Stephen King: Pieces falling into place for UK to join the euro

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Blair told: fix 1 May 2003 for euro poll

Suddenly, the Government has a better chance of navigating its way toward euro membership

When you first open the box of a 1,000-piece jigsaw puzzle, the challenge can seem quite daunting. Gradually, however, the pieces fall into place and an overall picture begins to emerge.

The Government's approach towards the euro could be seen in similar terms. When the euro policy box was first opened, the contents were jumbled up in a seemingly impenetrable fashion. Over the last few months, however, the first signs of coherence have begun to emerge. Like the jigsaw junkie, enough pieces may now be in place to provide a coherent overall impression. And with coherence comes a better chance of clear policy direction: suddenly, the Government has a better chance of navigating its way towards euro membership.

Think about some of the reasons for delay and obfuscation. One of them – held very strongly at the Treasury – is the fear of fiscal constraint. The Chancellor of the Exchequer has a long-term ambition to rebuild our public services. Up until now, that ambition appeared to be based on continued strong economic growth and a modest medium-term increase in government borrowing.

The growth story so far has not been too bad, at least relative to the UK's European neighbours. The borrowing story, however, has had the potential to be more awkward at least within a European context. The Chancellor's golden rule, for example, suggests that, although there is a constraint on borrowing for current expenditure, he can borrow – within reason – anything he wants to fund his cherished projects for health, education and transport.

The eurozone fiscal Stability Pact threatened to place a constraint on what the Chancellor could do. One part of the pact's philosophy is to ensure countries maintain a budget balance over a whole economic cycle, more a ball and chain rule rather than a golden rule. Faced with this kind of fiscal discipline, it would be harder for the Chancellor to deliver his spending ambitions.

Yet there are increasing signs of flexibility on fiscal policy, both from a eurozone perspective and from a domestic UK perspective. Germany was on the cusp of receiving a formal warning from other European finance ministers requiring action to reduce its budget deficit, which has been threatening to breach the 3 per cent of GDP Stability Pact limit. The threat was the imposition of fines on Germany – or some form of ritual humiliation – by its European partners. This, however, has been avoided. Germany has agreed, on an informal basis, to bring its budget deficit down but has avoided the formal censure that was initially feared.

Of course, this may simply mean the Stability Pact has teeth that don't bite very hard, something that financial markets might not be particularly keen on. Equally, though, it gives politicians a bit more flexibility on fiscal policy, a conclusion that should make the Chancellor feel a little more relaxed about the constraints on his fiscal strategy.

On the home front, the softening up of the electorate for tax increases in the April budget has begun in earnest. The Chancellor may be against hypothecated taxes but it's a lot easier to sell an increase in VAT to meet objectives for health specifically than to allow the money to be poured into an apparently bottomless pit.

If this softening up process works, this will also be good news for euro entry. The simple reason is that, from now on, the Government may find it easier to use tax as a source of public sector funding rather than borrowing. By doing so, the potential constraint from the Stability Pact becomes less relevant. A domestic victory for higher taxation also reduces the threat to spending plans coming from Europe.

Then there are the signs of softening on the five economic tests. Yes, we all know they are supposed to give a "clear and unambiguous" message but everyone knows that the scope for interpretation is huge. After all, even if the Government believed the tests had been passed in this stringent fashion, there might still be a hard job convincing the voters. After all, who would trust the conclusions coming from a bunch of economists?

Meanwhile, the economic performance of the UK could, finally, be moving in the right direction. I stress the word "could" because the data coming out are still highly ambiguous. To join the euro, you want to be able to ensure the economy is on a sustainable path over the medium term. After all, you don't want to tie yourself to another currency only to find everything then goes badly wrong domestically.

As we all know, the UK has faced a persistent "two-tier" economy problem in recent years: strength in consumer spending and weakness in manufacturing. Realistically, this story shouldn't continue over the medium term to the extent that we ultimately have to produce something to pay for what we consume. The danger, quite simply, is that an absence of manufacturing ability will leave income growth lower over coming years, leaving consumers with levels of debt that they cannot easily pay off.

At last, there are a few signs the problem is beginning to abate. The data last week seem to be offering some respite to the Bank of England's two-tier quandary. Retail sales, adjusted for inflation, fell in January for the second successive month, seemingly at odds with the optimistic message coming from the majority of high street retailers. Meanwhile, the latest CBI manufacturing survey is consistent with a return to rising output in the manufacturing sector.

Of course, these are only snapshots from the beginning of the year and, as yet, there is no sustainable pattern. Yet, if retail sales do slow and manufacturing does pick up, there would surely be a reduction in the medium-term risks facing the UK economy. Under those circumstances, the risk of instability for the UK economy following entry into the euro would presumably be lower.

Moreover, it's worth noting that some of the implications of the two-tier economy have not really come to pass. If sterling really is overvalued and domestic demand is too strong, one consequence should be a widening of the UK current account deficit. Yet, so far, the current account deficit has been smaller than expected. It's true, of course, that the trade in goods deficit has got a lot worse but, to date, this deterioration has been offset by improving balances for services and for interest, profits and dividends (see first chart).

This trend may not last but, if it does, it might suggest that the exchange rate is not so overvalued after all. Indeed, according to an ingenious argument from John Butler, my colleague at HSBC, it may simply be the case that the UK is increasingly developing a comparative advantage in services that, in turn, has led to an increase in foreign demand for sterling. As a result, the exchange rate's value has gone up. On that basis, the UK's overall success must imply a relative failure for manufacturing.

So, things are going well for the europhiles within the Blair Government. But there are still plenty of things that could upset the apple cart: public opinion, for example, has yet to shift in a decisive fashion (see second chart). From an economic and fiscal perspective, however, the jigsaw puzzle now looks a lot more complete. The euro may still not get off the ground as far as the UK is concerned but some of the key barriers are beginning to break down.

Stephen King is managing director of economics at HSBC.