Markets so far have shown a mixed response to Europe’s agreement on sovereign debt. That is reasonable. On the positive side, Germany, France, European banks, and other members of the eurozone have shown more direction, control, cooperation, and concerted action than previously, and in so doing, have taken a step to avoid panic and what could easily have become a global financial meltdown. But still, Europe and, consequently, the rest of the world remain far from out of the woods. This latest step is inadequate. To get a grip on the crisis, the European Central Bank (ECB) will need to add its substantial financial resources to those now on offer from the various finance ministries. More fundamentally, Europe will also eventually have to deal with the structural imbalances built into the euro. Still, with this latest action, the European Union (EU) has bought time for the world’s financial markets.

It surely understates to characterize Europe’s plans as complex. Private lenders, mostly European banks, have agreed to write down their Greek debt to 50% of its face value. Although some 40% of Greece’s €350 billion in public debt is held by the International Monetary Fund (IMF), which refuses to accept any losses, the write down on the remaining €210 billion in private hands will, the negotiators estimate, bring Greece’s outstanding public debt down to some 120% of that country’s gross domestic product (GDP) by 2020. Relieving immediate strains, the agreement should enable Greece to borrow an additional €30 billion for needed financing from what the communiqué refers to as “official funding,” presumably Europe’s newly enlarged bailout fund, referred to officially as the European Financial Stability Facility (EFSF).

Plans also aim to guard against a spreading contagion of fear by levering up the existing €440 billion in the EFSF to as much as €1.0 trillion. Since some €150 billion in the original fund has already gone to Greece, Ireland, and Portugal, the remaining balance will have to lever up four times or more to reach the €1.0 trillion goal. It is not apparent from where all the additional funds will come. Negotiators have spoken of contributions from cash-rich nations such as China and Brazil. Though it may seem dubious that China and other nations would buy into the fund, it would at least give them a way to support global markets with a general European credit instead of more questionable Greek, Spanish, or Italian credits. Greece has also pledged €15 billion for the fund on top of the €50 billion it already plans to raise from privatizations. But since Greece is already falling short on the original privatization plan, it is not apparent that it will make the contribution. It is a small part of the picture, anyway.

According to the agreement, this enlarged EFSF would support markets in three ways. One, it could buy the debt of distressed countries directly in secondary markets, as the ECB has done separately in recent weeks. Second, the facility could guarantee a buyer’s initial losses up to, say, 20%. Though the fund would only provide a partial guarantee, such help presumably would permit the periphery to borrow at a lower net cost than otherwise. Third, the facility may play a part in recapitalizing Europe’s banks. The plan calls for the banks to raise an additional €100 billion or more of Tier 1 capital by June 2012. Though most of the banks say that they can meet the goal through retained earnings, the European negotiators have spoken about the EFSF guaranteeing medium- and long-term bank debt and of nations borrowing from the fund to help their domestic banks raise the needed capital.

Clearly, Europe’s latest solution remains vague, susceptible in some ways to the classic characterization, “blue smoke and mirrors.” Even so, it has value on two counts. First, it shows a renewed commitment from the eurozone nations to overcome their national differences and create a European solution. Second, by relieving the most immediate pressure surrounding Greek debt and default, it buys time to improve arrangements and find other sources of relief. Key to this next step is the ECB.

So far in these troubles, the ECB has itself held largely aloof. Its leadership has claimed that it would exceed its mandate to do for Europe what the Federal Reserve did in the United States during the subprime crisis. But the need for the ECB’s tremendous potential liquidity is obvious. Even if the EU succeeds in leveraging the EFSF as planned, and there is room for doubt on this front, the extent of Europe’s problems, especially questions about the larger economies of Spain and Italy, still loom unmanageably large. And whatever the legal and political reservations among ECB leaders, the pressure to take part in the rescue will likely ultimately force a more active role. Indeed, it already has. For some weeks now, the bank has sought to stabilize conditions by actively purchasing Spanish and Italian bonds in the secondary market. If Europe’s new plan restores confidence, the need for the ECB’s contribution will diminish. But since chances are that present arrangements will fall short of that goal, the ECB will likely have to take on that more active role.

