PARIS, June 1 (Reuters) – Euro zone financial markets weakened yesterday 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.

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.

The euro briefly hit a four-year low against the dollar and European shares were down as much as two percent when US and British markets reopened after a long weekend and investors reacted to ECB warnings of more big write-downs to come for euro zone banks.

But they recovered after US 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. Yesterday came news that number two savings bank Caja Madrid has asked for up to three billion euros ($3.65 billion) from a government rescue fund as it continues merger talks with five smaller banks.

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.

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 co-ordination 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.