at stake as well as a radical new blueprint for a federalised eurozone on the table, Europe's leaders appeared bogged down on relatively minor issues.

They were more stridently at odds than ever before in the 30-month euro crisis, but with the stakes arguably at their highest since the currency and sovereign debt crisis erupted in Greece almost three years ago, the real substance of the summit was derailed, at least temporarily, by Italian and Spanish hardball tactics aimed at forcing Germany to soften its tough line on financial assistance to the weaker members of the eurozone.

Monti, who has been plaintively asking Germany to shift from its refusal to accept liability for others' debt, had been expected to deliver a plan late last night calling for help in reducing the cost of borrowing. Instead, he linked up with the Spanish to insist he would not sign off on the growth pact until the overall outcome of the summit became clear, witnesses said. The summit had been expected to quickly endorse the €120bn EU growth and jobs pact, more of a symbolic exercise in shifting the emphasis from austerity, involving little new money.

The tough Italian tactics paid off. The growth pact has been pushed mainly by France and it is the troubled economies of the eurozone, such as Italy and Spain, who are keenest to promote it in an attempt to turn the tide on the German emphasis on austerity and fiscal discipline.

Angela Merkel, the German chancellor, appeared to have little to lose by seeing the meeting blocked and a summit failure. President François Hollande of France sought to put a brave face on what might have turned out to be a debacle for him at his first big EU summit since he needed to take the growth pact home to prove he was already influencing European policy.

There is a risk the deal could yet unravel, though, as governments pick over the immense detail and complexity of establishing a new "banking union", putting the banks under a new eurozone supervisory authority. There will be arguments over how many banks should be covered, over pooled liability. The Germans insist there can be no common responsibility until the common rules are seen to be working properly.

Early on Friday morning, the leaders finally got down to the main topic of the summit, grappling with a "road map" for a 10-year march towards a eurozone political federation, embracing pooled banking, debt and fiscal policies and powers.

German officials maintained a tough line, insisting there were instruments available to help Italy and Spain, such as two eurozone bailout funds. But Italy would have to request aid and accept the same tough terms borne by others who had been rescued. Monti had used the runup to the summit to warn of disaster if his pleas went unheard, while Rajoy had declared that Madrid's borrowing costs were at the brink of what was affordable despite the benchmark 10-year yield falling below 7%.

It remains to be seen whether the steps agreed will be enough to deter market pressure and reverse rising borrowing costs for Spain and Italy. There will also be questions over whether the €740bn in the eurozone's two bailout funds will be enough to resolve a Spanish or Italian crisis.

After talks on Wednesday between Merkel and Hollande, it was clear from the remarks of German officials there was no meeting of minds; Paris and Berlin were seriously split at a summit for the first time in the crisis. "No sign of any warming between Berlin and Paris," said an EU official.

Vassilis Rapanos, the man appointed to be finance minister in Greece's new coalition government, quit without formally taking up his office. Photograph: AFP/Getty Images

Cyprus has become the fifth eurozone country to seek outside financial help to shore up its ailing economy after a day of heavy selling on financial markets prompted by fear that this week's European summit will end without a blueprint to rescue the single currency.

The government in Nicosia admitted that it had been caught in the backwash from the crisis in neighbouring Greece as it formally applied to Brussels for assistance.

On a day when Fitch cut Cyprus's credit rating to junk, a statement said: "The purpose of the required assistance is to contain the risks to the Cypriot economy, notably those arising from the negative spill-over effects through its financial section, due to its large exposure in the Greek economy."

The news followed an announcement in Athens that Vassilis Rapanos, the man appointed to be finance minister in the new coalition government, had quit without formally taking up his office, while the prime minister Antonis Samaras was not fit enough to travel to the Brussels summit after an eye operation.

Markets were also unsettled by comments by Angela Merkel which doused hopes that this week's talks would agree to radical proposals for a full eurozone banking union, common eurobonds and the use of Europe's bailout funds to recapitalise banks directly. The German chancellor said sharing debt liability would be "economically wrong".

