EMU - Criteria for Choice

- Wednesday, 17th May 2000



The Labour government make it pretty clear that they would try to bounce Britain into replacing the ? by the Euro early in the next Parliament were they to win the next election.

Abandoning the ? would be the most momentous monetary decision this country has ever taken. More significant than returning to the Gold Standard between the wars. More important than linking to the $ under the Bretton Woods system after the war. More far-reaching than joining the Exchange Rate mechanism at the end of the ?80s. Because all those systems had an exit door. If circumstances changed and they were no longer beneficial to our economy - we could leave.

Indeed, in each case Britain did leave. And we were then able to alter our policies and restore our prosperity.

But the Euro has no exit door. Membership is irrevocable. You join for the duration.

So to contemplate joining, we would need to be convinced that membership would benefit Britain not just now, but for all future time. That it would work not just in good times, but in a recession and times of economic hardship. That it would be good not just for some companies, but for the whole country.

We must demand higher standards of proof for a decision which is intended to be irrevocable than for one which, if mistaken, could be reversed, The Government has published the tests which it believes would need to be passed before they would recommend that Britain adopt the Euro.

I want today to consider:

- whether these are the right tests

- whether they are, or can be made, objectively measurable

- and whether additional tests are also required.

Two Types of Test

But first it is important to distinguish between the tests of convergence in the Maastricht Treaty and the Government?s own tests.

They are quite different in nature and purpose.

The Maastricht criteria are intended to establish whether a country?s economic performance would weaken the Euro if it were allowed to join.

The UK?s own tests are intended to establish whether membership of the Euro would weaken British economic performance.

As it so happens, Britain is one of the few countries which (without fudging) complies with all but one of the Maastricht criteria. Britain has an acceptably low debt ratio, budget deficit, inflation record, and long-term interest rates,

The sole criterion Britain has not met is two years membership of the ERM without devaluing. Yet the Government is adamant that it has no intention of rejoining the ERM. This is as bizarre as the position of a would-be monk who wants to take the final vows yet finds the novitiate too demanding.

Other countries, however, clearly had to fudge their figures to scrape under the wire. France just achieved a 3.0 per cent deficit by dint of counting the proceeds of selling France Telecom?s pension assets, but ignoring the pension liabilities which the state retained. Italy has debts at twice the 60 per cent level of GDP specified in the Treaty (?) but claims they are falling. Germany?s debts just exceed the 60 per cent level and are rising, but that doesn?t seem to matter.

Before the election, Gordon Brown said: ?There can be no fudging of the criteria?. But he has been unwilling to use the British Presidency to ensure that the criteria are applied rigorously. The result is a weak Euro which has exacerbated the problems facing British exporters. It also removes one of the previously claimed attractions of the Euro - that it would inherit the strength of the Mark.

However, the Maastricht criteria do not, and are not designed to, test whether membership of the Euro would be a boon or a burden to the British economy. So the Government is right to try to set separate tests to help answer that question.

In October, the Government published a document entitled ?UK Membership of the Single Currency - An Assessment of the Five Economic Tests.? It was forced to publish this rather ahead of its original plans because of our demands for a parliamentary Statement following conflicting press leaks of the Government?s intentions. Perhaps because of its premature publication, it is a rather more objective assessment than might have been expected, The spin doctors had less time to doctor the civil servants? analysis than normal - under this Government.

The five tests are listed under the five headings: cyclical convergence, flexibility, investment, financial services, and, finally, employment and growth.

The first test, rightly, is ?cyclical convergence?.

A single currency means a single monetary policy and the same interest rate across every country.

Yet Britain has a different economic cycle from the continent. We tend to be growing strongly when they are stagnant. And by the time our economy slows down they are expanding.

So, if we joined the Euro we would have to have interest rates set to reflect conditions in the continental economies.

When we were growing strongly and needed high interest rates to prevent an inflationary boom, we would have to have the lower rates needed to stimulate the continental economies. So our economy would overheat, inflation would rise, and in due course boom would lead to bust.

But when we were in recession and needed a low interest rate to recover, we would have to have the higher rate by then prevailing on the continent. That would make our recession worse.

This is not just abstract theory.

We carried out a laboratory experiment to demonstrate it.

We shadowed and then entered the Exchange Rate Mechanism.

This meant mirroring continental monetary policy even though our business cycle was out of phase with theirs.

We kept interest rates too low in the late ?80s stoking up a boom which re-ignited inflation.

Then during the subsequent downturn, we had to set interest rates too high making it the worst recession since the war.

The Government accept this analysis. Their report on the five tests says:

?If conditions in the rest of the EMU area were very different from those in the UK, Euro interest rates could often be too high or too low for the UK making economic conditions less stable. So it is important that the UK cycle is broadly in line when (sic!) we join EMU and that this convergence is sustainable.....?

