As euro reels, France and Germany push to rewrite the rules

In a much-needed show of unity, French and German leaders offered a potential balm to Europe's battered economies ahead of a crucial make-or-break week for the European Union and for a yet uncertain global economic recovery.

The Franco-German proposal suggests rewriting European treaties to enforce budgetary discipline by March 2012. The European Central Bank is also expected to lower loan rates on Thursday.

But the main event is the critical two-day EU heads of state summit that ends Friday, when leaders are expected to support the Franco-German plan to reestablish confidence in Europe.

Without that support, investors doubt European sovereign defaults can be avoided, something that could trigger a doomsday scenario for the continent: The collapse of the euro; a breakup of the EU; and a recession that would harm the economies of much of the rest of the world.  Months of indecision, even after Greece, Ireland, and Portugal had to be bailed out, has undermined confidence that European governments would all be able to pay back their debts.

But even i they do agree, there is no guarantee of economic recovery or no further defaults. Rewriting treaties take a long time, and would come amid severe disagreements between eurozone members on the best financial plan of action for the Continent.

The situation became critical two weeks ago when the borrowing costs of Italy and Spain surged. Investors and global powers like China and the US were no longer reassured by political promises and demanded concrete measures to secure an exit from the crisis.

President Nicolas Sarkozy of France and Chancellor Angela Merkel of Germany are now trying to deliver real action. They represent the continent’s two biggest economies and populations, as well as a broader regional split between northern fiscally responsible and southern spendthrift countries. So far though the two have offered different recipes for the same malady, in a big part driven by their domestic political setbacks.

Global shares rose on the agreement and the cost of borrowing for peripheral countries, including Italy and Spain, continued to drop. Italy’s approval Sunday of its most severe austerity measures yet have fueled optimism, but the Franco-German consensus is the main drive, analysts said.

“It’s a step in the right direction. It’s going to take a while and we’ll have to wait, but it looks as if their positions have narrowed. We’re getting there, we’re making progress,” said chief HSBC European economist Janet Henry.

'Merkozy'

Sarkozy and Merkel, nicknamed “Merkozy” by critics suspicious of the backdoor negotiations in the absence of other countries, agreed on the main sticking points that have so far delayed a common approach.

“In this extremely worrying period and serious crisis, France believes that the alliance and understanding with Germany are of strategic importance.... Disagreeing would mean risking the euro zone exploding,” Mr. Sarkozy said during a press conference. “What the chancellor and I want is to tell the world that in Europe the rule is that we pay back our debts, reduce our deficits, and restore growth.”

“We are absolutely determined to take decisions at the upcoming summit,” Chancellor Merkel said.

The proposal calls for “automatic sanctions” on countries that breach a deficit limit of 3 percent of gross domestic product set in EU treaties, which would only be avoided with the support of the majority of EU members.

They also called for an EU harmonized “golden rule” that each parliament would approve separately, to cap the public deficit. The two opened the door to a limited ratification of the new fiscal treaty to the 17-member eurozone that uses the euro as currency, allowing for more flexibility in case of dissent expected from countries like the UK that use their own currency.

The new plan also rules out another Greek-type rescue in which private lenders agreed to delay their returns in an effort to prevent default. The creation of permanent bailout fund would also be moved up a year to 2012, in a sign of how distressed some countries are.

The ECB will not issue its own bonds, as France and other originally wanted and which would have harmonized the credit worthiness of the eurozone, unfairly raising rates for the more disciplined and lowering them for the rest.

The new treaty, along with more austerity - especially in Italy and Spain, should nudge the ECB to take more aggressive action in the future to support sovereign debtors. 

“Market pressure is growing, and the risk of another half baked deal would likely be more detrimental for confidence, which would have a negative impact on economic activity,” said Citigroup in a research note.

But of course just about everything can go wrong. Expectations can be broken with politics as the main driver for all. Many countries continue to demand more solidarity in the form of eurobonds. Others see encroachment on their sovereignty.

Regardless, from Europe’s point of view, this is the week that decides its future.