For all the fanfare that preceded it, the latest European debt-crisis summit was a major disappointment. Although better supervision and transparency of fiscal behavior is needed, the markets do not have confidence that agreed fiscal rules will be obeyed, given the eurozone's track record. And by putting the entire emphasis on fiscal restraint, European leaders failed to address the eurozone's deeper problems.

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In a Deep Dive contribution in September, David Marsh, co-chairman of the Official Monetary and Financial Institutions Forum, brilliantly and mercilessly exposed the design faults in eurozone architecture and the history of policy blunders by politicians, Eurocrats, and central bankers. But one architectural flaw in particular is worth highlighting today as policymakers frantically search for ways to save the eurozone: missing Eurobonds -- specifically ones with conditions attached. Because Eurobonds are a kind of government debt security guaranteed by eurozone governments collectively, they do not carry the risk associated with any single country's inability to service its debt.

Even before Europe's Economic and Monetary Union was established in the early 1990s, Wim Boonstra, the chief economist at the Netherlands-based Rabobank, realized that reducing sovereign borrowing costs for countries with a history of higher inflation that adopted the euro would encourage fiscal laxity and, ultimately, moral hazard. He therefore proposed "jointly and severally" underwritten conditional Eurobonds with risk premiums conditioned on ratios of government debt and deficits to GDP. For the outside investor, in other words, German and Italian Eurobonds would be identically priced. But the riskier eurozone counties would pay a premium, or "spread," to safer eurozone countries for underwriting their common debt issuance and tolerating the extra risk that doing so would entail. Italy, for example, would pay a substantial risk premium to protect German taxpayers and give Italian governments the incentive for good fiscal behavior.

Although excessive government debt may be today's main obsession, there are two more eurozone fault lines: excessive rises in private credit in Ireland, Portugal, and Spain; and widening gaps in competitiveness, together reflected in large current account deficits. (In 1998, I warned of the tensions a common monetary policy would cause in liberal-credit economies such as Spain and Ireland and argued the case for Britain's staying out of the eurozone.) Conditional Eurobonds with risk spreads linked to competitiveness, current account imbalances, and government debt-to-GDP ratios would have greatly reduced tensions within the eurozone by giving governments strong incentives for prudent fiscal and financial policies and for structural reforms aimed at boosting competitiveness. Tough rules on supervision and transparency would have been required, but substantial fiscal decentralization, or "subsidiarity," would have been possible. (Subsidiarity delegates detail tax-and-spend decisions to individual parliaments, which are better equipped to respond to local democratic pressures than a Brussels-based fiscal authority would be.)

Lessons from history and the looming abyss of a new Great Depression may just be the necessary preludes for reform that Europe needs. Aided by market panic and confusion, German toughness has arguably transformed reform prospects for Europe. Greece, Italy, and Spain now have credible, reform-committed governments. Ireland, bailed out under tough conditions, has cut its unit labor costs -- the average cost of labor per unit of output -- by 17 percent over two years and is showing growth. Portugal is strenuously reforming its public sector and labor markets. Market panic, however, has been costly for the European banking system and for short-run economic prospects. This might have been a price worth paying if German Chancellor Angela Merkel can now complete the final stage of restructuring the eurozone. It would be seen as a remarkable moral, political, and economic triumph.

Many observers, including senior figures at the European Commission and the European Central Bank (ECB), agree that some form of Eurobond is essential to save the eurozone. Without "joint and several" underwriting of new issues of sovereign debt, the current costs of borrowing for Italy and Spain will make their debt levels unsustainable and heighten fear in the markets of a vicious circle of bank insolvencies, credit crunches, and economic slumps. Without the support of the fiscal authorities, the ECB cannot undertake in eurozone sovereign debt markets the types of interventions carried out by the U.S. Federal Reserve and the Bank of England. These interventions have driven the U.S. and British governments' borrowing costs to record lows, despite, in some respects, their inferior fiscal positions relative to the eurozone. Yet the eurozone's "no bailout" clause (under which no eurozone country can be held liable for the debts of another) and the German fear of a "transfer union," in which it's on the hook for its peripheral and less prudent partners, have conspired to make the very word "Eurobond" almost unmentionable in German political discourse. And Germany, after all, is spearheading Europe's response to the debt crisis.

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