PARIS (Reuters) - As a young aide to then-French prime minister Lionel Jospin in the late 1990s, Manuel Valls sat in on meetings as Britain's Tony Blair and Germany's Gerhard Schroeder tried to persuade his boss to help them reinvent Europe's Left.

Jospin, who at the time was readying the 35-hour work week long dreamed of by French Socialists, was impressed neither by Blair's "Third Way" nor Schroeder's "New Centre". But the talks made a deep mark on Valls, who 16 years later has become premier himself.

"Valls got it," said Denis MacShane, a former British Europe minister and Blair ally who during that period struck up a lasting acquaintance with Valls.

"But he also knew that if you stuck your neck out as a reformer, the French Socialist Party had a very well-oiled guillotine at the ready."

Valls, who makes no secret of his presidential ambitions, has now put his neck firmly on the line. He told the change-resistant Socialist Party last week that it must reform or die, and even toyed in public with the idea of changing its name.

Moreover he took aim at hallowed articles of Socialist faith, suggesting France's lengthy unemployment benefits and protective labor contracts could be revamped -- echoing the type of reforms already long accepted by German and British leftists.

It all comes at a watershed moment, both for the party and for France. The Socialists are in power for the first time in a decade, and the rest of Europe is increasingly alarmed that, after two years in the Elysee Palace, Francois Hollande and his allies have done little to revive the region's second largest economy.

For some in the party, Valls has declared war. If that is the case, the outcome could shape French economic policy over the next three years and determine whether the Socialists are real contenders at the next presidential election in 2017.

"Manuel Valls is going for a confrontation," said Christian Paul, one of the leaders of a group of rebel Socialist lawmakers seeking to resist what they see as Valls' lurch to the right.

"It is very Darwinian -- I'm not sure who is going to survive in the end," he said in one of a series of interviews conducted by Reuters with senior Socialist officials.

"TEACHERS' PARTY"

One by one, Europe's main leftist parties have moved away from their Marxist roots: Germany's Social Democrats in 1959, Spain's Socialist Workers' Party in 1979 and Britain's Labour Party in 1995. Italy’s post-communist left changed both name and ideology to become a centre-left party of government.

The French Socialists followed suit in 2008 with a little-remembered tract recognising the market economy. But in a country where the seating arrangements of the post-revolution 1789 national assembly gave world politics the terms "left" and "right", Socialists have yet to fully reconcile with capitalism.

While its German and British counterparts have histories dating back over a century, France's Parti socialiste (PS) was only founded in 1971. It has no firm claim to a working class vote that was once the preserve of the Communists but is now increasingly targeted by the far-right National Front.

With a small majority of French consistently identifying themselves with the Right, it has always been tough for the PS to win power and keep it. Sometimes derided as the "teachers' party", it faces competition for the left-wing vote from a mixed bag of anti-globalisation campaigners, ecologists and others.

Before Hollande, Francois Mitterrand was France's only modern-day Socialist president, and he spent much of his time in power from 1981 to 1995 in awkward power-sharing pacts with rivals, and uneasy alliances with Communists and other hard-left groups.

After a decade of conservative prime ministers from 2002, the return to government has again been tough for the Socialists. Alongside routs in mid-term city hall and European Parliament elections this year, thousands of members have quit the party amid disillusionment among left-wingers.

"In 10 years of opposition, the PS did not do the homework needed to prepare itself for government," Valls complained to a small briefing of foreign journalists in his office last month. "We need a Left that is reliable."

Outside observers might ask how serious Valls is, given that his government has just reneged on its latest promises to bring France's public deficit within EU limits and is under pressure from European partners to do more to revamp the French economy.

But that ignores the fact that it is precisely these two issues that are now threatening to blow the party apart.

"The fact that the Left has gone all out to subjugate all other policy goals to austerity is dangerous, pointless and absurd," said former economy minister Arnaud Montebourg, whom Valls fired along with two other rebel ministers in September.

"We have to realize that ordinary people cannot pay the bill for the crisis; they're the ones who make the economy work."

RISK OF SCHISM

The comment points to the main fault-line in the dispute between the Hollande-Valls duo and party critics who reject the president's conversion this year to supply-side policies aimed at restoring corporate margins while limiting public spending.

While acknowledging the need to rein in borrowing at some point, they argue that, with unemployment rooted at 10 percent and economic growth below 1.0 percent, to pursue deficit cuts now is to betray the left-wing principle of helping the needy.

Moreover, the repeated hints Valls is dropping about the need to free up France's heavily regulated labor market take aim at some of the proudest achievements of the French Left.

"This is a question of social justice," said Paul, the legislator. "Let's not underestimate the points of discord."

For now, Valls' line is holding -- just. A first component of the 2015 budget passed through parliament last week, but only narrowly, as 39 Socialists chose to abstain. With EU authorities yet to pronounce on the draft, the government line is that it can make no more savings, but will push through those it has pinpointed.

"We won't back down because of 30 or so deputies," Valls said. "We are pushing ahead; I believe the budget will pass."

There will be plenty of similar stand-offs in coming weeks on next year's welfare budget and planned changes to labor representation rules aimed at reducing charges for business.

But the most explosive clashes could come next year as the party gears up to determine who will get its ticket to run as president in 2017, and on what set of policies.

Whether the 52-year-old Valls decides to throw in his hat or bide his time depends largely on the fortunes of Hollande, who will need to produce a rapid turnaround in his record-low poll ratings of around 13 percent to bid seriously for a second term.

Possible rivals include Montebourg, a loose cannon who nonetheless came third in PS primaries for the 2012 election; and Martine Aubry, a former minister under Jospin who deflects talk of presidential ambitions but last week made a pitch for what she called a program of "new social democracy".

From his office at Socialist headquarters on the Left Bank of the River Seine, party chief Jean-Christophe Cambadelis argues that the real divisions between the main protagonists are narrower than they would have their audiences believe.

But he concedes that the party can ill afford a damaging public row, and risk seeing once again its candidate knocked out of the run-off for president by the anti-immigrant National Front, as Jospin was in 2002.

"A shock like that could trigger deep disputes in the PS, right up to a schism," he warned. "I don't want to have to be one who turns out the lights here."

(Additional reporting by Elizabeth Pineau and Brian Love; Editing by Kevin Liffey)