The leaders of France and Germany, racing to shore up the euro, on Monday issued an ultimatum to the 27 European Union governments, saying they must decide by week's end whether they will accept greater central control over their national budgets—effectively ceding some of their fiscal sovereignty.
Should some countries decide not to participate—the U.K., which opted out of euro membership, has shown little enthusiasm so far—the 17 countries in the euro zone will forge ahead with a more integrated union by signing a new agreement outside EU treaties, they said.
"We will see whether it will be 17 or 27," French President Nicolas Sarkozy said during a joint news conference with German Chancellor Angela Merkel. "But we're going full steam ahead to re-establish confidence in the euro and the euro zone."
The euro crisis took on renewed urgency Monday when Standard & Poor's Ratings Services in a surprise move put France, Germany and 13 other euro-zone nations on review for credit downgrades, highlighting rising concern about the currency bloc's prolonged inability to come up with a decisive fix for its debt woes.
The French and German leaders also made a commitment to never again pressure private investors into agreeing to voluntary losses on euro-denominated bonds—a central element of Greece's second bailout that is still being negotiated.
The commitment marked a shift on the part of Germany from earlier plans to enshrine private-sector participation in any future bailout agreements.
"Greece is and will remain an exception," Ms. Merkel said.
The pledge isn't an ironclad guarantee for bond holders but means that Germany has recognized the damage its insistence on private-investor participation has done to investor confidence.
"The message to investors from across the world is that in Europe we pay back our debts," Mr. Sarkozy said.
After meeting for two hours, Mr. Sarkozy and Ms. Merkel said they will use an EU summit on Thursday and Friday to propose altering EU treaties in order to bolster fiscal discipline.
"We're open to changing the treaties for the 27, that would be the most logical way," Ms. Merkel said. "But the euro is so important for us that we would also go the path of the 17 euro-zone countries."
Bond market investors on Monday were heartened by fresh budget and economic reforms offered by Italy over the weekend, as well as the signals that France and Germany are beginning a bigger push for fiscal union in the euro zone. Prices for bonds from Italy, Spain, France, Portugal and Belgium rallied sharply.
European bond markets were largely closed by the time reports emerged about S&P's move, but U.S. markets slid as hopes for a comprehensive European solution this week gave way to concerns about potential credit-rating downgrades in the euro zone. After opening with a jump of 167 points, the Dow Jones Industrial Average gave up nearly all those advances in the afternoon. The blue-chip index retraced some of those losses in the final minutes to finish with a gain of 78.41 points, or 0.7%, at 12097.83.
Asian markets opened slightly down on Tuesday morning, with Japan falling 0.6% and Australia falling 0.5%.
The Franco-German proposal is aimed at remodeling the architecture of the euro zone and resolving a two-year sovereign-debt crisis that has corroded investor confidence in the 12-year-old currency and led three countries—Greece, Ireland and Portugal—to seek financial assistance. Under current rules, the 17 euro-zone nations share the same currency but have little oversight over each other's budget policies.
A key plank in the Franco-German plan is to introduce more "automatic and immediate" sanctions on budget sinners. Such sanctions are already embedded in EU treaties but they haven't been enforced because of national political resistance.
The proposal marks an important step in a recent strategy aimed at rebuilding confidence in the euro zone. Some policy makers hope this will be enough to persuade the European Central Bank to step up intervention in government-bond markets to reverse recent selloffs and help bring down borrowing costs.
The Thursday and Friday summit in Brussels comes after a frantic succession of meetings over the past two years that have often buoyed investor hope only to later dash it.
If leaders at this summit succeed in making a decision on fiscal integration, European countries then have to agree on the fine print. Mr. Sarkozy and Ms. Merkel said they want those details to be agreed upon by March.
The pressure grew with S&P's unexpected move to put the bulk of the currency bloc on review for a credit-ratings downgrade.
Investors have speculated for months that France was at risk of losing its prized triple-A credit rating, a key pillar of the euro zone's bailout fund, with many analysts anticipating an initial move from one of the main ratings agencies early next year. But the decision to also put the ratings of Germany and the top-ranked euro-zone countries on review further reinforces the notion that the crisis is contaminating the core of the currency bloc.
S&P said it decided to act ahead of the Brussels summit because the gathering "provides an opportunity for policy makers to break the pattern of what we consider to have been defensive and piecemeal measures to date."
The decision is likely to fuel jitters about the risks underlying the region's bailout fund, known as the European Financial Stability Facility, whose own triple-A status stems from the guarantees provided by its triple-A graded members.
France and Germany issued a joint statement late Monday taking note of S&P's decision, saying they were determined "to take all the necessary measures, in liaison with their partners and the European institutions, to ensure the stability of the euro area."
Germany had initially indicated that it would be reluctant to knit tighter fiscal straitjackets just for euro-zone countries, for fear it could cause countries outside the euro, such as the U.K., to feel marginalized. But the worsening euro-zone crisis has made Berlin more willing to contemplate a two-tier Europe.
Whichever route they take, European nations face further challenges. Amending EU treaties could prove an uphill struggle, especially after the U.K. warned it would submit any proposal to relinquish more powers to the EU to a popular referendum.
And should euro-zone countries decide to pursue their own course toward deeper fiscal integration, they may still face difficulties in securing popular support for what some political forces are billing as a loss of sovereignty.
The political battle will be particularly hard fought in France, where voters go to the polls in a presidential race in the spring. Some of the candidates—including Socialist François Hollande and Marine Le Pen, from the far-right National Front—have accused Mr. Sarkozy of giving in to Germany and relinquishing sovereignty over national budget prerogatives.
In a speech last week, Mr. Sarkozy said France would risk descending into economic "recession or even depression" if it entrenched itself in protectionism.
At the heart of the debate over sovereignty is the issue of how to punish budget-rule busters.
On Monday, Ms. Merkel and Mr. Sarkozy said they had agreed on making financial sanctions—referring to penalties imposed on countries running a budget deficit in excess of 3% of gross domestic product—more automatic. Germany has long backed the idea of fully automatic sanctions, saying they would be a powerful deterrent to profligate budget policies. France has favored a more politically governed approach.
Under a proposed compromise, Mr. Sarkozy and Ms. Merkel said that sanctions would apply automatically and that only a weighted majority of European countries would have the authority to reverse the punishment.
Mr. Sarkozy and Ms. Merkel said they will detail their proposals in a letter to European Council President Herman Van Rompuy, a text that will be up for discussion at the EU summit later this week.
The two leaders will also call for monthly meetings of leaders from euro-zone nations and other countries willing to participate, as well as for fast tracking the creation of a permanent euro-zone bailout fund.
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