Although the German finance ministry believes a euro collapse could result in a 10% contraction in Europe's biggest economy, Berlin is insisting that eurozone member states must give up full autonomy over their budgets and the running of their banks in return for a deal.

In London, the FTSE 100 index closed down 63 points at 5451, the French CAC dropped 64 points to 3027 and Germany's Dax finished 112 points lower at 6152. The biggest falls on European bourses were in Milan, where the FTSE MIB slid 549 points to 13,114 and in Madrid, where the Ibex shed 252 points to 6624. With rumours that Moody's was poised to downgrade Spain's banks for the second time in a month, Wall Street's Dow Jones Industrial Average fell by more than 160 points in morning trading, while the price of Brent crude dropped below $90 a barrel due to concerns that the global economy is heading for a synchronised slowdown.

Cyprus is one of the smallest of the 17 members of monetary union and is expected to need a bailout of several billion euros to finance its debt payments and rescue its banks. It follows Greece, Ireland, Portugal and Spain in seeking formal help from the bailout funds set up by Brussels in response to the sovereign debt crisis.

Spain finally made its formal request for bailout money from the European Union on Monday, with a letter that failed to mention the amount needed and left markets guessing many of the details of how the country's troubled banks will be rescued.

The slow process of putting together the bailout of up to €100bn should see a memorandum signed at a meeting of eurozone finance ministers on 9 July.

Spain asked for the money to go to its FROB bank rescue fund, increasing the national debt.

But the country's foreign minister, José Manuel García-Margallo, added to confusion about the bailout process on Monday, saying Spain had not given up on its battle to have the money go directly to banks, without adding to the national debt. "The question of whether the money will go directly to the banks or to the state is still open," he said.

It was unclear how much of the €100bn bailout money Spain would finally ask for, and when it would be needed. El País newspaper suggested on Mondayyesterday that the government would ask for money as the needs of each bank became clear.

With a further round of stress tests on individual banks not due until September, some of the money might not be requested until after that.

Officials from the Spanish government and the Bank of Spain have repeatedly said the bailout funds are not needed urgently. They have also stressed that the €62bn top figure provided last week by two independent auditors of Spain's banking system would cover against a severe downturn in the next three years – suggesting their request may not go much higher than that.

Monday's letter requesting the loan said the amount "would be sufficient to cover capital necessities as well as an additional margin of security".

Analysts warned Spain against aiming too low. "It is essential that the loan provided exceeds by a certain margin the estimated capital requirements for the banks," said Vincent Forest of the Economist Intelligence Unit. "Anything too far from the announced €100bn could fail to reassure investors, and create further volatility and instability."

EU commissioner Olli Rehn said a deal on loan terms could be concluded within weeks.

David Cameron at a B20 meeting prior to the G20 summit in Mexico. Gordon Brown galvanised the world at the G20 in 2009. Photo: Esteban Felix/AP

All these words are Greek: crisis, chaos and apocalypse. Or, if the world was cleverer, this could still end in catharsis, and renewal. Market furies tear the heart out of Europe, first Greece, then Spain, Italy and France, and finally the world; so even beleaguered pro-Europeans give the euro's survival no more than a 50:50 chance. If all that's left is a tight little German and northern league, why would the EU stay together after that? The guttering flame of the European idea is hard to keep alight in this hurricane.

But it's not impossible. Look how decisively the French and Greek electorates reject the austerity economics that is killing growth in most of the EU. The tide of opinion is turning when even Standard & Poor's at last admits: "Austerity alone risks becoming self-defeating". The policy is tested to destruction. A patched-together coalition between old parties that brought Greece to its knees through corruption and cronyism only won because its pledge to get a better deal was marginally more convincing to a despairing electorate, short of food, medicine and fuel. But anti-austerity was the only message. Either default on debt or repay only once solid growth makes it feasible: more austerity leads back down the death spiral vortex.

If the new government gets no genuine relaxation of impossible bailout terms, more cuts may propel such protests that the radical Syriza will find itself in power shortly, after its meteoric rise from nowhere. How comfortable to be opposing, just a hair's breadth from power. It was not sour grapes (courtesy of Aesop, another Greek) for Syriza leaders to claim this is where they prefer to be for now.

