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Under heavy pressure to restore confidence in the euro zone following a dramatic market slump, President Nicolas Sarkozy and Chancellor Angela Merkel stopped short of increasing the bloc's rescue fund but vowed to stand side-by-side in defending the euro and laid the groundwork for future fiscal union.

Their message was that the focus should be on further economic integration rather than signing bailout checks, and suggested that straying from euro zone rules and fiscal targets would no longer be tolerated.

"We have exactly the same position on euro bonds," Sarkozy told a joint news conference with Merkel after their talks.

"Euro bonds can be imagined one day, but at the end of the European integration process, not at the beginning."

But many experts said the measures would fail to assuage markets, which believe a common bond is the only way to ensure affordable financing for euro zone members struggling with debt.

U.S. stocks dropped more than 1 percent and the euro slid as the proposals failed to ease worries about a debt crisis markets fear is spreading to the euro zone's core. Traders had hoped for signals that the issuance of common euro bonds, or an increase of the EFSF, were live options.

"This meeting is all stick -- fiscal rule enforcement -- and no carrot -- a pooling of fiscal resources via a common bond," Rabobank strategist Richard McGuire said.

The statement by the two leaders reflects deep hostility, among voters in northern Europe tired of bailing out the south at a time of austerity at home. That is particularly true in Germany, where growth slowed to almost zero in the second quarter.

"Anyone expecting this meeting to launch euro bonds was not paying attention to the state of political opinion or indeed to the kind of compromises needed for that to happen," said Julian Callow, senior economist at Barclays Capital in London.

"ECONOMIC GOVERNANCE"

In a further rap to financial market players, whose panic-selling this month wiped some $4 trillion off global stocks and sparked a temporary ban in Europe on short-selling, Sarkozy and Merkel also proposed taxing financial transactions.

In plans to be sent on Wednesday to European Council President Herman Van Rompuy, the two leaders want a president to be elected to represent the euro zone and twice-yearly meetings of the leaders of the embattled 17-nation bloc.

In one of the most far-reaching ideas, Sarkozy said the French and German finance ministers had been asked to prepare proposals aimed at having a common corporate tax base and tax rate in France and Germany from 2013. He said the two countries would keep a closer track of each others' economic outlooks.

Analysts queried the feasibility of a financial transaction tax, which was an unexpected proposal, given opposition from some European countries and the European Central Bank.

Callow said that while markets needed to see "more flesh on the bones" of the proposals, it was significant that the two leaders had broken into the August holiday period to meet.

"They are pledging a commitment to economic governance which is a step forward and there is also a commitment to a debt brake, although it remains to be seen whether that will be significantly strong," he said.

"Each side is surrendering some sovereignty which in the end could pave the way to much closer political union and so prepare the ground for the issue of euro bonds."

The full details of the written proposals to Van Rompuy will be made public on Wednesday, Sarkozy's office said.

EURO IS A SET OF RULES

Sarkozy and Merkel -- under pressure to convince markets the euro zone is sound or risk watching it unravel -- said their first proposal was for "a real economic government" for the euro zone, with a president elected for two-and-a-half years.

"Germany and France feel absolutely obliged to strengthen the euro as our common currency and further develop it. And it is entirely clear that for this to happen, we need a stronger interplay of financial and economic policy in the euro zone," said Merkel, who went on to a working dinner with Sarkozy.

Sarkozy said that if adopted, their proposal that euro zone governments should enshrine deficit-limiting rules into their constitutions would be obligatory, not optional.

"The euro has allowed us a lot of economic progress but the euro is not just a right, it's a set of rules, a duty, a discipline," he said. "Consequently if the rule is to be adopted by the 17, it will not be an optional rule but obligatory."

While it was unclear how governments could be forced to adopt politically difficult constitutional changes, Sarkozy's tone suggested there would be no more tolerance for straying from rules and even raised the specter of a two-speed union.

"TOO LITTLE TOO LATE?"

Officials in Paris and Berlin played down expectations ahead of Tuesday's meeting, saying euro bonds would not be on the agenda, but markets were still disappointed.

"Rather than the additional check-writing by core European governments that certain markets were looking for, including a new euro bond, they are getting a fiscal discipline golden rule, stronger economic governance, and a new financial transactions tax," said Mohamed el-Erian, co-chief investment officer at Pacific Investment Management Co in California.

The refusal to contemplate a euro bond at this stage is frustrating investors, who have seen Europe's response to the dragging crisis as too little too late. They see the common bond as the bloc's best chance of getting ahead of the curve.

Some analysts fear the European project could lose its way if domestic political pressures curb the ambitions of the leaders of France and Germany, the bloc's main political and economic powerhouse.

