Insight: Euro has new politburo but no solution yet

(Reuters) - Europe has a new informal leadership directorate intent on finding a solution to the euro zone's debt crisis, but it has yet to prove its ability to come up with a lasting formula.

Forged in the fire of a bond market inferno, the shadowy so-called Frankfurt Group has grabbed the helm of the 17-nation currency area in a few short weeks.

The inner circle comprises the leaders of Germany and France, the presidents of the executive European Commission and of the European Council of EU leaders, the heads of the European Central Bank and the International Monetary Fund, the chairman of euro zone finance ministers, and the European Commissioner for economic and financial affairs.

Europe's new politburo met four times on the sidelines of last week's Group of 20 summit in Cannes, issuing an ultimatum to Greece that it would not get a cent more aid until it met its European commitments, and arm-twisting Italy to carry out long delayed economic reforms and let the IMF monitor them.

In a tell-tale recognition of the new ad hoc power center, members wore lapel badges marked "Groupe de Francfort."

U.S. President Barack Obama attended one of the meetings, getting what he joked was a "crash course" in the complexity of Europe's laborious decision-making processes and institutions.

"He proved to be a quick learner," one participant said.

Two people familiar with the discussion said he argued for the euro zone to make its financial backstop more credible by harnessing the resources of the ECB, but German Chancellor Angela Merkel and ECB President Mario Draghi resisted.

Obama also supported a proposal to pool euro zone countries' rights to borrow from the IMF to help bolster a firewall against contagion from the Greek debt crisis, but Germany's central bank opposed this too, the sources said.

The president referred obliquely to the debate at a news conference the next day, saying: "European leaders understand that ultimately what the markets are looking for is a strong signal from Europe that they're standing behind the euro."

Hours earlier, a television camera in the Cannes summit conference room caught Obama and British Prime Minister David Cameron discussing the issue while waiting for the start of the final working session.

Cameron, whose country is not in the euro, has called publicly for the ECB to act as the lender of last resort for the euro zone, as the Federal Reserve does for the United States, and the Bank of England for Britain.

When Merkel entered the room, Obama pulled her aside for a private conversation. An open microphone caught his opening words: "I guess you guys have to be creative here."

ON THE HOOF

The Frankfurt Group came about on the hoof to try to fashion a crisis response in something closer to the short timespan of frantic financial markets.

It seems destined to endure, not least because the growing imbalance between a stronger Germany and a weaker France means other players are needed to broker decisions.

Crucially, it aims to bridge the ideological gulf between northern and southern Europe, and between supporters of the orthodox German focus on fiscal discipline and an independent central bank with the sole task of fighting inflation, and advocates of a more integrated and expansive economic and monetary union.

The presence of IMF Managing Director Christine Lagarde gives the group greater credibility in the markets, as well as providing a reality check on what international lenders expect and the limits to their willingness to support the euro zone.

It all began with a blazing row at the Old Opera House in Frankfurt on October 19 that spoiled Jean-Claude Trichet's farewell party after eight years as president of the ECB.

As the fallout from Greece's debt crisis singed European banks and panicky investors dumped euro zone government bonds, French President Nicolas Sarkozy, who had snubbed the ceremony in honor of Trichet, flew in at the last minute to meet a visibly irritated Merkel.

Sarkozy himself said that day that France and Germany were at odds over how to leverage the euro zone's financial rescue fund. The French wanted to let the European Financial Stability Facility operate as a bank and borrow money from the ECB.

"In Germany, the coalition is divided on this issue. It is not just Angela Merkel whom we need to convince," Sarkozy told lawmakers, according to Charles de Courson, who was present.

At the Frankfurt meeting, described by one participant as "explosive," Merkel and Trichet firmly opposed the idea, which they said would violate the European Union's treaty prohibition on the central bank financing governments.

Germany insisted on that clause when the ECB was created because of its own history of fiscal abuse of the central bank that fueled hyperinflation in the 1920s and funded the Nazis' massive rearmament in the run up to World War Two.

As French officials tell it, Merkel is not so hostile to the proposal as her finance minister, Wolfgang Schaeuble, and the head of the German Bundesbank, Jens Weidmann.

The French are convinced that Merkel understands the ECB will have to be more centrally involved in fighting bond market contagion, but she cannot get it through her divided coalition for now. They see the ECB as the main center of resistance.

After hearing a chorus of Obama, Cameron and the leaders of India, Canada and Australia at the G20, Merkel acknowledged that the rest of the world found it hard to understand that the ECB was not allowed to play the role of lender of last resort.

But the crisis may have to get still worse before the Germans and the ECB relent, if they ever do.

LEGITIMACY VS EFFICACY

The Frankfurt Group has already had an impact in euro zone crisis management but like all informal core groups it has begun to stir resentment among those who are excluded, and it has yet to prove its ability to craft a convincing longer-term solution.

North European creditor countries such as the Netherlands, Slovakia and Finland, where public hostility to further euro zone bailouts is fierce, are already grumbling about decisions being taken behind their backs.

In Greece and Italy, there has been strong criticism of the perceived arrogance of "Merkozy," as the Franco-German duumvirate are increasingly nicknamed, in summoning their prime ministers to receive ultimatums.

German and French officials shrug off such complaints as inevitable, noting that EU partners are even more unhappy when France and Germany do not agree, since that paralyses Europe.

"There is always a trade-off between legitimacy and efficacy," said an EU official involved in the Frankfurt Group. "The euro area institutions were not designed for crisis management so we need innovative solutions.

"In an emergency like this, we have to have a structure that works," he said, adding that the presence of the European Commission and of European Council President Herman Van Rompuy guaranteed that the interests of smaller member states would be taken into account.

EU officials had held conference calls with the 15 other euro zone states during the Cannes summit "to keep them in the loop." The head of the EFSF, Klaus Regling, was secretly flown to Cannes to brief the leaders on the state of accelerated preparations to leverage the rescue fund, one source said.

Merkel long resisted French pressure to create more of an "economic government" in the euro zone, not least because she did not want Germany to be in a minority on issues such as bailouts, free trade or the EU budget.

She also did not want to alienate German allies and neighbors such as Denmark, Poland and the Czech Republic, which are not in the euro zone.

But recent problems in smaller countries that aggravated market turmoil -- Finland's demand for collateral on loans to Greece and Slovakia's parliamentary wrangling over increasing the EFSF's powers -- convinced her of the need for stronger leadership to impose order.

Whether the Frankfurt Group will be the forum that finally convinces Germany to accept a bigger crisis-fighting role for the ECB, or the creation of jointly issued euro zone bonds, remains to be seen.

(Writing by Paul Taylor; editing by Janet McBride)