Europe's Leaders Pursue New Pact

Deal Would Bring Closer Fiscal Ties

By MARCUS WALKER, DAVID GAUTHIER-VILLARS and BRIAN BLACKSTONE

The Wall Street Journal

Euro-zone leaders are negotiating a potentially groundbreaking fiscal pact….

… persuade the European Central Bank to undertake more drastic action…

… a centralized fiscal-enforcement authority with power to seize control of national budgets…

It isn't clear how the ECB would respond to such a pact…

BERLIN—Euro-zone leaders are negotiating a potentially groundbreaking fiscal pact aimed at preventing the currency bloc from fracturing by tethering its members even closer together.

The proposal, which hasn't yet been agreed to, would make budget discipline legally binding and enforceable by European authorities. Officials regard the moves as a first step toward closer fiscal and economic coordination within the currency area. That would mark a seminal shift in the governance of the 17-nation euro zone.

European officials hope a new agreement, which would aim to shrink the excessive public debt that helped spark the crisis, would persuade the European Central Bank to undertake more drastic action to reverse the recent selloff in euro-zone debt markets.

The proposed pact represents the boldest attempt by Europe's leaders to halt the spread of the crisis since they agreed in July to offer Greece a new bailout and to bolster the region's bailout fund. Those steps, initially hailed as a breakthrough, quickly proved insufficient.

Two years into a crisis that has posed the biggest challenge to European integration since World War II, the Continent's leaders now appear to be pursing a path that officials have long regarded as economically necessary but politically untenable—fiscal union.

As recently as this summer, measures such as a centralized fiscal-enforcement authority with power to seize control of national budgets would have been viewed in most capitals as an unacceptable invasion of sovereignty. That such steps are now under serious consideration reflects the perilous turn the crisis has taken in recent months.

The turmoil recently has encroached into the core of the euro zone, fueling fears that the currency bloc could collapse. Thus far, the ECB has refused to intervene more aggressively, demanding that the region's governments pursue fiscal and economic reforms.

Germany and France are leading the negotiations on the possible new pact among the euro zone's 17 members. One European official said there remains "a lot of arm wrestling" over its precise contents.

The plan could face resistance from some governments worried about a loss of sovereignty. But euro-zone officials don't expect struggling southern European countries to resist strongly because most are desperate to stay in the euro and to entice the ECB to give them more help. Moreover, the proposed pact would merely create a mechanism for enforcing fiscal discipline that they have agreed to already. Under the terms of their bailouts, their governments agreed to accept close supervision of their budgets by the International Monetary Fund and the EU.

If agreement is reached, a pact could be announced before the next European summit in early December and could come into force as soon as early 2012, according to officials close to the talks.

A majority of euro-zone governments hope that the pact would be an unstated quid pro quo for massive intervention in bond markets by the ECB. Many policy makers, investors and economists believe that only decisive ECB action can stop the unraveling of euro-zone debt markets and the collapse of Europe's historic experiment with a common currency.

It isn't clear how the ECB would respond to such a pact, and any change in course would be highly controversial within the bank. At least some ECB officials are open to such a tacit bargain with governments, according to people familiar with the matter.

The ECB has long worried that buying government bonds in big enough amounts to bring down countries' borrowing costs would make it easier for national politicians to delay the budget austerity and economic overhauls that are needed. Many ECB officials see the Franco-German plan as reducing this concern about so-called moral hazard, thereby removing a roadblock to bolder bond buying.

An agreement among the 17 euro members is being considered because the normal way to change Europe's rules—amending the European Union treaty—would require a hard-to-forge consensus and a lengthy ratification process among all 27 EU countries, 10 of which don't use the euro.

"It's a pact of euro-zone members for a new governance—a governance with genuine regulation and genuine sanctions that create real confidence," France's budget minister Valérie Pécresse told French television station Canal Plus on Sunday. She said European governments are continuing to discuss the possibility of amending the EU treaty, but that it was vital to "give evidence of the flawless solidity of the euro zone" as quickly as possible.

France is most eager for a new deal among euro members, while German Chancellor Angela Merkel still hopes a wider consensus for an EU treaty change can be reached, officials close to the talks say. Germany worries that a new fiscal union among euro members could create tension with noneuro countries that feel marginalized, such as the U.K.

But the worsening euro-zone crisis, coupled with the likelihood that any EU treaty change would take too long to save the common currency, have made Berlin more willing to contemplate a two-tier Europe, these officials say. The German government aims to continue to press for EU treaty changes as a second stage.

Italy's rising borrowing costs have helped create a new sense of urgency, European officials say. Ms. Merkel and other national leaders had hoped that Italy's replacement of scandal-plagued premier Silvio Berlusconi with the internationally respected Mario Monti would reassure investors that it is safe to lend to Italy. Instead, the selloff of Italian bonds has deepened since Mr. Monti's appointment, pushing Italian borrowing costs to as high as 7.8% last week—a level the country can't afford for long.

The growing risk that Italy could need a bailout, which the rest of Europe would struggle to pay for even with help from the International Monetary Fund, has sparked calls for the ECB to come to the rescue—to use its virtually unlimited financial firepower to stabilize government bond markets so that Italy can stay liquid.

The ECB has been buying government bonds since last year, but only on a limited scale. Its efforts haven't prevented the borrowing costs of Italy, Spain and other countries from rising to unsustainable levels. ECB officials have given several reasons for not intervening more decisively in bond markets, including moral hazard, fear of losing political independence, and the limits of the its legal mandate.

Many economists argue that the ECB can do more, legally. They also note that large-scale bond purchases by U.S. Federal Reserve and the Bank of England haven't eroded the political independence of those central banks.

Some ECB officials are expected to vote against any increase in the bank's firefighting role, including German Bundesbank President Jens Weidmann, the leading critic of central-bank intervention in bond markets.

Governments are hoping other ECB members will outvote Mr. Weidmann—especially if they are confident the German government supports the move. The ECB, though independent, has been loath to take actions that could spark a political backlash against it in Germany, the euro's most powerful member.

The possible euro-zone pact would be open to noneuro members that volunteer to join, but it would go ahead with or without them, euro-zone officials say. One legal precedent for such a coalition of the willing, officials say, is the Schengen agreement, under which a subset of EU members scrapped controls at their mutual borders.

—Costas Paris and Stephen Fidler contributed to this article.

Write to Marcus Walker at marcus.walker@wsj.com, David Gauthier-Villars at David.Gauthier-Villars@wsj.com and Brian Blackstone at brian.blackstone@dowjones.com