Merkel's own conservatives are strongly opposed to a second bailout of Greece according to a recent poll. Sarkozy, already facing a tough re-election battle next year, is having to push through austerity measures to convince markets France can retain its triple-A rating.

Sarkozy and Merkel had already planned to meet this week to discuss their proposals on euro zone governance, but the stakes were raised when French assets hit in last week's market rout.

Investors dumped shares in French banks, which are exposed to Italian debt, as rumors circulated -- denied by rating agencies -- that France's AAA-rating could be at risk.

That sell-off was evidence markets were not convinced by a July 21 deal to give new powers to the euro zone's EFSF rescue fund and for proposals to be made on closer economic governance.

Some still saw Tuesday's ideas boosting the euro, however.

"Sarkozy talks about common governance for the euro zone, which I think is one step closer toward a fiscal union. That's positive for the euro overall," said currency strategist Richard Franulovich at Westpac in New York.

(Reporting by Nick Vinocur, Leigh Thomas, Daniel Flynn and Brian Love in Paris and Andreas Rinke and Stephen Brown in Berlin; Writing by Catherine Bremer and Jon Boyle)

The German economy slowed between April and June to its weakest quarterly growth rate since 2009, fueling concerns about an European economy already weakened by a fiscal crisis. German stocks .GDAXI fell 2.6 percent.

"German GDP data is the catalyst this morning that got us off to a bad start," said Paul Mendelsohn, chief investment strategist at Windham Financial Services in Charlotte, Vermont.

"Europe slowing down is not a good sign because if you are going to be cutting spending, raising revenue ... that makes the potential problem worse."

German Chancellor Angela Merkel and French President Nicolas Sarkozy were to meet later Tuesday to discuss measures to contain Europe's fiscal crisis. A joint news conference was scheduled at noon EDT.

S&P 500 futures fell 17.3 points and were below fair value, a formula that evaluates pricing by taking into account interest rates, dividends and time to expiration of the contract. Dow Jones industrial average futures lost 113 points, and Nasdaq 100 futures dropped 27.5 points.

On the earnings front, Home Depot Inc (HD.N) reported better-than-expected quarterly profit and raised its earnings forecast for the year.

Wal-Mart Stores Inc's (WMT.N) U.S. same-store sales fell 0.9 percent in the second quarter, marking its ninth straight quarterly decline, but profit topped estimates. Its shares rose 2.4 percent to $51.25 in premarket trading.

Dell Inc (DELL.O) was also due to report results.

Resource-related shares might come under pressure as U.S. crude oil prices fell 1.6 percent, while copper was also down 1.5 percent.

U.S. data coming later includes the Commerce Department's release of housing starts and permits for July and the Labor Department's report on import-export prices for the same month, both at 8:30 a.m. EDT.

Economists in a Reuters survey forecast an annualized rate of 600,000 housing starts versus 629,000 in June. Imports are seen falling 0.1 percent, and exports are expected to rise 0.1 percent.

The U.S. Federal Reserve releases industrial production and capacity utilization data for July at 9:15 a.m. EDT. Economists expect a 0.5 percent rise in July production and a reading of 76.9 percent for capacity utilization.

Wall Street stocks rose for a third day on Monday as investors used Google Inc's (GOOG.O) offer to buy phone maker Motorola Mobility Holdings Inc (MMI.N) as an excuse to jump back into the market after weeks of sharp selling.

(Reporting by Rodrigo Campos; editing by Jeffrey Benkoe)

President Nicolas Sarkozy and German Chancellor Angela Merkel are under pressure to show financial markets they are in agreement on doing more to shore up the embattled currency union -- or risk watching the euro zone unravel.

The two leaders could discuss obliging all euro zone countries to pass national laws on deficit limits and the idea of a permanent euro zone spokesperson or coordinator, a source close to the talks told Reuters.

Many experts believe the only way to ensure affordable financing for the bloc's most financially distressed countries would be for the euro area to issue joint euro bonds.

But officials in Paris and Berlin have tried to play down expectations over the 10 a.m. EDT talks and 12 p.m. EDT news conference, saying euro bonds are not on the agenda, and many analysts cautioned against expecting too much.

"(Sarkozy) is not going to pull out of a hat three wonderful rabbits that will reassure the world's markets," French political economist Alain Minc told Europe 1 radio.

Ordinary Germans have opposed more help for their weaker neighbours even while their economy has been roaring along. Data on Tuesday showing German GDP barely grew in the second quarter suggests a slowdown is starting to grip there, making underwriting of euro zone debt an even harder sell politically.

