European policymakers came out in support of a rescue fund that would mark a new phase of economic cooperation within the 16-nation euro zone, setting them on a potential collision course with its central bank.

German Finance Minister Wolfgang Schaeuble proposed the idea of a European Monetary Fund on Saturday, two days after debt-ridden Greece passed a key test of market confidence by selling a 10-year benchmark bond.

His Chancellor Angela Merkel -- who faces popular opposition to any use of German taxpayers' money to bail out Greece -- gave her backing on Monday, even if that meant changing the European Union treaty, as did the European Commission.

But European Central Bank Executive Board member Juergen Stark fiercely criticized the idea, which he said would break European rules, penalize countries with solid finances and encourage wayward spending.

Such a fund would become very expensive, set the wrong incentives and burden (those) countries with more solid public finances. he wrote in German newspaper Handelsblatt.

Economic and Monetary Affairs Commissioner Olli Rehn said in a newspaper interview published on Monday that the Commission was ready to propose such a European instrument that has the support of euro zone member countries.

Merkel said details would have to be sorted out but the EU needed a mechanism to help itself if it hit difficulties, even if it meant changing the bloc's rules, which would require the approval of all 27 member states and could be difficult.

I think the idea (of a European Monetary Fund) is a good one, said Merkel, who leads the EU's biggest economy.

Without changing the treaty, it cannot be done ... If the European Union is to be capable of taking action, it will run into such questions. The EU treaty will not be the end of history.

The Commission, the EU executive, said it was ready to propose a rescue fund for the 16 countries using the euro by the end of June, and would discuss it for the first time on Tuesday.

TOO LATE FOR GREECE?

Greek Prime Minister George Papandreou said on Monday his country supported the creation of a rescue fund, from which it would be able to benefit if need be, though Athens was not asking for financial assistance from the EU.

It is unlikely the fund would be in place in time to help Greece through its debt crisis, which has called the euro zone's unity and credibility into question, but it could help tackle any similar crises that arose in other heavily indebted EU states.

A Commission spokesman said it was too early to say whether the fund would be just a financial instrument or a new institutional body with its own staff and budget.

In an article appearing in Tuesday's edition of Handelsblatt, Stark wrote that public acceptance of the euro and the EU would be undermined and that such a mechanism would not be compatible with the principles of the monetary union.

Clemens Fuest, who chairs Germany's finance ministry's technical advisory committee, said the fund would make sense only if it permitted states to go bust.

Such a fund must provide for an insolvency procedure for countries, he told Reuters. A solution must be found for this, so that one country's bankruptcy doesn't lead to a new financial crisis, a Lehman II, he said referring to the failed U.S. bank.

The EU's Lisbon treaty that came into force on December 1 does not allow for bailing out euro zone countries, but it does permit aid to EU members outside the currency area.

Economic analysts said the new fund could be based on a provision in the treaty that allows one group of countries to cooperate on certain matters more closely than others. Following that path would boost policy coordination in the euro zone, but also leave behind EU countries outside the currency bloc.

MORE INTEGRATION?

To be genuinely effective, the fund's creation should be accompanied by increased political and fiscal cooperation, something that many countries have opposed so far for fear of ceding too much power to EU institutions.

If the fund marks the start of recognition that there needs to be further political integration, then great. If it doesn't, all it will be is sticking plaster, said Simon Tilford, an analyst at the London-based Center for European Reform.

The German government once opposed the idea of issuing a common bond for the single currency, but it may have changed its mind given the groundswell of public opposition to any Greek bailout, diplomats said.

Federalists in the EU like the idea of the fund, since it would probably mean closer integration of its members, one EU diplomat said.

A European monetary fund has been a subject of debate for decades. Its most recent proponents were economists Daniel Gros of the Center for European Policy Studies and Thomas Mayer of Deutsche Bank.

They said it should be funded first by market borrowing and eventually by contributions from states with debts and deficits exceeding EU limits.

(Additional reporting by Noah Barkin in Berlin and Paul Taylor in Paris, Lisa Jucca in Milan, Paul Carrel, Rene Wagner, Madeline Chambers and Gernot Heller, in Berlin; editing by Stephen Nisbet, John Stonestreet)

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