It was portrayed by Time magazine as a vibrant baby striding the globe, clutching a gold (euro) rattler. Robert Mundell, the father of the "optimal currency area" model, warmed to the idea that it would rank alongside the dollar as a global currency. Leading economists predicted a 40 per cent appreciation. It is still early days, but so far, these expectations have not materialised. The euro has taken a battering on the foreign exchanges, even slipping slightly against the Greek drachma, a currency humiliatingly excluded from the single currency club. Officialdom has been rather muted on the reasons for its decline. The Central Bank in its latest bulletin vaguely suggests that it is due to "differing outlooks for economic fundamentals".

But the fundamentals, if anything, appear to be on Europe's side. Last year, the euro zone recorded a balance of payments current account surplus equivalent to 2 per cent of GDP. The US, in contrast, clocked up a deficit of 2.7 per cent. Both the euro zone surplus and the US deficit are forecast to rise in 1999.

In addition, the euro zone has a lower inflation rate and a slower real growth rate compared to the US. The latter improves the balance of payments position as slow-growing countries tend to import less. Collectively, a balance of payments surplus, low inflation and a slow growth rate should result in currency appreciation. It has not happened. So much for the fundamentals.

What has happened is that, following the Asian crisis, a tidal wave of capital investment has landed on the US shore. This capital inflow into debt, equities and investments of all kinds has overwhelmed the outflows due to the current account deficit. The result is that the dollar has appreciated. Capital is flowing into the US because it is a vibrant economy offering a higher return on investment. US interest rates at 5 per cent are double euro zone rates.

US stock prices, corporate profits and dividends have all left those on this side of the Atlantic trailing in their wake. The euro zone, by contrast, is caught in the economic doldrums. While there have been a few positive signs recently, most of the major institutions have revised downward their growth forecasts for the euro zone in 1999 and 2000.

Industrial confidence indicators are also falling to new lows. Unfortunately, there is little prospect of a turnabout in the immediate future. Economic policy-making in the euro zone is too fragmented and there is no coherent policy to deal with recession should it arise. There seems to be a belief that somehow the economy will automatically right itself. But product and labour markets are not flexible enough for this to happen.

The European Central Bank (ECB) did respond to the forecast downturn by increasing the money supply (above its own reference rate) and lowering interest rates by half a percentage point.

It is doubtful, however, if this will have any lasting impact. Keynes, writing in 1933, likened this strategy to "trying to get fat by buying a larger belt". Lower interest rates did, however, contribute towards the euro's slide against the dollar, thereby improving the euro zone's competitive position. But this is not the way to go. A country with a balance of payments surplus should not resort to devaluation to stimulate growth. A different policy mix is required.

On the fiscal side, there is little scope for manoeuvre. The Stability and Growth Pact requires euro zone states to push from the current budget deficit position of 2.3 per cent of GDP to a balanced, or surplus, position. The US, in contrast, is enjoying a budget surplus and will find it much easier to meet the cost of the NATO offensive in Serbia. Exchange rate policy is non-existent. The decision to cut interest rates and the consequent weakening of the euro illustrates that the exchange rate is only of peripheral concern and is a residual to the ECB's monetary strategy. In real time, the euro baby would now be in custody and the parents in court on a negligence charge.

According to the statutes, responsibility for the euro lies with the European Central Bank, in consultation with the Council of Ministers. This means that states outside the euro zone (Britain, Greece, Denmark and Sweden) have a vote on issues relating to the currency. This is like agreeing to let the neighbours raise the child.

The prognosis, however, is not all doom and gloom. US interest rates are expected to increase in 1999 and the euro will fall further as a result. However, thereafter it should bounce back. The current interest rate differential of 2.5 per cent between the US and the euro zone is an indication that the financial markets expect the euro to appreciate sooner or later.

It is not difficult to see why. The capital inflows into the US are a de-stabilising force which must result in a corrective action at some future date. First, given the US balance of payments deficit, the capital flowing into the US is pushing the dollar's exchange rate in the wrong direction. Dollar appreciation makes imports cheaper, worsening the balance of payments position and moves the US economy away from equilibrium. This situation cannot be sustained indefinitely.

Second, the dollar appreciation increases US workers' real wages and this adds fuel to the consumer boom already under way. This is reflected in higher stock market prices making it even more attractive for foreign investment.

So far, a "seismic change" seems to have occurred in the US in the relationship between unemployment and inflation. Economic growth is creating wage inflation but, due to productivity gains and cheap imports, this has not translated into higher inflation. Unit labour costs in the US are, in fact, declining.

At some stage international investors will decide that either the balance of payments deficit is unsustainable or/and they revise inflation expectations upwards. That will be the signal to exit dollars.

Investors who get out first stand to gain most as they can sell dollars at a high exchange rate. The herd, however, will not be far behind and the whole process could result in an unseemly flight from dollars.

At present there are nine international institutions responsible for the supervision of the international financial system. However, they lack the co-ordination necessary to produce an effective counter-active policy. Unrestricted, financial capital can exit markets with an ease and speed which could provide a spectacular economics display in the millennium year.

Dr Anthony Leddin is senior lecturer in Economics at the University of Limerick.