BERLIN—German Chancellor Angela Merkel, under mounting pressure in and outside Germany to show stronger leadership in the euro-zone debt crisis, reached a late-night compromise with France over a fresh bailout for Greece ahead of a crucial European summit planned for Thursday.
The chancellor's six-hour meeting with French President Nicolas Sarkozy, which European Central Bank President Jean-Claude Trichet also joined, managed to find a mutually acceptable formula for how to involve Greece's bondholders in the expected new rescue package, according to a senior official present at the talks.
The official didn't give details of the joint proposal, which will be presented to Thursday's meeting in Brussels of all 17 euro-zone national leaders.
The agreement between the euro zone's two most important members, with the apparent consent of its top central banker, is expected to pave the way for a Europe-wide deal at the Brussels summit.
The expected bailout package for Greece will create further financial risks for European taxpayers—especially those in Germany—who are already funding rescue loans for Greece, Ireland and Portugal.
Ms. Merkel is fighting to limit the cost of the bailouts, which many German lawmakers and voters resent—but she is also under fire for not taking decisive steps to resolve the crisis and restore investor confidence in the euro zone.
Many observers say the festering crisis will eventually force Ms. Merkel and German voters to address a fundamental question about Europe's future: Must the Continent deepen its economic union if it wants to save its common currency? Or is the euro more hassle than it's worth?
So far, the chancellor has avoided that debate, fueling criticism of her leadership.
"She is temperamentally unsuited to an issue where you have to chart a course in the dark and make a bet on the future," says Josef Joffe, one of Germany's leading political commentators.
Ms. Merkel reluctantly agreed to Thursday's European summit, which European officials say was called at the insistence of other countries worried about the escalating crisis of confidence in euro-zone government debt. Bonds of Italy and Spain, which have much larger economies and debts than Greece, have come under strong pressure this month, fueling fears of an uncontainable conflagration. Euro-zone bond markets have stabilized in recent days, however, in the expectation that a rescue of Greece—and possibly a strengthening of Europe's financial-aid tools—will be agreed on Thursday.
Greece Prime Minister George Papandreou flew to Brussels on Wednesday to meet with top European Union officials and press them for a summit outcome that keeps the Athens government afloat.
The debt crisis also threatened to spread further Wednesday when Cyprus's central bank governor warned that country needs to take drastic action to avoid the need for a financial rescue, after a July 11 explosion at a naval base destroyed Cyprus's main power station, disrupting the already-fragile economy.
The spotlight, however, is on Ms. Merkel as leader of Europe's strongest economy and paymaster. For weeks, the chancellor and her finance minister, Wolfgang Schäuble, have angered most other countries in the euro zone by insisting that a new loan package for Greece must include a contribution from banks and other private investors in Greek bonds. Other countries fear that could lead to capital flight from other indebted euro members.
Euro members have now accepted that there will be some form of burden-sharing with investors—or else Ms. Merkel won't agree to new loans for Greece. But France and Southern Europe are more cautious than Germany and its northern allies about how great a burden should be put on bondholders.
Germany's insistence on involving bondholders has caused widespread resentment in other European capitals.
Around the euro zone, government officials complain that Ms. Merkel and Mr. Schäuble have exacerbated the financial-market turmoil by scaring investors with their demands for a bondholder contribution. A common criticism: Whereas past German leaders saw European unity as their calling, Ms. Merkel has put domestic politics first.
She has good reason to worry about domestic opinion, German officials say. A number of lawmakers in her center-right coalition say they will vote against further aid for Greece, while many others are prepared to swallow another bailout only if banks pay part of the cost.
Opinion polls show Germans are increasingly losing confidence in the currency. So far, however, there is no sign of any movement or party that could seriously challenge German membership in the euro. "The issue is too abstract, and people don't really understand it," says Manfred Güllner, head of opinion-polling institute Forsa in Berlin."There's nobody who could lead a populist movement against the euro," he says.
Some advisers to the chancellor say there is no guarantee against a popular backlash, and that she is being careful not to create an electoral opportunity for an anti-euro movement.
But with the German economy doing well, unemployment low, and the next national elections more than two years away, Ms. Merkel may have more room for maneuver at home than most other leaders of Western democracies. The problem, her critics say, is that the risk-averse chancellor just isn't using it.
"With such a complicated issue that the electorate doesn't understand, the chancellor has a lot of leeway in shaping the debate," says Mr. Joffe. But Ms. Merkel is failing to do so, he says: "It's almost as if she has left the stage and taken a seat in the audience."
Ms. Merkel remembers last year's tabloid campaign against her consent to the first Greek bailout, analysts say. But this year, she is coming under heavier fire from German media and business for her caution.
"The time for small steps that don't convince financial markets is over," Dieter Hundt, head of the German employers' federation, told newspaper Handelsblatt on Wednesday. The chancellor appears to lack a clear plan, he said.
Earlier this week Ms. Merkel dismissed calls for a "spectacular" single step to solve the crisis, saying she prefers "a controlled, manageable process of cumulative steps."
Many observers of German politics believe Ms. Merkel could persuade voters to support an ambitious solution to the euro crisis, if only she would try. "The Germans are at heart pro-European, even though they never loved the euro," says Mr. Güllner.
The chancellor doesn't want to test the limits of Germans' commitment to Europe, analysts say—but if the crisis continues to spread, she may have to.
—Charles Forelle and Costas Paris contributed to this article. Write to Marcus Walker at marcus.walker@wsj.com
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