The bond markets are sending Europe’s leaders an unmistakable message: The opportunity to contain the euro area’s debt crisis is slipping away. If they want to save the union and its currency, the leaders will have to consider something far more ambitious than what’s been spelled out so far. Perhaps the unspecified agreement French President Nicolas Sarkozy and German Chancellor Angela Merkel reportedly reached last night on Greek debt marks the beginning of a wider -- and bolder -- effort.

Only three weeks after Greece averted disaster by passing the harsh austerity measures needed for a second bailout, investors have refocused their concern on the much larger economies of Spain and Italy. The yield on the 10-year Italian government bond, for example, has risen almost a percentage point to 5.6 percent as creditors demand bigger returns to compensate for the perceived risk of default.

It’s hard to overstate how dangerous these developments are for the euro area and the world. Italy’s debts are about three times more than those of Greece, Ireland and Portugal combined. Even one extra percentage point in borrowing costs would require Italy to cut annual spending by an added $27 billion (19 billion euros) to stabilize its debt burden. To get there, Italy would need to roughly double the austerity measures it passed just last week.

European leaders’ decision to hold an emergency meeting this week suggests that they recognize the need to restore confidence fast. But they’re still behind the curve. Even a hefty increase in an existing $626 billion (440 billion-euro) stabilization fund, along with proposals to shore up banks, won’t fix the problems. There are two fundamental uncertainties: How much investors and banks stand to lose if Ireland, Portugal, Spain, Italy and even Belgium go through restructurings, and how policy makers will prevent those losses from toppling the region’s financial system.

Radical Solution

Only a radical solution can stop the rot. Politically fraught as it may be, Sarkozy and Merkel need to do what Alexander Hamilton did in the 18th century to resolve a similar crisis in the fledgling United States: Push for the creation of a federal finance ministry with the power to assume the debts of individual euro-area members and the taxation authority to pay the debts.

The finance ministry could offer to exchange the bonds of individual euro-area governments for new euro bonds backed by the full faith and credit of the entire 17-nation group. The ministry could make the trade at full face value or differentiate among countries -- offering, say, 50 cents on the euro for Greek debt. Immediate provisions would have to be made to recapitalize banks hit hard by such losses.

Far From Ideal

The solution is far from ideal. Germany and other fiscally prudent nations would probably face higher borrowing costs. Persuading individual leaders and the people they represent to cede so much sovereignty to a unified finance ministry would also be a massive political challenge. But it might be Europe’s best bet at providing certainty and restoring confidence.

Such a euro-zone debt swap isn’t as expensive as it might seem. The euro area’s combined government debt, including the cost of bailing out banks, would amount to roughly 90 percent of its total annual economic output. This is in line with the U.S. debt level and a bit more than Germany’s, which stands at about 80 percent of GDP.

In return for backing the finance ministry, Germany and France, the union’s core members, would get much more power to enforce debt and deficit limits. Individual governments would have no authority to issue euro bonds to finance excess deficits, and financially strapped governments such as Greece would have a hard time borrowing on their own.

The position of individual governments would be similar to that of American states, which must operate under self-imposed balanced-budget rules to maintain access to credit markets. To ease the pain of the fiscal straitjackets, a European finance ministry would have to help support countries’ social safety nets in difficult times, just as the U.S. government does by aiding the states with unemployment insurance and stimulus spending.

All too often, the political will to address financial crises comes too late -- after markets have done their damage. The unfolding damage is painfully visible; let us hope that the political will becomes equally manifest in the meeting rooms of Brussels.

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