"While German politicians are currently racking their brains on the pros and cons of common Euro bonds, the luxury of having an economy running at "wonder" speed is fading away," said Carsten Brzeski at ING.

The German economy grew by just 0.1 percent in the second quarter, while the French economy stagnated.

Sarkozy and Merkel had already planned to meet this week to push ahead on their July 21 pledge to come up with new proposals on euro zone economic governance, but the stakes were raised when France was slammed in last week's global market rout.

Fearing that the euro zone debt crisis is spreading to the continent's core, investors dumped shares in French banks, which are exposed to Italian debt, as rumors circulated -- denied by rating agencies -- that France's AAA-rating could be at risk.

The sell-off was evidence markets were not convinced by a July 21 deal to give new powers to the euro zone's EFSF rescue fund and for Paris and Berlin to come up with proposals on coordinating economic governance by the end of August.

The two leaders are expected to discuss holding regular euro zone summits, as France has long sought, ways to improve peer monitoring of fiscal policies or even fiscal harmonization.

Jean-Pierre Pollin, a member of France's Circle of Economists think tank, told the daily Le Parisien it was now unavoidable that euro zone states give up some sovereignty. "The monetary union inevitably implies a political union," he said.

DEBT SINNERS

Issuing euro bonds remains one of the most obvious ways to ensure affordable financing for high-debt members and many experts believe Germany may be forced to eventually back the idea, despite the upward impact on its borrowing costs.

Italian Economy Minister Giulio Tremonti said on Saturday that euro bonds would be the best solution to Europe's debt crisis, and Germany's export association said on Monday that all other means of fighting the crisis had run out.

Germany's mass-circulation Bild newspaper warned Merkel on Tuesday not to cede on the issue of euro bonds, which some backbenchers in her Christian Democrats (CDU) party say should at least be debated.

"Euro bonds would ultimately make Germany the paymaster of Europe," wrote Bild on Tuesday. "The government must stick to its NO on euro bonds. All the debt sinners must clearly sort themselves out once and for all."

Austria's finance minister said it was to early to imagine joint euro bond issuance and a Dutch government coalition party said it opposed the idea.

Sarkozy, who faces the tough choice of whether to close tax loopholes or trim spending eight months before a presidential election, has interrupted his summer holiday to meet Merkel and key French government ministers this week.

He has ordered his budget and finance ministers to find ways to plump up the 2012 budget by several billion euros as France strives to convince investors it will meet its deficit-cutting targets despite disappointing growth.

His and Merkel's proposals for tighter euro zone governance will be evaluated by European Council President Herman Van Rompuy, who has been charged with putting together a package on economic coordination for an EU summit in October.

French economist Jacques Delpla, who co-authored a paper proposing how euro bonds could work, said the euro zone faced collapse unless leaders go beyond their July 21 pledges.

"If we just stick to the July 21 agreement then, before the end of the year, there will be no euro zone, unless the ECB buys everything."

Economist Frederic Bonnevay at French think-tank Institut Montaigne also said more radical measures were needed, suggesting the EFSF rescue fund's firepower should be raised to as much as one trillion euros from 440 billion euros currently.

(Additional reporting by Marc Angrand, Nicholas Vinocur and Patrick Vignal in Paris and Andreas Rinke and Stephen Brown in Berlin; Writing by Mike Peacock and Catherine Bremer)

European stock markets also looked set to rise, with Britain's FTSE 100 seen up 0.2 percent and Germany's DAX called 0.3 percent higher.

But weakness in U.S. S&P futures could blunt any gains. The September contract was down 0.5 percent by 1:45 a.m. EDT.

Most in the market do not expect the meeting between French President Nicolas Sarkozy and German Chancellor Angela Merkel at 10 a.m. EDT on Tuesday to lead to substantial progress in solving the euro zone's debt troubles.

The German government sees no major breakthrough at the Paris talks, a spokesman said on Monday, while the French president's office said the creation of common euro zone bonds will not be on the agenda.

"Sovereign debt concerns remain a persistent negative for the (euro), as the EU's latest attempt at delivering a comprehensive solution to the region's vulnerabilities has disappointed investors," analysts at Standard Chartered said in a research note.

The euro slipped slightly to $1.4414, after holding just below a three-week high against the dollar earlier in the morning and after rising 1.4 percent on Monday ahead of the summit.

Traders were also awaiting German and euro zone second-quarter GDP data at 2 a.m. EDT and 5 a.m. EDT, respectively.

Japan's Nikkei was little changed, giving up earlier gains, while MSCI's index of Asia ex-Japan stocks rose 1 percent, largely as Korean shares caught up to regional gains on Monday, when Seoul markets were closed for a holiday.

