How we will learn to love the euro

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The Independent Online
THIS COLUMN usually concentrates on the outlook for inflation, growth and fiscal policy. I focus instead on politics and opinion polls, because a new factor is entering the economy's medium-term outlook.

The launch of the euro seems to have sparked a marked pro-EMU shift in UK public opinion. If, as seems likely, hostility to EMU fades further over the coming year, then markets will attach a higher likelihood to the UK joining EMU in 2001-03. This will tend to reduce short and intermediate interest rates and weaken sterling modestly - reinforcing the effect of the weak economy - while also lifting equities and preventing the pound from falling a long way.

The Government's plan seems to be to have a general election in early 2001, a referendum in late 2001 and EMU entry in early 2002. Sterling notes and coin would circulate for a further two or three years, but UK base rates would be set by the European Central Bank and the pound's exchange rate against the euro area would be legally locked as of early 2002. At present, markets do not believe that this timetable will hold. Markets imply that UK short rates in March 2002 will stand about 1.4 percentage points above euro area rates. This gap will be zero if the UK is in EMU.

The main obstacle to the UK joining EMU is the need to win over public opinion for a referendum. In December, polling by Mori for Salomon Smith Barney/Citibank showed a sharp rise in hostility to EMU, probably reflecting the tax harmonisation row. That issue has now quietened, and in January public hostility to EMU fell close to the mid-1998 level, which was the lowest since Mori started polling on this issue in 1991. EMU's smooth launch has been a further blow to those who predicted it would never happen. Recent months also have seen marked pro-EMU shifts in public opinion in Sweden and Denmark.

The split shows a close link between attitudes to EMU, incomes and political affiliation. The upper-income AB social group is slightly pro-EMU, with 45 per cent in favour of entry and 43 per cent against (balance of plus 2 per cent). The skilled working class C2s and lower-income DEs are strongly against, with balances of minus 22 per cent and minus 29 per cent. Among tabloid readers the balance of opinion against EMU is 28 per cent, while among readers of the broadsheet dailies there is a balance of 7 per cent in favour. Labour voters show a balance of 9 per cent against EMU entry, with a balance of 44 per cent against among Conservatives.

Looked at over a longer period, Mori's polls show a gradual but erratic drop in hostility to EMU since the Government's October 1997 statement in favour of the principle of entry. All polls since then - including that in December 1998 during the tax harmonisation row - have shown less public hostility to EMU than any polls in the previous three years.

The Treasury has highlighted the need to achieve sustained economic convergence before joining EMU, with the famous five tests. In practice, these tests really are a figleaf to disguise the near-term difficulty of winning a referendum. Of course, it would be better to achieve economic convergence before joining EMU than to be diverging. But the achievement of similar inflation and interest rates to other euro area countries for a year or two is very unlikely to ensure lasting convergence.

Inevitably, inside EMU, there will be times when the common interest rate is too high for the UK and times when it is too low. Regional divergences are common in large monetary unions. For example, individual states in the US show wide divergences in their growth and inflation rates, despite having more flexible labour markets plus greater integration of capital and product markets than the EU.

The key requirement is that public opinion needs to be persuaded that EMU entry and closer European political integration are desirable aims in themselves. Otherwise, the inevitable periods of economic divergence will cause huge political strains. If public opinion shifts in favour of EMU entry, then the Government can declare these tests met any time it likes.

The chances are that public hostility to EMU will fall further in the coming year. The euro area's mix of relatively low short rates and relatively high growth (compared to the UK in 1999) will probably seep into public awareness. The Government and many businesses will continue gently to nudge public opinion in a pro-EMU direction. The UK Government will feel more isolated outside EMU, and its aims of leading in Europe will look less plausible if, as seems likely, the Swedish and Danish governments hold referendums next year or in 2001, and falling inflation puts Greece on track to join in 2001 or 2002.

Moreover, opinion polls suggest that while UK opinion remains against EMU entry, a majority of the UK public view entry as inevitable eventually. Unless the anti-EMU camp can dent this view of inevitability, then the pro-EMU camp will aim to persuade the public that the UK might as well join in the next few years as later on.

A pro-EMU shift would help short and intermediate interest rates (out to about eight years) to fall towards euro area levels. Sterling probably also would fall as markets shorten the timescale for the pound to fall to a more sustainable level of DM2.50-2.60 (1 euro = 75-78p).

However, with the pound's forward rate for 2002 likely to become anchored around 75-78p to the euro, there will be less risk that rapid near-term rate cuts would cause the pound to collapse. This would make it easier for the Bank of England to cut rates a good deal further in the next year. Lower interest rates and a lower pound probably would lift UK equities, supporting the effects of high institutional cash levels. Financial companies and domestic-oriented sectors probably would gain most as interest rate expectations fall, leading to hopes of gains in consumer spending and construction.

Michael Saunders is UK Economist at Salomon Smith Barney/Citibank

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