In Britain gleeful anti-Europeans gloat "I told you so", with smirks on the faces of Norman Lamont, Nigel Farage and the rest. David Cameron on Monday yet again wagged his finger emptily at Germany, telling it to intervene, a bizarre stance from one who shares its austerity policy. In all the years of behaving badly to its neighbours, Britain has never been so ignored or so irrelevant to the key decisions taken by its vital trading partners. Despite sad reminders of Gordon Brown's worst traits at last week's Leveson hearings, compare and contrast Cameron's vacuity with Brown's finest hour: when no other leader stepped up, Brown galvanised the world to take fast action with a market-stunning £1trn rescue at the G20 in 2009. Cameron couldn't galvanise a flea circus.

Instead, his party wallows in a European crisis that will blow back at Britain. True, the blizzard will conveniently white out George Osborne's egregious economic errors, the zero growth and double-dip. Roll on a referendum, urge the Europhobes, but in or out of what? Their fantasy is that Britain can slip away to the European economic area on pick'n'mix terms, undercutting EU currencies and irksome trade rules: why wouldn't Europe wreak revenge for our obnoxious behaviour all these years?

At today's G20 no leader emerged to take the initiative, Barack Obama being deep in an election campaign, from which he may not return, and each country protecting its interests. Germany could save Greece, but not Spain and Italy. Germany could let the European Central Bank act as a firewall guarantee. It could allow inflation to ease the path, and embrace growth before debt. But faced by a choice between breaking the euro and abandoning German orthodoxy, Angela Merkel and her party would rather let most of Europe go: she has failed to warn her people of the enormous costs of that. Neither Obama nor Cameron could be seen to pay to save Europe – nor China, nor anyone else; and yet they all know the far greater cost of global collapse.

This is a return to the 1930s, Keynesians say: look where that leads politically. Or is this a dark echo of the first world war? Civilised countries thought protectionism and trade wars could never lead to bloodshed. But the world is no saner now than it was then. Countries pulling up drawbridges, undercutting and cheating each other with worsening relations in times of declining living standards, can still lead to European bloodletting. Look at the venom – the sneering at Greeks, Italians and Spaniards, lazy southern layabouts: blaming ineffective governments nastily morphs into blaming whole nations of inferior people. Germans are again represented as spike-helmeted automatons, bidding for a fiscal and political union that would reduce proud nations to town councils under Berlin's thumb. Germany v Greece on the Euro 2012 football field may be a comic coincidence this week, but nobody should dismiss the seriousness of the EU's "never again" founding purpose.

Europe's impasse needs new purpose, after the old economic certainties helped cause this cataclysm. Even if the EU scrapes through, that's not enough. What then? François Hollande and Ed Miliband are calling a summit of social democrats this autumn to challenge dogma and forge a growth and jobs programme for construction and investment. Keynesian parties need to draw Europe-wide strength and credibility by working together. Hollande proposes a £120bn redirection of EU funds to an emergency growth programme: he should throw in the CAP, too.

Abolishing tax havens, co-ordinating fair tax instead of destructive competition, ending secrecy of wealth and property ownership, cutting defence overspending by France, Britain and Greece: politically hard decisions are easier if social democrats can inspire people with the value of standing together, not falling apart.

The G20 may prove that there is no averting imminent calamity. But the rightwing austerians who caused it will have no solutions for its repair. Europe is phenomenally rich, yet has hardly tapped its own wealth. These governments are still in denial over the real depth of the emergency.

Germany imposed a solidarity tax to pay for reunification, taxing incomes, wealth and property. Britain has barely touched the abundance of its vast undertaxed wealth. This government can never rally the nation to unite in a crisis after hitting the weak hardest, with wealthy lifestyles remaining unchanged. The coalition may well fall apart sooner than expected: Labour needs to stand more ready than has yet been the case, with a radical alternative – easier to do as part of a Europe-wide appeal. In wartime bonds are issued to finance a national emergency by encouraging (or, from the rich, coercing) investment in a time of crisis. What Europe needs to escape slump is a war footing – but this time without the war.

