© Fabrizio Bensch/REUTERSFrench President Nicolas Sarkozy and German Chancellor Angela Merkel.
Angela Merkel and Nicolas Sarkozy, the German chancellor and French president, will meet in Paris on Monday to thrash out a deal on fiscal union that they hope will bring long-term stability to the currency zone. The blueprint will be presented to other European leaders at a Brussels summit at the end of the week.

Financial markets are also expecting an interest rate cut from the European Central Bank [ECB] on Thursday to give floundering euro economies a much-needed shot in the arm.

After months of deepening gloom that saw the eurozone lurch closer to recession and potential disintegration, a hint of optimism is in the air. There is a feeling in European capitals that moves to transform the currency union into a fiscal union, with greater centralised control over the tax-and-spend policies of the 17 member countries, could be the beginning of a solution for the debt crisis and calm the markets.

Merkel spelled out her proposals for fiscal union in a speech to the German parliament last week, and ECB president Mario Draghi has talked of the need for a "fiscal compact".

"They are clearly getting closer; they're singing perhaps not from the same hymn sheet, but their differences are not irreconcilable," said Grant Lewis, head of economic research at Daiwa Capital Markets. "Hopefully by Friday we'll have an agreement in principle." He noted, however, that the problems would start when politicians got down to the details at committee level. "The coming week may not be too bad for markets, but that doesn't mean the crisis is over. Ultimately what people want is eurobonds - effectively a German guarantee on Italian debt."

Merkel, backed by the Netherlands, wants a regime under which eurozone countries would surrender fiscal powers to an independent European authority that would be able to veto budgets. This could be a lengthy process, however, as it would require changes to EU treaties.

France is uncomfortable with the idea of automatic sanctions for fiscal rule breakers, and would prefer a less formal arrangement where heads of state would impose sanctions. Sarkozy also favours immediate measures such as eurobonds or a greater role for the ECB, which have met with stern public opposition from Merkel. But on Friday she acknowledged that a gradual evolution towards eurobonds was already under way, and appeared to be softening her stance on the ECB's role.

Analysts at Citigroup expect the EU council meeting on Friday will provide at least a roadmap on how to put in place stricter fiscal rules for eurozone countries. And the ECB might be willing, as suggested by Draghi, to take further action to support struggling countries by channelling rescue money through the International Monetary Fund.

Not all are convinced. "While it's possible that bold decisions could still be announced, we feel that the differences in the negotiating positions remain too large at this juncture for the latest 'grand plan' to tick all the boxes," said Jürgen Michels at Citi.

Others in the City are even more pessimistic. Raoul Raparel, of thinktank Open Europe, said: "Expectations ahead of this summit are much higher than they have been for a while and there is a chance some progress will be made. However, even if a political agreement is reached on closer budgetary integration, it will not provide a solution to the crisis, especially in the short term."

David Cameron, who met Sarkozy for lunch in Paris last week, indicated he would support Merkel's plan, although he stressed that he would defend Britain's interests if changes to the EU treaty were made.

Amid a more optimistic mood, interest rates on Italian and Spanish government bonds fell sharply and stock markets rallied last week., with the FTSE 100 index in London climbing 7.5%.

"It was the first happy week for markets in a long while," said Tobias Blattner at Daiwa Capital Markets. Disappointed by the Eurogroup meeting on Tuesday, 29 November, which saw euro area finance ministers admit to having failed to boost the EFSF bailout fund to the promised €1trn, markets rallied the following day when the world's major central banks stepped in to lower the cost of US dollar funding for banks in Europe and elsewhere.

"The rally carried right through to Friday, further supported by expectations of a cut in the ECB's key policy rate this Thursday and the EU summit on Friday, which will hopefully deliver plans to transform the currency union into a closer fiscal union," said Blattner.