By Richard Driver, analyst, Caxton FX

As we draw nearer to this Friday’s European Summit (EU) meeting, the economies and markets of the world wait to see if Europe’s leaders can sort out the worsening debt crisis.

On Monday we saw Merkel and Sarkozy put forward some ambitious plans and while it’s imperative that EU politicians take assertive action to fix Europe’s woes, the European Central Bank (ECB) must form a key part of the solution.

We clearly need to see some progress come out of the EU summit on Friday, particularly in light of Standard & Poor’s recent threat to downgrade 15 of the eurozone states, which remarkably includes Germany – the bank roller of Europe.

Plenty of options remain on the table, though judging by the rhetoric from Merkel this week, a Eurobond will not be part of the plan, something we believe would go a long way to help curb the deteriorating prospects of the single currency.

This Friday, Merkel and Sarkozy will be hoping to win the approval of the full 27-state EU community for their agreement on budget discipline and sanctions.

Countries outside of the eurozone, including Britain, are obviously concerned about their own financial interests and if they obstruct subscribing to debt limits, then France and Germany will pursue other means of realising their vision through a separate treaty.

Many of the decisions made at the EU Summit – assuming they are made – will be long-term in nature.

However, in order to calm the markets in the short-term, action is an immediate necessity, which must come in the form of greatly stepped-up bond-buying from the ECB.

In theory there should be less opposition to this if the plan for fiscal discipline is agreed at the EU Summit because it would no longer be a case of letting the periphery eurozone nations off the hook.

The ECB’s new President, Mario Draghi, is also odds on to cut rates for a second consecutive month on Thursday, which will further help measures to stem the debt crisis.

With the eurozone’s economic growth outlook for 2012 so negative, Draghi would be right to cut rates again; it would encourage banks to increase lending and get the economy moving again.

ECB’s Jurgen Stark has also projected that eurozone inflation is likely to fall next year, so the path is clear for a rate cut.

This is a remarkable turnaround, considering that Draghi’s predecessor Trichet hiked rates twice earlier on in the year, as well as the fact that he has been ECB President for just a couple of months.”

It is quite clear that the success of the EU Summit will largely rely on the agreement of responsible fiscal plans, coupled with the ECB taking a leading approach to calm bond yields in the short term.”

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