Quite aside from how the Greeks vote or not, Europe's recent agreement, though it will help the debt situation, remains entirely inadequate.

Even if the Greeks abide by their agreements and all of the still-vague elements of this recent plan work out as well as the French, Germans and other nations of the European Union (EU) hope, the problem goes far beyond Greece. The situation will ultimately demand additional financial resources that only the European Central Bank (ECB) can provide. And even if the ECB steps up, Europe must also address the underlying imbalances in the common currency that so contributed to today's financial tensions. Without action on this basic issue, problems will only recur, even if this latest remedies work out better than anyone expects.

This latest European plan is 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 euros in public debt is held by the International Monetary Fund (IMF), which refuses to accept any losses, the writedown on the remaining 210 billion euros in private hands will bring Greece's outstanding public debt down to an estimated 120% of that country's gross domestic product (GDP) by 2020. Furthermore, the agreement should enable Greece to borrow an additional 30 billion euros for needed financing from what is presumably Europe's newly enlarged bailout fund, known 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 euros in the EFSF to some 1.0 trillion euros. Since some 150 billion euros 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 trillion euros goal.

It is not apparent from where all the additional funds will come. Negotiators have spoken of 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 European and therefore global markets with a general European credit instead of more questionable Greek, Spanish, or Italian credits. Greece has also pledged 15 billion euros for the fund on top of the 50 billion euros 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.

This enlarged EFSF would support markets in three ways. One, it could buy the debt of distressed countries directly in secondary markets, as the European Central Bank (ECB) has done separately. Second, the facility could guarantee a buyer's initial losses up to, say, 20%. Though this 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 euros or more of Tier 1 capital by June 2012. Though most of the banks say that they can meet the goal by retaining 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 solution remains vague. 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 European Central Bank.

The ECB is essential because the problem is so much bigger than Greece. Actually, if Greece were all there was, the EU could manage matters easily. Total Greek public debt amounts only to a small 1.1% of the 31.7 trillion euros in assets held by euro area financial institutions. But Ireland is still running budget deficits even greater than Greece, in excess of 10% of GDP, in fact, and carries an outstanding debt burden of over 100% of GDP. Portugal projects deficits at over 6% of GDP and also reports an outstanding debt overhang at over 100% of GDP. Though Italy has deficits of only about 4% of GDP, its outstanding public debt approaches 120% of its GDP.

Similar problems are evident in Spain and Belgium. Rating agencies have downgraded many of these countries and put others on watch lists, while markets already have bid up rates on the debt of all these nations, squeezing their finances still more severely.

Though only the ECB has the financial wherewithal to deal with this broader need, 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 its tremendous potential liquidity is obvious. Even if the EU succeeds in leveraging the EFSF as planned, the extent of Europe's questionable debt, especially regarding the larger economies of Spain and Italy, dwarfs the resources of its stronger finance ministries.

The pressure to take part in the rescue will likely ultimately force a more active role. Indeed, it already has. For some time 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 up that more active role. Even if the EU and the ECB could devise a solution, Europe would still face problems due to the structure of the euro. When Greece and much of the rest of Europe's periphery joined the euro, they exchanged their national currencies at higher rates than their economic fundamentals of productivity and profitability could justify.

In contrast, when Germany joined, it made the exchange at a much lower rate than its economic fundamentals demanded. Right from the start, the common currency gave German producers a sales advantage. Its low rate of entry understated German incomes in Europe and created a feeling of austerity that encouraged saving. The periphery's initial rich exchanges imposed a pricing disadvantage on their producers and inflated their populations' buying power in euros, giving these nations a false sense of wealth that encouraged borrowing, spending, and an easy attitude toward public benefits.

Precision in measuring such differences is problematic. But, the IMF does offer a crude gauge in its regular calculation of the difference between existing exchange rates and the rate that would equalize the costs of tradable goods in different countries—purchasing power parity (PPP). When an exchange rate rises above PPP, the nation's consumers command an artificially high buying power and the economy's tradable goods become more expensive. When the exchange rate falls below PPP, the opposite is true. These IMF data show that Greece, Spain, and Ireland made their conversion to the euro some 6% higher than Germany did—a significant difference right from the start.

Matters only got worse. The situation encouraged German exports and savings, so Germany tended to improve its competitiveness over the years, rendering the original rate at which it joined still more advantageous to its exports. In contrast, the lack of savings incentives in the nations of Europe's periphery and their dependence on imports caused them to neglect their productive sides, inducing further deterioration in their competitive abilities and making the original high rate at which they joined the euro even less realistic. By 2009, 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%.

Other factors have influenced comparisons. Germany faced much more direct pressure from Eastern and Central Europe than did other countries. That imposed an economic discipline beyond those implicit in exchange considerations. No doubt, pre-existing industrial infrastructures in Germany and the lack in the periphery factored into the equation as well. Cultural differences are undeniable, though much popular commentary has shamelessly exaggerated these into crass national stereotypes. If these countries had separate currencies, they would have a reasonably straightforward way out of today's problems. 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 solution, even with complete Greek cooperation, a fully leveraged EFSF, and strenuous ECB efforts, is 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 price and wage inflation below that in Germany and 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. Stronger countries, too, will suffer extending credit to bridge needs while the adjustments slowly unfold. But it is the bed Europe has made for itself.


Milton Ezrati is the senior economic strategist
at Lord Abbett and affiliate of the Center on Economic Growth
in the Department of Economics at The State University of New York at Buffalo.