The Merkel plan: I'll save the euro with a federal Europe

Rift between France and Germany opens up after Sarkozy rejects leap towards a European state

Chancellor Angela Merkel insisted yesterday that the euro could only be saved by changes in the EU treaty to impose legally enforceable budget discipline on countries using the single currency.

Her words, in a landmark speech to the Bundestag, implied exactly the kind of federalist solution, over-riding national sovereignty, which was rejected the day before by President Nicolas Sarkozy. Efforts will be made to resolve the apparent gulf between the two leaders when they meet in Paris on Monday to agree draft treaty changes to place before a critical EU summit in Brussels on Thursday and Friday.

After talks with President Sarkozy in Paris yesterday, David Cameron said that any remodelled EU treaty must "enhance and protect British interests". One option under discussion is that the EU Lisbon Treaty could be amended by a "protocol" on fiscal discipline, bolted on to the existing text.

This would avoid risky and time-consuming referendums in some member states. Limited change of this kind might also help Mr Cameron to justify dropping demands for wider treaty changes to satisfy Eurosceptics.

How the apparent gulf between Ms Merkel and Mr Sarkozy can be bridged is unclear. Some officials in Paris said the differences between them might be more rhetorical than actual.

Hopes of a deal at next week's summit have calmed bond and stock markets this week. Fears have been reduced, for the time being, that an imminent meltdown of the euro is about to tip the world into a deep recession. In these circumstances, one official said, Berlin and Paris are "condemned to reach an agreement next week, starting with their talks on Monday".

In her speech to the Bundestag yesterday. Ms Merkel showed no signs of softening her line to please Mr Sarkozy. She said that the crisis in confidence in the euro could not be solved by "short-term fixes". A solution must be built patiently over many years. Markets must be convinced that the eurozone's fiscal rules, such as the 3 per cent of GDP limit on annual budget deficits, would be scrupulously respected in the future. The existing "stability pact", backed by vague penalties, had been breached 60 times in a decade, she said.

"In order to win back trust, we need to do more," she said. "Where we today have agreements, we need in the future to have legally binding regulations."

Germany has been pushing for a new Brussels commissioner to oversee national budgets and for stiff penalties on deficit backsliders that would be rigorously enforced by the European Court.

In a speech in Toulon on Thursday night, Mr Sarkozy agreed with Ms Merkel that there should be treaty changes and that penalties on erring members of the eurozone should be "more rapid, more autocratic and more severe".

He also talked of reducing the national right of veto by widening the scope of majority voting in the Council of Ministers. But he insisted that any changes in the EU treaty must avoid a drive towards a "supranational", federal European state. Only national governments, he said, had the final "democratic legitimacy" to take decisions on budgets and taxes. This appeared to reject the idea of control by a Brussels commissioner and sanctions enforced by the European Court.

For reasons of domestic political expediency, Mr Sarkozy cannot afford to surrender completely next week to Ms Merkel's federalist solutions.

President Sarkozy has already agreed to drop French demands for more active short-term involvement by the European Central Bank to prop up debt-laden members of euroland. There is said to be an understanding with Berlin that the ECB will become more active once new rules on long-term fiscal discipline are agreed.

France is not the only country to object to Ms Merkel's fast-track federalist approach. Bert Van Roosebeke at the Centre for European Policy in Freiburg, said yesterday: "It's all very nice and interesting to see what [Merkel and Sarkozy] will propose but it still has to be ratified by all 27 EU countries.... The Germans and French want treaty changes, but there are at least 10 other countries that don't want changes to the treaties – for political reasons."

Rescue Options: What's on the table?

Eurobonds

What's the plan?

The threat to the single currency is that, for some states, their borrowing costs shot up to unsustainable levels. If nations cannot roll over their debts at affordable rates they run the risk of default, plunging the currency union into chaos that could break it apart. Some see the solution as eurobonds guaranteeing that all eurozone nations can borrow at affordable rates.

Who's backing it?

The idea was first mooted this year by the Italian economy minister, Giulio Tremonti, whose own nation, which has debts of €1.9trn, is now experiencing painfully high interest rates. The President of the European Commission, Jose Manuel Barroso, left, also favours eurobonds, although he prefers to call them "stability bonds". Germany has repeatedly ruled out the introduction of eurobonds. As the largest eurozone state with the strongest fiscal position, Germany would be the most exposed nation under such a system.

ECB Intervention

What's the plan?

America's central bank has spent 18 per cent of annual GDP buying up US sovereign bonds in recent years. The Bank of England has spent an equivalent share of UK GDP buying up British government debt. The European Central Bank, by contrast, has spent less than 5 per cent of the eurozone's GDP in buying up European government bonds. Some argue this is the reason Europe is seeing borrowing costs soaring, and the solution would be for the ECB to commit to buy up the bonds of any eurozone member experiencing a dangerous spike in interest rates.

Who's backing it?

The leaders of distressed countries on the eurozone periphery are all in favour. So too is the French President, Nicolas Sarkozy. The opposition has come from key members of the governing board of the European Central Bank, who say any such move would be illegal under European law. The Bundesbank, has also been resistant, arguing that the financing of government debts through the creation of money would inevitably result in inflation.

Fiscal Union

What's the plan?

Europe has a single currency, but it does not have a single finance ministry. Some argue that this is the structural flaw in the eurozone and that the present crisis will not end until it is rectified. They claim that certain states ran unsustainable economic policies in the boom years and have now jeopardised the future of the currency bloc. The solution is therefore to give other European governments the right to supervise the economic policies of member states to ensure that responsible practices are followed.

Who's backing it?

Angela Merkel regards fiscal union as the road to salvation for the single currency. The new Italian president of the ECB, Mario Draghi, above, also thinks it is important. Other nations on the periphery of Europe are less enthusiastic about the permanent scrutiny of their economic decisions by other European governments. There was irritation in Ireland last month when the forthcoming Irish austerity budget was leaked to the media by the German parliament, which had an advance viewing.