Euro Speuro.

• Position: Brief Article

It first appeared a half-decade ago as the "Sakakibara Scenario," named after the former Japanese MOF official. The theory was that America's huge current account imbalance was a ticking time bomb. Global investors, sensing the ever-growing imbalances, could soon pull out of U.S. dollar-denominated financial assets and plunge an already over-valued American stock market and the dollar through the floor. Fearing the seizing up of liquidity, the Federal Reserve would panic and slash short-term interest rates, further weakening the dollar. The upshot: a vicious cycle of financial destruction.

That scenario never panned out, but every so often it raises its head. The latest proponent: many European policymakers, who see it as inconceivable that the euro can continue in its relatively weak position against the dollar. It is inevitable, many Europeans insist, that the euro will strengthen once global investors realize that once the U.S. economy recovers, those imbalances could balloon even larger. What's more, they add, last year's massive dollar-boosting European investment flows into U.S. financial assets were a one-time phenomenon.

Maybe so. But complicating this doomsday scenario may be the fact that since European monetary union, the world has essentially moved to a two-currency system (the dollar vs. the euro, with the yen an increasing politicized currency). With most of the world dollarized, the fear of massive capital outflows may have been exaggerated. As one German central banker mused cynically earlier this year, "When something good happens to the U.S., the euro weakens. When something bad happens, the euro weakens. And when something good happens to Europe ... the euro weakens."

This weakness has become a perplexing question for G7 policymakers. Is the euro weak because of the European Central Bank's restrictive monetary policy, or would the euro be even weaker without that policy in place? Perhaps most frustrating is that a lot of the euro-supporting "good" news has already been made public. Previous interest rate and growth differential advantages are fading rapidly. ECB strategists counter that the euro's woes may stem simply from the fact that European investors, who historically diversified among various European currencies, have had no choice but to move into U.S. financial assets with the single currency's arrival. Missing from this argument of course is the fact that massive European capital outflows into the U.S. continue...