FORTUNE -- In the late 1990s, as the European Union touted its grand plan for a single currency, I called Milton Friedman at the Hoover Institution to ask the 20th century's most influential monetarist for his view of how the euro would transform Europe. It was no surprise that the frugal Friedman called me back collect. He always did.
But I was amazed when his answer seemed to deny the inevitable. After the operator chirped, "Will you accept the charges from Milton?" Friedman chuckled, then turned darkly serious. "There will be no single currency in Europe," intoned Uncle Miltie. "The U.S. is an appropriate zone for a single currency. Europe is not, because its countries are far too different in terms of productivity and inflation. The euro would be such a disaster that it will never happen."
Of course, Friedman's prediction that the euro would expire as a utopian dream proved spectacularly wrong: On December 31, 1998, the euro effectively replaced the deutschemark, franc and lira, and it now reigns in 16 countries from Austria to Ireland to Portugal.
But Friedman was right on the economics. Today, Greece stands on the brink of a default, bond yields across Europe are soaring, and global investors are dumping the currency that once challenged the supremacy of the dollar. It's unlikely that the $1 trillion rescue package from the IMF and EEC will keep Greece from reneging on a big portion of its towering foreign debts. It's even possible that Greece, Portugal and other ailing countries will abandon the euro altogether, a scenario that was unthinkable just a few months ago.
Right now, it's impossible to say if the euro zone will fracture, and the drachma, escudo or peseta will return. The future of the euro is highly uncertain. But the legacy of 11 years of monetary union for Europe's weaker economies is rapidly becoming starkly, painfully clear.
Rising costs and easy credit
Those nations -- chiefly such Mediterranean members as Greece, Spain, and Italy --are almost certainly no better off, and probably worse off than today than if they'd kept their own currencies a decade ago. "The introduction of the euro created a lot of wrong signals and distortions," says Uri Dadush, an economist at the Carnegie Endowment in Washington, DC and author of the excellent new study Paradigm Lost, The Euro in Crisis. "The euro provided benefits, including reducing transactions costs. But on other hand, the euro has specifically caused a lot of the big problems these countries now face."
Monetary union has damaged their economies in two major ways. First, the cheap borrowing that made the euro look so attractive caused booms in their domestic consumption that enormously raised costs, especially for labor. That dramatically lowered their competitiveness both compared to stronger euro zone members such as Germany and France, and versus nations that didn't join the euro, notably Britain and Sweden.
Second, the easy credit enticed their governments to borrow and spend lavishly. As a result, they're now struggling with potentially ruinous levels of debt. Both problems were just what Friedman would have predicted. As he told me, a single monetary policy and one-size-fits-all interest rates simply won't work for economies as different as mighty Germany and wobbling Greece or Spain.
The before and after numbers tell the story. We'll focus on four countries that were weak before the joined the euro, and are most endangered today: Italy, Spain, Greece and Portugal; we'll also look at the problems in Ireland, a stronger economy that suffered from the same wrong signals that pummeled its weaker neighbors. These nations contribute around one-third of GDP for the entire euro zone.
To determine whether the euro has made these countries stronger or weaker, we'll examine three crucial metrics: public debt and government spending, both measured as a share of GDP, and competitiveness, gauged by their costs of production versus their trading partners.
Good days are in the past
On all three criteria, these countries look generally worse today than in their pre-euro era, especially in the critical measure of competitiveness. Let's start with the increases in government debt, the problem that's now bedeviling Greece. In 1998, Greece's debt-to-GDP ratio was a big but manageable 96%; by 2010, the IMF forecasts that it will reach 133%. The figure has gone from 52% to over 87% in Portugal, and 54% to 79% in Ireland. In Italy, the debt level under the euro has grown from 115% to an even more mountainous 119%. Spain is around even at approximately 67%, but the burden has almost doubled in two years, and is growing fast. And Spain already suffers from extremely high levels of private borrowing.
Under the euro, these countries have also seen significant increases in government spending. Unless it's reversed, that burden could significantly hamper their future growth.
In 1998, public expenditures accounted for 38% of national income in Greece and 40% in Portugal; for 2010, the figures were 50.4% and 49%. In Spain and Italy, spending has risen by 6.7 and 2.5 percentage points respectively, to 44% and 51%. Once a model of prudence, Ireland has practically jumped into the southern league, with government absorbing 46.6% of GDP, versus 31% in 1998.
To be sure, the recession is increasing those ratios because of the steep fall in GDP. But these countries are also finding it extremely difficult to lower the lavish spending that arrived with the boom in tax receipts during the flush times, a problem we will revisit shortly.
The Mediterranean economies have also lost ground to their stronger trading partners in competitiveness. Their costs for making products, especially for export -- everything from PCs to pieces of insulation -- has increased sharply versus their trading stronger partners, notably Germany and Britain. The best measure is called Real Effective Exchange Rate or REER, calculated by the EEC. The main component is labor costs, measured in the nation's currency -- in this case, the euro. The REER compares costs in 35 major economies.
Since 1989, the competitiveness ratings fell by 9% for Greece, 16% for Spain and Italy, and 26% for Ireland, which was renowned as a mighty exporter. Now, every one of them is struggling with costs that are between 16% and 31% above the norm for 35 nations. According to the index, labor and other expenses in Italy and Spain are now one-third higher than in the UK.
From bad to worse
It's important to understand that Europe's southern economies were weaklings before the introduction of the euro. They all suffered from rigid labor laws, expensive, bureaucratic regulations on business, and frequently, big government owned or dominated industries.
