When Otmar Issing joined the European Central Bank Executive Board in 1998, free market advocate and Nobel Prize-winning economist Milton Friedman sent him a friendly note: “Dear Otmar, congratulations on an impossible job.”

Friedman, of course, had no faith in ability of the Euro to stand the test of time. Today, long after Issing’s retirement, it looks like investors are finally beginning to understand what Friedman was talking about.

“Banks, investors and companies are bracing themselves for the possibility that the euro will break up — and are thus increasing the likelihood that precisely this will happen,” Martin Hesse writes for Spiegel Online (as translated from the German by Paul Cohen).

“There is increasing anxiety, particularly because politicians have not managed to solve the problems. Despite all their efforts, the situation in Greece appears hopeless. Spain is in trouble and, to make matters worse, Germany’s Constitutional Court will decide in September whether the European Stability Mechanism (ESM) is even compatible with the German constitution,” the report adds.

This anxiety has been exacerbated by the growing tension between lender and borrower countries. Prominent German officials have called for the expulsion of Greece from the 17-nation union while France’s socialist government has called for more “shared sacrifice.” Meanwhile, in the financial markets, the back-and-forth bickering between eurozone officials has accomplished one thing: It has weakened the euro.

And you better believe the banks are worried.

“Banks and companies are starting to finance their operations locally,” said former chief economist at Deutsche Bank Thomas Mayer.

In fact, a growing number of euro banks have drastically reduced their investments in risky EU countries and, as the report notes, the flow of money across borders has dried up.

“According to the ECB, cross-border lending among euro-zone banks is steadily declining, especially since the summer of 2011. In June, these interbank transactions reached their lowest level since the outbreak of the financial crisis in 2007,” Spiegel reports.

Adding to the growing financial storm is the fact that the fear of a collapse isn’t unique to Euro banks. Major private companies are also wary.

“There’s been a shift in our willingness to take credit risk in Europe,” announced Shell CFO Simon Henry, adding that the company had opted to invest in U.S. bonds and use U.S. bank accounts rather than risk anything in Europe.

“Many companies are now taking the route that US money market funds already took a year ago: They are no longer so willing to park their reserves in European banks,” said Uwe Burkert, head of credit analysis at the Landesbank Baden-Württemberg.

And although the U.S. dollar isn’t exactly in the best place right now, many investors believe it’s far preferable to what’s going on in the EU.

“We notice that it’s becoming increasingly difficult to sell Asians and Americans on investments in Europe,” asset manager Vorndran told Spiegel, adding that although the U.S., Japan, and the U.K. “are all lying in the same hospital ward,” as he puts it, “it’s still better to invest in a weak currency than in one whose structure is jeopardized.”

But more than market reactions and more than private companies shying away from the struggling currency, the one thing we should probably keep our eyes on are the old “short-selling” pros, that is, John Paulson (who made millions off the U.S. real estate crash) and, of course, billionaire philanthropist George Soros.

“Paulson, who is now widely despised in America as a crisis profiteer, announced in the spring that he would bet on a collapse of the euro,” Hesse writes.

At the same time, George Soros said in April that — were he still active trader — he would bet against the euro if EU officials failed to establish a central authority to deal with the crisis (as he so graciously suggested they should).

So far, neither Paulson’s nor Soros’ predictions have come true, but, as Spiegel puts it, “the deciding match still has to be played.”

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Read the full report here.

Front page photo source: The Associated Press