By Shriti Vadera, contributor

FORTUNE — The bailout agreement reached this summer to stop Europe’s downward spiral did not even buy time for its sacrosanct August holidays. Within two weeks of the pact, a reluctant European Central Bank was forced to step into the breach and buy Italian and Spanish bonds to counter the market’s assault. Leaders had agreed that Europe’s bailout fund could buy sovereign bonds in such a situation, but the deal has not yet been ratified by national legislatures, and in any case the bailout fund doesn’t have sufficient resources for the job. Inevitably, the focus turns to the country next on the firing line: France, the eurozone’s second-largest economy. You can expect the period ahead to oscillate between stagnation and the specter of chaos.

What has been lacking so far: action that’s a step ahead of the markets. Each European sovereign crisis has had a drawn-out run-up. Time has been wasted defending the indefensible before giving in to the inevitable. In these periods, yields for the majority of European government bonds have increased dramatically without being fully restored after a bailout. That increases the cost of borrowing. Solutions that might have worked a few months earlier become insufficient as the contagion hits more countries. As a consequence, a wider, more expensive response is required.

German Chancellor Angela Merkel prides herself on not making decisions until the last moment. That can reduce the political cost, largely because more time allows the public to understand the implications of inaction. In markets the opposite is true. One small positive: There are lessons from the past three years for governments handling a financial crisis — act quickly, overshoot market expectations, cover all foreseeable avenues of vulnerability, and don’t disagree with one another in public. In rare instances politicians have managed that — for example, Britain’s bank recapitalization plan in October 2008, rapidly followed by Europe’s and America’s.

Judging the latest — but not the last — European bailout package by those standards is bound to disappoint. The agreement fails even in the narrow objective of dealing with Greece, which is required to deliver an improbable austerity program while its debt, despite a restructuring, remains unaffordable (see “Will Europe Come Tumbling Down?“). That’s because European leaders allowed bank creditors to dictate their own terms. Three years after the financial crisis, the banking tail is still wagging the sovereign dog.

Europe cannot continue muddling through with stopgap measures, lurching from one crisis to another. The weaker European governments need belatedly, but definitively, to undertake wide reforms to liberalize their inflexible economies. The stronger countries — Germany, Finland, and the Netherlands — need to ensure that their citizens understand that they gain from belonging to the eurozone, and need to be prepared to put their balance sheets to work for a true economic union.

They have already taken covert steps to a “fiscal transfer union,” dreaded by the Germans, who believe their taxpayers will subsidize everybody else. The European Central Bank and the bailout fund can buy sovereign bonds in the secondary market, implying shared European risk.

Making these commitments overt and credible would allow Europe to focus on its real underlying problem — lack of growth. Without that clarity, the eurozone is running out of lives.

–Baroness Shriti Vadera runs a London consultancy. She was a minister in the British government from 2007 to 2009 during the financial crisis and, prior to that, on the British Treasury’s Council of Economic Advisers and a UBS Warburg banker.

This article is from the September 5, 2011 issue of Fortune.