?If the UK were to enter monetary union without durable convergence, then the loss of domestic monetary policy and lack of exchange rate freedom could make the UK cycle more volatile.?

Moreover the Government accepts that:

?At present, the UK?s business cycle is not convergent with the rest of our European partners.?

and that:

?The UK?s divergence is not a new factor.?

Indeed, they look back over more than a quarter of a century. They conclude that Britain?s economic cycle has moved more in line with the USA and the Anglo Saxon economies than with the continent.

What is more they find that far from converging with the continent, Britain?s business cycle has been growing increasingly out of step.

Finally, they rightly warn that:

?It is not safe to assume that the act of joining monetary union would automatically trigger convergence.? (p.8)

So on this crucial test British membership of the Euro-zone would be damaging as long as our cycle is different form the continent?s; it has been different for over a quarter of a century; its shows no signs of converging with the continent (rather the contrary) and joining EMU will not automatically bring about convergence.

The Government sensibly rules out membership at present on this ground alone. But it seems to suggest, albeit rather hesitantly, that the British and continental cycles might converge within a period of ?some years?.

The key question therefore is not will the UK and continental business cycles converge, but how could we establish that they had, and how long a period would be required to assess that the British and continental economic cycles had converged and that that convergence was likely to prove sustained and durable.

It is important to recognise that a monetary coincidence of interest rates or growth rates does not mean the cycles have converged. A stopped watch will show the right time twice a day. But it will not remain in synch for the periods in between.

Ministers sometimes talk as if we just have to jump on board the Euro at the moment our two cycles cross. But their ?five tests document? rules that out. It says ?the UK economy might be slowing while growth on the continent could be rising [but] it is not sufficient for economic conditions to coincide for a short time. It must be clear and demonstrable that our economies can remain sustainably converged?.

Unfortunately, the ?five tests document? does not spell out how cyclical convergence should be ?clearly demonstrated? to be ?sustainable?.

However, it does immediately go on to measure past divergence by measuring correlation coefficients between annual growth rates. As a rule of thumb, statisticians require at least eight observations to measure correlation. So a minimum of eight years would be required to established convergence by this measure.

Common sense also suggests that it would be essential to observe a full cycle before declaring that two countries? cycles has convergence. The last two business cycles have been about 6 and 10 years long respectively.

So in the unlikely event that the British economic cycle spontaneously aligns itself with the continent starting in a couple of years time, we are unlikely to be able to prove ?clearly and demonstrably? that this is sustainable before the end of the next Parliament.


Having declared that sustainable convergence must be clear and demonstrable, the Treasury then tacitly admit that they may relax that condition. They say:

?There will inevitably be some uncertainty over whether the UK economy has truly converged with the rest of the EMU area. This will place an even higher premium on well-functioning product and labour markets. If there is insufficient flexibility there may be adverse consequences for employment and living standards.? (p18)

There may indeed. And even if our economic cycle did suddenly click into phase with the continent, it could presumably click out of phase later on.

In large single currency areas like the USA, business cycles and conditions do vary in different states. Since movements in interest rates and exchange rates are not available to help adjust to that , the USA relies on three other adjustment processes:

- mobility of labour

- flexibility of pay levels

- and transfers of resources via federal tax and spend programmes.

The first two are subsumed under the Government?s second test - flexibility.

Unfortunately much of the ?five tests? discussion is in terms of mobility of labour within the UK. That is important and valuable in itself. But it is of little relevance to dampening economic cycles.

Loss of Britain?s ability to tailor monetary policy to our own needs is likely to increase the amplitude of our business cycles. That means even greater movements in and out of unemployment between the peak and trough of recession. It has little to do with movements between jobs. Indeed, deregulation which allows employers freedom to hire and fire will certainly not dampen the unemployment cycle. It could even exacerbate it.

In theory, the only thing which could dampen swings in UK unemployment in these circumstances would be mobility of labour across national borders. If during the boom significant numbers of people came here to work from the continent that would cool overheating and reduce wage inflation. Likewise if, during the recession, British employees could find jobs on the continent that would mitigate unemployment here.

The Treasury rightly shrink from advocating this.

The simple fact is that movements across borders within Europe are tiny by comparison with those between states in the USA. It is not such a big deal to move from Massachusetts to Virginia or from Texas to California. They speak the same language, share the same loyalties and operate the same social security systems. And there may be friends and relatives to help you settle in. By contrast to move between countries in Europe can be traumatic - difference of language, culture, social security, pensions and legal systems are daunting. Such movement as there is, in the Treasury?s words, ?tends to be focussed on highly paid professionals?.