Italian prime minister Mario Monti has spoken of the potentially disastrous consequences of the collapse of the eurozone. Photograph: Edgard Garrido/Reuters

Italy's prime minister, Mario Monti, has warned of the apocalyptic consequences of failure at next week's summit of EU leaders, outlining a potential death spiral that could threaten the political and economic future of Europe.

The Italian leader is to hold talks with Chancellor Angela Merkel of Germany, the French president, François Hollande, and Spain's prime minister, Mariano Rajoy, in the hope that the single currency's big four countries can pave the way for a breakthrough at next week's meeting.

Speaking to the Guardian and a group of leading European newspapers, Monti said that, without a successful outcome at the summit, "there would be progressively greater speculative attacks on individual countries, with harassment of the weaker countries". The attacks would be focused not only on those who had failed to respect EU guidelines, but also on those like Italy, which he said had abided by the rules "but which carry with them from the past a high debt".

Monti warned: "A large part of Europe would find itself having to continue to put up with very high interest rates that would then impact on the states and also indirectly on firms. This is the direct opposite of what is needed for economic growth."

Outlining the result of a failure at the talks, Monti said that, faced with creeping economic paralysis, "the frustration of the public towards Europe would grow", creating a vicious circle. "To emerge in good shape from this crisis of the eurozone and the European economy, ever more integration is needed," said Monti. Yet, if the summit failed to resolve the problems quickly, "public opinion, but also that of the governments and parliament… will turn against that greater integration".

Monti said he could see the beginnings of the process "even in the Italian parliament, which has traditionally been pro-European and no longer is".

He made his remarks hours after his predecessor, Silvio Berlusconi, acknowledged that his party had bled support because of its backing for the Monti government's unpopular budgetary measures and spoke openly for the first time of the electoral advantage it could derive from torpedoing Monti's non-party cabinet of technocrats.

Monti signalled that the key eurozone leaders were working on a plan designed to halt the spread of debt contagion while satisfying Germany's refusal to sanction financial irresponsibility. The plan, he said, was one of the "absolutely necessary" outcomes of next week's summit.

The first outcome, he said, would be a clear sign of the eurozone's willingness to integrate further "in such a way that Europeans know where they're going… [and] the markets are convinced that, having given birth to the euro, the will [of the member states] to make it indissoluble and irrevocable is there and will be strengthened by other steps towards integration".

He warned: "There may not be – indeed, there will not be – a fully-fledged, detailed blueprint, but there will some strong elements and a short road – I hope short, a few months – to get from there to the overall project."

Other minimum requirements were "a fuller banking union, with advances in terms of integrated, and if possible unified, supervision"; "a European deposit guarantee" system; and the plan that will be on the table on Friday for "new market-friendly policy mechanisms" to help out countries under attack – provided they had complied with EU demands for fiscal discipline.

On Thursday figures indicating that the eurozone is slipping into recession heightened fears that Italy will follow Spain in asking Brussels for rescue funds. Only a strong performance from Germany stopped the currency union from contracting in the first quarter. But separate data showed the German private sector suffered a severe downturn in May, made worse by a slump in manufacturing.

The German services sector continued to expand, but this solitary piece of good news is unlikely to keep the eurozone from recession in the second quarter, especially after both manufacturing and services contracted in France.

Elsewhere, the US suffered a slowdown in growth across the manufacturing sector and China registered its eighth consecutive contraction in production.

Without recourse to strongly growing export markets, Italy can expect to see its growth hit for another year, analysts said.

Monti said the proposed new mechanism would kick in "when there is a recognition by the European authorities of respect for the rules on public finance and structural reforms". Making intervention conditional on good behaviour could offer a way of providing relief for countries like Italy and Spain, while meeting German demands for fiscal discipline.

Monti avoided giving details but said he was "very favourable" to the purchase of the bonds of countries under attack. The present system, of assistance to the banking sector by way of the state, led to an increase in public debt that raised the yields – and cut the value – of government bonds, which in turn weakened the finances of the banks, creating "a disagreeable spiral… That is why measures to de-couple this are being studied", he said.

