What can cause the instability of the Euro?

Milton Friedman, the late Nobel laureate who invented monetarism, once predicted that the euro would not survive a recession.

As per Dr. Friedman the euro has no precedent. There has never been a monetary union, putting out a fiat currency, composed of independent states.

Inflation is a monetary phenomenon and it is made by or stopped by the central bank. The ECB (European Central Bank)held down the rate of monetary growth and thus there have been stable prices. The pressures in Europe, however are very strong. The main pressure is to print money and be more expansive in order to promote employment.

What the ECB does really depends on whether Germany and France and Italy will back it. Italy may well be the main problem. In this sense, the euro is good for Europe. But only if there is flexibility all around. The problem is that, in a world of floating exchange rates, as Italy was before the euro, if one country is subjected to a shock which requires it to cut wages, it cannot do so with a modern kind of control and regulation system. It is much easier to do it by letting the exchange rate change. Only one price has to change, instead of many.

But now, in the euro, that option is taken away. The only alternative if a state has to adjust to a shock is to let internal prices vary. It has to let wages go down, if necessary.

The ECB has responded to the downturn by cutting its interest rate to two per cent and allowing the euro to fall against the dollar – although it has risen strongly against the pound. Yet for Eurozone members like Greece, Ireland and even Germany, an interest rate of two per cent is probably still too high. Jean-Claude Trichet, the ECB's French president, now faces an impossible dilemma. Whatever interest rate he chooses will serve the interests of some Eurozone countries and inflict immense damage on others.

The most logical option would be for Greece and Spain to leave the euro. If the situation continues to worsen, their electorates may ultimately demand nothing less. The possibility of the euro breaking up under the strain of the present recession is taken seriously by the financial markets. The Maastricht treaty, which established the single currency in 1999, contains no legal route for a country to leave the euro. In practice, however, there would be no way of stopping a government from choosing this course. But the costs imposed on any country leaving the euro would be overwhelming. The markets would take fright and demand a far higher premium for holding the government's debts.