France and Germany agreed on Thursday to stop arguing in public over whether the European Central Bank should do more to rescue the euro zone from a deepening sovereign debt crisis.
President Nicolas Sarkozy and Chancellor Angela Merkel said after talks with Italian Prime Minister Mario Monti that they trusted the independent central bank and would not touch its inflation-fighting mandate when they propose changes of the European Union's treaty to achieve closer fiscal union.
They also demonstrated their confidence in Monti, an unelected technocrat, to surmount Italy's daunting economic challenges, in contrast to the barely concealed disdain they showed for his predecessor, media billionaire Silvio Berlusconi.
We all stated our confidence in the ECB and its leaders and stated that in respect of the independence of this essential institution we must refrain from making positive or negative demands of it, Sarkozy told a joint news conference in the eastern French city of Strasbourg.
French ministers have called repeatedly for the central bank to intervene decisively to counter a market stampede out of euro zone government bonds, while Merkel and her ministers have said the EU treaty bars it from acting as a lender of last resort.
Sarkozy said Paris and Berlin would circulate joint proposals before a December 9 EU summit for treaty amendments to entrench tougher budget discipline in the 17-nation euro area.
Merkel said the proposals for more intrusive powers to enforce EU budget rules, including the right to take delinquent governments to the European Court of Justice, were a first step towards deeper fiscal union.
But she said they would not modify the statute and mission of the central bank, nor soften her opposition to issuing joint euro zone bonds, except perhaps at the end of a long process of fiscal integration.
French aides had hoped Berlin would relent in its opposition to a bigger crisis-fighting role for the ECB after Germany itself suffered a failed bond auction on Wednesday, highlighting how investors are wary even of Europe's safest haven.
There is urgency (for ECB intervention), Foreign Minister Alain Juppe told France Inter radio before the meeting.
Sarkozy took a step towards Merkel this week by agreeing to amend the treaty to insert powers to change national budgets in euro area countries that go off the rails. Juppe cautioned that treaty change could take years because of the need for 27 national parliaments to ratify it.
With contagion spreading fast, a majority of 20 leading economists polled by Reuters predicted that the euro zone was unlikely to survive the crisis in its current form, with some envisaging a core group that would exclude Greece.
Analysts believe that sense of crisis will in the end force dramatic action. I think we are moving closer to a policy response probably, which could be either more aggressive ECB action or the idea of euro bonds could gain some traction, said Rainer Guntermann, strategist at Commerzbank.
In signs of public resistance to austerity in two southern states under EU/IMF bailout programmes, riot police clashed with workers at Greece's biggest power producer protesting against a new property tax, and Portuguese workers staged a 24-hour general strike.
Credit ratings agency Fitch downgraded Portugal's rating to junk status, saying a deepening recession made it much more challenging for the government to cut the budget deficit, highlighting a vicious circle facing Europe's debtors.
German bonds fell to their lowest level in nearly a month after Wednesday's auction, in which the German debt agency found no buyers for half of a 6 billion euro 10-year bond offering at a record low 2.0 percent interest rate.
The shortage of bids drove Germany's cost of borrowing over 10 years to 2.2 percent, above the 1.88 percent markets charge the United States and the 2.18 percent that heavily indebted Britain has to pay.
Bond investors are effectively on strike in the euro zone, interbank lending to euro area banks is freezing up, ever more banks are dependent on the ECB for funding, and depositors are withdrawing increasing amounts from southern European banks.
In one possible response, people familiar with the matter said the ECB is looking at extending the term of loans it offers banks to two or even three years to try to prevent a credit crunch that chokes the bloc's economy.
Monti repeated Italy's goal of achieving a balanced budget by 2013 but said there was room for a broader discussion about how fiscal targets could be adjusted in a worse-than-expected recession.
Italian bond yields' jumped this month to levels above 7 percent widely seen as unbearable in the long term, despite stop-go intervention by the ECB to buy limited quantities, triggering Berlusconi's fall.
Keeping Italy solvent and able to borrow on capital markets is vital to the sustainability of the euro zone. Key Italian bond auctions early next week will test market confidence.
German officials said the failed auction did not mean the government had refinancing problems and several analysts said Berlin just needed to offer a more attractive yield.
But it was a sign that, as the bloc's paymaster, Germany may face creeping pressure as the crisis deepens that may cause it to re-examine its refusal to embrace a broader solution.
Economy Minister Philipp Roesler of the Free Democratic junior coalition partner called for parliament to reject euro zone bonds because we don't want German interest rates to rise dramatically.
But some market analysts are convinced joint debt issuance will eventually have to be part of a political solution to hold the euro zone together.
Although it is not easy to see how the region will get to a fiscal union with Eurobonds, we believe that this is the path that will be chosen, JP Morgan economist David Mackie said in a research note.
With time running out for politicians to forge a crisis plan that is seen as credible by the markets, the European Commission presented a study on Wednesday of joint euro zone bonds as a medium-term way to stabilise debt markets alongside tougher fiscal rules for member states.
The borrowing costs of almost all euro zone states, even those previously seen as safe such as France, Austria and the Netherlands, have spiked in the last two weeks as panicky investors dumped paper no longer seen as risk-free.
Outside the euro zone, a top British financial regulator said British banks should make contingency plans for a potentially disorderly break-up of the currency area, or the exit of some countries, as the sovereign debt crisis rages on.
Good risk management means planning for unlikely but severe scenarios and this means that we must not ignore the prospect of a disorderly departure of some countries from the euro zone, Andrew Bailey, deputy head of the Prudential Business Unit at the UK's Financial Services Authority, told a conference.
In a Reuters poll conducted over the last 10 days, 14 out of 20 prominent academics, former policymakers and independent thinkers agreed the euro zone's make-up would change.
A new core euro zone with fewer members received qualified backing from 10 economists as a possible solution, with seven of them saying Greece should be excluded from it.
(Reporting by Stephen Brown, Noah Barkin, Natalia Drozdiak, Veronica Ek, Eva Kuehnen, Ana Nicolaci da Costa, Giselda Vagnoni; Writing by Paul Taylor, editing by Mike Peacock)