Vassilis Rapanos's appointment as finance minister was greeted with enthusiasm. Photograph: Louisa Gouliamaki/AFP/Getty Images

A new coalition government has been announced in Greece, as eurozone finance ministers met in Luxembourg.

In a surprise move, Vassilis Rapanos, a renowned economist with a radical past as an anti-junta activist, was given the post of finance minister.

With the country's future in the eurozone hanging in the balance despite the elevation to power of pro-European parties in Athens, Rapanos's appointment was greeted with enthusiasm.

"He's absolutely right for the post, he's one of the best we have," said Pandelis Kapsis, a prominent political commentator who served as spokesman for the emergency administration lead by Lucas Papademos until last month.

"As chairman of the National Bank of Greece he knows how the banking system works but he also has a great deal of experience and knowledge of our country's public finances," Kapsis said.

The cabinet's appointment was met with relief among Greeks exhausted by weeks of political paralysis since inconclusive elections in May. On Sunday the centre-right New Democracy party came out on top in fresh elections but failed to clinch an outright majority.

Under intense pressure from foreign lenders keeping the economy afloat, Greece's squabbling political elite put differences aside to create a three-party alliance led by the conservatives under the new prime minister, Antonis Samaras.

The 38-strong cabinet was dominated by New Democrats after its two minority partners, Pasok and Democratic Left, agreed their MPs would support the government but not participate in it.

With the exception of three ministers, including Rapanos, who were appointed at the behest of the junior parties, all were well known conservative politicians. In an attempt to allay fears that the government marked a return to the old order, several members were young and untried.

Samaras, who was to convene the cabinet's first meeting after a swearing-in ceremony, said he expected the administration would be long-lived and fulfil its four-year term. He faces a high-wire act of appeasing Greeks who despair of austerity measures and meeting the commitments Athens has signed up to in exchange for financial assistance.

Berlin, which has bankrolled most of the two bailout programmes that have propped up the Greek economy since May 2010, has made clear that punishing reforms will have to be made if Athens is to continue receiving funds. Foreign creditors have called on Greece to enact €12bn in further spending cuts next month.

All three parties in the new government want to renegotiate the bailout accord, once again putting Greece on a potential collision course with creditors. Officials said Giorgos Zanias, the outgoing finance minister who represented Greece at Thursday's euro group meeting in Luxembourg, would raise the issue of amending the austerity measures, citing fears of a descent into social chaos and collapse if Greeks are pushed too hard.

Dimitris Keridis, professor of political science at Panteion University in Athens, said: "The secret to this government surviving will be trust among the three partners. If they fragment the only beneficiary will be [the main opposition] Syriza. It won't be easy in a political culture that is not used to coalitions and in a country that faces such tough decisions."

The accident and emergency ward at a hospital in Athens. Greece is struggling to implement austerity measures due to the financial crisis. Photograph: Sean Smith for the Guardian

It's not working, is it? No matter how many summits there are, no matter how many times the Greeks vote or Barack Obama pleads or David Cameron lectures from on high, nothing happens. The yield on Spanish bonds, that beckoning finger of apocalypse, goes relentlessly upwards. All we do is howl, simper and plead for Germany to do something, even just kick the can down the road. Alongside Europe's tottering mountain of debt lies a pit of intellectual emptiness.

At such a time, most of us hold close to nurse for fear of something worse. To Tories, George Osborne and austerity must be right because he is a Tory. Labour believes in Ed Balls, co-author of our present misery, because he is Labour. I was schooled in the teachings of Maynard Keynes and Milton Friedman, who at least agreed on how to beat recession (not the present way). I thus hold fast to Keynes's vicar on earth, Paul Krugman. Anyone persuaded by Osborne's eulogy of reduced deficits at the Mansion House last week should read Krugman's End This Depression Now! His plea for immediate, universal demand expansion is unanswerable.

Europe is bankrupt. This means its bankers cannot hope to recoup the trillions of debts built up by the Mediterranean states over the past decade, short of their descent into eternal indenture and impoverishment. At present the "bailouts" allowed by the German authorities to Greece and Spain are not aiding those economies; they are merely propping up the dud loans of their own and other banks.

