Fixing the eurozone

France and Germany disagree on how to expand the firepower of the EU's main bailout fund

The expectation is immense. A deadline looms. Wednesday evening. The leaders of Germany and France set the date to deliver a solution to the eurozone crisis.

There are no easy tasks but the French president and the German chancellor began the day by calling in the Italian leader Silvio Berlusconi.

He was given a talking to, a dressing down. France and Germany both believe the Italians do not have a convincing plan to deal with their public finances. They want more cuts in public spending, reforms to make it easier to hire and fire, to set up companies and changes to the pension system.

Later German Chancellor Angela Merkel put it like this: "Trust will not just be achieved through a firewall, instead trust needs a clear perspective, and Italy has great economic strength, but Italy has also a very high total debt, and that must credibly be cut in the next few years. That is what is expected of Italy."

Increasingly they see Italy as posing the greatest risk to the single currency. It has low growth, high unemployment and a debt-to-GDP ratio of 120%. And Italy - with its large bond market - threatens the eurozone's banking system.

President Nicolas Sarkozy and Chancellor Merkel also attempted a display of unity after their row last week.

But progress is elusive. There clearly has been agreement on the need for the banks to raise more capital. Around 100bn euros ($139bn; £87bn). But that is the easy part and many of the details remain elusive, including which banks will be involved and where will the funds come from. Squeezing taxpayers has become politically impossible.

Britain's worry

The two big remaining challenges are how to deal with Greek debt and increasing the firepower of the zone's main bailout fund.

Discussion of these issues was delayed by a heated argument between President Sarkozy and David Cameron. The British prime minister had become concerned at being marginalised at a critical moment for Europe.

Although not in the euro, the fear of Downing Street was that decisions taken by the inner core of 17 eurozone countries could impact, say, on financial services.

So David Cameron wanted safeguards to ensure that British interests were protected. The argument also revolved around whether the last meeting on Wednesday night should involve the leaders of all 27 EU states or just the 17 members of the eurozone. The British wanted the wider EU to have a final say.

President Sarkozy would have none of it. He was pugnacious, pointing out that the UK wasn't even in the eurozone. It got very direct with the French president pointing out that as Britain hadn't put its hand in its pocket they shouldn't lecture others.

He said: "You're criticising us every day in the media, telling us what to do. Enough is enough. And now you want to interfere in our meetings."

In the event there will be a full European summit followed by a eurozone summit. But the row consumed two hours. What it signposts is future conflict, with Britain struggling to protect vital national interests in the face of a core group of countries that holds its own meetings.

The more closely integrated the eurozone becomes - as urged, for instance, by George Osborne - the greater the British fear will be that decisions will be taken that impacts on their major concerns such as preserving and expanding the single market.

Market judgement

Attention has now turned to Greek debt. The Germans insist that the problems of Greece must be put on a realistic footing and resolved. That means reducing Greek debt which is heading towards a debt to GDP ratio of 170%.

Berlin wants private investors - the banks - to take much bigger losses. Perhaps as much as 50%. But again the key questions have not yet been addressed. Will this be on a voluntary basis? Will the banks agree? The Greeks have insisted that any solution must be voluntary or it risks triggering a credit default.

And then there is the most contentious issue - how to expand the firepower of the EU's main bailout fund, the EFSF. It has already sparked a serious disagreement between the French and the Germans. Chancellor Merkel again ruled out turning the EFSF into a bank that could tap the European Central Bank for funds. Reluctantly, President Sarkozy seems to accept that.

Two options remain on the table. Firstly, enabling troubled countries to use the fund as a kind of insurance scheme which would limit the risks for potential investors. Secondly, some are suggesting using the EFSF to create a spin-off fund, a special purpose vehicle, which the IMF and emerging countries can invest in. The ideas are complex, untested and not fully understood even by some of the technical experts.

The hours between now and Wednesday night will involve long and tense negotiations. Success is not guaranteed although the leaders fear the judgement of the markets on Thursday morning if there is failure.

Angela Merkel says Wednesday night won't be the last step. Maybe not, but Europe's leaders have to convince the world they have a grip on the crisis.

A footnote. Treaty change is now firmly on the agenda. It will be needed to approve plans to more closely integrate the eurozone economies. The government has long opposed opening up the treaties but today David Cameron saw an opening.

Treaty changes require the approval of all 27 countries. At his news conference Prime Minister Cameron three times said that this gave opportunities to further advance British national interests. He did not set out what those interests might be. He did not indicate whether they might involve repatriating powers. But this was a message intended for his restive backbenchers who on Monday will seek a referendum on Britain's place in Europe. What the prime minister was in effect saying was - forget the referendum, there are other games in town.

That may be true but other countries are required to consult their voters on treaty changes. How could the British government deny voters a say if other countries are deciding on whether they accept a newly-designed EU? Treaty change carries great risks for the UK coalition.