Lagarde urges Berlin to boost domestic demand

Greece is battling a debt crisis, and there is concern that its problems could undermine confidence in the euro and spread to other indebted euro zone countries like Portugal and Spain.

Germany and France, the euro zone's biggest economies, have been the driving force behind the single currency and Lagarde's remarks revealed the gap that has opened between them over how best to tackle the Greek crisis and other strains in the zone.

Euro zone finance ministers meet later on Monday, hoping to agree on a way of providing Greece with financial aid, should it request it, without breaking EU rules. A senior EU source has told Reuters bilateral loans and loan guarantees are among measures being considered.

Lagarde said Berlin should encourage domestic demand to boost its partners' ailing export industries.

" those with surpluses do a little something? It takes two to tango," Lagarde said in the interview with the Financial Times.

"Clearly Germany has done an awfully good job in the last 10 years or so, improving competitiveness, putting very high pressure on its labour costs," Lagarde said.

"When you look at unit labour costs in Germany, they have done a tremendous job in that respect. I'm not sure it is a sustainable model for the long term and for the whole of the group. Clearly we need better convergence."

Last month French President Nicolas Sarkozy and German Chancellor Angela Merkel pledged to reinforce their alliance and strengthen economic governance in the wake of the financial crisis.

TRADE IMBALANCES RARELY DISCUSSED

But Lagarde said that although she was in frequent contact with her German colleague, the issue of trade imbalances was not often discussed.

"I talk to Wolfgang (Schaeuble) on an almost daily basis at the moment. The issue of imbalances is not one we address readily." "You can't ask one player, as big as it is, to pull the whole group. But clearly there needs to be a sense of common destiny that we have together with our partners," she said.

The debt crisis has exposed the difficulty members of the euro zone with weaker economies face when they cannot use interest rates and currency depreciation to improve their competitiveness.

Schaeuble has called for the creation of a European Monetary Fund that could provide emergency help to prevent euro zone states going bankrupt -- and avoid the need for them to seek help from the International Monetary Fund.

Lagarde did not rule out an EMF, but said it could take years to set up and was not a priority. The bloc should ensure that Greece implemented austerity measures designed to cut its budget deficit, and then show "creativity and innovation" to find scope for tightening financial surveillance and discipline.

She said the current threat of a fine for countries which break the rules outlined in the EU Stability and Growth pact was "not really a deterrent."

The biggest difference between Germany and other euro zone members including France is on the issue of expanding Germany's internal demand, she told the paper.

Lagarde also said she supported an EU plan for closer inspection of credit default swaps on sovereign debt, following reports that they were used to mask the true extent of Greece's debt problems and manipulate the price of Greek debt.

She said she had no evidence of such manipulation but added "the rapidity of movements is intriguing."

(Reporting by Caroline Copley; editing by Tim Pearce)