Europe’s hard choices

Cyprus today still is in total shock due to disruptions caused by a banking system that grew irresponsibly large. Consumption and investment have collapsed. Companies and households cannot freely access their bank accounts. And the little flow of funds that is taking place is unidirectional — out of the country.

Many in Europe would like to characterize the situation in Cyprus as unique. Yet what is happening speaks to three broader dimensions of the European malaise that have yet to be addressed adequately.

Where will growth come from?

Cypriots will eventually need to confront the unpleasant reality that their country’s economy now lacks a growth model. For years Cyprus opted for growth based on providing financial services to foreigners via a large offshore financial center. In the process, it allowed its competitiveness to erode, harming agriculture, tourism, and light manufacturing.

It will now take years for Cyprus to develop alternative growth drivers, especially since it can’t devalue its currency to facilitate resource reallocation. This growth tragedy isn’t limited to Cyprus. Recessions and sluggish growth are spreading from the weaker peripheral countries within the eurozone to the powerhouses. And very few are coming up with coherent policies to promote high and sustainable growth.

Whose euro is it?

While financial stability does not guarantee higher growth, the return of instability would preclude it. Accordingly, it is worrisome that the “single currency” eurozone is now home to multiple euros.

Within Cyprus, there are two types: those held in cash and fully transactionable, and those paralyzed by deposit levies and freezes. There are also two types of euros within the eurozone as a whole: those stuck behind capital controls in Cyprus, and those circulating freely among the other 16 member countries.

The two-tiered system highlights the bigger issue of financial segmentation. It encourages capital flows that accentuate the region’s challenges: Oxygen gets sucked out of the weaker economies and poured into healthier ones that do not need it, and some capital leaves the eurozone altogether, mostly ending up in Switzerland and the U.S.

How does the eurozone go from defense to offense?

Growth and financial fragmentation challenges will intensify until Europeans make a strategic decision between a smaller and less imperfect eurozone — thus placing sensible economics above politics — or maintaining the current size and composition by having creditors commit upfront and unambiguously to many more years of large and highly concessional cross-subsidization.

So far, no European leader has been willing to make this decision. But in opting for the muddled middle, they are repeatedly pushed into urgent crisis management and, more generally, into playing defense with imperfect measures and inadequate teamwork.

As Europe reflects on the tragic case of Cyprus, it would be well advised to draw one critical lesson: The longer it defers difficult decisions and remains on an unstable path, the greater the risk of losing control. At that point, the choice between two unappealing alternatives would give way to even more disruptive and prolonged waves of economic, financial, political, and social instability.

–Mohamed A. El-Erian is CEO and co-chief investment officer of Pimco, a global investment management firm.

This story is from the April 29, 2013 issue of Fortune.

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