Euro vision: The Chancellor calls the tune


If the smoke signals are to be believed, Tony Blair would be on the point of seeking popular consent for Britain joining the euro, if it wasn’t for the restraining hand of his Chancellor.


The paradox is that monetary union makes economic sense only in the context of the EU evolving into a state like the US with substantial taxing and spending powers. But it is the primary objective of Britain’s policy towards Europe to prevent that happening.  That has been implicit since Thatcher came to power, and in the aftermath of the dispute between the US/UK and “old Europe” over Iraq, it has never been more explicit. 


Blair has spent a great deal of effort in recent weeks countering the notion of a “multi-polar” world with France at the centre of a European pole.  As Blair told the Financial Times on 28 April 2003 (see extract here):


“Some want a so-called multi-polar world where you have different centres of power, and I believe that that will very quickly develop into rival centres of power. And others believe, and this is my notion of this, that we need one polar power but which encompasses a strategic partnership between Europe and America and other countries too - Russia, China - where we are trying to ensure that we develop as I say a common global agenda.”


It is difficult to fathom what this means other than a unipolar world, the pole being the US.  This prompted the FT journalist to ask the excellent question:


“But isn't the danger that one pole is so dominated by the United States that the only thing that the other so-called partners in this pole can do is say yes?”


In response, Blair blustered:


“Well that is the argument, but I don't think that is true. You see this is where I take a different view.  My view, I want a stronger Europe, more capable of speaking with a unified voice, but I don't want that Europe setting itself up in opposition to America, because I think that won't work, I think it will be dangerous and destabilising.”


It is a matter of conjecture if, left to its own devices, Europe would have developed as an alternative power centre to the US, with a different economic model.  But Britain’s interference, past and present, has been geared to counter that development (and to attempt to inflict the Anglo-American economic model on the EU).  It would have been far better for Europe, and the world, if the attitude of General de Gaulle had prevailed and Britain had been kept out of the Common Market.  And it would be far better if it left now, so that the EU could develop free from British interference.


It is clear that Tony Blair believes that joining the euro is a necessary condition for Britain being in a position to continue to disrupt the development of the EU, and he appears to be prepared to risk all on a referendum on the issue now, which he is certain to lose.  Unfortunately, he has been saved from himself by his Chancellor, to whom he foolishly accorded a veto in October 1997; at that time, he allowed the Chancellor to erect, and appoint himself the sole guardian of, five economic “tests”, which must be passed before it is deemed to be in Britain’s economic interest to join.


The five “tests”

The Chancellor announced to the House of Commons on 27 October 1997 that the Government was in favour of joining in principle subject to two conditions: (1) “the single currency is successful”, and (2) “the economic case is clear and unambiguous”.  He said nothing more about (1) but he set out five economic “tests” by which (2) was to be judged:


“These tests are, first, whether there can be sustainable convergence between Britain and the economies of a single currency; secondly, whether there is sufficient flexibility to cope with economic change; thirdly, the effect on investment; fourthly, the impact on our financial services generally; and fifthly, whether it is good for employment.”


And he published a 40-page Treasury document, UK Membership of the Single Currency: An Assessment of the Five Economic Tests, which purported to show that as of October 1997 none of the “tests” had been passed.  Because of this, he said, the UK was not going to join in January 1999 with the first wave of countries and he effectively ruled out joining until the next Parliament.  Now, two years into that Parliament a second assessment, this time extending to 1,800 pages, is in the hands of the Cabinet, and its publication is imminent.


It is, of course, impossible to establish, by applying these “tests” or by any other method, that there will be a “clear and unambiguous” economic benefit to Britain from joining – because the future cannot be predicted clearly and unambiguously.  The particular “tests” the Chancellor has set can be made to give any answers he wants, when he wants, which puts him in an all-powerful position on the issue.


No minister, not even the Prime Minister himself, is going to have the temerity to challenge the Chancellor’s judgement, backed up by 1,800 pages of detailed argument.  The meetings with individual ministers to discuss the assessment are a charade to give the impression that the cabinet is being consulted, when the decision, and its presentation to the world, has already been agreed between Blair and Brown.


A single interest rate

The most important consequence of Britain joining the single currency is that power to set interest rates is ceded from the Bank of England to the European Central Bank (ECB), which sets the one rate for the euro zone as a whole.  This begs a fundamental question about monetary union amongst independent states, namely, whether a single interest can ever be appropriate for all the economies of the individual states, or whether at any point in time it will always be too high for some and too low for others.


The Governor of the Bank of England, Eddie George, drew attention to this “potential downside” of the single currency as long ago as 12 September 2000, in a speech to the British Swiss Chamber of Commerce.  He said:


“Essentially the potential downside can be summed up as the risk that the single monetary policy – the ‘one-size-fits-all’ short term interest rate within the Eurozone, which is the inevitable consequence of a single currency – will not in the event prove to be appropriate to the domestic monetary policy needs of all the participating countries.


(Interviewed by Charles Wheeler on BBC4 on 21 May 2003, Joseph Stiglitz, former Chief Economist of the World Bank, said something similar, and also drew attention to the potentially crippling effects of the EU Stability and Growth Pact – see below.)


