After two years of doing nothing but talking, the European Central Bank actually increased interest rates by a quarter of a percentage point last week, warning that rising energy prices had raised the threat of inflation. Virtually every politician, business executive and commentator on the continent quickly denounced the move, saying it risked snuffing out what passes for an European economic expansion just as one was getting started.

In truth, both sides are right, which is a pretty good sign that Europe has worked itself into a situation in which there is no correct European monetary policy because, in truth, the "European economy" does not exist.

The problem with having one European currency, and one central bank, is that at any time, economic growth and inflation can be quite different in different regions. As a result, the tight monetary policy you might want in a place like Spain -- which is going gangbusters, thanks in part to a housing bubble -- can be quite unhelpful in a place like Germany, where unemployment is high, consumer spending flat and house prices stable. The compromise -- setting rates somewhere in between -- satisfies no one.

Europe expected to avoid this trap by integrating its economy at the same time it was introducing the euro. If Spain's economy was suffering from too much money chasing too few goods and workers, and Germany's from just the opposite, then an integrated market would quickly move things around so supply and demand came in balance everywhere. That's pretty much what happens here in the United States: When California booms, unemployed workers move in from Missouri while companies shift some activities to Missouri, where costs are lower.

But as it turns out, economic integration in Europe never happened, so the smoothing out never happens, either. While a single market exists for goods like cars or washing machines, the flow of workers, capital and services has been restricted by regulatory or cultural impediments. The result, explains Ted Truman of the Institute for International Economics, is somewhat akin to Europe putting itself back on the gold standard.

A second problem for the ECB is that even when it changes monetary policy, it doesn't have nearly as much impact as a Fed move in the United States.

These days, when U.S. interest rates fall, homeowners rush to refinance their mortgages, freeing up money that they spend lustily, generating jobs for workers and profits for shareholders. Lower rates also tend to increase prices for other assets, like stocks, which are widely held by Americans, many of whom respond to their increased wealth by spending more.

In Europe, however, mortgages can't be refinanced, so any change in rates affects only people who happen to be buying a house at that moment. Government regulations in most countries don't allow refinancing. And refinancing also requires a deep secondary market on which mortgages and mortgage derivatives can be traded. In Europe, this market doesn't exist.

Nor, for that matter, do large number of Europeans own stocks, preferring to put their savings in a banking system that remains fragmented and inefficient. Cross-border mergers are rare, in large part because regulators and politicians don't want their banks being bought up. And in many countries, bank loans are often made with an eye toward preserving jobs and boosting the provincial or national economy. As a result, the system misallocates capital while producing miserable returns for savers.

In fact, the absence of integrated, deregulated capital markets may be Europe's most pressing economic problem. Without a mechanism to attract savings from around the world and invest it in European companies that will put it to the highest and best use, European businesses don't just miss out on a steady source of risk capital. As important, they miss out on the harsh but effective discipline of financial markets that weed out weak companies and managers while turbo-charging those with the greatest chance of success.

European leaders had hoped to revive their economy while avoiding this "Anglo-Saxon model," with its rapacious hedge funds and hostile takeovers. Instead, they envisioned a government-driven reform, focusing on gradual liberalization of labor and product markets.

What they have discovered, according to Nicolas Veron, a research scholar at Bruegel, a Brussels think tank, is that democratic governments can't be the driving force in creating vibrant markets. There are simply too many entrenched interests able to use the political system to stymie integration, restrain competition, and punish companies that lay off workers or sell out to foreigners. Without the relentless push of financial markets demanding greater profits and efficiency, says Veron, Europe will be unable to reform its economy or pull itself out of its slow-growth rut.

Steven Pearlstein can be reached at