A policy which implicitly involves telling people to hop on the ferry to find work abroad would be seen as brutal and unrealistic. All the Treasury can bring themselves to say is that ?there might be some place for further measures designed to enhance cross-border labour mobility. Most notably there might be a case for further work on pensions mobility and language training?. (p22)

In principle, there is no difficulty in measuring the scale of cross-border mobility. Unless and until it starts to approach the scale that occurs within the USA, Europe could not be said to pass this test.

The document?s discussion of wage flexibility is also mealy-mouthed. It skirts the key issue. In the absence of exchange rate changes would British workers price themselves back into foreign markets? If inflation is low or negligible that may require cuts in money wages. That is something we have not seen to any significant extent since the 1930s.

Once again, the Government has identified the right test - are wages sufficiently flexible to compensate for the lack of exchange rate flexibility? It has then shrunk from spelling our the unpalatable implications: will employees accept real pay cuts to price Britain back into world markets? The very reluctance to face up to that issue is symptomatic of national unreadiness to meet this test. It is hard to see how any objective measurement of this test could be devised.


In theory the abolition of exchange rate uncertainties and transaction costs should make investment more attractive (so long as there are no offsetting disadvantages such as a more volatile business cycle).

In practice this has not been a dominant factor in determining the location of investment. Over the last twenty years the UK has secured the lion?s share of inward investment in Europe. Yet for most of that period we have not been members of the Exchange Rate Mechanism. Any investors who wanted to reduce exchanges would have put their investments in the core countries of the ERM zone. There is little reason to suppose that a single currency will be a significantly more powerful magnet than a fixed exchange rate zone.

Nonetheless, this is a reasonable test and it can in principle be measured. The amount of investment in any year is highly volatile. So a span of years, perhaps four or five, would be needed to give any indication of whether Britain?s share of inward investment had altered.

Effect On The City

Britain?s financial sector is one of our great strengths. It generates substantial overseas earnings and large numbers of jobs. The City is now one of the three pre-eminent financial centres in the world - in terms of non-domestic business probably larger than Tokyo or even New York.

It has not acquired this status on the basis of the national currency, sterling. On the contrary, it has been the City?s willingness to deal in any currency that has given it an edge. The London Stock Exchange, for example, will accept settlement in more than a score of currencies whereas, until recently, Frankfurt, Paris would require payment in DM/Francs [check this with the LSE].

The addition of a new currency, the Euro, in 1999 will pose no problems. The elimination of 11 national currencies in 2002 will be of small significance. (Although the City dominates most foreign exchange transactions the area where its share was smallest was in intra-European trading settlements between say Guilders and Belgian francs. So it will lose little by their elimination.)

The essential pre-condition for London?s growth has been its light but effective regulatory regime. The supreme objective must be to retain that.

In the first instance the European Central Bank will not have powers to regulate the financial sector and banking system. They will remain with member states or the Council of Ministers.

However, financial regulation and central banking naturally go hand-in-hand. Euroland countries are likely to want to centralise regulation of their banking and financial sectors. Already there are calls for a common system of mandatory reserves for commercial banks in the Euro-zone.

Many commentators presume without questioning that it must be commercially desirable for the British financial sector to operate in a wider political jurisdiction than the UK. In practice, however, we have tended to benefit from being outside other jurisdictions.

The reason the Euro/$ market is here rather than in New York is precisely because London is outside the jurisdiction of the US government. It is a market in $s earned by US companies abroad who do not wish to deposit them in the US where they would face US banking restrictions on interest. If Britain were the 51st State of the USA, the Euro/$ market would go further afield.

Likewise the reason London does more trade in German government bonds than do German firms is because British banks are not regulated by the heavy hand of the German authorities.

The greatest threat to the City of London would be to find itself subjected to the heavy handed regulation which has tended to prevail on the continent. That would undoubtedly drive some of our business to Switzerland or some other new and lightly regulated centre.

Of course if we were to join the Euro-zone, we would have some influence over the type of regulation which might collectively be imposed. Even if by some supreme diplomatic skill we persuaded the other 11 members to adopt our approach, all that we would have achieved is to extend to rival centres, like Frankfurt and Paris, the very system which originally gave us the edge over them.

In practice, there can be no objective measure of whether the City will gain or lose by joining the Euro-zone. Our analysis suggests we are more likely to jeopardise our key asset - light but effective regulation. The sensible strategy would be to observe how the zone develops. If it adopts heavy handed regulation (onerous reserve requirements on its banks for example), our institutions can exploit the competitive edge this gives them. If, however, the European countries emulate our approach, we have lost nothing by staying out.

Employment and Growth

The fifth ?test? is no more than a resume of the previous four. Would the overall impact of joining the Euro on the economic cycle, labour flexibility, investment and financial services enhance or undermine employment and growth? It adds nothing new to them.

