* EU's Van Rompuy expands on his idea for euro zone "budget"
* UK's Cameron mixes euro zone fund with wider budget talks
* Summit on Oct. 18-19 set to debate euro zone fund proposal
* Initiative is latest effort to get on top of debt crisis
By Luke Baker
BRUSSELS, Oct 11 (Reuters) - The European Union's top official fleshed out his ideas for a separate budget for euro zone countries on Thursday, and indirectly warned British Prime Minister David Cameron about using the proposal for his own political gain.
At a conference to discuss the state of Europe after nearly three years of debt and financial crisis, Herman Van Rompuy, the president of the European Council, said a separate euro zone budget was an idea that needed close examination.
Even if it is a long-term project and there are a host of political and financial obstacles to overcome, it could help underpin the stability of the single currency, he said.
"We have to do everything to stabilise the situation in the euro zone, and if a fiscal capacity or a separate budget can help and can contribute to this stability, then you have to reflect on it, to discuss it," he told conference delegates, who included several ministers from EU member states.
"Every currency union needs also a fiscal capacity, and certainly a fiscal capacity to stabilise the euro zone."
The 27 countries in the European Union currently finance a budget which amounts to around 130 billion euros a year - 1 percent of EU output - and which is used for spending on agriculture, science, infrastructure and other areas.
But there is no equivalent budget among the 17 countries that share the euro, a shortcoming that many economists believe has undermined the stability of the currency project.
Van Rompuy first raised the possibility of a separate euro zone budget in September and developed his thinking in a document sent to EU capitals in early October. It forms part of a series of initiatives to try to resolve the debt crisis.
Germany and France strongly support the proposal and, in a surprise to many EU diplomats, Britain does too, but for different reasons. Cameron sees a euro zone budget as a way of further separating Britain and its increasingly EU-sceptical electorate from the currency bloc and its problems.
He also sees a euro zone fund as a way of potentially reducing the amount Britain has to pay into the EU budget, which is negotiated annually as part of a seven-year framework. The issue has become particularly acute as the EU prepares to negotiate the next seven-year plan at a summit in November, a deal Cameron has threatened to veto unless he gets his way.
"There will come a time when you need to have two European budgets, one for the single currency, because they are going to have to support each other more, and perhaps a wider budget for everybody else," Cameron said on Sunday, the first day of his Conservative Party's annual conference.
Asked if he was prepared to block the long-term EU budget if spending wasn't cut further, Cameron replied: "If we cannot get a deal that has proper control of that budget, if they put forward ideas for massive increases, I won't say yes to it."
The concern for Van Rompuy and others is that Cameron is combining very early discussions on the possibility of a euro zone fund with negotiations on the EU budget, and by doing so putting both processes at risk.
"I want to clear out any confusion - this must not be mixed up with the European Union's multi-annual budget," Van Rompuy told the "Friends of Europe" conference.
"Since we decide on a multi-annual financial framework in November, it is important that we don't start mixing up that discussion with the embryonic idea" of a euro zone budget.
"The objectives are different and the timeframes are completely, completely different," he said, adding that those who try to mix the two should be careful.
But beyond trying to keep Cameron from muddying the waters, Van Rompuy also faces a battle to try to convince the European Commission and several euro zone member states that having a separate budget for them is a good idea.
Van Rompuy's thinking - firmly backed by Germany - is that some form of "fiscal capacity" among the euro-area countries will allow them to iron out labour market and other socio-economic imbalances that build up in the bloc.
The fund could be used to help a country such as Spain, which has unemployment of 25 percent and is struggling to reinvigorate growth. In exchange for budget rigour, the pan-eurozone fund could provide targeted assistance.
"The fiscal capacity could perform stabilising functions specific to the euro zone, for instance help countries absorb asymmetric shocks over economic cycles, so we limit the adjustment cost in terms of growth and employment," Van Rompuy said. "This would also make the euro area as a whole more resilient."
While economically it may make sense, politically it is likely to prove challenging to convince all 17 countries that they need to pay more into a fund they hope they never need.
(Writing by Luke Baker; Editing by Susan Fenton)
Keywords: EUROZONE BUDGET/VANROMPUY