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* Pressure to agree proposals before EU summit
* Euro zone must tell world it pays its debts -- Sarkozy
* EU treaty change might involve only euro zone members
* Italian austerity plan cheers market
By Catherine Bremer and Daniel Flynn
PARIS, Dec 5 (Reuters) - The leaders of France and Germany agreed a master plan on Monday for imposing budget discipline across the euro zone, saying the EU's basic treaty will need to be changed in the search for a sweeping solution to its debt crisis.
President Nicolas Sarkozy and Chancellor Angela Merkel said their proposal included automatic penalties for governments that fail to keep their deficits under control, and an early launch of a permanent bailout fund for euro states in distress.
They said they wanted treaty change to be agreed in March and ratified after France wraps up presidential and legislative elections in June. "We need to go fast," Sarkozy said.
Italy, the biggest euro zone nation in trouble, offered a glimmer of hope that the bloc could halt a crisis that is threatening the survival of the common currency. Its borrowing costs tumbled after its new technocrat government announced an austerity programme.
"What we want, with the (German) chancellor, is to tell the world that in Europe the rule is that we pay back our debts, reduce our deficits, restore growth," Sarkozy told a joint news conference after about two hours of talks in Paris.
Merkel added: "This package shows that we are absolutely determined to keep the euro as a stable currency and as an important contributor to European stability."
Confidence that European leaders will come up with a credible plan to lead the region out of its debt crisis at Friday's summit lifted world stocks on Monday, with European shares hitting a five-week high.
Investors and policymakers hope a summit deal on closer euro zone integration, combined with strict deficit reduction measures by heavily indebted states, will induce the European Central Bank to act decisively to stop bond market turbulence spreading.
"This agreement probably will give the ECB the political cover for intervening more actively on a temporary basis," said Uri Dadush, senior associate at the Carnegie Endowment for International Peace's International Economics Program in Washington
"The bad news is that this is all temporary. It is difficult to see how a deal like this hangs together without a quid pro quo in terms of some movement towards euro bonds or some form of long-term fiscal support for the countries in trouble."
Merkel and Sarkozy had already both wanted a system of more coercive discipline for euro zone governments that fail to keep down their budget deficits.
But they had been under unprecedented pressure to see eye to eye in a crisis that has split them on issues such as the role of the European Central Bank in lending to troubled states, and whether the bloc should issue jointly guaranteed euro bonds.
Sarkozy and Merkel said they would send off their plan on Wednesday, in time for a make-or-break European Union summit on Friday, and made clear their determination to drive through an EU treaty change despite objections from some member states.
If countries such as euro outsider Britain blocked a treaty change for the 27 EU members, the euro zone would proceed with an agreement among its 17 states, open to all who wanted to join, they said.
Sarkozy said the economic policy mistakes that led to the euro zone crisis must never happen again, accepting that France and Germany, the euro zone's two biggest economies, bore the biggest responsibility for finding a solution.
"In this extremely worrying period and serious crisis, France believes that the alliance and understanding with Germany are of strategic importance," he said. "Risking a disagreement would be risking the euro zone exploding."
Several governments, notably Britain, Ireland and the Netherlands, oppose treaty change because it might not win public backing in a referendum.
The British government said the changes proposed by Sarkozy and Merkel did not mean a significant transfer of power to Brussels and would therefore not require a referendum in Britain, which does not use the single currency.
The revised treaty would permit automatic sanctions against states that breach an existing deficit limit of no more than 3 percent of total economic output, unless a "supermajority" of states voted against the penalty.
That would reverse the current system where a majority of states must vote to launch disciplinary procedure.
It would also enshrine a budget-balancing rule in national constitutions across the euro zone, although they gave no detail of the proposed wording.
In deference to French concerns about sovereignty, they agreed the European Court of Justice could rule on whether euro zone states had implemented the fiscal rule properly in national law, but would not be able to reject national budgets.
Merkel appeared to have prevailed in her opposition to the issuing of bonds in theory guaranteed jointly by all euro zone countries, but in practice by the bloc's strongest member, Germany. "We reject the idea of euro bonds," she said.
Sarkozy rallied behind her, saying it would be absurd for France and Germany to cover the debts of countries on whose debt issuance they had no control.
In return, Merkel gave ground on the rules of a future permanent rescue fund for the euro zone, the European Stability Mechanism, which have been cited as a deterrent to investors.
Germany had insisted that explicit clauses be included in all bonds issued from mid-2013 stipulating that private bondholders may have to share the burden of future bailouts.
Instead, the rules will say the ESM will respect standard International Monetary Fund principles and procedures, and that the write-down taken by Greek bondholders is a unique case.
"We interpret this as an important step in the direction of more joint liability," Barclays Capital analyst Thomas Harjes wrote in a note to investors.
One of the most startling market moves was on Italian bonds as Prime Minister Mario Monti declared that his 30-billion-euro austerity plan had saved his nation from economic disaster.
"Without this package, we think that Italy would have collapsed, that Italy would go into a situation similar to that of Greece," Monti told the news conference.
Italy's technocrat cabinet approved the combination of tax rises, pension reforms and incentives to boost growth in a three-hour meeting on Sunday, opening one of the most crucial weeks since the launch of the euro more than a decade ago.
Markets reacted enthusiastically, with the yield on Italian two-year bonds plunging 85 basis points to 5.78 percent. This was far below the yields of over 7 percent last month -- levels at which Greece, Ireland and Portugal had to take international bailouts.
But unions immediately called a strike to protest against the "Save Italy" package, while Monti urged the ECB to play its part in the wider drive to restore investors' faith in euro countries' ability to repay their debts.
Ireland unveiled new spending cuts in a tough budget, accounting for nearly 60 percent of next year's 3.8 billion euros fiscal adjustment.
Speaking before Merkel and Sarkozy announced their plan, Monti said better budget enforcement, an increase in firepower for the existing EFSF bailout fund and involvement of the International Monetary Fund would persuade the ECB to move.
"I believe this combination of these factors, including what Italy, my government, did on Sunday, will induce the ECB to re-assess, in full independence, their future policies."
Top ECB policymakers have been reluctant to buy up debt from distressed euro states, as this would take the pressure off governments to get their finances in order. But ECB chief Mario Draghi has signalled that a euro zone "fiscal compact" could encourage the bank to act more decisively on the crisis.
French Socialist presidential hopeful Francois Hollande spoke out in favour of common euro bonds at Germany's opposition Social Democratic Party congress in Berlin and, unlike some other leftwingers, called for a strong Franco-German alliance.