Two weeks ago, Hans Eichel, the German finance minister, and Axel Weber, president of the Bundesbank, held a private meeting with a group of economists to discuss the economic management of the eurozone - how to deal with divergent inflation and economic growth rates among member states. One of the economists present, on Wednesday May 25 at 5pm, was Joachim Fels, chief European economist of Morgan Stanley, who expressed concern about the long-term sustainability of the euro. Also there was Thomas Mayer, European economist of Deutsche Bank, who said the eurozone would face a period of stress.

That was four days before France held its referendum on the European Union's constitutional treaty. The day after the French voted, the first report surfaced that the meeting at the finance ministry in Berlin had taken place. Neither Mr Eichel nor Mr Weber is understood to have commented directly on the future of the euro. But the idea that they were in the same room as people who did caused agitation in foreign exchange markets, accompanied as it was by the rejection of the constitution by the electorates of France and then the Netherlands.

As if that was not enough, Roberto Maroni, Italy's welfare minister and a leading representative of the Northern League, a member of the Italian centre-right coalition, said last week that his country should consider bringing back the lira. For the first time, a European minister had publicly raised the possibility of reintroducing a national currency. The euro was down 2.8 per cent against the dollar at the end of one of the most traumatising weeks so far for Europe's 12-nation single currency.

Six and a half years since the launch of monetary union, this was precisely what eurozone officials and central bankers had been dreading and seeking to avoid at all cost: a debate about the future of the euro. Officials from national governments and the European Commission, the EU's executive, tried to halt the discussion with statements of unwavering support for monetary union. Otmar Issing, chief economist of the European Central Bank, warned that members wanting to leave the eurozone would commit "economic suicide".

This is still the most commonly view held among economists and politicians alike. Bob Mundell, the Nobel Prize-winning economist and originator of the concept of an optimal currency area, represents a mainstream view when he predicts: "There is less chance that Emu will be disbanded than there is of a collapse of the dollar." Hardly any economists would predict, let alone advocate, an imminent breakdown of monetary union, or even its demise within the next five years. But there are an increasing number are publicly debating whether it can survive in the long run - whether "the euro is forever", as a Commission official put it.

How did it come to this? It was what doomsayers feared when, in November 2003, France and Germany secured EU ministerial agreement to suspend a procedure launched against them by the Commission for failing to keep their public sector deficits to below the 3 per cent of gross domestic product stipulated as the ceiling under eurozone rules. That in effect destroyed the stability and growth pact, the mechanism for enforcing fiscal discipline in the eurozone. Then came a rise in protectionism in France and Germany, counteracting economic reforms to improve economic flexibility. Germany plans to introduce a minimum wage to protect its workers from being undercut by cheaper labour from eastern Europe. France has been stepping up opposition against the Commission's proposed services directive, which aims to extend the single market to allow borderless operation by many service businesses. The No votes by the French and Dutch on the constitution added the one piece of the conspiracy that was still missing: the prospect, however remote, of political disintegration.

Paul de Grauwe, professor of international economics at the University of Leuven in Belgium, says the rejection of the constitution raises doubts about Europe's commitment to further political union, adding: "A monetary union requires a political union in the long run to maintain sustainability. It now seems that many Europeans do not want to go further in political integration. We have a choice here. If we want to retain the euro in the long run, we need political union."

But the constitution that would have taken Europe a step further towards political integration - creating a European foreign minister, improving transparency and strengthening the European Parliament - is headed for oblivion. Especially relevant for the eurozone was the clause that would have granted the euro group - the eurozone's finance ministers - official status. Under present European law, the ministers can act only in an informal capacity. The constitution would have made it easier for them to co-ordinate fiscal policy.

The argument that economic union requires political union is rooted both in history and economics. Historical experience has shown that all large-country monetary unions that did not turn into political unions eventually collapsed. The Latin Monetary Union of 1861-1920 collapsed partly because of a lack of fiscal discipline among its members - Italy, France, Belgium, Switzerland and Greece. A monetary union set up in 1873 between Sweden - which included Norway at the time - and Denmark failed as political circumstances changed. By contrast, Germany's Zoll­verein, the 19th century customs union that developed into a monetary union, succeeded precisely because of the country's political unification in 1871.

The economic argument is that economic unions normally require a high degree of macroeconomic policy co-ordination or maybe even centralisation, such as common unemployment insurance or some other redistributive mechanism to deal with divergent economic cycles and asymmetric shocks. Until the early 1990s, the Bundesbank was a champion of the view that political union was a requisite of monetary union. It supported what was then known as the coronation theory, which viewed the single currency as the final touch to a process of political union.

Europe's modern political and economic leadership does not accept that link. Mr Issing of the ECB said last Friday: "Monetary union can survive and function well without a fully fledged kind of state." The European Commission shares this view. The Brussels line is that the existing mechanisms in the Maastricht Treaty, which sets out the legal basis for economic and monetary union, in combination with the stability pact, obviate the need for a political union. As long as three conditions prevail - fiscal discipline, central bank independence and a reasonable degree of product and labour market flexibility - a monetary union should be able to survive on its own, the theory goes.

