Germany and France pledged on Friday to better align their tax and labor policies to foster convergence in the euro zone, but rejected calls for an increase in the bloc's rescue fund and joint sovereign bonds.

Earlier on Friday, European central bankers had told euro zone governments they could not count on the ECB alone to solve a debt crisis which has forced bailouts of Greece and Ireland, and heaped pressure on countries like Portugal and Spain.

At a news conference in the southwestern city of Freiburg, Chancellor Angela Merkel and French President Nicolas Sarkozy presented a united front ahead of a crucial summit next week where EU leaders are expected to agree the terms of a permanent rescue mechanism for the bloc.

Berlin has opposed calls by Spain and other countries to move toward a full-fledged fiscal union in the 16-nation bloc but appeared on Friday to have agreed to a limited form of policy coordination, although little detail was offered.

We have agreed to the convergence of German and French tax policies and I thank the German chancellor for this opening, said Sarkozy.

Merkel said it was up to Germany and France to set an example on questions of competitiveness, showing partners how far the bloc's biggest economies could cooperate in areas beyond pure budget policy.

We are talking about labor law, about tax law and if we are to improve the coherence of the economic aspects of the euro zone, then we should target these issues step by step and propose solutions, Merkel said.

The two leaders said they would present structural proposals next year in the area of economic coordination, but declined to elaborate.

We will defend the euro, because the euro is Europe, Sarkozy said. Our determination, both German and French, is total.

ECB WARNINGS

Pressure on high-deficit euro members eased slightly over the past week after the ECB bought government bonds in a thin end-of-year market, pushing down the borrowing costs of countries on Europe's southern periphery.

But Bank of Italy Governor and ECB Governing Council member Mario Draghi told the Financial Times that responsibility for dealing with the crisis ultimately lay with euro governments and the ECB could go only so far in helping weaker members by buying their bonds.

I'm only too aware that we could easily cross the line and lose everything we have, lose independence, and basically violate the (EU) treaty, said Draghi, a leading candidate to replace Jean-Claude Trichet as ECB president.

The euro, which fell to a 10-week low under $1.30 late last month as the euro crisis deepened, weakened slightly on Friday to trade at $1.3215.

The risk premiums investors demand to hold Portuguese and Spanish debt instead of German benchmarks edged higher on the day.

The EU summit is expected to finalize plans to introduce a permanent rescue mechanism for the euro zone to replace the 750 billion euro European Financial Stability Facility (EFSF) that it set up in May after bailing out Greece.

German demands that the new mechanism include the possibility of so-called haircuts for holders of euro zone sovereign debt have been blamed for exacerbating the crisis by scaring bond investors with the prospect of not getting all their money back.

European Central Bank Governing Council member Yves Mersch said expanding Europe's financial stability fund would be preferable to issuing euro area bonds in the short term to tackle any debt problems.

But Merkel rejected calls to increase the EFSF.

I'd say for us in Germany that the question of expanding the rescue mechanism is not now on the table, Merkel said. Less than 10 percent of the rescue mechanism has been used for Ireland. It is not on the agenda, she said.

Sarkozy also supported Merkel by coming out against a proposal pushed by Eurogroup President Jean-Claude Juncker and Italian Finance Minister Giulio Tremonti for so-called E-bonds, or joint euro zone sovereign debt issues.

I don't think we were consulted before this idea was proposed, so it shouldn't insult anyone if we say we are not in agreement with it, Sarkozy said, saying neither German nor French citizens could accept mutualizing euro zone debt.

(Additional reporting by Stephen Brown, Paul Carrel, Sarah Marsh in Berlin, Catherine Bremer in Paris, writing by Noah Barkin, editing by Mike Peacock)

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