Franco-German Proposal Disappoints

Sarkozy and Merkel Propose Euro-Zone Council for Better Governance

By NATHALIE BOSCHAT, BERND RADOWITZ and GABRIELE PARUSSINI

PARIS—The plan by France and Germany to create a head of the euro zone to shore up economic governance of the monetary union stopped short of more fundamental steps toward refashioning the area into a federal entity that would issue its own debt, disappointing investors hungry for a more radical solution to the euro-zone crisis

Tuesday's proposals followed a tumultuous few weeks during which the debt crisis spread, forcing the European Central Bank to widen its bond purchasing program to include Italian and Spanish debt.

The proposals outlined Tuesday from French President Nicolas Sarkozy and German Chancellor Angela Merkel were immediately criticized by investors as falling short of what was needed. U.S. stocks initially rose as investors saw signs of broader cooperation in the euro zone, but fell after Mr. Sarkozy said increasing the size of the euro-zone fund to bail out weaker countries wasn't in the cards. Demand for U.S. Treasurys surged and the price of gold also rose, as did the cost of insuring euro-zone sovereign debt against default.

The French and German leaders, who have a track record of finding breakthroughs at times of gridlock in the region, said a mix of increased economic coordination and tighter fiscal discipline would help restore investor confidence in the euro zone, where three countries are under bailout assistance and more are facing difficulties raising debt.

"We can't solve problems in a big bang," Ms. Merkel told reporters after a meeting with Mr. Sarkozy. "What we are proposing will allow us to regain confidence step by step."

Investors are clamoring for a comprehensive solution to the euro-zone crisis, particularly after market jitters spread to Italy and Spain, where governments now rely on assistance from the ECB to raise debt at affordable costs.

At the same time, France has found itself swept up in the broader reassessment of the credit-worthiness of highly indebted industrial nations, sparking questions of whether it can retain its prized triple-A credit rating at a time of stalled growth and bringing financial-market concerns closer to the core of the euro zone.

But the complexities of decision-making in a group of 17 disparate nations means proposals have routinely fallen short.

"A fundamental discrepancy remains between what markets need and what politicians can offer," said Jacques Cailloux, chief European economist at Royal Bank of Scotland, predicting more tensions in markets.

The debt crisis that left Greece, Ireland and Portugal seeking financial assistance from the European Union and the International Monetary Fund has exposed fundamental flaws in the euro-zone construction: 17 countries share the same currency but have limited oversight over each other's spending policies.

As a result, a profligate nation can run into budget woes and damage trust in the common currency. Unless the proposed euro-zone chief were empowered with the authority to sanction wayward spenders, the monetary union would be left to rely, once again, on the self-discipline of its members.

Some policy makers and economists say the time has come to recast the architecture of the euro zone and accelerate the pace toward deeper fiscal integration by creating a single entity that can issue debt on a euro-zone level and keep a tight leash on national finances. The entity would mirror the ECB in a similar fashion to the Federal Reserve's relationship with the U.S. Treasury.

Mr. Sarkozy and Ms. Merkel both said they were convinced the euro zone must move toward deeper integration but added that it was too early to introduce euro-zone bonds. Mr. Sarkozy said any such move could "crown" the euro-zone integration process, but couldn't constitute a foundation.

Among the measures outlined by the two leaders were more frequent meetings of euro-zone heads of government, balanced-budget rules enshrined in the constitutions of all euro-zone member nations, and coordinated French and German corporate-tax regimes. "We want France and Germany to move closer in terms of fiscal integration," Ms. Merkel said.

Also, finance ministers from both countries will get together twice a year to make sure the hypotheses underlying the presentations of their respective budgets are consistent. "France and Germany must converge; the status quo is impossible," said Mr. Sarkozy.

The French and German leaders said they would try to give renewed impetus to a proposal for a tax on financial transactions, an idea that has been floated regularly in recent years but faces strong opposition in the U.K., Europe's main financial hub.

The Franco-German proposals will be included in a letter to be sent to European Council President Herman Van Rompuy—whom the leaders recommended be the new euro-zone chief—on Wednesday. In turn, Mr. Van Rompuy will consult other euro-zone members. A representative for Mr. Van Rompuy wasn't available to comment.

—David Gauthier-Villars and Jonathan Cheng contributed to this article.

Write to Nathalie Boschat at nathalie.boschat@dowjones.com, Bernd Radowitz atbernd.radowitz@dowjones.com and Gabriele Parussini at gabriele.parussini@dowjones.com