Five tests, one enormous muddle

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WHILE travelling in the back of a taxi in Washington in 1997, Gordon Brown, the Chancellor, and his adviser, Ed Balls, drew up a series of five economic tests which would subsequently have to be passed before Britain could join the euro.

Despite the less than rigorous way in which the tests were originally devised, the Treasury has taken them very seriously ever since. After much sweat and tears from an army of economists and number crunchers, the verdict - pass or failure was finally released yesterday.

FIRST TEST: Are the British and eurozone economies sufficiently compatible so that we and others could live comfortably with euro interest rates on a permanent basis?

Brown verdict: Failure. Although better, conditions are still not good enough.

The Treasury believes there has been significant convergence since 1997, although it makes it clear it does not think this process has gone far enough to make it safe for us to join.

Convergence is crucial because joining the euro means subjecting the British economy to a one-size-fits-all interest rate determined by the European Central Bank (ECB) in Frankfurt.

Economies that share the same currency must have the same characteristics and be growing at similar rates at any given moment to avoid generating a boom in parts of the monetary union and a recession in others.

One important area of divergence between Britain and the eurozone is their housing market: most UK mortgages are either floating rate or fixed for a few years, while most European mortgages are fixed for 15-years or more. As a result, changes in interest rates have much more impact on the British economy that they do in Italy or Spain.

If the Treasury is to be believed, the UK is now more convergent with the eurozone average than several of its current members. But while Mr Brown may believe this shows how well Britain is doing, such a wide degree of divergence between the countries already in the eurozone hardly inspires confidence in the future economic prospects.

Last week, in a graphic illustration of the continuing differences between the British and eurozone economies, the Bank of England chose to keep interest rates on hold at 3.75 per cent, while the ECB slashed its rates to just 2 per cent.

Many economists now expect eurozone interest rates to fall further, perhaps to as low as 1 per cent, by the end of the year, while in the UK, the cost of borrowing is expected to fall to somewhere between 3 per cent and 3.5 per cent. That would mean that UK rates would be between three and three and a half times higher than in the eurozone by the end of the year; not exactly what even the most ardent euro-enthusiasts would call convergence.

The problem is that continental Europe is growing very slowly and several countries, have plunged back into recession, with their output shrinking and unemployment soaring, requiring far lower rates than the UK. While Britain is expected to grow at about 1.8 per cent this year, twice that of the eurozone, Germany will probably stagnate again this year and its jobless total reach five million or so.

Crucially, while boasting that Britain’s public debt meets European guidelines, the Treasury omitted to point out that many independent commentators now believe the UK budget deficit will this year bust Europe’s limit: 3 per cent of national income.

SECOND TEST: If problems emerge once we are in the euro, would the British economy be sufficiently flexible to cope?

Brown verdict: Failure. Although better, conditions are still not good enough.

The Treasury believes that, while UK labour market flexibility has improved since 1997, more needs to be done, both here and in the Eurozone, before Britain could "safely" join the euro.

The more flexible an economy, the easier and the less painlessly it can cope with unexpected economic shocks, such as higher war-induced oil prices or a sudden drop in demand from a key trading partner. A rigid jobs market, where the unemployed refuse to take jobs they do not like or where employers are forced to comply with reams of red tape, would almost certainly mean higher unemployment once in the euro.

This is why the Treasury’s assessment is so bizarre: on most measures, following the introduction of the national minimum wage and the adoption of the 48-hour week, Britain is less, rather than more flexible than it was a few years ago, reinforcing the case against the euro.

THIRD TEST: Would joining EMU create better conditions for firms making long-term decisions to invest in Britain?

Brown verdict: Failure. Improvements in convergence and flexibility are required first.

Although the Treasury maintains that the costs of investment would fall for British firms in the euro, it admits that "it is difficult to say with confidence that EMU has boosted foreign direct investment within the euro area".

The Treasury is undoubtedly exaggerating the importance of stable exchange rates while underplaying factors such as tax rates and regulation in determining whether a country provides conducive conditions for businesses to choose to make long-term investments.

In the past few years, the UK’s tax rates have increased significantly, taking them closer to the European average. Most notably, Mr Brown raided pension funds shortly after he became Chancellor in 1997 and in April he slapped an extra 1 per cent in National Insurance contributions.

Together with a flood of labour market regulations, some of which were designed in Westminster and others in Brussels, the British economy is beginning to look increasingly like those of Germany and France - not the right sort of convergence given those two economies’ poor performance in recent years.

If the government wishes to boost Britain’s traditionally poor productivity rates, it would be better off trying to make the UK economy more competitive by cutting taxes and reducing red tape, rather than relying on euro membership.

FOURTH TEST: What impact would entry into EMU have on the competitive position of the UK’s financial services industry, particularly the City’s wholesale markets?

Brown verdict: Pass-mark. It would be beneficial.

This is the only test that Mr Brown claims the UK has passed and where he says joining the euro would unambiguously benefit the British economy.

According to the Treasury assessment, "entry would offer [Britain’s financial services industry] greater potential to compete and capture the effects of increased EU integration".

However, the behaviour of the world’s largest financial institutions, which have overwhelmingly cut back on their operations in Frankfurt and Paris since 1999, moving staff and offices to London instead, suggests the Treasury is almost certainly exaggerating the benefits of the euro.

Arguably, membership of the single currency is irrelevant to the prospects of the City, whose bankers happily conduct business in as many currencies as required. Of far more importance is the UK’s traditionally benign regulatory environment, a large pool of motivated and qualified bankers and the use of the English language.

FIFTH TEST: Will joining EMU promote higher growth, stability and a lasting increase in jobs?

Brown verdict: Failure. An improvement in flexibility and convergence are required first.

At the heart of the case for joining the euro "when conditions are right" is Mr Brown’s forecast that trade between the UK and the eurozone would be boosted by up to 50 per cent over the next 30 years if the UK joined the euro and exchange rate instability was abolished. Such an increase in trade would increase Britain’s national income by between 5 per cent and 9 per cent during that 30-year period and boost long-term growth by 0.25 per cent a year to 3 per cent, according to the Treasury. This may not sound like very much, but if true, it would in fact represent a huge boost to the UK economy and to the whole population’s standard of living.

But this forecast relies heavily on a handful of academic studies on how tiny island states fared when they joined currency unions - which suggests that the effect on UK trade would be much less pronounced that Mr Brown believes.

While the assessment claims that trade with the eurozone has increased by between 3 per cent and 20 per cent more than it would otherwise have since 1999, the basis for this claim is also very dubious. The Treasury admits that a separate study of the effect of severing the currency union between the Britain and Ireland in the 1970s found that monetary union had no impact on trade at all.

• Allister Heath is the economics editor of The Business.