Sean O'Grady: Next stop in the crisis could be the collapse of the euro

It makes no sense in a single-currency zone if one country does its own thing

The Irish artist Conor Casby caused a bit of a stir recently by surreptitiously hanging unflattering likenesses of the Irish Prime Minister, Brian Cowen, in a couple of Dublin galleries. The Taoiseach himself remarked "that's not funny" when shown them. One artwork has the leader of the Irish nation holding a pair of veteran underpants; the other features him with pendulous man-boobs.

Not funny then, and not pretty, but as good a description as any of the Irish economy right now. The mighty of the G20 meeting in London are unlikely to give much thought to Mr Cowen and his artistic and economic challenges. Yet, in its own small way, Ireland and the other economic sick men of Europe could presage the most violent international currency crisis in decades; the break-up of the euro. Alarmist? Certainly. Impossible? Certainly not.

On Tuesday, the Standard and Poor's ratings agency downgraded Ireland's debt from its prime AAA rating to a AA+, with a "negative" outlook. It was expected, but no less disquieting for that. Ireland's budget deficit will approach 11 per cent of GDP next year; as bad as the UK. However, Britain's deficit is essentially a matter of private grief. Ireland's deficit, like those of Spain, Greece, Italy, Portugal and other fiscally incontinent states, is not. For they all have to share a financial bed – the euro – with the fastidious Germans. And the Germans may soon get a little impatient at the financial mess being created all around them.

Ireland joins Spain, Greece and Portugal, the other bad boys of the eurozone, in having her sovereign debt downgraded. Italy tumbled a while back. More may follow. The markets are already demanding "risk premia" – much higher interest on euro debt issued by the Greek and these other sub-prime governments compared to that issued by German government securities, the relatively safe Bunds.

So what? Well, simply that it makes no sense in a single-currency zone if one nation – or a group for that matter – just do their own thing on the public finances, endangering the credibility of the whole scheme and leaving the fiscally responsible, principally Germany, to pick up the pieces, and the bills.

Now, to be sure, the Germans are ideologically, almost mystically, committed to the euro in a way that few in these islands can properly comprehend. Since Helmut Kohl, at least, it has been an unwritten article of German nationhood to anchor the federal republic in the European project, the single currency being the proud symbol and instrument of that.

But, even in the Kohl era, there were limits to that ambition. Hence the strictures on budget deficits and national debt in the Maastricht Treaty, which framed the euro and left the UK with its famous "opt out".

True, that was never designed with the credit crunch and deflation in mind and the Treaty provides wriggle-room. Nonetheless, the Maastricht criteria were the next best thing to a Europe-wide Treasury controlling the budget deficits of member states. Without even the Maastricht barriers there is little to prevent the euro taking on the shape of a new drachma rather than the stentorian qualities of the old Deutschemark, guarded as it was for 40 years by the ever vigilant Bundesbank. The independent European Central Bank, headquartered in Frankfurt, was created on the Bundesbank model, yet that has not stopped big beasts such as Sarkozy and Berlusconi from trying to bully it.

Soon, though, the Germans may run out of cash, if not patience. The OECD say that the German economy will contract by 5.7 per cent in 2009 – even worse than the UK – and grow only very slowly after that. German unemployment is already at 8 per cent, and her exports are collapsing. Even if Berlin wanted to write blank cheques to Club Med, it may not be able to: Heaven knows what might happen if Germany's public finances spiral out of control and she has her own debt downgraded.

The problem with the euro – as federalists and eurosceptics in fact agree – is that it suffers from not having a single Treasury function behind it; someone or something to ensure that national budget deficits don't threaten the viability of the currency. The politics of it are just too difficult, and the European Commission seems to have given up trying to shadow the role. In the end, monetary policy and fiscal policy must face in the same direction, and that means a single Treasury working in harmony with a single central bank: the eurozone is a one-legged man auditioning for the part of Tarzan.

None of this would matter if the euro were the dollar, the yen, the pound, the Swedish kroner or even the Thai baht – the currencies of single indivisible states. The euro is not. Think about the US, say. If West Virginia or Michigan are having an especially rough time in the recession, no one pops up to say they ought to have their own currency and opt out of the dollar so they can devalue their way out of trouble. Neither will they be chucked out of the US.

That is because West Virginia and Michigan are not sovereign states. New York famously went bust in 1975 without leaving the US or exploding the dollar. Yet that possibility is attached to the fortunes of Italy, Greece and the others. It is not clear that the euro will be able to withstand these strains. Could Germany allow these nations to go bust? Could she actually afford to prop them up? And if she did, would she not then be "infected" by their debts and crumbling credit ratings?

All extreme scenarios, but we live in a world of extreme scenarios, one where Toyota makes a loss and the Royal Bank of Scotland ends up half nationalised. The euro too could be a casualty. It may well be that a euro, rather than the euro, would emerge; a curious currency made up of a mix of nations with relatively solid public finances and those so tiny they don't matter. Thus the new euro might comprise, under German leadership, Finland, Malta, Cyprus, Luxembourg and Slovenia, with France in borderline contention for membership. Ireland, Greece, Spain and the rest would go back to their old currencies, but flexibly pegged to the new euro. Not pretty, but not impossible.