These conditions have been breaking down one by one, however, along with the prospect of eventual political union. Central bank independence retains support. But the demise of the original stability pact and its replacement by a weaker version in March triggered a loosening of fiscal policies almost everywhere in the eurozone. In its latest economic forecast, also in March, the Commission predicted that five of the 12 eurozone member states would breach the 3 per cent deficit-to-GDP ratio this year. The primary balance of the eurozone member states - public sector deficits minus interest rate payments - has deteriorated spectacularly in the last few years (see chart). Europe's fiscal rules and the stability pact had virtually no effect on the way governments behaved. This is true especially of large countries.

The other condition - a flexible product and labour market to offset economic shocks - is also in doubt. The decision by French President Jacques Chirac to replace Jean-Pierre Raffarin as his prime minister in response to the No vote has been interpreted as a softening of his commitment to economic reform. Germany has redrafted welfare entitlements but has been criticised, by the Organisation for Economic Co-operation and Development among others, for failing to come up with a more comprehensive strategy. Italy's Silvio Berlusconi, who was elected prime minister on an agenda of reforms, has delivered almost none.

At the European level, the main programme for reform was the Lisbon agenda, agreed by heads of state and government at the EU summit in Lisbon in 2000 to turn Europe into the "the most competitive and dynamic knowledge-based economy by the year 2010". Since its adoption, the gap between the eurozone and the US in growth expectations has widened in favour of the US (see chart). Like the stability pact, the Lisbon agenda counts as one of the great failures of European economic policy this decade.

These deteriorating economic conditions increasingly alarm economists. The independent Centre for European Policy Studies in Brussels last week published a report* in which it raised the prospect that monetary union might fall apart.

At present, most attention is on Italy, which is in recession. In the past, when faced with competitive pressures, Italy reacted by devaluing the lira. That happened for the last timebetween 1992 and 1995, when the lira declined by 34 per cent against the Ecu, the pre-Emu basket of European currencies. As a eurozone member, Italy no longer has this option.

Yet the country's employers and trade unions behave as if nothing has changed. Between 1999 and 2004, Italian unit labour costs rose each year by 1.3 percentage point faster than the eurozone average and by 2.5 points faster than in Germany. Based on relative export prices, Italy's real exchange rate has appreciated by 15.6 per cent, compared with a decline of 1.3 per cent for France during the same period. Italy must either enter a prolonged period of relative wage moderation, as Germany did over the last five years, or else continue to lose competitiveness.

"Within the next 10 years we are going to have a crisis. I still hope that Italy will ultimately get its act together. But the present situation cannot last," says Daniel Gros, director of CEPS and a co-author of the report. "The problem is that this crisis is gradual. There will always be an opportunity to blame the Chinese, or the stability pact, or something else. If Italy goes the same way as Germany, they [Italians] too will start to complain about high real interest rates, which is what the Germans are doing now."

But an Italian crisis alone is unlikely to lead to the break-up of the eurozone. Badly performing economies with high rates of debt have a disincentive to leave, since their debt is denominated in euros. If Italy got out and reintroduced a depreciating lira, its debt service payments would explode.

The problem for the eurozone is that Italy is not alone. The CEPS report says: "Portugal and Greece are in a similar situation. These two countries are also running the highest government budget deficits in the eurozone. Even a strong performer like Spain masks under the strong growth a deteriorating competitive position that, were its housing market to slow down, would put its economic performance at risk. Thus, the list of countries at risk is increasing, and could easily become a majority soon."

Mr Mayer of Deutsche Bank describes how the grand project could unravel. First, according to his scenario, the watered-down stability pact would not prevent Italy and other countries with competitiveness problems from raising their budget deficits in the long run. At the same time, the Italian government would put pressure on the ECB to pursue an expansionary monetary policy. France and Germany might support this, since they also face economic difficulties. Eventually, an excessively loose monetary and fiscal policy would increase inflationary expectations.

At that point, the eurozone would be at great risk. If the ECB fails to stabilise the outlook for inflation, countries with a preference for price stability would be better off if they left the eurozone. If they emerged with appreciating national currencies, their debt service payments would fall. "The pressure to leave the eurozone will not come from its weak members but from its strong members," Mr Mayer maintains.

So far, the ECB has been able to resist pressure by governments to cut interest rates. However, as the eurozone economy endures its fifth year of disappointing performance, the pressure is mounting. Given the political and economic environment in which it operates, the ECB has had less scope to stabilise the economy than the US Federal Reserve.

According to an index constructed by Deutsche Bank, evaluating monetary conditions as a combination of interest rates and the trade-weighted exchange rate, monetary conditions in Germany, France and Italy hardly changed since the euro was brought into being, irrespective of whether the ECB raised or cut interest rates. Indeed, a simulation by the bank shows that monetary conditions would have been little changed even if the ECB had cut short-term interest rates to 1 per cent in 2003.

The eurozone is trapped in an environment in which monetary policy has in effect become defunct and fiscal policy unsustainable, while its national economies remain too inflexible to adjust to globalisation or the EU's recent enlargement.

Irrespective of whether the debate about the sustainability of monetary union is framed in terms of political union, as the Bundesbank used to do, or in terms of economic and institutional factors, one arrives at the same answer. Present policies, institutional arrangements and political attitudes are incompatible with a sustainable economic and monetary union in the long run. Something will have to give.

The author is an associate editor of the Financial Times. His column on Europe appears on Mondays

* Emu at Risk. Daniel Gros, Thomas Mayer and Angel Ubide. Seventh annual report of the CEPS Macroeconomic Policy Group. Centre for European Policy Studies, June 2005. www.ceps.be