The president is pushing Iran to halt its uranium enrichment in a verifiable way. Iran insists it is enriching only for peaceful purposes.
Bush said, "I told the chancellor my first choice, of course, is to solve this diplomatically." He quickly added, "all options are on the table."
Merkel said if Iran does not agree to suspend its enrichment program, additional sanctions would be needed.
"The offer has been put on the table to Iran, but ... if Iran does not meet its commitments, then further sanctions will simply have to follow," she said.
Europeans want to wait on stiffer sanctions until after the European Union's foreign policy chief, Javier Solana, visits Tehran to present a package of incentives in exchange for stopping its enrichment program. The offer, an updated version of one that Iran ignored a few years ago, was developed by the United States, along with Germany, Britain, France, Russia and China.
The diplomatic pressure came as Iranian President Mahmoud Ahmadinejad on Wednesday said Bush's era "has come to an end" and he has failed in his goals to attack Iran and stop its nuclear program.
Ahmadinejad said pressures and sanctions won't succeed in forcing Iran to halt its uranium enrichment program. "If the enemy thinks they can break the Iranian nation with pressure, they are wrong," he said.
Bush, in the midst of a farewell trip through Europe, visited with Merkel and addressed reporters in another session dominated by Iran.
The U.N. Security Council has imposed three sets of limited sanctions against Iran for refusing to halt uranium enrichment, a technology that can be used to produce nuclear fuel or materials for bomb. Iran continues to defy them.
Bush on Tuesday won new European promises to tighten pressure on Tehran, possibly with new sanctions. The president had not mentioned the prospect of "all options" on Tuesday in Slovenia when discussing Iran, although he has before.
"Our position is that we ought to enforce the sanctions in place and we ought to work with our allies to levy additional sanctions if they choose - if the Iranians choose to continue to ignore the demands of the free world," Bush said.
Merkel said she favors having sanctions decided through the U.N. Security Council, but that doesn't preclude any discussion within the European Union about whether there are other punitive measures, perhaps in the banking sector.
Addressing opponents of taking certain sanctions, Merkel said "Let us think of the people in Iran. This is what is essential. I think these people deserve a better outlook. ... And we would hope that the leadership in Iran would finally see reason."
Bush also was asked about the war in Iraq, and he said the U.S.-led invasion in 2003 was the right decision.
"I don't regret it at all," Bush said, although he said he wished he hadn't used some language such as "dead or alive" when talking about Osama bin Laden or "bring them on" when talking about insurgents in Iraq.
Bush also said he is not seeking permanent U.S. military bases in Iraq.
The Bush administration is seeking an agreement with Baghdad that would provide for a normal, permanent U.S. military and diplomatic presence in Iraq. The word "permanent" has been a flashpoint for many who oppose the war, both in the U.S. and Iraq.
Stiff Iraqi opposition has raised to the deal has raised doubts about whether Bush will be able to get the deal done before he leaves office.
"I think we'll end up with a strategic agreement in Iraq," Bush said confidently, yet without indicating a timetable. "There's all kinds of noise in their system and our system. What ultimately will win out is the truth."
Bush said the United States is in Iraq at the invitation of the sovereign government there, and that accounts that the U.S. is seeking permanent military bases are "erroneous."
The two leaders also discussed climate change, Afghanistan, how the demand for biofuels is exerting upward pressure on food prices and trade.
Merkel said she has not given up hopes of completing global trade negotiations being conducted under the auspices of the World Trade Organization. However, the so-called Doha Round of trade negotiations is at an impasse because of battles between wealthyL TV *(mandatory on-air credit))
