The euro zone's institutional weaknesses have been laid bare. The attempt to run a common monetary policy without a common treasury has failed. Investors do not know what they are buying when they purchase an Italian bond - is it backstopped by Germany or not?
We now know that the best credit must stand behind the rest, or else bear runs, such as those that have derailed Greece, Ireland and Portugal - and that now threaten to do the same to Italy and Spain - are inevitable. Debt mutualisation alone will not save the euro, but without it, the euro zone is unlikely to survive intact.
The euro zone summit on July 21 was a small step forward. Leaders agreed to lower interest rates on loans made by the European Financial Stability Facility (EFSF), and they recognised that Greece's debt burden had become unsustainable. But this falls far short of what is needed to arrest the currency union's deepening crisis. Borrowing costs remain unsustainably high for many euro-zone economies - and not just those in the periphery. The economic growth potential of Spain and Italy, for example, now hovers at about 1 per cent, but their borrowing costs exceed 6 per cent. By contrast, German sovereign yields have fallen sharply, lowering public and private-sector borrowing costs.
This is a recipe for further economic divergence and insolvency in the euro zone. To prevent this, it needs a "risk-free" interest rate.
The struggling economies need lower borrowing costs or they will suffocate economically and political support for euro-zone membership will evaporate.
Only mutualisation of debt issuance can generate the low (risk-free) interest rate needed to enable these countries to put their public finances on a sound footing and lay the basis for a return to economic growth. All euro-zone countries should, therefore, finance debt by issuing bonds that would be jointly guaranteed by all member states.
The obvious problem with eurobonds is moral hazard: how to prevent fiscally irresponsible countries from free-riding on the creditworthiness of other member states. This is the understandable fear of countries such as Germany and the Netherlands.
One possible solution would be to permit member states to issue debt as eurobonds up to, say, 60 per cent of GDP, and to require them to be individually responsible for any debt exceeding that level. This would give countries with high levels of public debt an incentive to consolidate their public finances.
Had the euro zone introduced such a system from the outset, it might well have worked.
But it is too late for that now. For several euro-zone economies, the additional borrowing would simply be too expensive.
A better solution would be to create an independent fiscal body to establish borrowing targets for individual member states, together with a European debt agency to issue eurobonds (up to a certain level) on their behalf.
How would the new fiscal rules be designed? A dogmatic target of budgetary balance four years hence, irrespective of a country's position in the economic cycle, would achieve little: targets are meaningless if they are impossible to implement. So the rules would have to be set with reference to each member state's cyclically adjusted fiscal position, for which the Organisation for Economic Co-operation and Development (OECD) already produces estimates.
Careful thought would need to be given to the composition of the new fiscal body. A board of 17 people, one from each euro-zone economy, would be unwieldy, and unlikely to win the support of the euro-zone's principal creditor countries. At the same time, a board dominated by the creditor economies would be unlikely to win the backing of the debtor countries. A board of nine economists, from the big euro-zone members, the European Commission, the European Central Bank (ECB) and the OECD might form a good basis.
The euro zone has a poor record of enforcing fiscal rules, implying the need for strong non-compliance penalties. If a country deviated from its fiscal targets, it would be barred from borrowing additional funds at the risk-free interest rate. It would have to borrow under its own rating, which would be prohibitively expensive for fiscally weaker countries. To provide additional incentives to abide by the rules, the ECB could refuse to accept debt issued under national ratings as collateral. Alternatively, a new EU financial regulator could handicap own-country bonds by requiring banks holding them to set aside more capital.
Fiscal rules of the type envisaged (and a new body to enforce them) would not necessarily require a treaty change. And, while various creditor countries rightly fear that eurobonds would push up their borrowing costs and constitute a transfer union, opponents might eventually come around to seeing eurobonds as the most favourable option.
The risk is that, by then, it could be too late to save the euro from a partial break-up: what might work if adopted promptly could be ineffective if adopted in six months.
For core countries, eurobonds would certainly be a cheaper option than underwriting loans to struggling member-states, which essentially means throwing good money after bad. They will book large losses on EFSF loans, and those losses will be even larger if some borrowers end up leaving the euro zone and defaulting on their debt.
Simon Tilford is the chief economist at the Centre for European Reform
* Project Syndicate