By Noah Barkin and Andreas Rinke and Catherine Bremer and Elizabeth Pineau
BERLIN/PARIS (Reuters) - In the lush gardens of the Elysee Palace in Paris, the seeds of a new Europe may have taken root. It was there, hidden away from EU summits and photocalls, that French President Francois Hollande and German Chancellor Angela Merkel began to forge a closer relationship than many expected.
On June 27, the two leaders met privately in Paris and, after weeks of public tension preceding Hollande's May 6 election, had a lengthy one-on-one discussion, French officials said.
Hollande took Merkel for a 10 minute walk around the Elysee gardens, before settling at a wooden table on the terrace with interpreters for a half hour chat on the state of the euro zone. They then adjourned to the Salon des Portraits, with its opulent gold-painted walls and crystal chandelier, for a 90 minute dinner with close advisers.
According to several sources, Merkel sought Hollande's buy-in for bold steps towards greater political union. It is unclear what she offered in exchange.
"She wants a project that she can show people before the German election next year. She needs something very quickly," a senior French official told Reuters.
"We've just arrived. We don't need to put a big project on the table, especially when there is not a broad consensus for this in France or in Europe," he said. "A more integrated Europe is fine, but only if there is more solidarity, the possibility of mutualising debt."
However, the two did agree to a deal that had been floated five days earlier in Rome: direct bank aid from the European Stability Mechanism (ESM) rescue fund in exchange for centralized supervision of European banks. But they kept the pact secret, senior EU officials briefed on the meeting said, because Merkel was facing a key domestic vote.
If news of the deal leaked, the German side feared, Merkel might struggle to get the two-thirds majority she needed in parliamentary votes two days later on the ESM and her "fiscal compact" on budget discipline.
"She had to show German lawmakers and the public she was being tough," one senior EU official told Reuters.
In the early hours of Friday June 29, EU leaders at a summit in Brussels agreed to ease conditions for countries receiving aid from the ESM. At the time is was interpreted by many as a defeat for Merkel and big victory for what the media dubbed Europe's new "southern bloc" - France, Spain and Italy.
Lost in the post-summit spin was the fact that the core of the deal had been sealed between Merkel and Hollande in Paris before the summit, not forced down the German leader's throat in Brussels.
Their relationship, and how they resolve points of disagreement, will be key to the future of Europe. Through interviews with the two leaders' closest aides and European officials who have witnessed them in action, Reuters has been able to sketch out a picture of the Franco-German couple's crucial first weeks and assess where they may take Europe in the decisive months ahead.
Socialist Hollande swept into office promising to shift the thrust of policy in Europe towards more growth.
During the French election campaign, he was a vocal critic of the bitter austerity medicine Merkel, a conservative, had prescribed for struggling euro zone countries and had vowed to end the "exclusive" relationship his predecessor, conservative Nicolas Sarkozy, had cultivated with the German chancellor.
Merkel, for her part, had openly backed Sarkozy's re-election bid. On the day after Hollande's victory, she was forced into an awkward pivot, promising to welcome with "open arms" the man she had shunned for months.
It was a stormy start in more ways than one. On May 15, the day he was inaugurated as president, Hollande flew off to meet Merkel in Berlin. Minutes after takeoff from Villacoublay air base near Paris lightning struck. A loud blast and burst of red-orange light jolted the dozen passengers in the sleek French-made Falcon jet's narrow cabin.
After the shock of the bang subsided, Hollande approached the cockpit. "Are you sure, absolutely sure we have to turn back?" he asked.
The pilot was firm. Merkel would have to wait.
After returning to Paris to switch planes, Hollande arrived over an hour late. With drizzle wetting the stone courtyard of the Chancellery, he stepped out of a black Mercedes that had rushed him from Tegel airport and met the German leader for the first time. On the red carpet, Merkel discreetly guided the novice by the elbow as they reviewed an honor guard.
Hollande, who speaks better English than Sarkozy, chatted to Merkel without interpreters for 20 minutes. Later they dined on veal schnitzel and asparagus, washed down with a French red recommended by Merkel herself.
By the end of the meal the tension that had built up between the two during a hard-fought French election campaign, in which Merkel had refused to meet the French Socialist, had all but vanished, people who were present said.
Within a week of that meeting, however, Hollande was sending powerful signals that he would practice what he had preached to voters. At a G8 summit in Camp David, Hollande joined U.S. President Barack Obama in demanding bolder steps to boost growth in recession-hit European countries like Greece and Spain, leaving Merkel uncharacteristically isolated.
Back in Europe days later, Hollande broke with tradition and chose not to meet Merkel before an informal summit of EU leaders. Instead, he invited Spanish Prime Minister Mariano Rajoy to Paris, later travelling by train with him to Brussels - a symbolic slap at Berlin.
At the summit, Hollande clashed openly with Merkel over common euro zone bond issuance and pressed for an ambitious "growth pact" he had championed during his race to the presidency. Without that, he made clear, he would not back a separate pact on budget discipline favored by Merkel.
