Get article background
BY THE first week of June, Gordon Brown, the chancellor of the exchequer, must announce the results of the most comprehensive study the Treasury has ever made of a single decision: whether or not Britain should join the euro. His answer will be: not yet. This will make it virtually impossible to join the euro before the next election, which will probably be in 2005.
The Treasury's analysis has spawned 18 supporting studies and will run to 2,000 pages. But at its heart are five tests, which Mr Brown first set in October 1997. Are business cycles and economic structures compatible so that Britain can live permanently with euro interest rates? If problems emerge is there sufficient flexibility to deal with them? Would joining the euro encourage investment? How would the City of London be affected if Britain joined the euro? Finally, will joining the euro promote higher growth, stability and a lasting increase in jobs?
Leaked reports suggest that four out of the five tests will be “failed”—the same result as six years ago. But whatever the pass rate, the judgment will be less damning than the dunce's report of 1997. This is especially clear with the first test, about convergence. Short-term interest rates are now much closer than in 1997. So, too, are output gaps, which measure whether economies are overheating or running below capacity.
So does this mean that Britain passes the convergence test? Probably not. The house-price boom of recent years has highlighted a fault line between Britain and the euro area. A house-price bust could weaken demand. As long as Britain retains its own currency, the Bank of England can respond with lower interest rates. A Europe-wide interest rate would make that impossible. Mr Brown revealed in last month's budget that he is looking for ways to make housing finance less reliant on short-term floating-rate mortgages and so less vulnerable to short-term interest rates, which suggests he thinks that Britain has not yet achieved the goal of “sustainable and durable” convergence.
What of the second test, about flexibility in the event of economic mishaps? At present the pound can fall if Britain's costs get out of line with those of the euro area. But once Britain joins the euro, wages will have to fall to restore competitiveness. In 1997, Mr Brown concluded that Britain's economy was not yet flexible enough to join the euro. In his budget speech, he seemed still to be worried about the issue. With good reason: wage costs carried on rising in the trading sectors of the economy when the pound appreciated so sharply in the late 1990s. So the real loss of competitiveness was even greater. This is a further reason to doubt whether the recent fall in the pound against the euro has gone far enough.
The way that the Treasury initially assessed the second test also gives it scope to find fault on another ground: the euro area's own lack of flexibility. The European Council agreed a set of ambitious targets to unclog labour markets when it met in Lisbon three years ago. Progress since then has been disappointing.
The Treasury will find it more difficult, however, to score the third test, about investment, as a “fail”. For one thing, higher investment is potentially the big prize from joining the euro. Businesses will no longer have to worry about exchange-rate risk. Currency unions can give a big boost to trade; and this seems to be happening within the euro area. More trade and greater price transparency should mean more competition and thus higher productivity growth.
Set aside the potential gains in higher investment from joining the euro: staying out could mean less investment, especially from overseas companies. After several years in which Britain was usually the top recipient in the EU, its share of foreign direct investment fell sharply in 2002, according to preliminary estimates from the United Nations Conference on Trade and Development. On balance, it seems difficult to see why this test should not be marked as a “pass” unless Mr Brown invokes broader concerns about the impact on investment if Britain joins the euro before full convergence.
The fourth test is about the effect of joining the euro on Britain's financial services. Staying out has done the City no harm: its current difficulties arise from the general weakness of financial markets. Still, the Treasury concluded in 1997 that it would do better within the single currency area than outside it, so it is likely to stick with that assessment.
The fifth test will highlight the euro area's disappointing record on growth and jobs. Britain has grown faster than the euro area since its launch in 1999 and by even more in the past ten years. That looks set to continue. The OECD is forecasting that Britain will grow by 2.1% in 2003 and by 2.6% in 2004, compared with 1% and 2.4% in the euro area. And it expects Britain's unemployment rate to be 5.4% of the labour force in 2003, compared with 8.8% in the euro area. Mr Brown peppered his budget speech with such unfavourable contrasts, which suggests that the Treasury will also score this test as a “fail”.
So on at least three of the five tests, the decision will be: not yet. But this judgment leaves a lot to play for. Given the clear and stable majority in the opinion polls for staying out, that is clearly the safer option politically. But Mr Blair still wants to go in. Paradoxically, a period when Britain's economy is under-performing the euro area would help him make the argument.
If Mr Blair is determined to take the gamble, the best time to call a referendum would be a few months after a third election victory—in late 2005, say. For that to happen, the Treasury's negative judgment will have to have a positive spin. The five tests are therefore likely to generate two answers. One will be: not yet. The other will be: but we're getting there. Mr Brown may bury the issue for the rest of the parliament, but it is likely to be resurrected a lot earlier than many now expect.
Copyright © 2003 The Economist Newspaper and The Economist Group. All rights reserved.