Will the Euro Survive?

I was a little puzzled last week after reading Wolgang Munchau's column in the FT. He noted that some of the European countries outside the Eurozone--specifically Denmark, Hungary, Iceland--are now wishing they were members and probably will become so in the near future. Based on these developments he argued the global financial crisis should actually lead to an enlargement of the Eurozone. While his argument makes sense in the case of the few countries mentioned above, what about the broader Eurozone? Does not the global financial crisis add more stress to the viability of the Eurozone? In a reply to Munchau, Desmond Lachman says yes:

Sir, Wolfgang Münchau seems to be very wide of the mark in asserting that the present global financial crisis will lead to the early expansion of the eurozone... For, as the marked widening in interest rate spreads on Italian and Spanish government bonds would suggest, the more pressing question raised by the crisis is not so much whether the eurozone will expand but rather whether or not the euro can survive in its present form.

In 1998, when the euro was launched, Milton Friedman famously warned that the euro would be truly tested by the first major global economic recession. He issued this warning in the belief that, lacking labour and product market flexibility, Europe was not an optimum currency area in the sense that was the case of the U.S. economy.

Judging by October's alarming plunge in global equity prices and the virtual freezing up in global credit markets, there can be little doubt that Europe, along with the United States, is at the start of its worst economic recession in the postwar period. And judging by the bursting of Spain's outsized housing market bubble and by the precarious state of Italy's public finances, there can be little doubt that Spain and Italy will be the two major European economies that will be put to the severest of tests as the global recession deepens.

For in order to cope with their respective problems, Spain and Italy will need low interest rates and weak currencies that continued euro membership clearly precludes.

In short, Lachman is questioning whether the Eurozone in its current form is an optimal currency area and, thus, whether it can truly survive. Apparently, so are some investors thinking this way. Over at intrade.come there is a contract on whether "any country using the Euro to announce their intention to drop it on/before December 2010." Here is the latest figure--where price equals probability-- from the contract (click figure to enlarge):


Currently the probablity of say Spain or Italy leaving the Euro is between 30-35%. Although not very high, it is a sizable increase from when the contract was introduced in early 2008. So what is the future of Euro?

Update: Here is a related post from Naked Capitalism. Here are some papers from a conference on the future of the Euro hosted by The Economist magazine and CATO.