The return of Silvio Berlusconi to the Italian political stage sends an unmistakable message to Europe’s leaders: They will have to be a lot more ambitious if they want to hold their currency union together.

In parliamentary elections this week, Italian voters handed Berlusconi just enough power to make forming a stable government extremely difficult. In doing so, voters soundly rejected the technocratic policies of outgoing Prime Minister Mario Monti, whose efforts to raise taxes, cut pensions and curb budget deficits helped bring the government back from the brink of insolvency. One in four Italians further rebuffed Monti’s austerity diet by voting for a comedian. Stock markets plunged, and the yield on Italy’s 10-year bond rose to 4.9 percent, its highest level since November.

The turnaround illustrates the complicated game Europe’s policy makers are playing as they seek simultaneously to calm nervous markets and to push the euro area’s afflicted members to repair their finances. To make solvency achievable for countries such as Spain and Italy, the European Central Bank has rightly pledged its unlimited support to keep borrowing costs down. By removing the threat of imminent financial Armageddon, however, the ECB’s support has taken the pressure off voters to keep approving austerity policies that are driving their economies into recession.

Italy’s rebellion against austerity ― egged on by Berlusconi’s populist pledge to reimburse property taxes ― bodes ill for other euro-area countries. Some have much further to go than Italy to get their finances in order. Spain must still cut spending or increase revenue by almost 6 percent of gross domestic product to stop its debt burden from growing. That’s more than seven times the across-the-board spending cuts that are set to take effect March 1 in the U.S. Polls in Greece, which still has a lot of belt-tightening to do, already suggest that the anti-austerity Syriza party would triumph in a new election.

Even if governments could stick to their austerity programs, they might only succeed in killing the economic growth they need to restore financial health. Last week, the European Commission forecast that the euro area will experience another year of economic contraction in 2013 ― its third in five years. Unemployment is set to reach 26.9 percent in Spain and 27 percent in Greece. Senior officials at the International Monetary Fund, meanwhile, are publicly reassessing the effects of deficit-cutting during times of distress, saying that it’s more economically damaging than they previously thought.

The way out isn’t easy. Austerity measures will never be popular with voters unless they are convinced the pain is widely shared and short-lived. What’s more, countries with such divergent economies can’t share a currency unless they put in place some risk-sharing mechanisms. The best way to deal with both shortcomings is through a system of fiscal transfers. This would involve sending money from growing economies to those in recession, easing the difficult adjustments the latter must make to recover. We have demonstrated that such a mechanism, if properly designed, need not entail a permanent subsidy from Germany to governments in the euro-area periphery.

The euro area also needs a better way to keep its members’ borrowing in check. Jointly issued and collectively backed euro bonds, for example, have the potential to lower borrowing costs while giving a central authority significant control over individual governments’ ability to run budget deficits. Interestingly, this idea is supported by German Chancellor Angela Merkel’s main opponents in elections scheduled for September.

All the best solutions to the euro crisis have one thing in common: They involve the creation of a much deeper union. It’s up to Europe’s leaders ― and particularly Germany’s ― to convince their constituents that such a union is in their best interests.

(Bloomberg)