The strategy of muddling through has failed, no matter what Europe's leaders say, writes ARTHUR BEESLEY,European Correspondent in Brussels

EUROPE’S GRUELLING debt emergency is into a dangerous new phase. A “Big Bang” solution to the turmoil is as elusive as ever as anxiety intensifies about the fate of Italy and Spain. But what might the endgame involve?

There are no easy answers. If the firefight to save Greece is stretching EU leaders to the limits of their endurance, big compromises will be required to achieve a final settlement of the wider debacle.

These are fraught with risk – political and financial – but the intensity of the crisis right now suggests that a critical moment is not far away. No matter what Europe’s leaders say, the strategy of muddling through has failed.

In reality there are two inter-related crises: deficits and debt. The solution to the former lies in the continuation of bruising austerity measures throughout Europe, difficult as that is. Fixing the debt crux is immensely more complex, and has a big bearing on deficits in view of the interest payment required to sustain large borrowings.

To find a way out of the mire, EU leaders will have to tackle prickly questions they have been desperate to avoid in the 21 months since Greece admitted lying about its feeble public finances.

To most observers the solution centres on their willingness to contemplate sovereign debt default, deeper upfront support for the rescue effort and the eventual issuance of Eurobonds, as debt with a common euro zone guarantee would be known.

Each one of these notions is anathema to one or more protagonists in the saga, meaning yet more political tension is in store. The extent to which each idea is developed will determine the extent to which the others are deployed or not. The puzzle is akin to a Rubik’s Cube: to move one part is to move them all.

Debt default is deeply contentious because of the consequent risk of contagion. While the conviction that Greece’s debt is unsustainable is gathering force, the European Central Bank sticks rigidly to the position that to trigger any form of default is to invite trouble. The EU Commission’s stance is similar to the ECB’s.

However, acute pressure is building in Germany, the Netherlands and elsewhere for measures to reduce the weight of Greece’s debt. The argument goes that it is futile to continue lending to a country which cannot repay its debts. Nevertheless, the stance of these prosperous countries is mainly grounded in political resistance to taxpayer-backed bailouts for errant neighbours.

Private sector involvement in the second Greek bailout is all but inevitable now – to an unspecified degree – even though it is one of the prime forces behind the current wave of turmoil.

A further factor here is the (perfectly reasonable) demand that private creditors face the consequences of their poor investment decisions.

That raises the prospect of unexpected bank losses, which may need to be made up by taxpayer-funded recapitalisations. Thus the heavy exposure of French banks to Greece helps explain why a French plan for private investor involvement in the Greek rescue is less severe on investors than its German counterpart. German institutions have gradually reduced their exposure to Greece.

Other ideas are quietly under discussion in the background.

One proposal would see the creation of a special purpose vehicle – operating in the long-term under the aegis of Europe’s bailout fund – to retire existing Greek debt in exchange for new bonds of lesser value. Such measures could, in theory, be used to reduce the burden of Ireland’s bank debt, but it is far from clear whether the wider plan is a runner.

After all, the fund’s euro zone backers would be on the hook for the losses it incurred in the process of retiring existing debt. This would make it difficult to achieve political approval for the increased financial support necessary to go down that road. Parliamentary approval in euro zone countries would also be needed to widen the fund’s remit. Don’t hold your breath.

Then there is the question of the fund’s size. Together with the IMF, the European Financial Stability Facility has a lending capacity of some €750 billion. That’s rather large, but the fund would reach its capacity if required to bail out Spain and would not be big enough to prop up Italy.

Although there is some talk of doubling its lending capacity to €1.5 trillion, that also raises tricky political questions for wealthy countries. The sense already is that Germany is rapidly running out of political leeway.

It is for this reason the introduction of Eurobonds remains a distant prospect. The beauty of the idea is that even the weakest euro zone members would benefit when borrowing from the superior firepower of strong countries such as Germany and France.

That, however, would raise the level of risk attached to the debt of strong countries, increasing their borrowing costs. This remains a big no-no for Germany.

Still, the argument goes that Eurobonds may yet be the price of preventing full-blown crisis from taking hold in the core of the euro zone as it spreads from the periphery. If Spain and Italy are each “too big to fail” and simultaneously “too big to save”, then increased pressure on those countries carries grave new risks for euro zone leaders.

They have resolved that there will be no break-up of the euro, something that carries potential for chaos. But they have yet to produce a solution which ensures it sticks together.