Needlessly shutting people out of work and depriving them of spending power is immoral and counter-productive. That was the message Keynes drew from the Great Depression, to widespread agreement. Friedman, the so-called monetarist, had no quarrel with him on this. As with a patient haemorrhaging blood, cash had to be injected into a collapsed economy.

With painful slowness it is becoming accepted that some "orderly" default of European bank debt is inevitable, along with a drastic boost to European demand. The claim that bond market confidence cannot stand the shock of default – or of rising deficits – merely postpones the day of reckoning. The important thing is to implement the defaults and the stimuli quickly. Ben Bernanke, the US Federal Reserve chairman, made his reputation by arguing this during Japan's long and disastrous flirtation with austerity in the 2000s.

How to retain the continuing confidence of bond markets is a real question, but their power, so mesmeric over 24/7 politicians, is grossly inflated. The IMF has studied 173 cases of austerity packages since the 1970s and all led to recession not growth. Each bailout to "boost confidence" in Greece and Spain further collapses the bond markets. Confidence is best served by the prospect of growth, and not the dilatory growth of government-controlled infrastructure projects, but the crude printing and distribution of money – whether through social benefits, tax cuts or dropped by Friedman's famous "helicopters".

Yet who in Europe is to lead us down this path? Almost every political speech or editorial nowadays ends with banal cries for "the authorities to get their act together … show leadership … a strong hand … a coherent programme". It is an echo of the 1930s, of nations losing their democratic compass and requiring rescue by unnamed forces beyond their sovereignty.

This is the same treason of the clerks that claimed, in the 1990s, that nation states were dying and should be replaced by an oligarchy of bankers and bureaucrats. Only under the banner of the euro would Europe find lasting stability. The cliche now holds that the euro would have worked "if only" a single European government had been installed at the same time. That was never on. It is like saying communism would have worked if only it had been tried.

There is no political entity called Europe, as there is a United States of America. That elitist fantasy of the class of '45 is being torched in the streets of Athens and Madrid. Europe is a confederacy, not a sovereign authority with electorally accountable cabinet, party system and police force. Its statesmen are first and foremost national politicians, while its gilded cardinals glide from one convocation to another, caring only for their poisonous dwarf, the euro. They can no more decide with urgency than can the G20, parading its impotence this week on Mexico's beaches.

Though no one has noticed, it is Europe's democracies that are displaying a sense of responsibility at present. Over the past year Italy, Spain, France and the Netherlands – even Greece – have seen voters struggling to do the best they can, pondering options, trying to balance growth with fiscal prudence, mandating governments accordingly. But they are prisoners in Colditz, incarcerated in a citadel of a currency and monetary union with all the flexibility of granite. Only when national governments, or their domestic banking communities, choose to desert the euro might they begin to escape.

Until then the citizens of southern Europe are doomed to an ever more dreadful poverty. I cannot see how liberal people can still wish this, unable to liberate themselves from the groupthink that the euro answers every prayer. The euro was the Nicene creed of European liberalism.

What is doubly tragic is that the euro's fate should be ensnared in the pre-Keynesian politics of austerity. This has an older pedigree, in the morality of sin and redemption. For governments of the right, it is collective corporal punishment for past profligacy, usually of those least to blame. As Krugman puts it: "Deficit spending just seems wrong … to central bankers and other financial officials whose sense of self-worth is bound up with the idea of being the grownups who say no." Good people do not have deficits, except of course when they are us.

Rising deficits create bubbles during expansion, but during recession the planning of controlled and transparent deficits holds the key to economic rescue. Membership of the euro denies this rescue to Greece or Spain, but it remains open to Britain. London has a responsible government with sound credit and a floating currency. There is no need for enforced short-term austerity in Britain. There is every need to reflate demand. That is the best way for Cameron to set an example to the rest of Europe.

• Follow Comment is free on Twitter @commentisfree

The opening day of the G20 summit was threatening to deteriorate into a fractious row between eurozone countries and other non-European members of the G20, notably the US, as EU commission president José Manuel Barroso insisted the origins of the eurozone crisis lay in the unorthodox policies of American capitalism.

