It is 2020 and Labour is on its way out of government. In the opinion polls, the Conservatives are well ahead. Yet, despite their lead, there is an element of controversy in their manifesto. They want to hold a referendum on the euro. They want the British population to decide whether to stay in or, instead, whether to ditch the euro and bring back the pound.
Ideally, the Conservatives want to persuade the British public to bring back sterling. The opinion polls, however, are rather tight. Despite initial scepticism, the British public attitude towards the euro has thawed. It is hardly a love affair – Brussels and Frankfurt are not the most popular destinations for the average British holidaymaker – but, nevertheless, the euro has found a home in the purses and wallets of the British public, if not in their hearts and minds.
The Tories do not want to hold a referendum as soon as they get elected. There is too great a danger of losing. Instead, they adopt a policy of "prepare and decide". As part of this approach, they come up with five economic tests. Only when the tests have clearly been passed will the incoming Government recommend a pro-sterling vote to the electorate.
According to Conservative sources, the five tests will be as follows. Are business cycles and economic structures sufficiently incompatible so that we are unable to live with euro interest rates? If problems emerge, will exchange rate uncertainty reduce our ability to deal with them? Would leaving EMU create better conditions for companies making long-term decisions to invest in Britain? What impact would departure from EMU have on the competitive position of the UK's financial services industry? In summary, will leaving EMU promote higher growth, stability and a lasting increase in jobs?
On election, the new Conservative Chancellor passes the tests on to the Treasury mandarins. Some of them – having been around for a few years – think that these tests are eerily familiar. "Didn't we have something like this in 2002?" says one of them. Nevertheless, as good civil servants, they scurry away to start the assessment.
What are their conclusions? Let's kick off with business cycles and economics structures. In 2019, the UK entered recession. Since then, things have not been great. Indeed, that is one of the key reasons why Labour was voted out. But the recession has proved to be relatively mild and a lot less severe than the downturns seen in France and Germany. Before then, Britain's economy had grown roughly in line with other European countries, although had not performed quite as well as the US.
The Treasury experts scratch their heads. There appears to be a good argument for staying in the euro. Britain's economic cycle has generally been convergent with the cycle elsewhere in Europe. Moreover, the flexibility of its labour and product markets appears to have given Britain a comparative advantage over the last year or so, limiting the scale of recession compared with its near neighbours. But there's also another argument. Surely, if Britain had some additional exchange rate flexibility, it could have devalued, thereby making its recession even smaller. After all, as a small open economy, devaluation isn't going to hurt anyone else too much. So the answer to the first question is only "maybe".
The experts move on to the second test. They are worried about the impact of exchange rate uncertainty. Devaluations may work from time to time but, for the most part, membership of the euro appears to have been no bad thing. Problems have come and gone but, generally speaking, the flexibility of British labour and product markets has minimised the scale of any problems. Germany's industry may have been undercut by the new members of the euro – from Poland through to Latvia – but Britain has managed to compete well.
The experts look back in history. Digging through the Treasury's archaic filing system, they come across the ERM crisis of 1992, the inflationary exchange rate policy of the late 1980s and the recessionary exchange rate policy of the early 1980s. "We don't want to back to that era again," they conclude. Then again, wasn't that a period in which the UK growth rate was persistently higher than those seen in Germany and France? The conclusion on the second test is only "maybe".
On to the third test. Would it be better to be out of the euro for the purposes of long-term investment? This is a tricky one. British companies have invested a lot but, for the most part, they have been opening plants on the eastern side of the eurozone, in the Czech Republic and Poland. That has been great for British shareholders but job creation within the UK has been a bit disappointing. British tax levels, however, are lower than those elsewhere in Europe and, as a result, the exodus of capital to the east has been smaller than for either Germany or France.
However, there have been a few bust ups at the European Central Bank. The British contingent has disagreed with some of the interest rate decisions. The asymmetric inflation target has meant that interest rates have been persistently on the high side, at least according to the CBI. So there is some evidence to suggest that, outside the euro, things could be a bit better. Oh dear, the answer to the third test is another "maybe".
This is not looking too good. Surely the mandarins can be more definitive on the fourth test? Once again, there is good and bad news. After Britain first joined the euro about 15 years before, London had emerged as the pre-eminent financial centre in Europe. Both Frankfurt and Paris were in decline. The experts start to worry. Their political bosses are not going to be happy if they fail this test. Then they spot a flaw in the argument. Yes, London has done very well relative to Frankfurt and Paris but all three have lost out relative to New York. Global investors have simply steered clear of Europe. Again, they are forced to conclude "maybe".
On to the fifth test and, by this stage, they know what the answer is. In summary, the answer is still only "maybe". In each of the tests, there are both pros and cons. They go along to the Chancellor and, with heads bowed, tell her that the tests have not worked. They cannot tell for sure whether the UK would be better off staying in the euro or relaunching sterling. The Chancellor, clearly exasperated, tells them to try again. "What do you expect," she says. "Honestly, I ask my five best economists for a simple answer and I seem to have ended up with eight different opinions!"
The experts apologise profusely but point out that economics is hardly a precise science. She asks them what she should do. "Well, Chancellor, at the end of the day the decision is yours. After all," they say, "it was a political decision to join in the first place."
Stephen King is managing director of economics at HSBC.Reuse content