David Cameron flew back from Brussels to a hero's welcome from his Eurosceptic backbenchers and a storm of protest from his coalition partners, who believe that by thumping his metaphorical handbag on the table, he's set Britain on course for economic and political isolation. But while the UK is sucked into an existential debate about its role in the world, the question that really matters in the short term is whether this weekend's deal will safeguard the euro.

Unfortunately, despite the self-congratulatory rhetoric from Merkozy, the single currency is no more secure this week than it was at the end of the last make-or-break summit in October.

Rather than force Europe's clapped-out banks to face losses on the unrecoverable loans they made to Greece, Portugal and Ireland, eurozone governments have opted to concentrate on imposing forced deflation through drastic austerity measures.

The tighter tax-and-spending rules that will be enshrined in the new "fiscal compact" might help to prevent member countries from accumulating debts in future; but they do nothing to tackle the unpayable debts of yesterday, which are still hanging round the necks of Athens, Lisbon and Dublin.

Germany believes the only solution to the crisis is to force other countries to endure the kind of painful "internal devaluation" it has achieved over the past decade, through pay cuts and productivity improvements that have helped to make it more competitive without a currency devaluation.

But Germany had the benefit of industrial titans such as Volkswagen and Siemens; rampant growth in China and the US; and a credit-fuelled boom in its less wealthy neighbours. For countries without Germany's industrial clout, the consequences of imposing austerity in the teeth of recession can be devastating, as timely research from the Washington-based Centre for Economic Policy Research shows.

The CEPR has studied the case of Latvia, which received a €7.5bn bailout from the EU and the IMF at the height of the credit crisis in 2008. Latvia is regarded as a model pupil by its paymasters: it's not a euro member, but its currency, the lat, is pegged to the euro. Instead of trying to restore its competitiveness through a devaluation, it was encouraged to keep the peg in place and to impose stringent spending cuts and tax rises. Last week, it "graduated" from the bailout – apparently a success story for the tiny Baltic state.

But, as the CEPR argues, if this is success, it's terrifying to think what failure would look like. Despite the bailout, Latvia suffered the largest decline in economic output of anywhere in the world between 2007 and 2009 – a 24% drop in GDP. Unemployment quadrupled; and that doesn't include the estimated one in 10 of the workforce who left the country to look for a better life somewhere else.

Yet the same logic that drove Latvia's policies is now being doled out Europe-wide. Nothing in last week's summit addresses either the impossible debt burden that will hang around the necks of Greece, Portugal, Italy and Spain for many years, or the risk of a deep recession. Internal devaluation only works if there's someone to export to. If everyone's slashing and burning at once – and if, as many analysts now believe, China is heading for a hard landing – there is no buyer of last resort. As Paul Krugman has argued, "somehow southern Europe is supposed to deflate its way to prosperity, while everyone runs a trade surplus, presumably against that potentially habitable planet we've discovered 600 light years away."

There were some positive steps in the deal, including an agreement to channel €200bn to the IMF, which Europe's leaders hope will tempt emerging economies such as China to chip in too; but even combined with the €500bn European stability mechanism, that looks paltry when compared to Italy's €1.8tn debt.

At the heart of the problem is the failure to acknowledge that, as Sir Mervyn King has repeatedly argued, Europe's problem is not a short-term lack of liquidity, which could be solved by the kinds of emergency lending measures announced by ECB president Mario Draghi last week, but solvency.

And ironically, while Cameron was riding in to protect Britain's financial sector, eurozone leaders were also, in their own way, doing the bidding of the banks. One of the few battles Angela Merkel has lost over the past 12 months has been to force investors to bear some of the costs of rescuing Greece. "Private Sector Involvement", as it was euphemistically known, was one of Germany's key demands, and a rare concession to common sense amid the upside-down logic of euroland.

Unchecked by toothless regulators and set free by poorly drawn capital requirements, the banks rampaged across the continent, chucking cheap money at Greece and Italy, on the tacit assumption, now explicit, that if something went wrong, their richer friends in the eurozone would bail them out.

Merkel oversaw two sets of negotiations with Greek bondholders, in July and October, imposing progressively larger "haircuts" on the banks. But with the bond markets running scared, PSI has now been abandoned.

As Charles Wyplosz, of the Graduate Institute in Geneva put it last week, "it is a tragedy that, in Europe as in Japan 20 years ago, the bank lobbies have effectively captured their governments."

It's a sign of the times that experts at Jubilee Debt Campaign, who have spent more than a decade exposing the devastating impact of unpayable debts on some of the world's poorest countries, have begun calling for debt relief at the heart of Europe. Without it, Europe faces a Japanese-style lost decade which Britain will struggle to escape, whatever David Cameron does with his handbag.