Don't bank on Britain being in EMU by 2002

Gavyn Davies on why the markets should discount reports of an early entry
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The Independent Online
THE UNSEEMLY summit row over the appointment of the new president of the European Central Bank was most unfortunate, but it will soon be forgotten. The fact is that the euro has now been launched, and the question of the date of Britain's eventual membership is becoming increasingly real.

Barely a week goes by without a rumour swirling in the financial markets that the UK government is about to spring a huge surprise and announce an early date for membership. This jumpiness is, of course, partly the result of last autumn's spate of conflicting and misleading newspaper headlines which led to unnecessary volatility in financial markets. There is constant fear of another "random" surprise.

In fact, this appears improbable. In recent weeks, the Chancellor, Gordon Brown, has become increasingly insistent about two things. The first is that the UK is now committed in principle to eventual membership of the single currency. The second, however, that this is not a realistic option for the present Parliament.

According to the forthcoming book on Gordon Brown's first year at the Treasury by Hugh Pym and Nick Kochan, this is precisely the formulation which the pro-EMU Chancellor suggested to the less pro-EMU Prime Minister last autumn. The idea of ruling out Economic and Monetary Union (EMU) membership in the current Parliament was seen as a pro-European manoeuvre, since it would enable the Government to organise a fully-prepared push for membership immediately after the next election. According to Philip Stephens of the Financial Times, the Chancellor now favours an early election in 2001, followed by a quick referendum a few months later.

Since it is the pro-EMU camp within the Government that is arguing against membership in the current Parliament, financial market paranoia about sudden surprises is not well-founded.

Whatever view is taken about the desirability of EMU in the long term, two factors rule it out as a realistic option for at least four years.

First, sterling is now severely overvalued against the euro, as last week's appalling export data in the CBI Survey demonstrate all too clearly. (Incidentally, these results constitute the kind of genuinely new information which was needed to change the balance between monetary hawks and doves at the Bank of England. Even a staunch supporter of the hawk's case such as myself would now admit that a pause for reflection is required.)

Second, and equally obviously, the stark divergence between the economic cycle in Britain and the rest of the European Union currently makes a one-size-fits-all European monetary policy entirely unsuitable for the UK's needs.

Not everyone accepts this. For example, in the middle of 1997, there were some elements in the Labour Party pressing the Prime Minister to use his political honeymoon to win an immediate EMU referendum. However, with the valuation of sterling and the state of the economic cycle in effect making first-round EMU membership impossible, it would have been absurd to have taken the political risk of a referendum several years in advance of possible membership.

Once that crucial decision had been taken, it became clear that the first possible date for a referendum would be 2000, by which time the early effects of the launch of the euro could be observed. But such a referendum could come in the midst of mid-term unpopularity for the Government and could therefore prove hard to win. This led to the inexorable conclusion that membership would probably be impractical during the current Parliament.

It is much easier to see that this remains the case at present than it is to plot a clear path to EMU membership after the end of the current Parliament. The Chancellor has laid out five separate economic tests for membership but, in fact, only two considerations seem likely to prove compelling. The first is British politics, and the second is the cyclical convergence between the UK and European economies.

On the political front, there would seem every reason for Tony Blair to like his current position on EMU, and relatively little pressure on him to change it. The Government's commitment in principle to join the euro seems to be enough, for the time being, to keep Labour's pro-European camp happy. Meanwhile, William Hague's opposition to membership for the next two Parliaments is leading to an increasingly open split between the Conservative leadership and British business, with consequent severe funding problems for the Tories.

All this is, of course, music to Mr Blair's ears, and there seems little reason for him to lance the Conservatives' boil by holding a premature referendum campaign. Why not instead watch Mr Hague wriggle as the pro- European camp inside the Tory Party seeks to change his 10-year commitment to stay outside EMU?

This argument will apply at least up until the next election, but what about the election itself? Might it be sensible to wrap the EMU question into the general election campaign, either by making it an overriding election issue or by holding a referendum on the same day? Almost certainly not - it would be far too risky to hang the life of the Government on such an uncertain issue. Therefore, it seems likely that the question will not be put to the British people until after Mr Blair wins a second turn.

But even at that point, a referendum will only be held if it appears overwhelmingly probable that the Government would win. With British business conducting a lengthy campaign in favour, this might be the case, but there are other factors weighing against. The European economic cycle might be turning down at around that time, causing the first bout of real political turbulence within the euro area. In addition, a great deal of political flak may be generated when the euro finally replaces national currencies in the shops, and in people's bank accounts, in 2002.

Memories of the political unpopularity of UK decimalisation of the coinage in the early 1970s suggest that 2002 may not be a propitious date to ask the British people for their opinion on the euro. If so, then another lengthy delay would become probable, since a referendum in 2003 or thereabouts may once again coincide with mid-term political blues. It is quite possible that this would lead to a further postponement of the issue beyond even the following general election.

The economic cycle also poses great problems. It is not sufficient for UK interest rates briefly to coincide with European rates, since this could be simply a "crossover point" followed by further declines in UK rates and increases in European rates. What is needed is a more permanent convergence, which seems likely to be maintained more or less indefinitely. There is no guarantee that such a high degree of synchronisation will take place at any time in the next five years, or even 10. Finally, at some point the Bank of England will have to be told to "shadow" the euro (instead of inflation) for a two-year period to stabilise exchange rates ahead of joining. This does not seem likely to start ahead of the election.

All in all, the Government may currently intend to join somewhere in the 2001-2002 window, but this is very far indeed from a fait accompli.