The plan offered by Jean-Claude Trichet, who stepped down in November 2011 as ECB president, would address a fundamental weakness of the 13-year-old single currency, the survival of which is threatened by the Greek crisis.
The monetary union has always defied economic principles, because the euro was launched ahead of European fiscal or political union. This has caused strains for countries running huge budget deficits - namely Greece, Portugal, Ireland, Spain and Italy - that have led to financing difficulties and over-stretched banking systems.
For the European Union, a fully fledged United States of Europe where nation states cede a large chunk of fiscal authority to the federal government appears politically unpalatable, Trichet said.
An alternative is to activate the EU federal powers only in exceptional circumstances when a country's budgetary policies threaten the broader monetary union, he said.
"Federation by exception seems to me not only necessary to make sure we have a solid Economic and Monetary Union, but it might also fit with the very nature of Europe in the long run. I don't think we will have a big [centralised] EU budget," Trichet said in a speech before the Peterson Institute of International Economics in Washington.
"It is a quantum leap of governance, which I trust is necessary for the next step of European integration," he said.
Obama will press Europeans
His proposal was presented in Washington on the eve of the G8 meeting of the world's major economies, hosted by US President Barack Obama who will press Europe to intensify its efforts to resolve the sovereign debt crisis, which threatens a fragile global recovery.
It also comes ahead of a critical meeting of EU leaders on 23 May to discuss ways to support growth. Its strict budgetary policies to date have led to recessions in many countries, political unrest and in Greece a political stalemate after recent elections.
Trichet said the building blocks already are in place for moving ahead with his fiscal plan.
Countries have agreed to surveillance of each other's budgets and they have agreed to levy fines on countries that run excessive budget deficits, giving them fiscal oversight authority.
The next step would be to take a country into receivership when its political leaders or its parliament cannot implement sound budgetary policies approved by the EU. The action would have democratic accountability if it were approved by the European Council of EU heads of states and the elected European Parliament, he said.
The idea earned a warm reception from leading economists and prominent Europeans attending the session.
"It is a very radical proposal, couched as a modest step," said Richard Cooper, international economist at Harvard.
Caio Koch Weser, former German economics minister, said he found it "very attractive" because it addresses the problem of a strong European Central Bank, a weak European Commission which acts as the EU's executive branch, and a confused European Council, which provides political leadership.