FORTUNE -- Pundits and politicians are blaming the euro's crisis on profligate nations that violated the budget rules designed as a pillar of the single currency. If Spain, Italy and Greece could shrink their yawning budget deficits and halt the rise in their mountainous debt, the experts argue, prosperity would return to the eurozone. Hence, the proposed solutions are all about "fiscal integration," imposing new regulations that would give the European Union broad authority to impose spending and borrowing limits in the member states -- with penalties so strict that no eurozone member could stray.
That's the basis of the blueprint negotiated at a December summit between German Chancellor Merkel and French President Sarkozy. On Monday, the two leaders met in Berlin to renew their pledge to present a "fiscal compact" for the 17 eurozone countries, promising a new set of stiff rules and penalties by March 1.
Their master plan won't work. Europe's principal problem isn't the size of its members' debt and deficits. In fact, the eurozone's debt to GDP ratio now stands at less than 90%, a big number, but well below the U.S. level of 100%, not to mention Japan's 227% ratio.
The real rub is growth: The weak eurozone nations can barely grow as long as they remain in harnessed to the euro. As a result, an Italy or Greece can't generate the tax revenues to shrink those deficits, or lower their debt burden, nor can they generate the exports needed to create new jobs. In other words, the fiscal burdens that a "growth" nation such as the U.S. can handle prove insurmountable for countries that can't grow.
Competition at the core
Why can't Europe's weaklings grow? The reason is basic: Their economies are uncompetitive on world markets so long as they're stuck with an extremely over-valued currency that they and their powerful northern neighbors seem determined to preserve. The easiest way to understand why the euro isn't working is to ask what would happen if the ailing nations restored their own currencies, so that their value was established by the market, instead of imposed upon them.
Europe's ticking time bomb: Credit default swaps
If the world's consumers and investors voted with their dollars and yen for Greek or Italian products and plants, a new Drachma or Lira would be worth perhaps 30% less than the current euro. Conclusion: By shunning their goods at these prices, the global market is telling us that the stricken countries' currencies are overvalued by more than 40%.
A Greece, Portugal, or Spain simply can't compete, or grow, with that handicap. A "fiscal compact" will not change the market's verdict.
What's pummeling weaklings is a wonkish but crucial number called "unit labor costs." It refers to the labor cost of making one car, PC or backhoe. (Labor typically accounts for 70% of total expense.) Let's say it takes three workers an hour to make a widget in Spain, and two workers can do the same job in Germany, meaning that the German economy is a lot more productive. Nevertheless, the Spanish workers earn 90% of German wages. The Spanish widget is going to cost at least 25% more than the German model.
Spain can still sell its widgets abroad, but only if its currency declines versus the German money to the point where its wages are lower than German wages. That adjustment process was constantly happening in the pre-euro days. Now, it can't happen.
To understand how the crisis struck so unexpectedly, let's briefly examine the euro's savior-to-spoiler history. It was the euro's influence that caused unit labor costs in the strong vs weak economies to diverge far faster than they did in the pre-euro days, and that simultaneously eliminated the crucial shock absorber that allowed an Italy or Greece to keep growing in the past.
The weak get weaker
To simplify, we'll divide the eurozone into the two parts, the "core" stronger economies, chiefly Germany, the Netherlands and Austria, and the "southern" zone of Italy, Spain, Greece and Portugal, and one ailing nation that doesn't belong geographically, Ireland. Even before the euro was introduced on January 1, 1999, interest rates were falling sharply in for the southern countries. By the mid-2000s, consumers and governments were borrowing at less than 5%, compared to 12% a decade earlier. Credit exploded, and the easy money flowed mainly into industries that don't face foreign competition, what economists call the "non-traded sector," encompassing everything from real estate to insurance to landscaping and hair care.
As a result, wages and prices in those strictly domestic industries soared. From the late 1990s to the late 2000s, prices rose an average of 1.5% faster in the southern countries than in the Germany and rest of the core.
