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Columbia University Professor Robert Mundell was appropriately traveling in Europe in mid-October when he learned that he had been named this year's Nobel laureate for economics. His work 30 years ago on the benefits of implementing a single currency within a geographic region was cited by the Royal Swedish Academy of Sciences in awarding the Canadian-born Mundell the Nobel Prize.

In effect, he's the godfather of the euro, the common currency launched by the

European Union

at the start of 1999. He's also a part-time resident across the pond, having long owned a rambling Roman-style palazzo in Tuscany (where actor

Mel Gibson

is a neighbor) in the north of Italy. He says that part of his $1 million prize will go toward fixing it up.

Back teaching at Columbia, Mundell recently spoke with

Jack Egan

, who follows economics and domestic and global financial markets for

U.S. News & World Report

magazine, about what he sees happening in the U.S. and the world economy and how it might affect investment markets.

Jack Egan: You've long been considered to be on the short list for the Nobel prize in economics. Did you think this would be your year?

Robert Mundell:

People keep asking me if I was surprised. I always say "yes." But I thought the odds this year were about 50-50, so I was half-surprised.

Egan: I'd like to start by asking you about the dollar's slow but continuing decline. It's down about 10% from a year ago against a basket of currencies. Is there any reason investors should fret?

Mundell:

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The dominant factor governing the value of the dollar is the growth rate of the U.S. economy. When growth is strong, the dollar is strong. Conversely, if growth slows here the dollar will weaken. I don't see enough signs to convince me that a slowdown has started, though it's likely the U.S. economy will be turning that corner in the next few years, maybe even next year.

Egan: So why has the dollar already softened if growth keeps powering ahead?

Mundell:

We're seeing at least some signs of economic deterioration. One is the increase in long-term interest rates -- a big spread has developed between European and American interest rates. That gap reflects the expectation that the dollar will depreciate against the euro. If that continues to happen, other negative factors will come into play for the dollar.

Egan: Such as?

Mundell:

People already are bothered by the size of the U.S. trade deficit and what it will take to finance it. They'll worry more if the dollar drops. Conversely, there will be concern that if the euro gets stronger, which I expect, it will naturally become more attractive as a reserve currency. So countries will not want to keep adding to their dollar holdings. Quite the contrary, they will want to add euros to their reserves until the position reaches a kind of equilibrium.

Egan: What size shift do you see in the cards?

Mundell:

By the end of the next decade, I believe many governments will want to split their reserve assets almost equally between euros and dollars. If that comes about, you'll have a growth in demand for euros of something like $100 billion per year, on average, over the next 10 years -- or $1 trillion. The U.S. economy has gotten used to depending on what has been steadily increasing annual demand for dollars from abroad to finance the trade deficit. When that's no longer the case, and the desire to hold dollars actually starts to decline, that could become a major negative -- not just for the economy -- but for U.S. financial markets, which have relied on foreign investors.

Egan: Besides no longer buoying stock prices, how will an outflow of capital affect interest rates?

Mundell:

When the economy slows, a weaker dollar will cause capital to flow out, and that will unfortunately have an adverse impact on interest rates because foreigners will also sell. When there's a slowdown or recession, the

Federal Reserve

loosens monetary policy to stabilize the economy. But if the next slowdown gets coupled with a weaker dollar, interest rates will continue to go up. We might in fact already be moving to a new plateau where interest rates remain higher than might otherwise be the case for the next two to four years.

Egan: Just how much higher?

Mundell:

I see very little chance of long-term rates falling much below 5%.

Egan: So you feel that if the dollar erodes and creates capital outflows, we'll see a rise in rates here even -- if there's a slowdown?

Mundell:

Yes. Due to a weakening dollar, we'll probably see pressure on inflation. Imports will cost more. And if the dollar seriously weakens, that would almost certainly lead to a big increase in oil prices -- and in gold prices.

Egan: Does the move of gold from $250 an ounce to more than $300 suggest to you that inflation is creeping higher?

Mundell:

Not necessarily. You could say the earlier decline to below $250 an ounce reflected deflation. Some countries, such as Japan, indeed experienced a very slight deflation. Also, when gold went to $300 and then to $250, it could also be argued that this reflected monetary policy had become too tight.

When gold went up again recently, it was of course partly in response to the announcement by the European central banks that, contrary to expectations, they would not sell more than 100 tonnes of gold a year from their reserves for at least the next four years. That took a weight off the market, which had kept it depressed.

Egan: But how would you interpret any continued rise -- though lately of course it's fallen back to less than $300.

Mundell:

Should it increase, and increase substantially, say it goes through $350 to $375, and maybe higher, this would be an indication that we're really starting to do something wrong with our economy.

Egan: With the advent of the euro, do you see OPEC perhaps going to a combination of pricing oil in both dollars and euros?

Mundell:

Sure they might. They could even shift entirely from the dollar to the euro. However, the OPEC countries are also quite conservative when it comes to changing their policies, so they're not going to shift very easily.

In part two of this interview, scheduled for Sunday, Mundell shares his policy prescriptions for the inevitable U.S. slowdown.

Jack Egan follows economics and domestic and global financial markets for

U.S. News & World Report

magazine.