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European Affairs
Finance and Banking
The Euro: Britain Will Need More Time
Alasdair Murray
Director, Economics and Social Policy Unit, Centre for European Reform
When Tony Blair recently told the British press that, at this moment in time, he would not vote in favor of euro entry, he seemed to be conceding that the "no" vote in the recent Danish referendum had closed off hopes of Britain joining the single currency in the near future.
While the British Prime Minister was careful to state that his opinion was based on current economic circumstances, the media was in little doubt that the government had decided to downgrade its commitment to the euro.
With an election looming this year - and the euro one issue on which the Labour government appears vulnerable - hard political reality appears to have triumphed over the Prime Minister's professed support of euro entry.
Yet the Labour government appears incapable of maintaining a consistent line on the euro for long. Within days, London newspapers were awash with reports of fresh divisions within the government over economic and monetary union. Ministers and officials close to Gordon Brown, the Chancellor of the Exchequer, and Robin Cook, the Foreign Secretary, began briefing against each other.
Mr. Brown is seen as the leader of the euro pragmatists' school, determined not to let the euro become an obstacle to a second general election victory. Mr. Cook has, in the past, been much more overtly positive on the need for British euro entry.
In truth, the latest battle appeared to be less about policy substance than a turf war over which department rightfully leads on euro matters. But only an even bigger European dispute - this time between the government and opposition Conservatives over the creation of a European Rapid Reaction Force - finally succeeded in knocking the cabinet feuding off the front pages.
The latest Labour euro wobbles have been a godsend for the opposition Conservative party, which is still trailing in the opinion polls. Although the Conservatives are not without their own euro divisions, the strong line taken by their leader, William Hague, has largely quelled dissent.
Their "not quite never" euro policy - ruling out membership for at least another full term of Parliament, which can last up to five years - appears much more in tune with British public opinion.
More ominously for the government, the Conservatives appear to be shifting the terms of the debate from the euro to the perceived failings of the European Union in general. Europe is the one clear issue on which the Conservatives feel they can embarrass the government.
In this sense, Mr. Blair's comments on the euro should be considered a touch disingenuous. It is less the economics, as he suggests, than the stubborn anti-euro sentiment amongst British voters that is preventing the government from moving as quickly as it would like.
In many ways Britain's economy is far more suited to euro entry than many of the 11 countries that actually joined in the first wave at the beginning of 1999 - a point recently made by such august international organizations as the International Monetary Fund. But it appears increasingly likely that, unless the economics are absolutely right, the British population will not be swayed by the virtues of membership of the single currency.
One of the principal problems the government faces is that it is not just the general electorate that is dubious about the economics of the euro. Unlike in Denmark, which voted against the euro by 53 percent to 47 percent in September, even the British economic policy-making establishment harbors serious doubts. British opinion polls have consistently shown much greater opposition than in Denmark.
Eddie George, Governor of the Bank of England, recently made it clear that he perceived the pound's high level as making entry untenable at present. But reducing the pound to a "sustainable" level would mean cutting interest rates to a level "which would destabilize our overall domestic economy," Mr. George argued.
This view is, to an extent, shared by the Treasury, which is more than aware that the pound's high value against the euro has helped to keep inflation in check. And it is the Treasury that will have the final say on when the economy is ready for membership of the single currency.
The Treasury, under Mr. Brown, is the guardian of the government's five "economic tests" - the criteria the government will use to determine when, and whether, euro entry is appropriate.
The Treasury's dilemma is accentuated by the good performance of the British economy. The UK, once regarded as the economic sick man of Europe, is enjoying a period of prosperity unparalleled in recent history.
Unemployment is at historically low levels, while the equally important employment rate is at record highs. The inflation rate is amongst the lowest in Europe, a fact for which the government can take some credit, thanks to its decision to grant independence to the Bank of England.
This is not to say that all sectors of the economy are prospering. The manufacturing sector has long struggled with the high level of the pound. A number of major foreign investors, including Japanese carmaker Honda, have strongly hinted that they will have to reconsider their UK factories unless the government looks more favorably at euro membership.
Economists calculate that more than 30,000 jobs have already been directly lost because of Britain's reluctance to embrace the euro. The real figure, once the impact is considered all the way down the supply chain, is likely to be much higher.
In recent months, however, exports to the euro area have been picking up, suggesting that many British manufacturers are beginning to adjust to the high exchange rate. Nor is there clear evidence that overall levels of foreign direct investment are falling away.
For the moment then, the economic arguments in favor of British membership of the euro are not clear-cut. The government has, in effect, found itself in a Catch-22 situation: the very success of its economic management has made the euro a far less attractive option.
Put crudely, only a substantial economic slowdown - which in itself could lead to electoral defeat and the return to government of the anti-euro Conservative party - seems likely to shift public opinion.
So what could convince the British population of the economic necessity of joining the euro? The "easy" element is economic convergence with the euro zone. While there will always be high-flown arguments about whether convergence is permanent or temporary, it is perfectly feasible to guide the pound down and ensure that UK and euro zone interest rates keep roughly in line.
As Mervyn King, Deputy Governor of the Bank of England, has remarked, assessing convergence will always be a matter of judgement, not pure science.
In fact, some form of convergence is likely to continue in the next couple of years even without direct policy action. Most City economists believe that British interest rates have peaked.
In the euro zone, on the other hand, inflation is continuing to overshoot the European Central Bank's target rate and, as a result, interest rates are likely to rise from lower levels closer to the British rate.
If and when the euro finally turns steadily upward on the foreign exchange markets, the pound is likely to fall quickly toward a rate that most economists would regard as more sustainable.
The far harder task is demonstrating to the British electorate that the euro is a strong and stable currency and that the country is missing out by not becoming part of a dynamic economic zone. While much of Europe has grown faster than the UK this year, the perception remains that the euro zone economy is sclerotic.
The structural reform efforts already underway in many European countries have been largely ignored by British economic commentators and, more importantly, by the currency markets.
This is why Mr. Blair is redoubling efforts to keep structural economic reform on the European agenda. He recently teamed up with José Maria Aznar, the Spanish Prime Minister, to issue a joint statement on their ambitions for this year's summit meeting in Stockholm, the follow-up to the Lisbon meeting that committed EU leaders to economic reforms last spring.
The two leaders noted that, while economic reform is important to Europe as whole, it is essential for "a strong and successful euro." They are calling upon the EU not only to make further efforts to liberalize key sectors such as telecommunications, but also to implement a steady reduction in the level of state aids and to tighten European competition policy.
In a sense, European economic reform has become the British government's sixth, and arguably most important, economic test. Yet there is probably also an unspoken seventh test, and one over which the British Prime Minister has no control. The future of the U.S. economy is also pivotal to the debate in Britain.
At present, the general view is that the British economy is more in tune with the low-cost and flexible U.S. economy than with the "unreformed" European model. As long as the United States continues to outperform Europe - as is best demonstrated by the dollar's strength against the euro - the belief will hold that Britain is better off imitating the United States than joining the euro zone.
Reversing these perceptions will take time. While pro-euro campaigners still harbor hopes that a referendum will be called in the autumn of 2002, there are many analysts who now believe Mr. Blair will not put the issue formally to the electorate until after he has won a third term in government.
This implies that Britain would not be a member of the euro zone until the end of the decade. But such is the extent of opposition to the euro, the British economy will probably have to suffer some real economic pain before the tide begins to swing in favor of euro membership.