Why Europe bungled another rescue

March 19, 2013, 5:56 PM UTC

FORTUNE — The botched bailout of Cyprus sheds light on more than just the difficulties Europeans face in collectively designing a complicated country rescue package. It also serves as a reminder of the mismatch between Europe’s multiple objectives and its more limited tools. And it illustrates why short-term tactical compromises are no substitute for proper, albeit much more difficult, strategic decision making.

After long and protracted negotiations, the Cypriot government and European officials announced early on Saturday an agreement only to see it attract immediate criticism. (see my column A Muddled and Risky Approach to Cyprus.) Within hours, outside questioning fueled contradictory finger pointing within the official community.

As the blame game expanded, virtually everyone involved in the design of the agreement scrambled to disown it. Cypriot citizens expressed outrage. Their government was forced to announce an extraordinary two-day closure of the domestic banking system. And both Cypriot and European officials are now back behind closed doors debating potential modifications.

It is easy to dismiss all this as idiosyncratic. After all, Cyprus is, to use descriptors favored by the official community, quite “unique” and “exceptional.”

Its banks had grown excessively and irresponsibly before getting whacked by serial defaults in Greece. They constitute an offshore center that some European officials feel should be regulated more tightly as it attracts funds from dubious sources. And the country has just gone through a change of government.

MORE: Why Cyprus matters to U.S. investors

Yet the focus on Cyprus’s peculiarities should not preclude us from discussing how this case sheds light on general ailments that continue to weaken Europe in the third year of its regional economic and financial crisis.

Under the current framework, European officials — be they creditors or debtors — still pursue too many objectives with too few instruments. Rather than alter the context by making painful but necessary strategic decisions, they naturally end up stumbling through a series of messy compromises. Often, and as illustrated most vividly in the last few days by the case of Cyprus, each compromise is deemed to make sense to some negotiating party or parties. It is even blessed by the IMF. In aggregate, however, they risk constituting an incoherent and unsustainable whole.

Here is the usual pattern:

  • Official creditors — led by European governments, the ECB, and the IMF — seek to contribute the smallest possible financing in return for maximum policy leverage. And their quest for conditionality reflects the distrust they have in debtor countries’ ability to sustain reform efforts within the established framework.
  • Official creditors are also hesitant to carry too much of the financing burden. They appropriately seek contributions from the private sector. While hoping for voluntary contributions, they know that a certain amount of coercion is likely to be needed (formally known as a bail-in or “PSI,” for private sector involvement).
  • On its part, the debtor country wishes to maximize external financial support in order to facilitate the implementation of reforms and minimize the burden borne by citizens and vested interests. It also struggles with the adverse impact that PSI could have on domestic confidence and the longer-term attractiveness for foreign investment.

These factors played out dramatically in Cyprus.

Official creditors imposed an overall limit on their financial contributions (EUR 10 billion) and shied away from highly concessional terms. They insisted that the residual (EUR 8 billion) should be covered through a combination of Cypriot efforts and PSI. They also wished to change what they perceived as Cyprus’s standing as a lax offshore banking center.

Cyprus felt constrained in what it could deliver in the short term. It agreed to PSI but found that there were not enough of the usual suspects (including junior bond holders).

MORE: Cyprus “crisis” may be short-lived

Cypriot and European officials opted to reconcile all this through the use of a levy on all bank accounts, including those previously covered by deposit guarantees. This unprecedented step, which impacted small savers as well as large foreign deposit holders, provoked a massive national outcry — risking political disorder and social unrest. It is also attracted widespread condemnation as it risks adverse international spillover effects by undermining the sanctity of deposit insurance schemes.

Officials have now been forced to go back to the drawing board in an attempt to come up with something more coherent. They do so under the glare of an increasingly mistrusting population, and with too few instruments to meet the multiple objectives.

Look for them to tweak the most outrageous aspects of Saturday’s Cyprus package. But do not expect them to resolve the underlying inconsistencies that have undermined the European policy response from day one. Left largely unattended, these inconsistencies continue to slowly eat away at the economic, financial, political, and social integrity of the European integration project.

In a perfect world, the bundled Cyprus rescue would bring European officials closer to making the strategic decisions needed to get ahead of the region’s crisis. But the strongest players, including Germany and the ECB, do not seem in a position as yet to make the biggest strategic call of all — either target a smaller and less imperfect eurozone, or agree to a very substantially larger and more permanent subsidization of the weaker members of the union.

European officials are likely to again opt for temporary tactical compromises. Yet in seeking fewer disruptions upfront, they end up complicating the implementation of the strategic decisions that will ultimately be forced on them by the painful logic of economic stagnation, political dysfunction, insufficient policy instruments, and a mistrusting population.

Mohamed El-Erian is the CEO and co-chief investment officer of PIMCO. He also heads the U.S. global development council.