By Stella Dawson
WASHINGTON (Reuters) - Failure by European leaders at their summit this week to fix the fatal flaw in the euro zone, its lack of political union, would risk tremendous market upheaval, a rupture of the common currency and global economic fallout.
The world economy already is slowing, leaving it increasingly vulnerable to shocks reverberating from Europe. China cut reserve requirements for banks last week for the first time in three years and its factory sector shrank to levels not seen since February 2009. Brazil also lowered rates for the third time since August.
Only the United States has enjoyed a steady stream of improving data. The unemployment level dropped to 8.6 percent in November, the lowest level in 2-½ years, factories expanded and retail spending accelerated, pointing to a slow and gradual pick-up in growth.
But Europe casts a pall over everything. So serious are the risks that it could disrupt three years of painful global economic recovery that politicians, central bankers and market strategists are starting to compare the danger of European leaders deadlocking to the collapse of Lehman Bros in September 2008.
That shock plunged the world into its deepest recession since the 1930s.
"Let us not hide it: Europe may be swept away by the crisis if it doesn't get a grip, if it doesn't change," French President Nicolas Sarkozy said on Thursday.
Bank of England Governor Mervyn King warned of a "systemic crisis," adding that "none of us really know" how the euro zone would survive if the crisis explodes into sovereign default.
"This is Lehmans, Take Two. Cubed," said Kathleen Gaffney of Loomis Sayles, a part of Natixis Asset Management.
Leaders got a peak into the abyss when credit lines froze over the last 10 days after Germany failed in late November to sell all its bonds and yields jumped, not only for heavily indebted Italy and Spain, but also for countries at the very heart of the euro project -- France and Germany.
It took five major central banks cutting interest rates on currency lines last Wednesday and extending those lines to restore a measure of calm to financial markets.
But the uneasy peace will not last unless Sarkozy and German Chancellor Angela Merkel, who meet on Monday to discuss changes to the EU Treaty, can finalize a fiscal deal that imposes tough budgetary rules on the 17 euro-zone members and then convince all 27 EU leaders on Friday to back the plan.
Their summits are littered with a history of half-baked solutions and broken promises. Few have illusions that this one will produce a definitive solution to the euro crisis.
But investors want to see the famously fractious European leaders make significant progress and show they are willing to give up some national control over budgets and march toward political union.
Though it will be a long and trying road, only then can the future of the decade-old euro zone project be assured. To do less would invite market upheaval, and eventually could lead to bank failures and sovereign default, said Mark Geitler, professor of economics at New York University.
"Global recession would likely follow and there would be pressure to break up the euro zone. An unpredictable chain of negative events would then likely follow," Geitler said.
Treasury Secretary Timothy Geithner is flying to Europe next week to press the urgency of the matter, meeting politicians from France, Germany, Spain and Italy, as well as the European Central Bank. His assistant secretary for economic policy, Jan Eberly, said a European recession would blight U.S. recovery and is "absolutely a source of concern."
Even if a political deal for fiscal union is struck on Friday, it likely will require EU treaty changes and take many months to implement. Meanwhile, the world economy will remain highly vulnerable to further market stress unless a second step is taken to guarantee solvency of governments and stabilize the European government debt market.
There are several ways of taking that second step: The European Central Bank could unleash a massive round of bond buying, dubbed using the "big bazooka." The International Monetary Fund could agree on backstop funding programs for indebted countries that are having trouble tapping bond markets, such as Italy and Spain; or a beefed-up Europe's bailout fund could buy up the debt.
The ECB made an important move last week by signaling flexibility if leaders move forward on a fiscal compact. The central bank is widely expected to cut interest rates and expand its liquidity facilities when it meets on Thursday.
More focus will be on ECB President Mario Draghi's news conference, where he could expand on the ECB's readiness to act as lender of last resort -- a path urged upon it by the United States and France, but staunchly resisted by Germany on grounds it discourages budget discipline.
But if the scaffolding toward a German-led fiscal union can be erected at the EU summit, the ECB may be willing to bend. It also would provide some assurance to investors that the fatal flaw in monetary union will be fixed, averting a cataclysmic end to the euro project and return to Great Recession.