The public divide between the two leaders was stark - but that suited Hollande in the days before a French parliamentary vote in mid-June. He wanted to send a message to his domestic audience that he was rebalancing ties after the "Merkozy" era.
Merkel's frustration bubbled over on June 15, days after Hollande, in a breach of protocol, had welcomed leaders from Germany's opposition Social Democrats (SPD) to the Elysee. In a speech to business leaders the chancellor pointed to a "growing gap" between the German and French economies, a not-so-subtle swipe at Hollande.
Hollande's Socialists ended up clinching a decisive victory in France's parliamentary vote on June 17. In control of the Assemble Nationale and Senat, as well as most towns and regions, he is now in the strongest position of any French leader in decades.
Yet the French president has little economic room for maneuver. His country's debt has swelled to 90 percent of gross domestic product (GDP), its trade deficit is at a record 70 billion euros and nearly one in four young French workers is unemployed.
"Hollande is extremely constrained in what he can do," said Arthur Goldhammer, an expert at the Centre for European Studies at Harvard University who writes a blog on French politics. "Germany's economy gives it a lot of power. Hollande simply can't afford to get lumped together with Italy and Spain."
At the G20 summit in Los Cabos, Mexico, on June 18-19, Merkel shifted the debate away from growth towards closer fiscal integration in Europe. Only by aligning economic policies more closely and moving towards a "fiscal union", she told world leaders, could the euro zone hope to win back the confidence of the markets. President Obama appeared to be firmly on her side.
With pressure rising on European leaders to announce bold new steps to stem the crisis, Merkel, Hollande and Rajoy travelled to Rome on June 22 to hold talks with Italian Prime Minister Mario Monti at the Renaissance Villa Madama. The four unveiled plans for a modest 130 billion euro "growth pact" - a symbolic victory for Hollande.
Behind closed doors they also discussed a new deal, senior EU officials told Reuters. The euro zone's new rescue fund, the ESM, would be allowed to inject aid directly into struggling banks - a key demand from Spain. Beforehand, a new authority would be set up to supervise European banks - a measure in line with Merkel's vision of tighter central control. A post-meeting news conference verged on a public relations disaster, with Hollande once again venting his frustration with Merkel for opposing euro bonds any time soon.
"Euro bonds have to be an option, but not in 10 years time," he said.
To avert disaster, it was agreed that Merkel and Hollande would meet in Paris the following Wednesday, ahead of an EU summit at the end of the month. They duly strolled in the Elysee garden, talked at length and developed an understanding that was not publicly appreciated in the wake of the subsequent Brussels summit.
That relationship was reflected by Hollande in an interview last week with French weekly magazine Marianne where he said of Merkel: "I quickly understood her personality, strong but not stormy. You know what she wants. She takes a clear position but also has a sense of compromise."
In the early 1990s, German conservative Helmut Kohl compromised, giving up the most potent symbol of West Germany's post-war prosperity, the Deutsche mark, in exchange for French Socialist Francois Mitterrand's support for German reunification.
Two decades later, with the single currency in deep crisis, a similar "grand bargain" will be needed from Merkel and Hollande - former proteges of Kohl and Mitterrand - to save Europe's bold but flawed experiment.
Germany, Europe's dominant economic power, will have to come to terms with the idea of a "transfer union" in which money from the bloc's more-prosperous north flows to its battered southern periphery, possibly via some form of common euro zone bonds.
Is Merkel prepared for more "solidarity" if that is what is needed to save the single currency?
For France, it will mean accepting a fiscal straitjacket made in Berlin, and the major loss of sovereignty that Berlin's nascent push for a European "political union" implies. Can the cautious Hollande persuade the French to go down this route?
Time is not on their side. Without a convincing Franco-German answer in the coming months, markets could push up the borrowing costs of Italy and Spain to unsustainable levels, triggering the need for mammoth bailouts Europe cannot afford.
"In the long run, the euro is not sustainable without a grand bargain between France and Germany," said Charles Grant, director of the Centre for European Reform, a London think tank.
When leaders return from their summer breaks, Hollande is likely to come under pressure from Merkel to help her set the foundations for a "fiscal union" in Europe. For such a project they will need to work closely. Their aides say that after a rocky start, the past weeks have shown they can build a relationship of trust.
On Sunday, they were in Reims to mark the 50th anniversary of a historic reconciliation meeting between Charles de Gaulle and Konrad Adenauer, which led to the signing in January 1963 of the Elysee Treaty cementing Franco-German friendship.
After embracing Merkel publicly for the first time, outside the city's cathedral, Hollande said: "At each step of European construction, the German-French friendship was the base. I propose to you that we open a new door to even tighter friendship."
In an indication that tough bargaining still lies ahead, Hollande referred pointedly in his speech to the need "to combine national sovereignty - to which we are attached here in France, as in Germany - with our European commitment".
(Edited by Janet McBride)