Tuesday, March 13, 2007

Gordon Brown's 5 Economic Test for Joining Euro

As Gordon Brown approaches his last budget as chancellor many are reviewing his tenure as Chancellor and evaluating his success or failure. One important contribution he made was to steer the UK away from joining the Euro on the ground that "it would not be in Britain's economic interest". The justification for this was based on his 5 economics tests.

Before deciding whether the UK should join the Euro the Chancellor, Gordon Brown drew up 5 economic tests which the UK must pass for the UK to join. The main principle behind these 5 economic tests was whether the UK would cope with a common monetary policy. The 5 tests are in some ways superfluous. The main test being is really whether the UK has a degree of economic harmonisation with the rest of Europe.

5 Economic Tests for Joining the Euro

  1. Economic Harmonisation.

    The UK economy must be harmonised with the Euro zone. If the UK economy was growing much faster than EU then UK interest rates would need to be higher. For example, at the moment if the UK joined interest rates would fall and this may cause inflation. Therefore it is essential that the UK has a similar economic cycle to Europe. Even if there is temporary harmonisation there is no guarantee it will continue on a permanent basis.

  2. Is there sufficient Flexibility?

    If the UK went into recession could it be able to cope? It would have no influence over Monetary policy but also Fiscal policy is limited by the growth and stability pact. This limits the amount of government borrowing and therefore limits the scope for expansionary fiscal policy.

  3. Effect on Investment.

    Would joining the euro create better conditions for firms making long-term decisions to invest in Britain? UK inward Investment has not suffered since the UK decided not to join

  4. Effect on Financial services.

    What impact would entry into the euro have on the UK's financial services industry? London as a financial centre has boomed in recent years.

  5. Effect on Growth and Jobs

    Would joining the euro promote higher growth, stability and a lasting increase in jobs? There is no clear evidence that it would. UK economy has done better outside the Euro than in the Euro.

At the moment the weight of economic opinion is that the UK is better off not joining the Euro. One important factor is that the UK housing market is very sensitive to interest rates. Many UK householders are homeowners and also many mortgages are variable. Therefore the cost of mortgages fluctuates with changes in the base rate. Thus a small change in European interest rates could potentially have a damaging effect on UK economy. For example, if the UK was to join now, interest rates would fall causing a potentially harmful inflationary boom.

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Anonymous said...

hi i think the information that you have provided on your site regarding the euro is very detailed and interesting. Can you please explain why "If the UK were to enter the EMU at this stage, interest rates would fall and this could cause inflation?" if you could leave a continuation of the answer from where you left off i would be really grateful. Thanks!

Tejvan Pettinger said...

thanks for question.

Answered in new post.

Anonymous said...

I would just like to comment on the following sentence: "UK economy has done better outside the Euro than in the Euro."

This is obviously not correct as the the UK economy as never been part of the Euro. Hence, you're comparing a factual with a fictional scenario on the basis that the latter has happened in reality. I presume that you mean that the UK economy is doing just fine outside the Euro, which, at least so far, has been the case.

On that note, it is often pointed to the strong performance of non-Euro economies since 1999 (Denmark, UK and Sweden) as a indication of the presumption you make above. This is however fragile as these economies were outperforming the other EU-15 economies before the Euro as well, largely as the result of reform that took place in the eighties (in the UK) and early nineties (in Sweden and Denmark). Moreover, Euro economies, in particular Ireland, Finland and the Netherlands are performing well. As always, the story is more complicated than it seems.