Merkel Calls for More 'Concrete' Union

The Wall Street Journal

By WILLIAM BOSTON and MARCUS WALKER

Ms. Merkel's first challenge, however, is to overcome her differences about the way forward with French President Nicolas Sarkozy…

… that euro members would have to accept a loss of national sovereignty, and that there is no quick fix to the crisis.

… they are prepared to sign a fiscal pact among the euro zone's 17 governments if the wider, 27-country EU won't agree…

…massive ECB intervention, …, if it doesn't work, could leave Europe staring into the abyss with no more cards to play…

…the potential for bondholder losses in future has helped to undermine investors' confidence…

BERLIN—German Chancellor Angela Merkel called on the euro zone to accept a strict regimen of legally binding budget discipline, ahead of another European summit next week that many hope will be a turning point in the euro crisis.

Ms. Merkel's first challenge, however, is to overcome her differences about the way forward with French President Nicolas Sarkozy at a meeting in Paris on Monday.

Ms. Merkel is—so far—defying pressure from Mr. Sarkozy to stop the capital flight from euro-zone government bond markets by resorting to radical measures, such as giving a green light to the European Central Bank for massive bond-market intervention.

Instead, the chancellor wants to focus on what she sees as the root causes of the crisis by creating a long-term regime of fiscal discipline, while changing the European Union's treaty to give European authorities new powers of enforcement.

In a speech to Germany's parliament on Friday, she warned that euro members would have to accept a loss of national sovereignty, and that there is no quick fix to the crisis.

But fear is growing even in Berlin that Ms. Merkel's long-term fix may not be enough to stop the panicked exodus of investors from government debt markets. The price of failure, German officials know, is a wave of national insolvencies in a swath of the euro zone, which could plunge Europe into a depression and batter the global economy.

In the latest sign of financial strains in the euro zone, overnight deposits by the region's banks with the ECB hit a new high for the year on Thursday, rising to €314 billion ($422.7 billion). Analysts said the growing use of the ECB deposit facility is reminiscent of the 2008 banking crisis, and shows that banks are so wary of lending to each other that they would rather stash their money in a safe haven that pays very low interest.

Ms. Merkel and Mr. Sarkozy aim to push through a tough overhaul of euro-zone governance at an EU summit in Brussels on Dec. 8-9, demonstrating to markets that euro-zone nations are more strongly committed than ever to political and monetary unity.

But a deal at the summit hinges on Berlin and Paris overcoming differences on issues ranging from the role of the European Central Bank and how to boost the euro zone bailout fund, to exactly what it would mean to allow European authorities to supervise the national budgets of euro members.

Ms. Merkel is redoubling Germany's quest for automatic sanctions, administered by European bureaucrats, against euro-zone countries that violate European limits on budget deficits. Mr. Sarkozy, in a speech Thursday, appeared to warm to the German argument that only binding restrictions would work, but he still said only that France would support "more automatic" sanctions.

Germany and France have made it clear to other European countries that they are prepared to sign a fiscal pact among the euro zone's 17 governments if the wider, 27-country EU won't agree quickly to changing the EU treaty. A separate euro-zone pact outside the EU framework would be a worry for EU members that don't use the euro, but don't want to be left on the margins of a "core Europe."

France is hoping a deal among governments on fiscal discipline will encourage the ECB to step up its intervention in government markets, to keep countries' borrowing costs from rising to ruinous levels. The ECB has been reluctant to increase its limited bond-buying partly because it fears doing so would take the pressure off national governments such as Italy's to curb their debts.

Ms. Merkel, however, remains skeptical about massive ECB bond buying funded by money printing, fearing that it could undermine the bank's credibility as an inflation fighter, which Germany views as the ECB's most important mission.

In Berlin, policy makers are increasingly worried about the worsening euro crisis and are inching closer to accepting that unorthodox measures may be needed to prevent government bond markets from collapsing. But Ms. Merkel remains wary of massive ECB intervention, which she sees as a high-risk move that, if it doesn't work, could leave Europe staring into the abyss with no more cards to play.

Ms. Merkel insisted again on Friday that the integrity of the ECB must be protected. Germany is open to one new measure involving the ECB, according to people familiar with the matter: A proposal for the ECB's constituent banks, the central banks of euro nations, to make bilateral loans to the International Monetary Fund to beef up the IMF's treasure chest for dealing with the European crisis. No decision has been taken and the amount of such loans isn't clear.

Analysts say that while such a step would help, it wouldn't be the "bazooka" that investors are looking for from the ECB.

While Mr. Sarkozy is pushing for short-term moves to stop the crisis, Ms. Merkel's proposals on Friday focused on making the euro zone more stable in the long term and preventing a crisis of excessive government from recurring.

Ms. Merkel said her strategy is to use the crisis as an opportunity to achieve long-term change in Europe, especially to make significant progress on building a closer political union in Europe to compliment its currency union.

The problem, say many policy makers and economists around Europe, is that such long-term reforms aren't enough to stem the immediate crisis, which is that investors are increasingly unwilling to lend to a growing number of euro-zone nations at affordable rates.

Most analysts say only the ECB, with its ability to create euros, possesses the firepower to give governments the time they need to repair their public finances and enact pro-growth overhauls of their economy. ECB President Mario Draghi indicated on Thursday that the central bank is willing to do more to help fight the crisis, provided governments make the first move. But the central bank remains wary of taking unorthodox steps that could spark a political firestorm in Germany, the euro's most important member.

Officials around Europe are now hoping that France's acceptance of binding enforcement of budget discipline across the euro zone will allow Ms. Merkel to be more tolerant of large-scale ECB intervention in bond markets. Germany and France have also sparred for months over whether bondholders should suffer losses when countries such as Greece need a bailout from their euro-zone peers. Europe leaders agreed in March to establish a permanent bailout fund, the European Stability Mechanism, with a rulebook that could often lead to losses for bondholders when countries need aid loans.

Critics say that highlighting the potential for bondholder losses in future has helped to undermine investors' confidence in European government bonds, worsening the crisis. France is now pushing back against Germany's demands for bondholder participation in bailouts, and wants to drop or at least downgrade the provisions about debt restructuring. Even Berlin chancellery officials now accept that the decision in July to restructure Greece's bonds, while needed to reduce Athens' crushing debt load, has fuelled investor fears that euro-zone government bonds are no longer safe assets.

Ms. Merkel signalled on Friday that she is having second thoughts about the wisdom of emphasizing bondholder losses. "We have a draft for the ESM, which must be changed in the light of developments" in financial markets since the Greek-restructuring decision in July, she said after meeting Austria's chancellor in Berlin.

Austrian Finance Minister Maria Fekter, speaking at a conference in Hamburg on Friday, was more direct. "Trust in government treasuries was so thoroughly destroyed by involving private sector investors in the debt relief that you have to wonder why anyone still buys government bonds at all," Ms. Fekter said.

—Bernd Radowitz and Mary M. Lane in Berlin, and David Gauthier-Villars in Paris contributed to this article.

Write to William Boston at william.boston@dowjones.com and Marcus Walker at marcus.walker@wsj.com