The Hindu : Five tests and an evasion

Online edition of India's National Newspaper
Monday, Jul 14, 2003

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Five tests and an evasion

Though the British are known for pragmatism in promoting their national interests, this Euro mess has been troubling them for long.

FOR THE U.K. Government and the British people, the question whether they should give up the pound sterling and adopt the Euro is a tormenting issue. More than politics or economics, it hurts their national pride. No other country has had such a long record of its currency. Its achievement preceded that of France by more than 600 years and Germany's and Italy's by nearly 900 years. As Glyn Davies puts it, it is "a factor perhaps in Britain's instinctive reluctance to embrace a single European currency.''

The island mentality retains its hold even when post-war developments drive the country to seek new pastures and alignments. Though the British are known for pragmatism in promoting their national interests, this Euro mess has been troubling them for long. It delayed their entry into the EC until 1973. Even after its entry into EC, it has remained a morganatic marriage giving them access to the EC market without the other obligations attached to a legal wedding, that is, a currency union.

Difficult decision

To continue with the simile, the adoption of the Euro is like wedlock without the option of a divorce. Rules do not permit exits and any decision to join the Euro is irreversible. Moreover, the adverse consequences of an exit would be incalculable. This alone differentiates it from the earlier experience with the ERM (exchange rate management) and makes the issue more difficult. Naturally, it breeds a tendency to delay decision and to engage in studies and debates to gain time.

It is an area where politics is inextricably linked with economics. There is a schism dividing the country, its political parties, classes, masses and academics. The divide is between Europhiles and Eurosceptics. There are innumerable research papers and programs on all aspects of EU/Euro and it is difficult to keep track of them. Plenty of material is available on most issues and to suit any political stance. What seems lacking is the will to take the leap of faith.

At the European end, most leaders look upon it as a political program to promote a larger union of European states. For them, the EU is primarily a political agenda and the Euro is an instrumentality to deepen the union. Sadly, the insularity of the British eye does not share this vision. Rather, it leads to attempts to segregate the politics of Euro from its economics. Repeatedly, the attempt has been to bring forward the economic rationale and push behind the political agenda. Such attempts have gone on since 1997.

From the start, the British approach to the Euro remained hesitant and sceptical. It is accepted that ultimately the decision has to be backed by a positive vote in a referendum. However, it is unclear when it would take place. More importantly, it is subject to five economic tests being satisfied.

The five economic tests

These tests were spelt out in a Treasury document (U.K. Membership of the Single Currency — An Assessment of Five Economic Tests, October 1997.) These tests are:

1. Whether there can be sustainable convergence between Britain and the countries of the single currency;

2. Whether there is sufficient flexibility to cope with economic change;

3. The effect on investment;

4. The impact on financial services industry; and

5. Whether it is good for employment.

In its evaluation, the U.K. Treasury took the view that the U.K. economy failed in all the tests but was capable of achieving a more favourable position in the future. The idea was to wait for better days. At the same time, there was no hint of committing its entry into the Euro.

Some economists faulted the Treasury for posing imprecisely defined tests in contrast to the well-defined Maastricht Treaty's convergence criteria. There is also circularity attached to the tests inasmuch as four of them are inter-dependent and cannot be segregated for independent evaluation. Though the U.K. Treasury persisted with its efforts, there has been growing uneasiness over its methodologies.

As reported in Financial Times (December 29, 2002), eight leading international economists, including three Nobel laureates, felt that "the chancellor's methodology appears seriously flawed" and believed that it was impossible to make an economic case "clearly and unambiguously.''

The schism was indeed deep within the Labour Party and the cabinet. Mr. Tony Blair nurtured his ambition to `lead' Europe and was conscious that this would not be practicable if Britain stayed out of the Euro. As analysed in the Economist (May 1, 2003), "while the Blairites have a dream of an EU whose agenda is set by an ascendant Mr. Blair, they also have a nightmare, in which Britain's failure to join the Euro leads to the country being progressively marginalised within the EU.'' Therefore, Mr. Blair had to engage in a balancing act.

He had to contend with Eurosceptics within his fold such as Chancellor Gordon Brown and maintain friendly lines across the channel. Early in May 2003, Ian Duncan Smith rejected the five tests set by the Treasury as a precondition for joining the Euro and urged the government to hold a referendum. Mr. Robin Cook also joined and set the target date as January 2007 for British membership.

It was on June 5 that the British cabinet met and agreed on whether (or when) Britain should join the single currency. They fell in line with the view that, economically, time was not ripe for Britain to join the Euro. The cabinet decision led to the statement by Chancellor Gordon Brown on the June 9 unveiling the government's stand on the Euro. It was heralded as "the biggest peacetime economic decision that this nation faced.'' In the end it was a damp squib.

It consisted of 1738 pages and 18 documents and provided the views of a galaxy of economists on the vexed issue, in particular the costs and benefits of joining the Euro. There was no surprise, as much of the material had already leaked out or been made available through other sources.

Timing and convergence issues

Unlike in 1977, this time only one of the five tests was passed — the impact on the City. Others were not dismissed out of hand. There was a shift in emphasis to reflect the political compromise reached in the cabinet. He explained that if two others — convergence and flexibility — were passed, the other two — investment and output and jobs — would also flow. The emphasis thus shifted to achieving `significant progress in achieving cyclical convergence.' There was a reference to special areas like housing in the U.K. and mortgages. Throughout the speech, there were repeated commitments to join the Euro. The reservation was only over the timing and the convergence issues, which time alone can solve. By a sleight of speech the European fears were allayed; the domestic Eurosceptics were disarmed; Europhiles were signalled to remain calm.

What Mr. Brown could not add was that the EU itself was not ready to receive Britain into its single currency. If the decision had been announced in the late Nineties, it would have sent shock waves along the corridors of Brussels.

In recent years, the EU, especially its Stability and Growth Pact, has lost its shine. The fundamentals of SGP and its one-size-fit-all approach have been called into question. There are nagging doubts over the assumptions and theoretical validity of optimal currency areas (OCA). The success of OCA and a single currency experiment call for so many reforms within the EU that it is difficult to visualise when they will all be put through. Meanwhile, the passing of a draft Constitution for the Community raises new hopes of revision in the basic EU approaches. The enlargement of the EU also brings in its train more problems. There is relief in the EU that Britain has decided to postpone its entry into Euro. Its entry would possibly create more problems for Germany and reduce its relative importance in the union. As the Economist (June 12, 2003) half-seriously poses it, "the better question is not whether Britain should join the currency, but whether Germany should leave.''

It brings us to the end of our analysis. The five tests are indeed an exercise in evasion. More than the five tests, Britain has been favoured by the collapse of the SGP and the ongoing reassessment of EU reforms and structures.

K. Subramanian

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