Selloff raises stakes in Sarkozy-Merkel talks

(Reuters) - The leaders of France and Germany face a stark choice in talks on Tuesday over whether to begin steering the embattled euro zone toward closer fiscal union or risk watching the bloc unravel.

French President Nicolas Sarkozy and German Chancellor Angela Merkel meet in Paris to discuss what further measures they can take to contain Europe's debt crisis, which is now spreading to the continent's core.

Italy has been forced to ramp up its austerity measures and financial market jitters hit France last week with French banks' shares subject to panic selling following rumors that the country could be next to lose its prized AAA debt rating.

Many experts say the only way to ensure affordable financing for the bloc's most financially distressed countries would be for the euro area to issue joint euro zone bonds -- although officials in Paris and Berlin said Tuesday's talks would not address that possibility.

Although the German government has long opposed the idea, support is beginning to emerge, with the country's export association saying on Monday that all other means of fighting the crisis had run out.

Italian Economy Minister Giulio Tremonti said on Saturday that euro bonds would be the best solution to Europe's debt crisis, and some economists say that the euro zone will inevitably come around to accepting the idea.

Ordinary Germans have opposed more help for their weaker neighbors even while their economy has been roaring along. Figures on Tuesday showing German GDP barely grew in the second quarter suggests a slowdown is starting to grip there, making underwriting of euro zone debt an even harder sell politically.

"While German politicians are currently racking their brains on the pros and cons of common Euro bonds, the luxury of having an economy running at "wonder" speed is fading away," said Carsten Brzeski at ING.

The German economy grew by just 0.1 percent in the second quarter, while the French economy stagnated.

"EURO ZONE COLLAPSE"

French economist Jacques Delpla, who co-authored a paper proposing how euro bonds could work, said the euro zone faced collapse unless leaders went beyond an agreement reached at a July 21 emergency summit on the debt crisis.

"If we just stick to the July 21 agreement then, before the end of the year, there will be no euro zone, unless the ECB buys everything."

At the July summit, euro zone leaders agreed to a second bailout package for Greece and to give their European Financial Stability Facility rescue fund broader powers, but the moves provided only a brief respite in the debt crisis, forcing the European Central Bank to buy Italian and Spanish bonds last week.

Euro bonds aside, Sarkozy and Merkel will focus on proposals to improve the euro zone's economic governance, which they told fellow leaders in the bloc at last month's summit that they would issue by the end of August.

In particular, they could discuss holding regular euro zone summits, as France has long sought, or ways of improving peer monitoring of fiscal policies.

Economist Frederic Bonnevay at French think-tank Institut Montaigne said more radical measures were needed even if they did not include euro bonds for now.

"The size and powers of the EFSF need to be expanded dramatically -- that's a secret to no-one," he said, suggesting that its firepower should be raised to as much as one trillion euros from 440 billion euros currently.

Sarkozy, who broke off his summer holiday last week to deal with the market meltdown in French stocks, is to meet with Prime Minister Francois Fillon over lunch to fine tune France's position before he meets Merkel from 10 a.m. EDT.

A joint news conference is due at 12 p.m. EDT.

(Additional reporting by Nicholas Vinocur and Patrick Vignal; Editing by Mike Peacock)