Will Europe suffer the Swiss Syndrome? Confronting anew the problems if the world moves into euros.

• Author: Hudson, Michael

Diversification of central bank reserves into larger holdings of euros is much in the news these days. Quite apart from the widening U.S. trade and payments deficit, the Iraq war has created a backlash that has led some Arab and Islamic politicians to urge OPEC countries to price and sell their oil in euros and shift their central bank reserves out of their present heavy weighting in dollars.

If this were the 1960s, central banks would be cashing in their dollar inflows for gold. But since the United States went off gold in 1971, a built in market for U.S. Treasury bills has emerged as the only practical alternative to gold.

The question is whether this central bank market lot U.S. Treasury securities is infinite. If it is, then the United States would find its interest to lie in a permanent policy of "benign neglect" for its federal budget deficit and the balance-of-payment deficit that helps finance the government deficit via foreign central bank recycling.

U.S. officials have come to recognize that if OPEC-held dollars or U.S. Treasury bonds are exchanged for securities denominated in euros, these dollar securities simply will be passed on to the central banks of Europe. Oil-exporting countries would sell their U.S. Treasury bonds and buy those of European countries. This would oblige Europe's central banks to choose between lending their dollar inflows back to the United States by buying U.S. Treasury securities (financing America's federal budget deficit in the process), or seeing their currencies appreciate against the dollar, much to the disquiet of their domestic producers and exporters.

The fact that this problem persists more than thirty years since the United States went off gold shows how successful its economic diplomacy has been in turning seeming problems into unanticipated success. If matters continue on their present course, OPEC would solve its dollar problem by passing it on like the proverbial hot potato. A shift of dollar's from OPEC or other countries probably would not reduce global central bank holdings of U.S. Treasury securities, but merely would shift these holdings out of OPEC and Islamic central banks to those of Europe.

Europe's dollar dilemma explains why today's currency markets are more volatile than at any time since the 1930s. The euro's roller coaster against the dollar has lifted its exchange rate to $1.20 and then pushed it down by 10 percent in the past few months. Put in its global context, the problem facing the currency markets--and central bankers--is as follows: If countries diversify their official reserves...