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By Marc Jones and Huw Jones
LONDON (Reuters) - A heated debate about Europe's austerity drive flared back into life on Thursday with leading IMF and European Central Bank officials sharply at odds and Angela Merkel declaring that Germany required higher interest rates.
With the threat of the currency bloc's break-up receding, some euro zone officials are saying now is the time to throttle back on debt-cutting drives because calmer financial markets will not react badly.
The International Monetary Fund is also pushing that prescription - for both the euro zone and Britain - but Germany and the ECB are opposed.
"There is ... a risk that Europe could fall into stagnation, which would have very serious implications for households, companies, banks and other bedrock institutions," IMF First Deputy Managing Director David Lipton told a conference in London.
"To decisively avoid that dangerous downside, policymakers must act now to strengthen the prospects for growth," he said.
But at the same conference, the Economist's Bellwether Europe Summit, ECB Executive Board member Joerg Asmussen urged governments to push on with budget consolidation and reforms.
"Delaying fiscal consolidation is not an easy way out. If it were, we would have taken it," Asmussen said.
"Delaying fiscal consolidation is no free lunch. It means higher debt levels. And this has real costs in the euro area where public debts are already very high," he said.
The ECB is expected to cut interest rates next week, although a quarter-point reduction is unlikely to lift the euro zone economy out of recession.
"It will probably require additional unconventional measures from the ECB," Lipton said, while Asmussen said monetary policy was not an "all-purpose weapon".
Further clouding the debate, German Chancellor Angela Merkel said if monetary policy were set for her country alone, rates would have to rise.
"The ECB is in a difficult position. For Germany it would actually have to raise rates slightly at the moment, but for other countries it would have to do even more for more liquidity to be made available," she said at a banking conference, in an unusually outspoken comment on central bank policy.
Survey evidence this week suggested even the German economy is struggling, however, and its economy ministry forecast growth of just 0.5 percent this year.
Rhetoric aside, the EU is expected next month to give struggling countries like France and Spain longer to meet their deficit-cutting targets.
European Commission President Jose Manuel Barroso has said austerity had reached its natural limits of popular support and the bloc's economics czar, Olli Rehn, said the pace of debt-cutting was slowing.
Rehn will preside over May's decision on member states' deficit targets. Spanish figures showing unemployment topping 6 million and more than half the country's youth out of work showed the kind of pain crisis-hit parts of the currency bloc are experiencing.
"We have been clear that the pace of fiscal adjustment should take into account each country-specific economic situation," Rehn told a conference in Brussels. "The pace of fiscal consolidation is now already slowing down in Europe."
But any relaxation is likely to be limited, and economists warn that the euro zone crisis will only be over once a robust banking union has been established.
Berlin is baulking at joint euro zone mechanisms to underpin weak banks.
The ECB said on Thursday that financial markets had calmed since its pledge to do whatever it took to save the euro but could be put into a new tailspin if there were signs of banking union plans stalling.
Germany, Europe's largest economy, fears such a scheme would leave its taxpayers footing the bill for mistakes made by banks in other countries, and Merkel reaffirmed her opposition to a Europe-wide bank deposit guarantee.
"The worst of the fiscal tightening is definitely behind us because they can't afford to be so aggressive given economies are already in recession," said Annalisa Piazza, market economist at Newedge Strategy.
"But they need to find the right balance. They can't afford to be too loose on fiscal policy either."
(Additional reporting by Andreas Rinke in Dresden, Sakari Suoninen in Frankfurt, Martin Santa and Jan Strupczewski in Brussels and Swaha Pattanaik in London. Writing by Mike Peacock; Editing by Hugh Lawson)