As Europe's leaders came under intense pressure to act decisively to cure the euro's ills, and a campaign gathered pace to relax some of the austerity programmes laying waste to countries with unsustainable debt levels, Barroso said Europe had not come to the G20 summit in Mexico to receive lessons on how to handle the economy. Asked by a Canadian journalist: "Why should North Americans risk their assets to help Europe?" he replied: "Frankly, we are not here to receive lessons in terms of democracy or in terms of how to handle the economy.

"This crisis was not originated in Europe … seeing as you mention North America, this crisis originated in North America and much of our financial sector was contaminated by, how can I put it, unorthodox practices, from some sectors of the financial market."

Late on Monday , Antonis Samaras, the Greek election victor, announced he had agreed to build a coalition with the head of the socialist Pasok, Evangelos Venizelos, with aides saying they expected negotiations to be concluded by Tuesday. The moderate Democratic Left party may participate as well.

The European council's president Herman Van Rompuy, speaking alongside Barroso, said a draft G20 communique showed "support and encouragement for the euro area countries and leaders and for the European Union as a whole to overcome this crisis".

"We are not the only ones that are so-called responsible for the current economic problems all over the world," he said.

Germany's chancellor, Angela Merkel, is under pressure to soften her hardline stance on the austerity measures Europe imposed on indebted eurozone members, which the British chancellor George Osborne has claimed has killed economic growth. Barroso said he expected G20 leaders to "speak very clearly in favor of the approach the EU is following."

After the Greek election at the weekend, which may have shifted terms of the debate over how to shore up the euro, world leaders meeting in Mexico focused on the European crisis amid strong signs of big trouble brewing in Spain.

Madrid's 10-year cost of borrowing went through the 7% barrier on the bond markets for the first time in the single currency era, the level at which borrowing becomes unaffordable. The Spanish government demanded intervention from the European Central Bank.

Spain's prime minister, Mariano Rajoy, is expected to ask for up to €100bn in eurozone bailout funds for Spain's stricken banks at a meeting of eurozone finance ministers in Luxembourg on Thursday, senior Eurogroup sources said. Voicing exasperation with the European response to the debt crisis, Robert Zoellick, the outgoing American head of the World Bank, warned the G20 summit in Mexico of a growing rift between the Europeans in charge of the bailouts and the IMF.

"The world's waiting for the Europeans to say what they want to do," said Zoellick. He predicted a showdown between the IMF and Europe by the end of the summer in the absence of any decisive action.

Barack Obama was expected to press Merkel, in Mexico on Monday night on the issue of eurobonds – the pooling of liability for single currency countries' debt. But there is no chance of Merkel agreeing to underwrite the debt of other European countries for the foreseeable future.

Britain might have to seek fresh export markets outside the EU as the euro crisis was now facing such entrenched political obstacles that it could be impossible to resolve, he warned. "It may be that the eurozone crisis is going to continue for some time, in which case the UK must do all it can to put its own house in order and link up with the fastest growing parts of the world."

He said a longer term roadmap for a more stable single currency was going to be hard to achieve.

Fresh from his victory in the Greek election, the centre-right leader, Antonis Samaras, promptly tabled demands for a softening of the draconian austerity programme that Greece has to implement for the eurozone bailout.

Samaras, the prime minister-designate pledged to stick broadly to the Greek bailout terms but added: "We will simultaneously have to make some necessary amendments to the bailout agreement, in order to relieve the people of crippling unemployment and huge hardships."

Politicians and officials in Brussels and Germany appeared to suggest that the new Greek leader's demands could be at least partly satisfied by extending the repayment schedule on the bailout loans or lengthening the target deadlines for cutting the budget deficit.

There were also reports that the terms underpinning Ireland's bailout could also be relaxed, giving Dublin a much longer repayment schedule on the loans. The talk of rescheduling the Greek bailout terms surfaced quickly on Sunday night, with the German foreign minister, Guido Westerwelle, suggesting the Europeans could alter the timings. That triggered a row in Germany among the political class over the pros and cons of going easier on Greece.

