France unveiled plans on Thursday to add a German-inspired commitment to cutting its budget deficit to its constitution, as European discord over debt and financial regulation rattled global markets.

Public argument between Paris and Berlin over how to handle Greece's debt crisis, and a unilateral German decision to ban some trading of euro government bonds and financial stocks this week, have sapped confidence in the euro and sent investors fleeing European stocks and bonds to safer havens.

It has spread fears worldwide about the impact of Europe's debt problems on a fragile global economic recovery.

In Washington, a top official of the U.S. central bank said Europe's debt crisis posed a potentially serious risk to the U.S. economic recovery because it threatened global credit markets and large American banks.

Federal Reserve Governor Daniel Tarullo said Europe's problems, if not contained, could cause financial markets to freeze and spark a global crisis similar to the market meltdown of late 2008.

The European sovereign debt problems are a potentially serious setback, Tarullo said in testimony prepared for delivery to two Congressional subcommittees.

The constitutional amendment outlined by French President Nicolas Sarkozy appeared far less constraining than Germany's debt brake, which is intended to force the federal government to limit the deficit to 0.35 percent of national output by 2016.

But the fact that free-spending France is contemplating such a measure at all highlights how the debt crisis is forcing all 16 states in the euro zone to give new priority to cutting debt and deficits.

This reform will oblige each government coming out of an election to engage in a five-year path dealing with the deficit, Sarkozy said, adding that governments would have to commit to a deadline for balancing public finances.

Early this month, Greece was forced to adopt draconian spending cuts and tax rises in exchange for a 110 billion euro ($135 billion) bailout from other euro zone governments and the International Monetary Fund.

Last week Spain and Portugal, struggling with high deficits that prompted market pressure on their bonds, announced fresh deficit-cutting measures. Highly indebted Italy is planning deficit reduction steps, while France has proclaimed a three-year public spending freeze.

GOODWILL

France's constitutional plan appeared designed to both shore up its AAA credit rating and show goodwill to Germany, after Paris clashed with Berlin over the German decision to ban naked short-selling of euro government bonds in an effort to curb financial market speculation.

Naked short-selling involves selling a financial instrument without first borrowing the instrument or ensuring that it can be borrowed, as would be done in a conventional short sale.

The euro zone crisis continued to spook markets on Thursday, with European stocks falling 2.2 percent, bringing losses so far this month to over 8 percent. The euro was near a four-year low against the dollar.

Investors worry that other euro zone countries might eventually follow Berlin's lead by banning short-selling in some instruments, which could hurt liquidity in those markets.

Fears that Europe's austerity measures could crimp world growth hit stocks globally and helped drive crude oil prices down to an eight-month low.

Germany said restoring confidence in the euro was its top priority, demanding tougher regulation and oversight to protect the single currency, as well as joint action by the European Union in withdrawing emergency economic stimulus measures.

Finance Minister Wolfgang Schaeuble said Berlin would press at a high-level EU meeting on Friday for a process permitting the orderly insolvency of states. The meeting may also discuss possible changes to the EU treaty to enforce stricter fiscal discipline, he said.

Chancellor Angela Merkel said the euro zone's problems must be tackled at their root, telling a financial conference that rules governing the single currency zone should be tightened.

But France, smarting from Germany's failure to consult it on the trading ban, said it did not agree with Merkel's comment that the euro was under threat.

I absolutely do not think that the euro is in danger, French Economy Minister Christine Lagarde told RTL radio on Thursday. The euro is a solid and credible currency.

Germany is the main EU donor in the bailout of Greece and a $1 trillion financial safety net being created for other indebted euro zone nations.

But Merkel, forced to ditch an electoral promise of 16 billion euros in tax cuts to fund the rescue packages, is under pressure within Germany after voters angered by the aid to Greece punished her coalition in a key regional election.

IRRATIONAL MARKETS

Jean-Claude Juncker, chairman of the forum of euro zone finance ministers, said the weakness of the euro, down more than 7 percent against the dollar in the past month, was likely due to fears economic growth in the zone would slow.

But he insisted that the markets were acting irrationally.

There is a certain reluctance to believe the Greeks can overcome the current crisis. I don't think the markets are behaving in a rational way, he told Reuters in Tokyo.

Speaking to reporters after meeting Japanese Finance Minister Naoto Kan, Juncker said he did not see any immediate need for intervention in the foreign exchange markets to halt the euro's slide, but that central banks were in close contact.

Greeks staged another 24-hour general strike on Thursday in their latest protest against austerity measures demanded by the EU and the IMF. The main protest march was smaller than a mass demonstration that turned violent last month and some workers, such as air controllers, did not join the strike.

China said the euro crisis was adding to global uncertainty, a factor underlined by weakness in its own stock market.

The European sovereign debt crisis is a challenge not just for the countries that are party to it, such as Greece. In fact, it is a challenge to the stability of the entire international financial market, said assistant finance minister Zhu Guangyao.

It concerns the recovery of the entire international economy, and so it demands a common response from the international community, he said.

(Additional reporting by Stanley White and Holger Hansen; Writing by Paul Taylor and Jon Boyle; Editing by Andrew Torchia)

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