Resident Fellow Desmond Lachman

In 1999, on the occasion of the launching of the Euro, Milton Friedman famously questioned whether the Euro would survive its first real test. Ten years on, with the onset of what will almost certainly be the world's deepest and longest post-war recession, it now appears that the Euro's moment of truth has finally arrived. And judging by the abrupt widening in sovereign bond spreads for Ireland and the Euro's Mediterranean country members, markets now appear to be taking bets that in the end Milton Friedman will have been proved to be right.

At the core of the Euro's long-run challenge is the fact that a one-size-fits-all interest rate and exchange rate policy is highly unlikely to simultaneously meet the needs of all of the Euro member countries. This problem becomes especially acute when, as at present, a host of individual Euro member countries have marked economic weaknesses that are being severely stress tested by a major global economic slump.

In present circumstances, what might be an acceptable interest rate for a healthy Germany and France might be overly burdensome for countries like Ireland and Spain, which are in the throes of major housing busts. It might also be burdensome for countries like Greece and Italy, which have highly compromised public finances. Similarly what might be an acceptable Euro exchange rate for member countries that have strong external fundamentals might be excessively punitive for countries like Greece, Portugal, and Spain that do not.

The acute strains that lie ahead for the Euro are perhaps best illustrated by Spain's present predicament. Until very recently, buoyed by a housing market bubble that made that in the United States pale, Spain's economy was amongst the fastest growing in the Euro-zone area. However, now that its housing bubble has burst, Spain is in the throes of a severe recession.

The severity of Spain's recession is underlined by an unemployment rate that has already risen from 8 percent to 14 percent and that is widely expected to top 18 percent by year-end. Yet trapped within the Euro, Spain cannot emulate the United States by sharply reducing interest rates and by allowing its currency to weaken.

Further clouding Spain's long-run economic outlook is the fact that, during the boom years, Spain lost more than 20 percent in cost competitiveness to Germany. That loss has contributed importantly to a widening in Spain's external current account deficit to US$180 billion, or to an absolute level that is second only to that of the United States. Yet without its own currency to devalue, Spain is forced to regain lost competitiveness by a prolonged period of deflating against a highly competitive Germany.

Spain's grim economic outlook raises two basic questions about its continued long-run membership in the Euro. Will Spain have the political will to endure the prolonged period of very high unemployment and deflation necessary to restore Spain's competitive position? Can one count on the rest of Europe to continue financing Spain's outsized external current account deficit now that the good times for Europe's financial system have long passed?

Seemingly oblivious to the break up of other "immutably" fixed exchange rate systems like that of the Argentine currency board in 2001, the optimists argue that the prohibitively high financial and economic costs of exiting the Euro leaves a country like Spain with little alternative but to endure the rigors of Euro membership. It is supposed that somehow the political class will prevail in explaining to the people that there is really no choice. This might very well turnout to be the case. However, the recent riots on the streets of Athens and Spain's own fractured politics should give one some pause.

Turning a blind eye to the present lack of European financial institutions to conduct massive IMF-styled bailouts, the optimists also contend that the stronger members of the Euro will in their own self interest rally to the financial support of any member country under real pressure. However, this line of reasoning fails to factor in the rise of economic nationalism in France and Germany or the enormity of the financial support that might be required if a large country like Italy or Spain finds itself in deep trouble.

It also fails to factor in today's present reality that not one but rather five Euro member countries are simultaneously being shocked by the global slump. For different fundamental economic reasons, the economies of Greece, Ireland, Italy, Portugal, and Spain, derisively referred to as the PIGIS on Wall Street, are all under increased market pressure that is unlikely to abate anytime soon. This has to make any sustained bailout of these countries prohibitively expensive.

In the end, the Euro might very well survive its present stress test. However, policymakers in Europe risk making a big mistake by ignoring the recent rating agency downgrades of Europe's Mediterranean countries or the marked widening of those countries' bond spreads. It would seem that the long run survival of the Euro would best be served by a more aggressive easing of ECB monetary policy and by a better coordinated effort at fiscal stimulus that offered the hope of a more buoyant overall European economy.

Desmond Lachman is a resident fellow at AEI.