The Chancellor’s creation

One of the Chancellor’s first actions when he took up his job in May 1997 was to hand responsibility for setting UK interest rates to the Bank of England.  He established a Monetary Policy Committee (MPC) in the Bank and charged it with setting interest rates to meet a symmetric 2.5% inflation rate.  The whole world believes that this has been a great success, since inflation rates and interest rates are lower than they have been for a generation, and economic growth has been substantially greater than the EU average.


But if Britain joins the euro, the Chancellor’s much praised creation, the MPC, will be abolished and Britain will have to accept the interest rate set by the ECB for the euro zone as a whole – which may or may not be appropriate for the British economy at any time.


This is a momentous step: giving up the freedom to set interest rates appropriate to Britain at any time, means giving up a large measure of control over domestic inflation and economic growth, and hoping that the ECB will set rates for the euro zone as a whole which are appropriate for Britain.  Eddie George once described joining the single currency as a leap in the dark.  It is hard to disagree with him, and it is hard to believe that the Chancellor is going to endanger his legacy by recommending that Britain take that leap, now or ever.


Stability and Growth

The more so, when joining the single currency also means submitting to the fiscal constraints of the EU Stability and Growth Pact, which demands, amongst other things, that public sector borrowing be kept below 3% of GDP.  Failure to do so can, in theory, lead to the offending state being fined by the European Commission.  That is a recipe for making a bad economic situation worse. 


Public borrowing tends to rise automatically when an economy slows down, even if governments do nothing, because tax revenues do not come up to expectations and spending on welfare benefits tends to go up as a result of rising unemployment. Trying to reduce borrowing in these circumstances by raising taxes and/or cutting public spending removes spending power from the economy and reduces economic activity – and makes matters worse.  But that is what the Pact demands that states within the euro zone do if their public borrowing approaches 3% of GDP. 


The Chancellor has been criticised two years’ running by the Commission for his public expenditure plans.  In 2001, the Commission said that if Britain were inside the euro zone his planned public expenditure increases would fall foul of the rules.  The same happened in 2002 when he was told that, inside the euro zone, he would have to cut public expenditure, or increase taxes, by £41bn over the three years up to and including 2005-6.  Outside the euro zone, he could ignore the Commission’s strictures, and he went on to announce even larger increases in public expenditure. But the Commission will not be so easily ignored if Britain becomes part of the euro zone – as Portugal and Germany have already found out to their cost.


In Portugal and Germany

Portugal breached the Pact in 2001-2 with a public sector deficit of 4.1% of GDP, and was forced to cut public spending and increase taxes and sell off public assets, including the national airline and the water company supplying Lisbon.  Defence expenditure was halved – in March 2002, all naval vessels were ordered back to port in order to save fuel.


Germany is also in trouble.  Its economy is close to recession, with unemployment approaching 5 million, and it is struggling to keep its public sector borrowing below the euro zone limit.  If Germany had the power, interest rates would have been cut long ago, and public sector borrowing would have been allowed to rise.  Those may or may not have revived the economy, but they are the obvious measures to try.  But they are no longer available to Germany, or any other state, within the euro zone.


As Germany has found to its cost, entering the euro zone entails giving up the most important instrument for macro-economic management – setting interest rates – and puts limits on the second most important – government spending.  It is difficult to believe that the Chancellor is ever going to go down that road.


Convergence ?

No doubt, the pro-euro lobby would argue that the problem of a single interest rate will disappear if the Chancellor’s first “test” is passed, that is, if there is “sustainable convergence” between the British economy and the economy of the euro zone, the same interest rate will be appropriate for both from then on.  Here, we are talking primarily about whether Britain’s business cycle is in sync with that of the euro zone, and whether this will continue.  But even if the historical record showed convergence over a period – which it doesn’t – the future is a priori unknowable.  Mervyn King, who is about to replace Eddie George as Governor of the Bank of England, told the Commons Treasury Select Committee in May 1999:


“It will probably take 200 or 300 years to collect all the economic data. We will never be able to arrive at the point where we can say that the economic cycles have converged. It will be a matter of judgement.”


In a national economy

Of course, a single interest rate is not necessarily appropriate within a national economy either, and variation by geographic region or by economic sector might be more appropriate.  Arguably, for example, areas of high unemployment could do with a lower interest rate than areas of low unemployment. But within a national economy there are other means of coping with this, for example, by labour migration, or by national government redistributing resources to poor regions or economic sectors, as happens now within, for example, the UK or the US.


Neither of these mechanisms is operative to any great extent across national boundaries within the EU at present.  Cultural differences, and reasonably well-developed national welfare systems, inhibit the movement of labour across national boundaries at the moment.  And, the EU hasn’t got the taxing and spending capability to redistribute lots of resources across national boundaries.


European monetary union makes economic sense only in the context of the EU acquiring substantial taxing and spending powers, like the Federal Government in the US, at the expense of the existing nation states. Monetary union without political union of this kind is of doubtful long-term viability.  And that seems unlikely to develop, even if Britain’s disruptive role were eliminated.