Why can't Europeans get along?
"The single monetary policy was too loose for the weaker countries, and too tight for Germany and the northern nations," says Uri Dadush, an economist at the Carnegie Endowment in Washington, DC. The easy money allowed both consumers and governments in the southern nations to borrow at rates far lower than the pace of inflation inside their borders, encouraging both to pile on huge debt, chiefly from abroad.
The march of wages was another daunting problem. The boom in the non-traded sector caused a tight labor market, and drove up pay for exporters who had to compete with the construction industry for workers. It didn't help that, with the exception of Ireland, the weaker countries did nothing to tame their extremely inflexible labor markets. The laws in those countries are virtually designed to raise wages faster than productivity growth. The combination of rigid labor laws and the explosion in domestic demand caused wages in the southern zone to jump 5.9% a year for the decade ending in 2007, 2.7 points faster than in core Europe.
The southern zone's growth spurt was ephemeral. The blanket monetary policy had precisely the reverse effect on redoubtable Germany, where rates were too high, restraining growth. German wages didn't see nearly the increases that Greece or Spain experienced. That brings us back to unit labor costs. From 2000 to 2010, they rose 36% in Greece, 31% in Italy and Spain, and 29% in Ireland. For Germany, the figure was 4%. So Germany and the other core countries gained an enormous competitive edge while the south lived on borrowing, as did the U.S. and China, which also benefited from a fall in the dollar and yuan versus the euro.
Following Ireland's lead
That's only half the story. German, Chinese and American imports became far cheaper than domestically produced goods that Italians and Spaniards used to buy. A flood of cheap imports replaced goods that Spain or Italy used to make at home.
How low will the euro go?
When the domestic bubbles popped in the southern tier, their nations couldn't increase exports to restore growth, and their domestic industries frequently couldn't compete with imports. Their products were simply too expensive both on world markets, and in their own shops and supermarkets.
The southern tier is doing its part to restore a bit of competitiveness. The sharp increase in rates for Spain, Italy and Greece has finally moderated the rise in wages, so that the unit labor cost gap is no longer growing. But wage growth isn't shrinking remotely fast enough to restore anything resembling the countries' pre-euro growth rates.
The southern countries are in a box. They have only two options to lower their unit labor costs to the level where they can compete on the world stage: They must substantially lower wages, or they must become far more productive by selling off inefficient, state-controlled companies and eliminating restrictive labor laws and a maze of anti-competitive regulations.
So far, Ireland is the only nation that has pursued that painful course. Greece, Spain and Italy show little inclination to follow. Their failure to enact draconian reforms doesn't necessarily spell the end to the euro.
"I'm very hesitant to say that leaving the euro is inevitable for the weaker countries," says Dadush. "They can stay in with a combination of debt relief and grants from the richer countries." That course, however, sentences Spain, Italy and the others to a future of extremely slow growth.
The alternative is to restore their own currencies, default on a big portion of their debt, and then grow far faster. The euro has failed. The best option is for all eurozone members to radically deregulate their markets, and also enjoy the flexibility of their own currencies. Unless they do the former, they will never become vibrant economies. But if they do the latter, at least they can grow again.
If the eurozone stays together, the crisis won't end. It will drag on a lot longer, burdening the world economy with years of uncertainty. It may be best to take the pain now. Faced with grinding, stagnant future, unable to export or grow, the weaklings may eventually warm to the solution they now brand as unthinkable, an exit from a union that just three years ago looked like their salvation.
Shawn Tully has been writing feature stories for Fortune since 1980. He's covered stories as varied as the Vatican's finances, the exile of fugitive commodities trader Marc Rich, and the disastrous merger between Guidant and Boston Scientific. He specializes in banking, federal budget and spending issues, and health care. Tully holds a B.A. in English from Princeton University, an M.B.A. from the University of Chicago, and a master's in Applied Economics from the Universite Catholique de Louvain in Belgium.
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