* EU, U.S. failed to dissuade generals from crackdown
* Options now include suspending aid, trade benefits
* But punishing Egypt could be counter-productive
By Paul Taylor
PARIS, Aug 15 (Reuters) - Having failed to dissuade Egypt's military-dominated rulers from launching a bloody crackdown on supporters of an ousted Islamist president, Western governments are venting condemnation and groping for ways to influence the outcome.
The United States and the European Union tried jointly to facilitate a peaceful, political solution to the stand-off between the army and toppled President Mohamed Mursi's Muslim Brotherhood, appealing right to the end to avoid violence.
"What could we have done otherwise?" asked Menzies Campbell, a senior lawmaker in Britain's Liberal Democrats, junior partner in the government coalition. "It just emphasises not so much a failure of Western diplomacy, but a powerlessness.
"These divisions are absolutely fundamental, about the kind of society that each side of the argument wishes to have," Campbell told Reuters in a telephone interview.
The inability to sway military strongman General Abdel Fattah al-Sisi and the security establishment leaves the West in quandary as to how to square its democratic principles with a vital interest in stability in the Arab world's most populous nation, straddling the Suez Canal trade corridor.
"The West needs to find a calibrated way of suspending aid and economic benefits that shows the non-military political class, including the business community, that they will pay a price in things that matter to them," said Daniel Levy, Middle East director of the European Council on Foreign Relations, a policy think-tank.
The United States, which has maintained a strategic alliance with Cairo since President Jimmy Carter engineered the first Arab-Israeli peace treaty between Egypt and the Jewish state in 1979, deplored the violence and urged restraint and a political solution.
President Barack Obama strongly condemned the steps taken by Egypt's government and announced on Thursday the cancellation of a major joint military exercise with Egypt, in a symbolic blow to the pride of the Egyptian armed forces.
Facing growing pressure in Congress to curtail the $1.3 billion in annual military assistance to Egypt, the president said he was studying further steps that could be necessary in the relationship with Cairo.
That aid, mainly in the form of arms sales, pales when compared with the $12 billion that Gulf monarchies Saudi Arabia, the United Arab Emirates and Kuwait promised Cairo as soon as the army ousted Mursi on July 3 in response to mass protests.
Obama added that Washington wanted to be a long-term partner with Egypt and was guided by national interests in this long-standing relationship.
"BREATHE DOWN ARMY'S NECK"
"The correct reaction now is for America to be breathing down the neck of the army, saying they'll stop the money tomorrow," said Britain's Campbell, a veteran member of the House of Commons foreign affairs committee.
"That won't make the slightest difference to the capability of the army ... I wouldn't do it publicly, but I certainly would be saying in private 'do you realise that all this support could be in jeopardy?'"
The Obama administration has few other levers it can pull, having upset conservative Gulf states by embracing Arab Spring pro-democracy uprisings, and given the Democratic president's known aversion to U.S. intervention in the Middle East.
Washington and European allies could stop the International Monetary Fund from lending to Egypt, but talks on a $4.8 billion package broke down under Mursi and the new interim government has said securing IMF funds is not its priority.
A visit by outspoken Republican senators John McCain and Lindsey Graham to Cairo last week, intended to help pull Egypt back from the brink, seemed to backfire, enabling the military to rally public opinion against "foreign interference".
Obama began his term trying to repair ties with the Arab and Muslim world, severely damaged by U.S.-led invasions of Afghanistan and Iraq. After initial hesitancy it embraced the 2011 Arab Spring uprisings that toppled several autocrats including veteran U.S. ally Hosni Mubarak in Egypt.
But Washington appears to have ended up with the worst of both worlds, blamed by many Egyptians for having supported Mursi while being accused by the Muslim Brotherhood of being an accomplice to a military coup against the freely-elected leader.
Levy said General Sisi had either concluded that the United States was bluffing and would not dare suspend aid because of the Israel treaty, or that the amount involved was insignificant compared with Gulf funding for Egypt.
In Europe, French President Francois Hollande found the strongest words to condemn Wednesday's crackdown, in which at least 525 people were killed according to official figures, although the Brotherhood says more than four times that died.
Hollande personally summoned the Egyptian ambassador - a rare diplomatic event - to condemn the use of force and demand "an immediate halt to repression", saying everything must be done "to avoid civil war", an official statement said.
Paris also said it would raise the crackdown at the United Nations, although French officials acknowledged that Russia and China, which have obstructed U.N. action against Syrian President Bashar al-Assad, would probably block any Security Council action on Egypt, arguing that it is an internal matter.
Swedish Foreign Minister Carl Bildt said the EU's chances of influencing events in Egypt were extremely limited as hardliners in command in Cairo seemed intent on pursuing a tough course.
The EU would need to look over its aid programmes to Egypt, he told Reuters, but economic sanctions would probably have little political impact.
He also saw no room for EU mediation at the moment. "I think the possibilities that might have been there a week or two ago have been blown off completely by what's happened. I think there will be a period of severe repression and problems," he said.
However, Bildt opposed cold-shouldering Cairo. "Even during that period we should try to keep channels of communication open to all sectors in order to be there once it's possible to do something," he said.
EU sanctions are often easier to start than to lift, given the requirement for unanimity in decision making.
Jonathan Eyal, director of international studies at Britain's RUSI think-tank, said the worst response would be for the West to retreat into a mood of "self-righteous indignation".
Suspending aid should be a prelude to trying to engage the Egyptian military with the aim of persuading Sisi to avoid what Eyal called the "ultimate nightmare" of outlawing the Muslim Brotherhood, driving it underground and holding "make-believe elections" that would preclude any compromise in the future.
The ECFR's Levy said the EU should set in motion a process that could lead to the suspension of its association agreement with Egypt, potentially stripping Cairo of trade preferences as well as financial aid, which is relatively small and mostly on hold anyway.
Italian Foreign Minister Emma Bonino said the 28-nation bloc was likely to hold an emergency meeting of foreign ministers next Monday or Tuesday to consider action on Egypt after its mediation efforts failed.
Levy said calibrated, rolling sanctions could strengthen the hand of EU envoy Bernardino Leon and U.S. Deputy Secretary of State William Burns in pressing Egypt's rulers for a return to the path of democracy and civilian rule.
Leon said the mediators had put forward not a complete peace plan but a series of mutual confidence building measures, starting with prisoner releases, that could have led to a negotiated settlement to the stand-off.
"I am convinced that there was a political alternative," he told Reuters. Liberal Egyptian Vice President Mohamed ElBaradei said the same when he resigned over the crackdown on Wednesday. (Additional reporting by William James in London, Anna Ringstrom and Alistair Scrutton in Stockholm, John Irish and Alexandria Sage in Paris and Arshad Mohammed and Lesley Wroughton in Washington; Writing by Paul Taylor; editing by David Stamp)