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Will EMU fly?

The end of the first week of June is the deadline the Chancellor has set for announcing whether the UK has met the Five Tests for entry into the single currency. If the tests have been satisfied, and if parliament votes in favour, the final decision will rest with the public in a referendum.

So this is the year Britain decides if we are going to decide! Even if all the hurdles are cleared, entry is still some way off. The official Changeover Plan will be a transition process lasting 34-40 months once the decision had been made. So if the government wanted the referendum and the introduction of the euro to take place in the same parliament, July is about as late as the verdict on the Five Tests can be left.

Nonetheless, the prime minister has said that the economic advantages to the UK joining the single currency must be “clear and unambiguous” before the government could support entry. When the tests were originally applied in 1997, it was obvious that entry was not a realistic proposition, but since then much has changed. Both the europhiles and eurosceptics believe their cases have been strengthened by recent events.

Of the Five Tests, the first is the most important. Sometimes referred to as the ‘touchstone’ or acid test, it is concerned with whether the business cycles are sufficiently synchronised to make the ‘one size fits all’ monetary policy appropriate for the UK. Convergence, moreover, has to be sustainable, not just momentary.

In 1997, the economic cycles in the UK and Euroland were miles apart.

After the recession of 1990-92, the UK achieved a strong recovery in output and employment, moving more in line with the US than Europe. For most continental European economies, though, the recession came later and recovery has been more sluggish.

Following the implementation of the new macroeconomic policy framework in the UK in 1997, however, several of the key indicators have started to move more in line with Europe. In terms of growth, interest rates and inflation, the gap has narrowed. Even the recent decline in sterling has helped, weakening the arguments of those who were concerned that we could lock into the euro at an uncompetitive rate. In addition, more technical measures, such as the output gap, structural trade patterns and dependence on the US, have all come closer together in the past few years.

Encouraging as these movements are for euro supporters, they are not the whole story. Structural issues have to be taken into account. It is always possible that events will occur which will have a greater impact on some countries than others. A recent analysis by HM Treasury concluded that the eurozone remained too inflexible to respond to external pressures.

In one key respect, however, it is the UK which stands apart from most of the rest of the EU in a way that increases the risks associated with the introduction of a single interest rate.

While the global economy has been heading south in the past couple of the years, the UK has managed to sustain reasonable rates of GDP growth.

But the UK, with owner-occupation well above the Euroland average and record levels of consumer debt, is especially sensitive to interest rate changes. Borrowing in Britain is usually at variable rather than the fixed rates common in the EU. Any given change in interest rates, therefore, has a larger impact on the UK than on the single currency. Given how precariously placed the economy is at the moment, and the key contribution the housing market has made to activity, this may not be the best time to hand over control of monetary policy to the ECB.

The issues that should matter, if and when a referendum is held, can be summarised by the rhetorical question, What do the letters EMU stand for? The answer is not, as many believe, European Monetary Union but rather Economic and Monetary Union. Monetary union refers to interest rate and exchange rate policy, but economic union is about issues such as taxation, labour market regulation and the funding of pensions. What economic union means, and how much we need to make monetary union work, have not be spelled out by the policymakers.

The most likely outcome of the Treasury deliberations is that we will pass some but not all of the tests. In this context, 3-2 is not a victory; only 5-0 will do. But being able to report progress on the 1997 assessment keeps the hopes of europhiles alive without risking a referendum that will be hard to win. At a time when the economic case is not proven, delay looks like the best solution.

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