What’s next for Europe?

FORTUNE — The European Central Bank has thrown cold water on the sovereign debt crisis by injecting billions of euros into the banking system, but the embers of the crisis are still smoldering. S&P says the eurozone has a 40% chance of entering a severe recession this year, with the economy projected to shrink by as much as 2%. Unless comprehensive reform creates a much tighter fiscal union, uncertainty will continue to cast a dark cloud over Europe’s economic future.

It may seem as if Europe is out of the woods. Bond yields for Italian, Spanish and French debt have come off their record highs from last year, allowing the countries to issue more debt at lower interest rates. Greece has received some much needed breathing room and has been able to negotiate massive haircuts on its debt with its private creditors, many of which are hedge funds and investment banks here on Wall Street. And most importantly, European banks are no longer facing an imminent liquidity event, sparing the continent of a Lehman-like shock to its financial sector.

The root of all this easing comes from the European Central Bank’s decision in December to flood the eurozone banking system with cheap cash. The ECB’s long-term refinancing offering (LTRO) saw nearly half a trillion euros injected into the banking system in one major slug. A second LTRO auction is scheduled for the end of the month, which is anticipated to be as large as the December auction.

With the ECB riding to the banking sector’s rescue and the U.S. Federal Reserve guaranteeing the banks access to cheap dollar funding, the crisis seems to have stabilized. There’s no longer fear that a short-term liquidity event will cripple one of France’s major banks, which rely heavily on cheap cash from the private sector to facilitate their lucrative and risky trading operations. Italian and Spanish banks, which buy up a lot of their respective nation’s sovereign debt, now have plenty of cash on hand to participate in bond auctions, sending yields down to pre-crisis levels.

Spain’s big fix will enrage many workers

But despite all the progress, the eurozone is still in deep trouble. The ECB’s actions, while helpful and sorely needed, are only a temporary fix for this seemingly never-ending crisis. While the bond market vigilantes may have backed off their attacks on the big European economies, they are still at work in the background, pushing up bond yields for eurozone members on the far periphery.

Portugal problem

Last week, banks required massive upfront payments to buy credit protection (credit default swaps) on Portuguese debt. The CDS news, coupled with some sour economic news, sent yields on 10-year Portuguese bonds to a record high of nearly 18%. There is now talk that Portugal, like Greece, will need a second bailout to make its upcoming interest payments. It seems that the ECB couldn’t justify lending enough money to the Portuguese banking sector to keep the country afloat. Such a scenario could eventually face Spain and Italy and we could be right back where we started.

There is no easy solution to ending this crisis, which is now entering its third, grueling year. The ECB’s actions were necessary to contain the crisis, but aren’t sufficient to put an end to it. Eurozone members must now work to bring back confidence to the single currency. A call for the formation of a fiscal union among eurozone members seems to be the first logical step to buttress the crumbling single currency’s reputation. But in order to form a strong fiscal union — one that would instill real confidence back in the euro — individual eurozone members must be willing to give up some degree of control of their national budgets to a central European authority.

A world in chaos? That may be a good thing.

The European sovereign debt crisis has proved that it is difficult, if not impossible, to have a monetary union without a fiscal union. The founders of the euro chose to put in place rules to limit members from engaging in profligate spending, as opposed to centralizing fiscal policy, because it was politically expedient. Those rules proved to be totally ineffective in controlling member behavior. The main fiscal rule that limited members from running budget deficits equivalent to no more than 3% of their GDP was broken by almost all members at some point in the last 10 years, including Germany.

Greek fix?

Last week, a leaked draft German government document proposed that an EU commission be formed to oversee Greece’s fiscal decisions as a precondition to receiving their second 130 billion euro bailout. The commission would basically take over Greek fiscal policy to ensure that the nation stays within the bounds of its prescribed budgetary agreements made with the eurozone. It was the first test of a true fiscal union.

The Greeks went ballistic. The Greek education minister called the document “sick,” while another said it was an unacceptable attack on the nation’s sovereignty. But what the German draft document implies is the beginning of a true fiscal union. Greece felt insulted because it was singled out. For this to work, all the members must be willing to submit their budgets to a central authority with the power to basically say “no, you can’t afford that.” This loss of sovereignty should be expected once a government turns over its monetary policy over to a central authority.

For now, the Europeans have moved collectively to form a pan-European fiscal pact over a true union. This pact would force governments to pay fines to the EU if they exceeded certain debt limits. The European Court of Justice would be put in charge of overseeing the rules.

The pact doesn’t seem strong enough to stabilize the euro crisis. For starters, the legality of the pact is in question as it calls on existing EU institutions to sanction members, something that most EU scholars believe would eventually require a treaty change by all 27 members of the EU, not just the 17 members of the eurozone.

Great Britain vetoed a treaty change in December, so it may be best for just the eurozone members to get together and create a whole new institution to enforce a true fiscal union. A fiscal pact that moves to cap spending based on some arbitrary number won’t cut it, either. Tax and spending decisions should ultimately be harmonized to ensure proper redistribution of resources. That would ensure that the entire eurozone economy moves together as one cohesive unit. This would then allow the ECB, the eurozone’s centralized monetary institution, to set interest rates that would be in the best interest of all members.

For now, European leaders don’t seem to have the political will to make such a bold move. Giving up budgetary control would be a major surrender of power for member states, which may be too much to ask at this early stage in the euro’s history. It may take decades before Europe is ready to take such a leap forward in its integration. But without a true fiscal union soon, the euro may not outlive the time it takes the politicians get their act together.