It's been a very long race, but we're finally getting close to the end. The finishing line may not yet be in sight but the long distance runners have just heard the bell for the final lap ringing in their ears.
It's been a very long race, but we're finally getting close to the end. The finishing line may not yet be in sight but the long distance runners have just heard the bell for the final lap ringing in their ears. Six months to go before they finally reach the end, at which point the Treasury will raise the victor's arm aloft. But whose arm will it be? The Europhile's? Or the Europhobe's? And who will be left lying on the floor, panting with exhaustion at the end of a long, but ultimately unfulfilling, journey?
Yes, 2003 is the year in which sterling thrives or dies. The Treasury's five economic tests will be either passed or failed. If they're passed, we then move on to a referendum. If the Europhiles were to win not impossible even though they're still behind in the opinion polls we can wave goodbye to sterling and say "bonjour" and "wie gehts?" to the euro.
Ultimately, though, I doubt that, on their own, the five economic tests are really good enough for the Treasury to reach a decision. One of the key problems with the tests is their assumption that economic relationships are predictable over time. Let me give you a prime example of where these relationships are a lot more unstable than officialdom likes to admit. Back in 1997, when the Treasury first carried out its five tests, it observed that "the continuation of low inflation should ... help to make our housing market less speculative, reducing the influence of past volatility".
The Treasury boffins were certainly right about part of this story. The rate of inflation has remained low over the past five years. House prices, however, have simply refused to behave. Year-on-year increases of 30 per cent hardly support the idea that there is a link between low inflation and the level of speculation in the housing market (see left-hand chart). More generally, it should be obvious from the experience of the past five years that asset markets can be very disruptive to economic activity even if inflation itself is well-behaved.
The housing market is likely to prove a major headache for those that are in favour of joining the euro. Assume, for the sake of argument, that the housing market is a genuine bubble. If this is true, there will inevitably come a point when house prices fall away quickly. Should this occur, consumer spending may prove highly vulnerable. What should policy makers do? The most obvious reaction is to cut interest rates. Given that UK rates are currently higher than those in the eurozone, this could be done as part of a trajectory towards euro membership.
Yet rate cuts on their own are unlikely to be enough. Faced with a weak housing market and consumers overburdened with debt, the ideal policy is exchange rate depreciation. As the currency falls, exports take up the slack left by newly cautious consumers. This, of course, is what Messrs John Major and Norman Lamont discovered rather late in the day when sterling left the ERM in 1992. Ultimately, sterling's decline paved the way for economic recovery in the mid-1990s despite the problems within the domestic housing market.
So, assuming that the housing market is heading for a fall, the ideal approach is to allow space for sterling depreciation against the euro before entering the eurozone. All absolutely fine from a UK point of view. But how about the rest of the eurozone? Are they really going to be happy to allow sterling to gain a competitive advantage at their expense before the UK joins the single currency?
At this point, we get into rather serious problems. At HSBC, John Butler and myself have been taking a rather close look at the extent to which the UK economy passes the first of the five tests, by far the most important in the decision-making process. This is the one that asks whether the UK and others can live both from a cyclical and structural point of view with a common interest rate.
As far as we can tell, the UK is more convergent than it was when the Treasury conducted its tests back in 1997. It's also more convergent than the founder members were before they joined the euro. Even more interesting, the UK is more convergent than some of the eurozone's current members. Specifically, the UK is more convergent with the euro than Germany. If you compare the UK and Germany with the eurozone excluding Germany, you find that on growth, inflation, interest rates and budget deficits, the UK suits the "one size fits all" approach a lot better than Germany. Even more surprising, the UK is more convergent with the rest of the eurozone on owner-occupation: the Germans are the odd men out (see right-hand chart).
In other words, should the UK joint the euro, Germany would be left even more marginalised than it is already. Currently, Germany makes up about one-third of eurozone GDP, giving it a sizeable presence. Should the UK join, however, Germany's share would fall back to about one-quarter. This would leave three-quarters of the eurozone the UK included potentially heading off in a different direction to Germany.
Under these circumstances, Germany's best bet would be to allow the UK to join but only on terms that suit Berlin. One of the most obvious stipulations is likely to be no devaluation of sterling. After all, most economists now think that Germany has an overvalued real exchange rate reflected in low levels of profitability, weak domestic investment and a persistent desire for German companies to open factories in every country other than Germany itself. Why on earth, therefore, would the Germans acquiesce in allowing sterling to fall when this would simply make Germany's own problems that much worse?
This leaves the UK in a catch-22 position. If it joins before the housing bubble bursts thereby avoiding the need to devalue sterling in the short term the Germans would be happy but the UK might eventually find itself in a housing straitjacket that would be impossible to remove. On the other hand, if the UK tries to join after the housing market bubble bursts thereby requiring a fall in sterling the Germans would have every excuse to kick up a major stink.
On a lot of measures, the UK has converged with many parts of the eurozone. Two peculiarities, however, could ultimately scupper UK membership of the eurozone in this Parliament. The first peculiarity the UK housing market is entirely a domestically generated affair. Oddly enough, however, it could be Germany's lack of convergence with the eurozone that provides the biggest banana skin lying on the path towards euro membership. And should membership finally be put on the backburner, sterling might in any case eventually head lower, leaving the Germans in yet another economic pickle.
Stephen King is managing director of economics at HSBC. firstname.lastname@example.orgReuse content