EURO

Many experts say the only way to ensure affordable financing for the euro zone's most struggling, debt-laden countries would be for the bloc to issue joint eurobonds.

But even if a common euro zone bond were issued, it would not end the euro zone's debt woes at a stroke.

"There still hasn't been debate about just how much issuance would be possible and just how much issuance the German public would be okay with," said Makoto Noji, senior bond and currency strategist for SMBC Nikko Securities in Tokyo.

The dollar index against a basket of major currencies edge dup 0.2 percent.

Against the yen, the dollar traded around 76.84, down from more than 80 yen earlier in August.

EQUITIES

Asian shares drew succor on Tuesday from news that Google has offered to buy Motorola Mobility Holdings Inc for about $12.5 billion. The deal helped push up major Wall Street indexes by as much as 2.2 percent.

The MSCI Asia ex-Japan index had lost around 14 percent over the past two weeks, part of a global market rout in which billions of dollars were wiped off share indexes.

Pranay Gupta, chief investment officer Asia Pacific at ING Investment Management, said Asia's corporate sector is struggling despite the region's strong economic fundamentals, due to debt woes in the United States and Europe, and the appreciation of Asian currencies.

"The anomaly that we have today is that companies in Asia are facing a much more uphill struggle both on the sales front and on the margins front given that demand from the West is waning," he said.

He said that the ING Investors Dashboard Pan-Asia (ex-Japan) Sentiment Index, a measure of private investor confidence in the region, had dropped 11 percent in the second quarter compared to last year's third quarter.

The S&P 500 last week hit its lowest in nearly a year after the first-ever downgrade of U.S. sovereign credit ratings, but have since rebounded almost as sharply.

Gold, seen by many as a safe store of value in turbulent financial markets, is one of the best-performing assets this year. It traded at $1,765 per ounce on Tuesday, down a touch from Monday's close and around $50 off its peak.

U.S. crude oil futures slipped 58 cents to $87.30 per barrel after a $2 rise on Monday.

(Additional reporting by Masayuki Kitano, Frederik Richter and Kevin Plumberg; Editing by Kim Coghill)

French President Nicolas Sarkozy and German Chancellor Angela Merkel meet in Paris from 1400 GMT (10 a.m. EDT) to discuss what further measures they can take to contain Europe's debt crisis, which is now spreading to the continent's core. A joint news conference is due at 1600 GMT (12 p.m. EDT).

Italy has been forced to ramp up its austerity measures and financial market jitters hit France last week with French banks' shares subject to panic selling on rumors that the country could be next to lose its prized AAA debt rating.

Many experts say the only way to ensure affordable financing for the bloc's most financially distressed countries would be for the euro area to issue joint eurobonds -- although officials in Paris and Berlin said Tuesday's talks would not address that possibility.

Although the German government has long opposed the idea, support is beginning to emerge, with the country's export association saying on Monday that all other means of fighting the crisis had run out.

Italian Economy Minister Giulio Tremonti said on Saturday that eurobonds would be the best solution to Europe's debt crisis , and some economists say that the euro zone will inevitably come around to accepting the idea.

"EURO ZONE COLLAPSE"

French economist Jacques Delpla, who co-authored a paper proposing how eurobonds could work, said the euro zone faced collapse unless leaders went beyond an agreement reached at a July 21 emergency summit on the debt crisis.

"If we just stick to the July 21 agreement then, before the end of the year, there will be no euro zone, unless the ECB buys everything that's problematic."

Eurobonds aside, Sarkozy and Merkel will focus on proposals to improve the euro zone's economic governance, which they told fellow leaders in the bloc at last month's summit that they would issue by the end of August.

In particular, they could discuss holding regular euro zone summits, as France has long sought, or ways of improving peer monitoring of fiscal policies.

At the July summit, euro zone leaders agreed to a second bailout package for Greece and to give their European Financial Stability Facility rescue fund broader powers, but the moves provided only a brief respite in the debt crisis.

Economist Frederic Bonnevay at French think-tank Institut Montaigne said more radical measures were needed even if they did not include eurobonds for now.

"The size and powers of the EFSF need to be expanded dramatically -- that's a secret to no-one," he said, suggesting that its firepower should be raised to as much as one trillion euros from 440 billion euros ($635 billion) currently.

Sarkozy, who broke off his summer holiday last week to deal with the market meltdown in French stocks, is to meet with Prime Minister Francois Fillon over lunch to fine tune France's position before he meets Merkel.

(Additional reporting by Nicholas Vinocur and Patrick Vignal; Editing by Jon Boyle)