Wednesday, February 05, 2003
Still not ready for the euro
Posted by David Smith at 05:01 PM
Category: David Smith' s magazine articles

The clock is running down on one of the most important economic decisions in recent years. The Treasury has until the end of June to produce its assessment of Britain's readiness for euro entry, based on the famous five economic tests.

In practice, we are told, the assessment is likely to come some time ahead of the deadline, to avoid destabilising speculation in the markets. It could happen any day now.

So should we get ready with our Union Jacks and EU flags for the referendum battle ahead? Or will the Treasury, as its body language has suggested, kick the issue into the very long grass?

Let me say at the outset that the argument is not as clear cut as those on opposite extremes of the debate would suggest. As one who has argued against entry, I would concede that the case for euro entry has grown somewhat stronger in recent months.

If we look at the plus side, the euro over the past year has ceased to be a "basket case" currency (some in the currency markets had even ruder nicknames). Against the dollar it has shown a decisive recovery, of nearly 20% from its 2002 lows at time of writing.

The European Central Bank (ECB) can look forward this year to the appointment of the Frenchman Jean-Claude Trichet as the replacement for Wim Duisenberg as president, a move that will be welcomed in the markets. Even before that change of personnel it has started to talk some sense.

While Europe's political leaders continue to debate the institutional changes that will accompany enlargement to the east, the ECB is already working on some firm proposals. It wants, for example, to limit the size of its decision-making council to 21 members, however large the European Union, or rather the euro zone, becomes. That still sounds somewhat unwieldy in comparison with our own nine-member Bank of England monetary policy committee but it is a move in the right direction.

The ECB is also taking a look at the way its inflation target operates. Since the euro's inception in 1999, it has operated with a 2% inflation ceiling. This has been a little embarrassing, given that for quite a lot of the time inflation has been above 2%.

Now the ECB is talking of a 1% to 3% target range, which would be a significant change. It would mean that, like the Bank, it would be operating with a symmetrical target, with penalties for undershooting as well as overshooting.

There are still problems with the institutional framework under which the euro operates. The ECB will never, it seems, publish the minutes of its meeting or details of votes on interest rate changes, even if those votes take place.

The fiscal policy side of the euro, in addition, remains problematical. Not only was the stability and growth pact (SGP), which limits budget deficits to 3% of gross domestic product, badly designed. It could also pose problems for Gordon Brown quite early on. His own fiscal rules are flexible enough to permit the present increase in UK government borrowing as a "prudent" response to slower economic growth. The SGP would be less forgiving, requiring tax hikes or spending cuts.

If the institutional argument has, on balance, been moving in favour of entry, so have some of economic arguments. It seems, though the figures are still the subject of some debate, that Britain has been losing inward investment in the past two or three years. There could be any number of explanations for that, including higher UK taxes and the economic problems in America, Japan and the rest of Asia. But it is happening, and at the margin Britain's non-participation in the euro may be a factor.

Will all this be enough for the Treasury to deliver a "yes" verdict? I think not. The central requirement for safe entry into the euro is sustainable convergence between Britain and the euro economies. Britain, as a recent analysis by HSBC suggested, may be more converged with the core euro economies than Germany, formerly Europe's core economy.

Even so, there are areas of acute divergence between Britain and the euro area. Even with somewhat higher interest rates, the UK has had a house-price boom and sustained strength in consumer spending, in contrast to most of the rest of Europe. Britain is running its worst monthly trade deficits since record began in 1697, while the other big European economies are running surpluses.

If you could wave a magic wand in response to this set of circumstances, you would be right to conclude that the UK economy needs a somewhat lower exchange rate and rather higher interest rates. Euro entry should be at a lower level for sterling but it would also involve lower, not higher, interest rates. The risk would be an Irish-type acceleration of the housing market, consumer spending and inflation.

There are other arguments against euro entry. I would argue that Europe is a long way from being an optimal currency area, mainly because of its inflexible, geographically immobile labour markets.

I suspect, however, the Treasury's big concern will be that entry would risk the macroeconomic stability the government has been so proud to achieve. "If it ain't broke, don't fix it," is likely to be the Treasury's motto, however much a decision to go for entry would please the chancellor's Downing Street neighbour. And "no, not yet," is likely to be the official verdict on entry. No need to get the flags out this year.

From Professional Investor, February 2003

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