* Euro zone markets weaken on bank, recovery worries
* France repeats call for euro zone economic government
* Euro zone unemployment highest in nearly 12 years
* Spain's second savings bank seeks rescue funds
* Italian default insurance hits record level
By Paul Taylor
PARIS, June 1 (Reuters) - Euro zone financial markets weakened on Tuesday amid rising concern about banks' bad debts and doubts about the pace of economic recovery.
France reaffirmed a longstanding call for a formal economic government of the 16-nation euro area, which has aroused German suspicions in the past of an attempt to undermine the independence of the European Central Bank. [ID:nPAB008371]
The European Commission defended to trade unionists the need for austerity measures to curb public debt and deficits swollen by the financial crisis, as new data showed unemployment hit an almost 12-year high of 10.1 percent in the euro zone in May. [ID:nLDE65019A]
The euro
But they recovered after U.S. manfacturing data pointed to a continued steady recovery in the world's biggest economy, in contrast to the euro zone, where manufacturing activity grew at a much more sluggish pace in May than April.
Middle East tension over Israel's storming of a convoy of Gaza-bound aid ships, and concern over slowing growth in China contributed to a flight from risk.
But jitters over Spain were also a factor after last Friday's downgrade of Madrid's sovereign rating to AA+ from AAA by Fitch Ratings. On Tuesday came news that number two savings bank Caja Madrid has asked for up to 3 billion euros ($3.65 billion) from a government rescue fund as it continues merger talks with five smaller banks. [ID:nLDE6500O7]
Although the amount is within expectations, the request disclosed by a source close to the company highlights the headache the Spanish government faces in funding an overhaul of the "cajas" in a climate of rising money market costs.
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Euro zone credit ratings: http://r.reuters.com/get52k
Greek bailout: http://link.reuters.com/rad45k
Euro zone graphic: http://link.reuters.com/fyw72j
Overview of euro zone crisis: http://r.reuters.com/juv74j
For an analysis on EU strains [ID:nLDE64Q2M9]
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"ECONOMIC GOVERNMENT"
In Paris, Economy Minister Christine Lagarde told parliament: "We must imperatively strengthen the economic governmance of the European Union and even more the euro zone with a true economic government."
Her comment came after Le Monde newspaper said President Nicolas Sarkozy was pressing European partners to install the group of euro zone leaders with a secretariat to act as an economic government for the single currency bloc.
European Union finance ministers will discuss next week how to strengthen fiscal discipline to prevent a repetition of the Greek debt crisis and improve economic coordination in the bloc.
German Chancellor Angela Merkel accepted the notion of "economic governance" for the first time earlier this year but Berlin remains suspicious of French efforts to give governments too much economic power at the expense of the market.
Germany's top priority is to improve budget discipline -- backed by tougher sanctions on laggards -- including in France, which is forecast to run a deficit of 8 percent of output this year and a public debt of 88 percent of GDP.
Worries about divergent budget trends as well as a widening gap in competitiveness between Germany and its southern European partners have increased tensions in credit markets.
The cost of insuring Italian government dbet against default reached a record 250 basis points on the credit default swaps market, according to Markit data, while France's CDS edged up to 76 bps over the German benchmark.
In Brussels, EU Employment Commissioner Laszlo Andor told the European Trade Union Confederation that governments needed to balance austerity and economic growth to overcome the crisis.
"Europe's economy is under the stress of financial market speculation, while national governments face excessive public deficits and must engage in austerity programmes," Andor said.
Trade unions face a tough choice between acquiescing to austerity steps at the risk of angering members, or fighting them with strikes that could undermine economic recovery and cause a market backlash. [ID:nLDE65019E]
(additional reporting by Jonathan Cable and Ntsuko Waki in London, Tim Heritage in Brussels, James Mackenzie in Paris; editing by Jason Webb)