Chancellor Angela Merkel on Friday said European nations had started to create a "fiscal union" in the bloc’s battle to overcome the crippling debt crisis. Merkel also stated that a solution to the crisis will "take years".

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REUTERS - German Chancellor Angela Merkel called on Friday for rapid EU treaty change to remedy the root causes of the euro zone's debt crisis but warned that Europeans faced a long, hard "marathon" to restore lost credibility.

Outlining a long-term approach to tighter fiscal integration in the single currency area, with tougher budget discipline, she dismissed quick fixes such as massive Fed-style money printing by the European Central Bank or issuing joint euro zone bonds.

"Resolving the sovereign debt crisis is a process, and this process will take years," Merkel told parliament, vowing to defend the euro, which she said was stronger than Germany's former deutschemark.

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"The European Central Bank has a different task from that of the U.S. Fed or the Bank of England," the German leader said.

However, sources close to Merkel said she was willing to see the ECB step up its buying of troubled euro zone countries' bonds as a bridging measure until budget controls took hold, but did not see it as a durable solution.

Speaking a week before a European Union summit seen as make-or-break for the 17-nation single currency area, Merkel ruled out issuing common euro zone bonds, saying that would breach the German constitution.

Instead, she called for a mixture of greater European powers to control national budgets, to be enshrined in treaty changes, and smart use of the euro zone rescue fund to stabilise markets.

Merkel's speech set the agenda for seven days of intense diplomacy to try to frame a new political deal to restore shattered market confidence and give the ECB grounds to act more decisively to defend the euro.

World stocks and European bonds continued to recover on hopes that euro zone leaders may be moving closer to a comprehensive solution to the debt crisis.

In a crucial signal to markets, ECB President Mario Draghi opened the door on Thursday to more aggressive action to help fight the euro zone's sovereign debt and banking crisis if governments adopted a new "fiscal compact".

On Monday, Merkel will travel to Paris to outline joint proposals with French President Nicolas Sarkozy for treaty changes to entrench stricter budget controls, with automatic sanctions on deficit sinners.

Sarkozy embraced German calls for a new treaty tightening fiscal discipline in a policy speech in Toulon on Thursday, but in contrast to Merkel, he made no mention of greater powers for the European Commission and European Court of Justice.

Instead, the French leader, struggling to win re-election next May, called for an "intergovernmental" Europe in which the presidents and prime ministers of euro zone Countries would be the ultimate arbiters over national budgets.

His socialist opponents denounced him for advocating an "austerity treaty" dictated by Germany.

Merkel went out of her way to rebutt such accusations, telling the Bundestag it was "misleading" to suggest Germans were trying to dominate Europe.

Markets recover

Sarkozy will try to persuade British Prime Minister David Cameron on Friday to accept EU treaty changes to allow closer euro zone integration without insisting on returning powers over social and judicial affairs from Brussels to London.

Cameron is under pressure from Eurosceptics in his own Conservative party to loosen Britain's ties with the EU while securing guarantees that any move towards fiscal union on the continent does not harm the interests of the City of London financial centre.

Despite their very different tone, Merkel and Sarkozy coordinated their speeches in advance to ensure they would not be incompatible, aides to both leaders said.

EU diplomats said Paris and Berlin hoped to find agreement among all 27 member states for limited treaty amendments rather than having to take the more divisive route of drafting a separate among the 17 euro zone states or fewer.

German officials praised the conservative Sarkozy's courage in telling voters, in what the business daily Handelsblatt called a "blood, sweat and tears speech", that France would have

to overhaul its social model and cut public spending.

Peter Altmaier, chief whip of Merkel's conservatives in the Bundestag, told German radio: "In Germany we have been tightening our budget for some years. Nicolas Sarkozy said

yesterday that Europe must achieve a reduction of its debt, and that will only happen with iron discipline in national budgets.

"We have so far managed to fix a German-French position on all the important decisions on Europe in recent months. I am very confident that we will be able to reach a common position with our French friends by the summit next week. There is much more uniting us than dividing us."

On the markets, German 10-year Bunds outperformed safe-haven U.S. Treasuries and British Gilts as investors saw prospects of an EU summit deal and ECB action to ease funding for cash-starved banks and to counter a looming recession in Europe.

Sentiment has turned more positive since the world's major central banks took emergency joint action on Wednesday to provide cheaper dollar funding for European banks.

Yields on Italian and Spanish debt fell further on hopes of a euro zone solution. Italy's 10-year bond was down to 6.65 percent, well below the danger levels close to 8 percent they hit last week, which analysts said could make it impossible for Rome to refinance its debt next year. Spain's 10-year borrowing cost tumbled to 5.68 percent.

A key measure of dollar funding stress felt by euro zone banks, the three-month euro/dollar cross currency basis swap, which shows the rate charged when swapping euro interest rate payments on an underlying asset into dollars, has narrowed by 30 basis points since the coordinated central bank move to around minus 130 bps. The basis swap was at its widest since end-2008 -- at the height of the global financial crisis -- before the central banks' move.

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