Dec. 8 (Bloomberg) -- The euro area has so far defied Milton Friedman’s forecast that it would splinter as soon as the “global economy hits a real bump.” As the euro marks its 10th birthday, the monetary union is hitting the biggest bump yet.

While the 15-nation region remains in one piece amid its deepest financial crisis, the turmoil is placing new demands on the European Central Bank. Among the most urgent: shifting focus as the recession quashes the inflation threat that dominated the ECB’s agenda for the last decade.

With deflation looming as the greater danger to the world economy, President Jean-Claude Trichet is signaling the ECB may continue to lag behind other central banks in cutting interest rates, risking a delayed recovery that undermines the euro’s initial success. A further threat to the currency’s stability comes from abroad, as weaker neighbors seek shelter from the financial crisis through early entry into the euro bloc.

“Serious new challenges are taking shape that could still jeopardize the very survival of economic and monetary union,” says Thomas Mayer, chief European economist at Deutsche Bank AG in London. Still, he says, “there will be a lot to celebrate at the 10th anniversary.”

The euro region will start its second decade Jan. 1 in better shape than some economists once imagined possible. Even in the current recession, it has avoided the bank and currency runs that have plagued neighbors such as Iceland and Hungary. Foreign retailers and central banks increasingly use the euro, which reached a record $1.6038 in July and an unprecedented 87.26 pence against the pound last week.

Difficult Birth

That’s a far cry from the bloc’s difficult birth, when the bank’s first president, Wim Duisenberg, was criticized for sending confusing policy signals. Global governments intervened to rescue the euro after it plunged in its first 21 months.

Those early days gave some credence to the view of Friedman, the late Nobel-Prize-winning economist, that “internal contradictions” would destroy the currency. Harvard University Professor Martin Feldstein warned in a 1997 article that monetary union would spark greater political conflict within the region. While it’s impossible to predict whether such conflict would lead to war, Feldstein wrote, “it is too real a possibility to ignore in weighing the potential effects” of monetary and political union.

While early critics may have been wrong, the credit crunch amounts to what ECB Executive Board member Juergen Stark describes as the region’s true “litmus test.”

“The current global financial distresses pose challenges of a significant and unprecedented nature to the ECB,” he said in a Nov. 14 speech.

Battling Inflation

After battling inflation above its 2 percent limit for much of its lifetime -- even raising its benchmark rate a quarter point to 4.25 percent in July -- the Frankfurt-based bank changed tack only in October. That was more than a year after its U.S. counterpart, the Federal Reserve, started lowering borrowing costs.

Trichet and colleagues suggested last week that the ECB’s response to recession will remain less aggressive than that of other central banks.

Avoiding Trap

While its 0.75 percentage-point rate cut on Dec. 4 was its deepest ever, the shift was dwarfed by reductions in the U.K. and Sweden. The ECB’s benchmark rate, at 2.5 percent, is still the highest among major economies, and Trichet indicated reluctance to lower it much more, saying the bank must avoid being “trapped” with “much too low” rates.

In a signal that rates may not be cut next month, Governing Council member Ewald Nowotny said in a Dec. 5 interview that the “situation is open.”

“This tells of an ECB not yet fully aware of how serious and bad is the recession hitting the euro area,” says Aurelio Maccario, chief euro-zone economist at Unicredit Group in Milan.

Already since July, the euro has dropped 20 percent against the dollar and is poised for its first yearly decline against the U.S. currency since 2005.

The bank also may be behind its counterparts in addressing the risk of deflation and how it will operate as interest rates get closer to zero. While Trichet dismisses the likelihood of a prolonged decline in prices, economists say he must assure investors he has a strategy for such an eventuality, as Fed Chairman Ben S. Bernanke did last week.

Plan B Needed

“The ECB should lay out as soon as possible a Plan B in order to dispel the notion that it might be running out of ammunition,” says Jacques Cailloux, chief euro-area economist at Royal Bank of Scotland Group Plc in London. Options include purchasing financial assets, buying commercial paper or easing collateral rules when making loans.

After cutting rates at an historic pace and releasing unlimited cash into the banking system, Trichet argues the bank always does what’s necessary to aid the euro economy. Investors are betting it will deliver more interest-rate cuts next year.

“If new decisions are needed, we will take new decisions,” Trichet told reporters last week. “We continue to look very carefully at the situation.”

As it guides its own economy through the turbulence, the ECB has also been forced to act beyond its borders by providing liquidity assistance to central banks in Poland and Hungary. Their economies have been hammered as investors dumped riskier assets, sending their currencies sliding.

Flight of Capital

The flight of capital has Eastern Europe’s emerging markets envying the protection that other countries with heavy debt burdens, such as Italy and Spain, enjoy with membership in the euro bloc. “There is stability and security in numbers,” says Barry Eichengreen, a professor at the University of California at Berkeley.

Economists at Morgan Stanley predict Poland and the Baltic states may seek admission in 2012 and Hungary in 2013, a year earlier than they foresaw in the middle of this year.

The dilemma for the ECB is that, while the desire to join the euro region is greater, qualifying is becoming harder: Membership requires countries to meet targets for inflation, budgets, currencies and interest rates -- a tall order in the middle of a recession.

Allowances have been made before. Greece assumed membership in 2001 on data that proved to be fudged. Inflation rebounded in Slovenia after it joined last year.

Compromises

The consequences of similar compromises would be greater now, says Paul Donovan, an economist at UBS AG in London. Enlargement would expose the euro area to more bank failures and make it harder to manage a one-size-fits-all monetary policy.

“While smaller countries outside the euro are more willing to join as a result of the crisis, the rest of the euro zone may be less willing to contemplate their admittance,” he says.

A widening gap between the region’s weakest and strongest economies would add to concern about a breakup. Harvard’s Feldstein says individual nations could still leave the euro bloc if they find monetary policy too tight or fiscal rules too onerous.

“The global economic crisis provides a severe test of the euro’s ability to survive in more troubled times,” he wrote in a column last month. He said the growing gap between interest rates on German bonds and on those of more heavily indebted Italy suggests investors “regard a breakup as a real possibility.” The gap, or spread, has more than quadrupled in a year to 1.4 percentage points.

Still, Elga Bartsch, chief European economist at Morgan Stanley in London, bets the crisis will fortify the currency union by broadening membership rather than shrinking it and boosting the reputation of its central bank.

“It’s in testing times that the euro area’s mettle is likely to be shown,” she says. “Economic and monetary union will likely pass this first real test of its policy framework.”

To contact the reporter on this story: Simon Kennedy in Paris at skennedy4@bloomberg.net

Last Updated: December 8, 2008 09:11 EST