Pro-euro ministers are pushing the Chancellor to revisit his five tests of single currency entry later this Parliament. This would hold open the prospect of a referendum before the next general election, which could be as late as 2006. The more sceptical members of the Cabinet, Mr Brown among them, fear that a rerun of tests so soon would undermine their credibility. They are right to be concerned.
Britain is nearer to satisfying the Chancellor’s five tests than it was in autumn 1997, the time of the last assessment. But there is some considerable way to go before a “clear and unambiguous” economic case can be made for UK euro membership. Indeed, as MPs on the cross-party Treasury Committee pointed out yesterday in their report on the subject, it is doubtful whether the economic case for joining the euro will ever be totally unambiguous. Economics is never black and white, and an element of political judgment is inevitable.
Early leaks suggest that the Treasury has found that only one of its five tests has been passed — number four, which asks whether the euro would help the UK’s financial services industry. This test was also met in 1997, with the Treasury arguing then that the City would enjoy more opportunities inside the euro than out. For the financial services industry, the euro would mean deeper, more liquid capital markets as well as greater opportunities for expansion. The Treasury is probably right to conclude that, in this area if no other, the euro would have a beneficial effect.
Euro-enthusiasts should stop reading now. Six years after the initial Treasury assessment of the economic case for entry, and more than four after the launch of the euro itself, it is far from clear that any of the other five tests have been met. Some are closer to being passed than they were, and may be achievable in the relatively short term. But, in other areas, the UK is as far away as ever from the eurozone.
Aside from the potential impact of the euro on the financial services industry, there is only one other test that has a decent chance of being passed within the next few years. Indeed, some economists already believe that the answer to test three — would joining the euro encourage firms to invest in Britain? — is a yes. Others are more doubtful, saying that it depends crucially on whether progress has been made on the Chancellor’s other economic criteria.
There are good reasons to expect a short-term boost to overseas investment were Britain to say yes to the euro. Many multinationals do not care about the minutiae of the euro decision, but they do care about the exchange rate. Fear about sharp swings in sterling is one reason why some companies say that they would prefer to base their operations in continental Europe than in the UK. Signing up to the euro would remove an important element of exchange rate uncertainty, and would, in the short term, probably improve inward investment prospects.
Yet it is still far from clear that joining the euro would be good news for investment over the long term. Were the UK to join at the wrong exchange rate, or if it could not live with eurozone borrowing costs, the country’s competitiveness would suffer. Longer term, the attractiveness of the UK to overseas investors would be undermined. This could potentially outweigh the benefits of any short-term boost to investment seen during the first flush of single currency membership.
Test three falls into the “no, but getting there” category. Some argue that test one, probably the most important of any of Mr Brown’s assessment criteria, belongs in the same file. Were there to be a yes to test one — which asks whether the UK could comfortably live with eurozone interest rates — then the Government would be in a strong position to argue the case for single currency membership. The trouble is that, although the UK is closer to passing test one than it was, sustainable convergence with the eurozone remains some way off.
There has been a degree of convergence between the UK and the eurozone since 1997. Business cycles are more in sync than six years ago, while the difference between UK and eurozone interest rates has fallen from 4 percentage points to one. Supporters of early single currency entry claim that progress on convergence means the UK could now operate successfully under eurozone borrowing costs. This, they say, means that test one has been passed.
But although business cycles between the UK and the eurozone are more similar than they were, important differences remain. Britain’s recent growth record has been better than that of the eurozone, and its prospects are brighter. There also are big differences between the make-up of economic growth in the UK, and that elsewhere in the eurozone. In the UK, for example, consumer demand has surged in recent years; in Germany it has collapsed. Even taking into account the consumer slowdown expected by most forecasters in the UK this year, there is still a considerable gulf.
Cyclical economic convergence — that is, convergence between the business cycles of the UK and the eurozone — may be closer. Yet structural convergence is as far away as ever. It is one thing for two business cycles to move in line at a given point in time. It is quite another for them to stay together through hell and high water, as would be required for the sustainable convergence criteria to be unambiguously fulfilled.
Substantial structural differences remain between the UK and the eurozone. This means that Britain and Europe are likely to respond differently to certain economic shocks. As a result, it is hard to argue convincingly that the UK could live comfortably with eurozone interest rates at all times, as required under a strict interpretation of test one. This lack of structural convergence also means that the UK has not yet passed test two — which requires there to be sufficient flexibility to cope with economic change.
The labour market is one important source of structural difference. The UK jobs market is more flexible than most in the eurozone, as well as being more effective in getting people back to work. Long-term unemployment is lower, and part-time working is more common. This has left the UK jobs market better placed than many in Europe to cope with economic shocks such as the IT boom and September 11.
The fondness of the UK homeowner for variable rate loans is another key structural difference. The UK has a much higher proportion of owner-occupiers than most other countries in Europe. The overwhelming majority of these have their home loans on variable, rather than fixed, rates. As a result, the UK consumer is highly sensitive to changes in the short-term rate: a relatively modest cut in interest rates typically fuels a spate of housebuying, pushes up property prices and leaves owner-occupiers feeling better off. Consumers elsewhere in Europe tend not to react in the same way, and this could cause no end of problems were the UK to become the single currency’s thirteenth member.
The Chancellor’s fifth and final test — would the euro be good for economic growth and employment — throws up yet more hurdles to entry. The fifth test is, in some ways, a wrap-up test that can be passed only if the other four criteria are fulfilled. But it also covers big picture topics not dealt with elsewhere, such as the appropriate level of the exchange rate and regulatory reform.
Presuming that the recent fall in sterling against the euro is sustained, the exchange rate is not the barrier to single currency entry that it has been for most of Labour’s time in office. Yet many problems remain. Among the developments that have most infuriated pro-euro ministers in recent years is the failure of Europe to make meaningful progress on institutional and regulatory reform.
On the institutional front, there is widespread irritation at the eurozone’s inability to agree changes to the Stability and Growth Pact — the Brussels rules on tax and spending that have been blamed for stifling growth. On regulatory reform, the UK remains streets ahead than most of the eurozone. In “old” Europe in particular, a failure to deregulate means that inefficient state monoliths still dominate many industries. Unless and until more progress is made, it is hard to argue that going into the euro will leave the UK unambiguously better off.
There is only one sort of euro “no” that makes good economic sense at the moment. And that is one that rules out single currency entry until at least the second half of the next Parliament. Any other verdict would be a triumph for politics over economics, and would put the UK’s hard-won prosperity at risk.
lea.paterson@thetimes.co.uk
