Can the euro survive its ‘hair shirt’?

Lachman, a former Salomon Smith Barney strategist and onetime policy adviser at the International Monetary Fund, has been saying for more than a year that the center can’t hold in Europe. But now he says the next year could bring a crisis that will likely end with weaker countries streaming for the euro zone’s exits.

Ireland, Greece, Spain and Portugal desperately need to devalue their currencies to restore competitiveness, he says, but can’t because they’re wearing what he calls the euro “hair shirt” – which forces them into austerity measures that stand to deepen already sizable downturns.

The countries also need to restructure their massive debt – an event policymakers can’t countenance because it could precipitate a European banking crisis.

These tensions are behind the spring’s economic meltdown in Greece, the fall’s bailout of Ireland, and the run on European government debt that has seen spreads widen even in austere Germany — which isn’t yet embracing its role as the lender of last resort to its weaker cousins.

But even now Lachman, now a research fellow with the American Enterprise Institute in Washington, contends most people continue to underestimate the severity of the problem.

He says the euro zone could be in disarray by this time next year, thanks to the increasing strains on weak economies and growing political unrest. The result is a tight fix that defies easy answers – which unfortunately are the only kind European policymakers seem willing to agree on at the moment. I quizzed Lachman on the subject at length last week.

Fortune: How did we get here?

Lachman: Once you’re in a fixed exchange rate system and you allow internal and external imbalances to start building, it’s impossible to fix without a massive recession. But a deep recession undermines the political will to make the needed changes, and it erodes the tax base, which means the government ends up collecting less money even with taxes going up.

That’s one of the problems we’re seeing in places like Greece and Ireland – the governments are assuming the economy will grow, but it can’t because you can’t overcome the sort of contraction the fixed exchange rate forces on you. Greece just can’t collect enough taxes to overcome the kinds of problems it has allowed to build up.

If that’s not bad enough, the way you see it, any attempt to ‘fix’ these problems will inevitably lead to a new set of problems.

There’s a reason for the pessimism, and that is that we are seeing these problems hit four countries at a time. First the crisis hits a country, say Greece or Ireland, then it sours the outlook for their neighbors, like Spain or Portugal. It seems to be never-ending.

The stakes are incredibly high, because this problem doesn’t just afflict these countries. It also affects the banking system at the core of Europe, the banks of Germany and France. So if you have a default in one of these peripheral countries, you could have a full-fledged banking crisis again on the Continent.

So you have talk about expanded bailouts – and then you have Germany saying no, no, no. Yet they’ll have to give in to the bailout mentality too, right?

Well, it’s worth looking at what’s really going on with Germany. They appear to be schizophrenic right now. The political elite, you can believe they would be willing to kick the can down the road. But the electorate is turning against bailouts, and there’s an awareness of that.

That’s the reason Angela Merkel is insisting the the Irish pay market-related rates for the loans they’re getting under their rescue package, even though it makes absolutely no sense to pile high debt costs on top of all the problems they already have. Merkel is saying, “We’re not really bailing them out,” for the sake of the political constituency at home. But it makes no sense. It is not providing Ireland with much relief.

So how long can this charade go on?

There are signs it is moving a lot more quickly than we might have anticipated. I think 2011 is going to be incredibly difficult.

You look at what’s ahead in Ireland – they have to pass a budget and hold and election, and that’s going to lead to instability for a few months, and you have Sinn Fein getting more active. That’s going to make the politics very difficult. The Irish are looking at losing their sovereignty, with the IMF and the European Union coming in, and it makes you wonder what’s going to be happening in 12 months’ time.

You say a political crisis in a peripheral country like Ireland could provide the spark to get this fire really roaring.

There are two difficult things about these sorts of crises, predicting the timing and predicting the catalyst. But in terms of what can make Europe come unstuck, I think of three things: a loss of political will in a country that has to make massive reforms, a flight of capital – and we’re seeing that already in places like Ireland, where bank deposits are really falling – and the Germans just saying enough.

The whole thing is already showing signs of fraying.

You said last month at a conference that there’s no way this will go on for three years. Now you’re saying 12 to 18 months. But why not next Tuesday, say?

Oh, there will be a fight. The stakes are so high. The European Central Bank is supposedly concerned with looking after the stability of the currency, monetary stability, but here they are lending 130 billion euros to the Irish banks. That’s on the order of 80% of GDP. That’s just mind-boggling.

They’re trying to slow things down, but they have big problems at the ECB. There are questions about whether they can get ahead of this crisis. Last week there was an expectation we might see a shock and awe sort of program out of them to shore up the peripherals, but all they did was some minor tinkering.

Another concern is on their independence. You have the German representative, Axel Weber of the Bundesbank, saying he doesn’t agree with the ECB’s policies, and you wonder if that’s just him playing I told you so for the domestic political audience or if it’s the German view that the ECB is getting loaded down with poor quality paper.

And that’s just with Ireland, Greece, the smaller countries. With Spain you’re talking potentially about a 500 billion-euro commitment. That’s humongous. At some point you need a debt restructuring.

So is all the kicking the can down the road actually making things worse?

Well, it depends on whose perspective you take.

For Greece, yes. They have done the Greeks a disservice because they are loading them down with official debt (that issued by the EU and IMF) that they can’t restructure, on top of all the debt they already have that they can restructure. And they are wasting another year or two or three in a plan that can’t work, while not avoiding the breakdown that’s coming anyway. So the Greeks get two or three years of suffering for nothing.

For Europe, on the other hand, the delays could work out because they give the French and German banks two or three years maybe to get recapitalized, which they’re going to need when this finally happens.

For Ireland, they are taking a bad choice but it’s better than the alternative, because if they tried dropping out of the euro now they would get cut off, which would force their economy to make a huge adjustment all at once. So that’s not doable.

What about the United States?

We’re starting in a better position, with much less debt than countries like Greece. And as Europe melts down the dollar will rise and there will be more demand for Treasuries, even though we have this terrible deficit problem. I guess that will give us more rope to hang ourselves with.

A shock to the European banking system could certainly reverberate through world financial markets, but I don’t think the U.S. banks are going to get terribly hurt. We took our hits and recapitalized last year, and the Fed has been keeping rates low, yield curve steep. So the U.S. banks won’t be at the epicenter.

What is the most nerve-wracking part of this crisis?

What freaks the ECB out is seeing the spreads blow out in Italy and Belgium , because those are countries that weren’t supposed to be affected. Now it’s looking like contagion. Italy is highly vulnerable because of the huge amount of debt it has to sell next year, and Belgium is at risk of a political fracture.

That’s the way these crises usually come to a head, you get hit with something out of left field. Belgium could be that, or who knows what. But a situation like this is just like a wildfire, because all it takes is a spark.