In Brussels, the respected Bruegel thinktank said: "It is now increasingly clear that the [Greek] programme is severely off track. The [Samaras] victory doesn't change this fact and it has become unavoidable to open a discussion about the shape and form of a new Greek programme. This is a fact now broadly acknowledged by policymakers and in particular by German officials who have openly discussed the possibility of stretching fiscal targets."

Martin Schulz, the German social democrat who presides over the European parliament, added: "The new Greek government will be able to count on our constructive cooperation in possible fine-tuning of its reform strategy and economic targets. If Greece sticks to its commitments, the EU can examine what could be done further to solve the crisis."

From Mexico, however, Merkel appeared to dismiss any easing of the Greek conditions. "The new Greek government has to implement the commitments entered into by the country. The programme framework has to be kept."

The eurogroup source said that Samaras was expected to show up in Luxembourg on Thursday for the meeting of eurozone finance ministers which will grapple with Spain and how to respond to the Greek election results.

Socialist party leader Martine Aubry promised the new parliament would be more representative of France. Photograph: Yoan Valat/EPA

François Hollande's Socialist party has won an absolute majority in the French parliament, giving him a free hand in his attempts to drag France out of its economic crisis through a mixture of deficit-reduction and growth measures.

The left now holds a historic concentration of power in France as it controls both the assembly and the senate. But Hollande faces the difficult task of tackling France's economic gloom, high unemployment and rising debt. His plans include raising taxes on the wealthy. An audit of the country's dire public finances will set the tone for the first summer parliament session, which begins later this month. The prime minister, Jean-Marc Ayrault, appeared to be preparing France for difficult choices and sacrifices in his speech after the vote, saying: "The task ahead of us is immense."

The Socialists are predicted to take between 308 and 320 seats in the 577-seat National Assembly, well over the required 289 for an outright majority.

One outcome of the night was the two seats won by the far-right Front National, which will sit in parliament for the first time since 1986. Marion Maréchal Le Pen, the 22-year-old granddaughter of the Front National's figurehead, Jean-Marie Le Pen, won a seat in the southern constituency of Vaucluse. A law student who sat her exams during the campaign, and denied being pushed into running for parliament by her famous family, becomes the youngest French MP in modern history. The lawyer Gilbert Collard also won a Front National seat in the Gard in southern France. He said he would be on "a democratic ball-breaking mission" in the assembly. The Front National leader, Marine Le Pen, was beaten after a high-profile struggle in the northern constituency of Henin-Beaumont, losing by 114 votes to a Socialist and has demanded a recount. An MP for the far-right Southern League was also elected in the south. The last Front National MP was elected in 1997 but the result was annulled over funding irregularities.

Nicolas Sarkozy's UMP party, which had led the assembly for a decade, is braced for a bitter internal leadership battle after a low score and the defeat of key figures such as Claude Guéant, the hardline former interior minister and Sarkozy ally, who was running for first time, and ex-minister Nadine Morano. The party had been under fire for courting the far-right vote and will now begin soul-searching over it positioning.

The centrist presidential candidate François Bayrou was defeated in his fiefdom in Pau.

The Green party, thanks to an election deal with the Socialists, won around 19 seats and will form a Green parliamentary group for the first time in France.

One of the biggest upsets for the Socialists came in La Rochelle, where the Socialist former presidential candidate Ségolène Royal was beaten by a dissident candidate expelled from the Socialist party for standing against her. Royal's battle was at the centre of a presidential private-life saga this week when Hollande's partner, the journalist Valérie Trierweiler, tweeted her support of the dissident. Hollande had backed Royal, who was his partner for 30 years and is mother of his four children.

The Socialist party leader Martine Aubry promised the new parliament would be more representative of France, with more women and MPs from France's diverse ethnic make-up. In the last parliament there was only one black MP representing mainland France. As final counts continued, the exact number of women or ethnic minority MPs was unclear.

In the last of four elections in two-months, including the two-round presidential race, there was a notably low turnout of about 56%.