The overall assessment must be that on the Government?s tests, membership would be inadvisable so long as Britain?s economic cycle remains out of kilter with the continent and cross-border labour mobility and wage flexibility do not remotely match those which enable the USA to adapt to different business patterns in different States; flows of inward investment are unlikely to be attracted to a single currency zone if they were not attracted to the ERM zone and the City could risk its supreme asset of light regulation by entry and could gain by independence.

There is no way to measure the overall impact of joining or not joining. But the case for entry is invariably stated in terms which imply that membership of a large currency zone is likely to enhance economic growth and employment.

If that were the case, large countries should be richer and faster growing than small countries. That does not seem to be the case. Switzerland is the richest country per capita in Europe and has the strongest currency. Yet it is one of the smallest and has stood aside from the EU and even the European Economic Area. In Asia the city states like Hong Kong and Singapore have outstripped their larger neighbours. (In negotiating the return of Hong Kong to Chinese sovereignty, we secured its right to retain a separate currency for 50 years. All concerned took it for granted that the advantages of a separate currency exceeded those of adopting the currency of the rest of China!) And medium sized countries like Korea, Malaysia, Taiwan and Thailand do not seem to be handicapped by constituting smaller currency zones than the giants of India, China and Indonesia.

As far as jobs are concerned, there is also no evidence that larger currency areas bring higher employment than smaller areas. The Netherlands have achieved a lower level of unemployment that their large German neighbour. More telling still is the contrast between East Germany since it merged its currency with the Deutschmark and the Czech Republic. East Germany and the Czechlands were the two most similar economies in Eastern Europe. Since East Germany was integrated into the Federal Republic, it has had billions of DM poured in from the West. That has not stopped unemployment reaching 20 per cent.

By contrast, the Czech Republic, retaining its independence in monetary and other matters, has got unemployment below the level of many West European countries.

Additional Tests

The Government asserts that the issues covered by its tests are the only ones which are relevant.

But are there other tests which need to be applied?

Above all, will the creation of a single currency for Europe lead inexorably towards a single government for Europe?

Some hope, and others fear, that this will be the inevitable consequence.

Certainly, there never has been a currency in recorded history without a government to run it.

From the 1st January 1999, there will be such a creature. The Euro will be run by an independent Central Bank responsible to no legislature and with no government to manage the tax, spending, borrowing and other policies which normally complement monetary policy.

Many advocates of the Euro make no bones about it being the key stepping stone on the path to a United States of Europe. They tend not to emphasise this publicly because the electorates in most countries are not enthusiastic about that project. But the French government is now explicitly calling for ?un gouvernement economique de l?Europe?. The Commission has started a programme of tax harmonisation measures. The European parliament is calling for..............[check Mathers note].

As long ago as 1963, the Bundesbank pointed out:

? ?[check this]

Already EMU involves the stability pact which severely limits governments? powers over fiscal policy. [quote Trichet]

The analysis of the ?Pros and Cons of EMU? published by the Treasury last Summer acknowledged that no monetary union had survived which controlled less than 20 per cent of national spending at a Federal level.

So when Gordon Brown declared in October that the Government saw ?no constitutional obstacle? to British membership of EMU he was talking through his hat.

Either he is denying that setting up a single currency will reinforce pressures to centralise governmental powers to tax, spend and borrow at a federal level.

Or he is saying that that would be acceptable to this Labour Government.

Most commentators - whether enthusiasts or critics of the single currency assume it will lead towards a federal government. However, a few deny this. The test must be experience. If after a significant period members of the Euro-zone have not found themselves subject to pressures to centralise the levers of economic power the constitutional concerns would be much diminished.

This issue is often referred to as the constitutional issue. It is suggested that it is of arcane interest to constitutional freaks and of no relevance to business people.

This is nonsense. The fundamental issue is whether Britain could retain the right to mould its tax, spending, borrowing and other economic policies to the needs of British business.

There is nothing arcane about this. For example, Britain has by dint of considerable effort over the last 15 years reduced the tax burden on business relative to our continental competitors. That gives us a perfectly fair advantage. Does anyone imagine that our advantage would last long if tax rates were harmonised let alone set by a federal government?

Influence over Policies

This raises a further question. Can Britain in practice use its sovereign powers to pursue policies of its own choosing? Or are they, as some argue, in practice determined by global economic forces? is there a sort of invisible hand which constrains governments as to which policies they can actually pursue?

Clearly if such forces determined the policies of large states as well as smaller ones, there would be nothing to gain by joining a bigger unit But implicit in this argument is the assumption that larger states can buck the trend. Consequently, Britain could gain influence by having a vote (albeit one out of 15) on the Union?s policies.

This is an issue which can be and has been put to the test. Britain has successfully pursued different policies from its neighbours in taxation, labour market regulation, etc. More specifically, we were told when we were in the ERM that Britain could not pursue our own monetary policy. This was pretty much the consensus view. Even Ministers asserted that there was no point in leaving the ERM as our interest rates could not in practice be reduced.

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