Even with full-fledged support from the ECB, Europe would still need to find a way to remedy the currency issues underlying today’s financial strains. These lie in the euro itself. Not only does the common currency continue to block the ability of any weaker country to ease its debt problems through devaluation but also its basic structure will continue to put the periphery at an economic and financial disadvantage to Germany.

Because the exchange rates at which each nation joined the euro differed from their respective economic fundamentals, the whole structure of the common currency was skewed against the periphery at its start. Germany exchanged its deutschemarks for euros at a remarkably low rate relative to its productivity and profitability fundamentals. In that rate, German producers found great pricing advantages over their competition elsewhere in the currency union. Greece and much of the rest of Europe’s periphery exchanged their national currencies for euros at much richer rates than their economic fundamentals could justify, making them natural consumers of those attractively priced German products. Still more, the low exchange rate of Germany’s entry understated German incomes in Europe, creating a feeling of austerity that encouraged people there to save and to cooperate with cost containment efforts. Because the periphery’s initial rich exchanges inflated the euro buying power of its populations, these counties had a false feeling of wealth that encouraged spending, borrowing, and an easy attitude toward public benefits.

Precise estimates of these relative advantages and disadvantages are elusive. The IMF does, however, offer a gauge of sorts in its regular comparisons of existing, now fixed exchange rates and the rate that would equalize the costs of tradable goods in different countries, what economists call purchasing power parity (PPP). When an exchange rate rises above the PPP rate, the country’s consumers command an artificially high buying power, and the economy’s tradable goods become more expensive than foreign goods. When the exchange rate falls below the PPP rate, the opposite is true. These IMF data show that Greece, Spain, and Ireland made their conversion to the euro some 6.0% higher than Germany did.

The differences then grew wider over time. High levels of German sales and savings improved that economy’s competitive fundamentals. Because euro valuations in the periphery discouraged savings and encouraged importing, these countries neglected their productive, competitive sides, making the original high rate at which they joined the euro less and less realistic. By 2009, just before the crisis broke, IMF figures show that Greece’s pricing relative to PPP had deteriorated to 12% above Germany’s, Spain’s to more than 20%, and Ireland’s to fully 32%.

If these countries had separate currencies, they would have a reasonably straightforward way out of today’s problems. Market pressures would push the (former) Greek drachma down into line with that country’s economic fundamentals, lowering the prices of Greek exports and raising those of the German competition, at least to Greeks. Germans, then, at the margin, would buy less at home and more from Greece. Greeks would buy more at home and less from Germany. The implied upward valuation of the deutschmark would raise the buying power of German incomes, raising German inclinations to borrow and spend, while the devalued drachma would have the opposite effect on Greeks. The patterns that have created the crisis would go in reverse and restore a better, if not a perfect balance.

But a single currency renders such adjustments impossible. Unless the euro dissolves, Europe’s only ultimate solution, even with a fully leveraged EFSF and strenuous ECB efforts, clearly involves a long painful adjustment in the relative economic fundamentals of its periphery. Greeks, Irish, Italians, Portuguese, and Spaniards have to restrain their economies long enough to create outright deflation, as Ireland is already suffering, or at least to hold wage and price inflation below that experienced in Germany and in other stronger economies in the union. In time, and sadly with a great deal of unemployment in the periphery and wealth destruction generally, relative changes in pricing and incomes would achieve the same result as revaluations and devaluations. It is an ugly prospect, for these weaker economies especially. But even with the best of rescue efforts, it is the bed Europe has made for itself.

Milton Ezrati, Partner and Senior Economist and Market Strategist, has been widely published in a wide variety of magazines, scholarly journals, and newspapers, including The New York Times, Financial Times, The Wall Street Journal, The Christian Science Monitor, and Foreign Affairs, on a broad spectrum of investment management topics. Prior to joining Lord Abbett, Mr. Ezrati was Senior Vice President and head of investing in the Americas for Nomura Asset Management, where he helped direct investment strategies for both equity and fixed-income investment management.

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