"They were constantly devaluing their currencies in an attempt to remain competitive," says Steve Hanke, an economist at Johns Hopkins. What these nations needed was more flexible labor markets to raise their productivity levels, and lower government spending to tame chronically high inflation, since their governments often swelled their money supply to pay back foreign debt in cheaper pesetas or lira.
How did such a widely acclaimed, noble-sounding concept go wrong? Before these countries joined the euro, their interest rates were generally in double digits, and averaged about twice the levels in Germany. Those lofty rates reflected both their both their higher levels of inflation, and the risks of lending to both businesses in bumpy, erratic economies and governments vulnerable to excessive spending.
But when the euro debuted in 1999, the picture miraculously changed, or so it seemed.
First, interest rates in most of those countries dropped to near German levels in the mid-single digits. On average, the reduction was on the order of between 3% and 5%. Suddenly, it became far cheaper to get a mortgage, to borrow on credit cards, or to obtain a car loan. Credit became not just cheaper, but far more plentiful.
"In Spain, inflation rates were so high that it was extremely difficult to get a mortgage, especially a long-term loan," says Hanke. "But with the euro, long-term lending suddenly became easy to obtain."
Second, investors in Europe and around the globe became highly optimistic about the future of countries such as Spain, Portugal and Italy. The theory was that since those nations could borrow at German rates -- now that their cost of capital had suddenly declined -- they'd lift themselves far closer to German and French living standards at a rapid pace, achieving growth rates far higher than those of their richer northern neighbors for years to come.
The concept was called "convergence." "There was a naïve belief that German rates could bring German living standards," says Barry Eichengreen, an economist at the University of California at Berkeley.
Short-term gain, long-term pain
For a time, it appeared that convergence was fashioning a miracle. In the period from 2002 to 2007, some of those countries went on a remarkable spurt of growth. Greece and Spain expanded at between 4.3% and 3.5%, and Ireland roared fastest at 6.5% -- all dwarfing the EU average of around 2%.
The problem was the type of type of growth that the euro brought with it. The boom came not from producing lower-priced exports, but from a wild fiesta in domestic consumption. Business exploded for restaurants, landscapers, hairdressers, nannies, and hotels. The loudest boom came in real estate. Spain and Ireland, for example, multiplied the production of homes in suburban Dublin and condos on the Costa del Sol.
The surge in domestic demand rapidly raised prices. The main problem was a sudden shortage of labor. One of Europe's weaknesses is a lack of labor mobility. When Spain needed more workers, they didn't flood in from France or Belgium, where jobs were scarcer, as workers migrate from New York to Texas.
As a result, wage costs soared, with the government sector leading the way. But even as prices kept climbing, the feast didn't end. At fault was the perverse influence of the cheap borrowing. The renewed inflation failed to raise rates and choke off the boom, the natural course in any country with its own currency.
Dadush summarizes the results: "You got lopsided growth in services and real estate," he says. "And exports became less and less competitive because of the rise in labor costs."
That was only half the problem. Tax revenues poured in from real estate transactions and rising wages, and the governments spent all the money as if revenues had shifted permanently to a higher plane.
The European Central Bank fed the frenzy. Remember, the ECB can't tailor monetary policy and interest rates to the needs of individual countries. So the ECB kept borrowing costs extremely low to boost growth in Germany and France. That helped those countries, but further inflated the bubbles building in the southern states and Ireland.
The music stopped when the ECB, suddenly worried about inflation, switched to a far more restrictive stance. The swift rise in rates destroyed the real estate bubble. Tax revenues collapsed.
But instead of lowering spending, Greece, Ireland and other countries kept borrowing to make up the difference -- at higher rates, to be sure, but at far lower cost than they'd have been forced to pay with their own currencies. As a result, the governments made little or no attempt to reverse the giant spending increases that occurred during the boom.
Financing the future
The domestic bubbles left a burden that will be hard to shed: High costs that hobble their ability to export, and ruinous levels of government debt (except in Spain, where federal debt is still manageable, but corporate and consumer debt is crippling). Says Eichengreen: "These countries imported German rates without importing German productivity or flexibility."
Let's not claim that a Spain, Greece or Portugal would be thriving now were it not for the euro. It's more likely that they would still suffer from rigid labor markets and serial devaluations. The point is that their costs, debt and government spending would likely be lower.
Now, they have to face those euro-induced problems, and at the same time attempt what they've never been able to do -- increase productivity by deregulating their economies. If those countries had their own currencies today, they could devalue by 20% to 30% and quickly get the costs of their exports in line with products from competing nations. But the euro doesn't give them that option.
Hence their only choice is to lower wages through grinding years of deflation and high unemployment. The big question is whether they can do it. Workers are demonstrating in the streets of Athens to protest pay cuts. In Spain and other countries, strong unions and an indexation system that automatically raises wages will make it extremely hard to reduce labor costs.
The euro's supporters hope that Greece and the other countries will impose spending and wage discipline, under pressure from the EC and the IMF. Indeed, many Asian countries became far more fiscally responsible following their debt crisis in 1999. Right now, the wreckage is causing the players to talk about becoming sober and responsible. A repeat of past excesses seems impossible.
But it's far from impossible. When Europe recovers, the perverse incentives that the euro offers will again pose a threat. As long as governments can borrow on the cheap, and companies and consumers can get mortgages or corporate loans at less than their rate of inflation, Europe will always be vulnerable to another synthetic boom that looks like real prosperity, followed by another bust.