How a second euro could save Europe

FORTUNE -- The European sovereign debt crisis may be off the front pages while all eyes are on Egypt, but that doesn't mean its problems are any closer to being solved.

Indeed, it's tough to see how the euro will survive the next two years in its current form given the economic and political troubles plaguing some of its more vulnerable members. For now, there are many powerful constituents fighting to keep the union intact. Eventually, though, the euro zone will have to face the music and come up with some way to allow members to leave the common currency in an orderly fashion.

One method that seems to be gaining some steam would be an introduction of another currency to carefully allow for such a transition -- a possible second euro. Such a move would be controversial and time consuming, but could be the best solution to avoid a shock to the weak European banking sector, which holds most of the euro zone's troubled sovereign debt.

The total dissolution of the euro has been pondered ever since the European debt crisis flared up last spring. But instead of shrinking since then, the euro zone has actually expanded, welcoming its 17th member, Estonia, on January 1st. The European Central Bank has set up a contingency fund to allow members to borrow money to service their debt, equating to a backdoor bailout for many European banks holding the troubled bonds.

But the fund is largely seen as not being big enough to accommodate the coming need for cash from the euro zone's most vulnerable members. Greece's debts may be 140% of its GDP, but that equates to just 300 billion euros -- a relative drop in the bucket. Troubles in Spain or Italy, which have much larger economies and far bigger debts, could bring the system to its knees.

"I do not think the deal they are putting together now is going to last past the summer," says John Taylor, founder of the currency hedge fund FX Concepts, regarding the ECB's plan to strengthen its reserve fund.

Global support, but no solutions

The healthier members of the euro, namely Germany, have a strong incentive to keep the zone together, since it helps their exports find suitable markets. In addition, their banks are holding much of this debt and could find themselves in trouble if the weaker members start defaulting. That could set off a chain reaction, which could cripple the economies of the healthy members.

Even China is pushing for the euro to stay together. Stephen Jen, managing director of macroeconomics and currencies at BlueGold Capital Management, estimates that China has $800 billion held in euro-denominated assets. To protect their assets, he says, China is busy buying up European debt to prop up the euro's value. The euro is also a valuable tool for China in its ongoing battle with Washington over its weak exchange rate with the dollar.

But not even China can solve the euro zone's biggest troubles. Without a more cohesive political and fiscal union, the euro looks doomed. Forcing nations like Greece and Spain to adhere to massive austerity measures is bad enough, but the prospect of facing higher interest rates due to strong economic growth in the northern European countries will cripple their economies. These countries need expansionary fiscal and monetary policy to get back on track, something the northern European-controlled ECB frowns on given its fear of inflation.

"It is really sad to watch but I don't think the peripheral countries will make it," says Jen.

Wanted: An exit strategy

So how would one actually leave the euro? There are books written on what a country needs to do to join the common currency but not much written about how one actually leaves.

Greece is seen as the euro zone member most likely to depart first. But just pulling out would mean a massive devaluation of its debts all at once as its new currency hits the market. The ECB stability fund could cover the cascade of defaults to follow from a Greek pullout, but it could not absorb the defaults that would come its way if Spain or Italy needed to exit the common currency.

One potential solution would be another large common currency to support the transition from euro back to the national currency -- a second euro. By creating a system early for an orderly transition between the currencies, it could lessen the pain for the banks and the ECB. It would also prevent the euro from appreciating rapidly, which would hurt export-led economies like Germany's.

Countries with similar economic needs could band together and roll out this new currency, which would trade alongside the original euro for a set time period. Eventually, once those economies move closer in sync with the original euro nations, they could possibly transition back in to the zone. Jen likens the transition to the way the Hong Kong dollar currently circulates alongside the Chinese renminbi. Eventually the renminbi will displace the Hong Kong dollar over time, allowing for a smooth transition.

But it wouldn't be easy. Creating a second euro would require a monumental effort of strategic planning and cooperation among members -- a feat that some believe makes it dead on arrival.

"It's frankly delusional," says Constance Hunter, chief economist of Aladdin Capital Holdings. "I am skeptical about the ability to recreate all the institutions required to have a second euro given the environment needed to have a break up."

But the alternative seems an even harder pill to swallow. Hunter recognizes that the euro cannot last in its current form but believes that the ECB would do best to just bailout the banks and let the troubled members go on their merry way as fast as possible. But the European banks currently hold around half a trillion euros in sovereign debt from the region's troubled nations, which may be too much for the ECB to truly absorb even though the EFSF is supposed to be $750 billion euros. Eventually that cash will have to come from somewhere and it's still unclear who will fill this kitty.

A second euro could allow for an orderly transition and give the euro zone some time to catch its breath. A quickie divorce appears to be in no one's best interest, making a temporary split one of the best hopes to save this troubled marriage.