Exchange rate on entry

A strange feature of the Chancellor’s economic “tests” is that there is no mention of the sterling-euro exchange rate on entry, which is obviously of crucial economic importance, since it is theoretically going to be maintained forever. How is this to be determined?  One of the Maastricht criteria is that a currency joining the euro should be a stable member of the Exchange Rate Mechanism (ERM) for two years prior to entry, and this would essentially determine its exchange rate on entry.


Sterling has, of course, not been a member of the ERM, since it fell out on Black Wednesday in October 1992, and any suggestion that it rejoin would be met with derision, since its membership of the ERM is universally regarded as a disaster.  But the rules as they stand are that sterling must be in the ERM for two years prior to joining the euro (the period was reduced to one year for the Greek drachma, which joined later than the initial eleven currencies).


For the past few years, until recently, it was universally assumed that the sterling-euro exchange rate was much too high, to the great disadvantage of British manufacturers selling in the home market and into the euro zone.  In 1992, sterling fell out of the ERM band, the bottom of which was at 2.80 Deutsche Marks (in old money) and fell to under 2.20 Deutsche Marks, but in recent years it has been around 3.20 (and as high as 3.40) Deutsche Marks.  Since the beginning of the year, sterling has dropped sharply against the euro and is now trading at around 1.38 euros (2.70 Deutsche Marks in old money).


This rise, and recent fall, of sterling against the euro has largely been a side effect of the rise, and recent fall, of the dollar relative to the euro.  Having lost about a quarter of its value against the dollar shortly after its creation, the euro has regained it all in recent months and is now trading at a record level against the dollar.  The latter is due to the fact that after many years the US has abandoned its “strong” dollar policy, in order to promote exports and restrain imports.  Since sterling tends to track the dollar, it has fallen dramatically against the euro as a side effect of the fall in the dollar: economic factors local to Europe have played little or no part.  All of which suggests we should be thinking of joining the dollar rather than the euro (as a first step to political union with the US!).


Saving British manufacturing used to be the chief reason advanced for joining the euro, the assumption being that sterling would join at a considerably lower rate than it then was, and therefore British manufacturers would be in a better position to trade with the euro zone.  That was why both manufacturing employers selling into the euro zone, and trade unions with a base in manufacturing, were keen on joining.  But with sterling’s recent fall against the euro, that reason has disappeared.  The only reason left on this front is the lack of exchange rate stability, which could be achieved without joining the euro, by rejoining the ERM and retaining the ability to set domestic interest rates.


Economic reform

On 20 May, the Chancellor made a speech to the CBI, which demanded “economic reform” in the euro zone.  This was interpreted by the pro-euro lobby as a sixth “test”, which the dogmatically anti-euro Chancellor had added to his list to thwart them.  Nobody recalled that the author of this “test” was in fact the Prime Minister, when in February 1999 he announced a “change of gear” on the road to joining the euro.


Test number two – whether there is sufficient flexibility to cope with economic change – as originally stated by the Chancellor in October 1997 was concerned with the UK economy.  But in February 1999, the Tony Blair made it clear that test two applied primarily to the rest of the EU:


“… it will take some time to make a clear judgment about whether the direction of economic reform in Europe will enable us to meet the tests that we have set out, particularly on flexibility and jobs


“Economic reform is crucial, not just to the success of Britain's participation in the euro, but to the euro itself. I understand the worries of those who, while not ruling out the euro in principle, are none the less concerned about the type of euro zone that we might be joining. That is a real question. We must be sure that the EU is moving forwards, not backwards.” (House of Commons, 23 February 1999)


In other words, the euro zone has to adopt the Anglo-American capitalist model, before it will be fit for us to join.  The Prime Minister probably doesn’t remember laying down that condition, but you can bet your life that the Chancellor does – and has mentioned it to him recently.



A referendum now is unwinnable, and may never be winnable.  It is impossible to prove that there will be a “clear and unambiguous” economic benefit to Britain from joining.  Predictions of economic benefit can never be anything more than that – predictions.  And to set against them, there is hard evidence from Portugal and Germany that, to put it at its mildest, there is a downside to the euro system as presently constituted.  That has persuaded a large section of the Labour Party, and the public sector unions, that joining the single currency is a bad thing.


The chief economic argument advanced for joining – that trade with the euro zone depends on having the same currency as the euro zone – is bogus.  That over 50% of UK exports go to the euro zone now proves that it is possible to trade without having the same currency.  If exchange rate stability against the euro is deemed to be a problem, then we can always join the ERM.


People might be persuaded to take a risk if there was a sense of idealism about the EU project emanating from those who are promoting joining the euro.  But there isn’t.  Their ideal, which they share with Ian Duncan Smith, is that the EU should not develop any further supranational characteristics, and they exert a lot of energy resisting even the appearance of such a development, as they have done in the Convention.


But the same people who successfully repelled Brussels by having the word “federal” excised from the EU Constitution are in favour of Frankfurt setting our interest rates and Brussels monitoring our public spending.  It doesn’t make sense, does it?



Labour & Trade Union Review

June 2003