Hamish McRae: Now the eurozone must pass five tests before we join

Economic overview

Gordon Brown presented his assessment of the five tests as a "getting closer but not there quite yet". And he added the sweetener that over the next year he would make changes to British institutional arrangements that might smooth the path to entry. But he also casually slipped in tests that the eurozone would need to pass before it would be appropriate for Britain to join. The implication was that just as we needed to make changes, so did they.

The key has always been the ability to pass the first two tests - convergence and flexibility - as the Chancellor acknowledged yesterday. The others - investment, the City and employment - all flow from the first two. If you achieved economic and finance convergence and could meet changes in the economic environment flexibly you would get more inward foreign investment, the City would prosper and the economy would create more jobs. (The City seems to be doing fine in or out of the euro so that is why that is the only test already clearly and unambiguously passed.)

So how have we done on those first two tests? The Chancellor correctly said long-term interest rates had converged, so tick that box. He did not say the gap between US and euro long-term rates had also converged, as part of the general downward movement of long rates, a move associated with the collapse of inflation everywhere. Short-term rates have converged somewhat but this too is a function of global forces, in particular the fears of a world recession. The gap between UK and European rates has widened, but this is because of the divergence of growth between the eurozone, which is on the brink of recession, and the UK.

There has also been progress on convergence of the currencies, with sterling, the Chancellor hinted, at a level that could be sustained in the long-term. But getting the appropriate entry rate into a currency union is tricky: there is an acceptance that Germany entered the euro with the mark at too high a rate. But that objection was not raised at the time; indeed there were concerns that other countries with a history of currency weakness might not be able to keep up with the mark.

If we were to join, we would have to have convergence on housing finance. That makes sense. At present, it is useful to be able to have an economy particularly sensitive to changes in interest rates. Cuts in interest rates cut mortgage costs and put money directly in the economy. If there is to be another leg to the world recession it is jolly useful to be able to pump up demand this way. But in the long run it would make more sense for people to finance home purchase, a long-term commitment, with long-term fixed rates. Our housing market is too volatile, though whether the changes suggested by the Chancellor will have much impact is not clear.

Finally, there has been convergence on inflation, part of the trend away from inflation that has swept the world. Here, moving to the European method of calculation makes sense, because our rate includes changes in a key asset price, that of houses. There are good reasons why central banking authorities should care about changes in asset prices. Had the US Federal Reserve cared more about the surge in share prices in 1998 and 1999, it might have pricked the bubble earlier and saved the US, and the world, from the misery of collapsing equity markets. But if a consumer price index is supposed to measure prices, housing should not be in it.

On the other hand, since we are assured that pensions, benefits and index-linked gilt payments will be calculated as they are now, it looks as though the conversion to the euro-friendly measure of inflation will have more theoretical than practical significance. Legally, it would be difficult to change the index-linked contracts, and politically, it would be hard to cut pensions and benefits to suit the eurozone's tally of inflation.

If convergence is "not yet", so too is flexibility, though the problem seems to be the flexibility of Europe, not of us. The Chancellor noted a string of areas where continental Europe was insufficiently flexible. These included reform of the stability and growth pact, reform of the European Central Bank, uncertainties over the European Convention and the need for tax competition, not tax harmonisation.

True, there were areas where we needed more flexibility. These included public-sector pay. The Chancellor did not say it but official calculations suggest public-sector pay is up to 40 per cent above market levels in some regions including the North-east and Northern Ireland, and it is 10 to 15 per cent below market levels in London and the South-east. This is causing huge distortions, and encouraging the shift of private-sector jobs from these regions, for the private sector cannot compete for good people against public- sector pay scales. But getting more flexibility into public- sector pay will not be easy, especially if Europe gets the blame. The main changes, though, were those that the Chancellor requires of Europe. Reading this speech, with that at the CBI last month, it is possible to identify five tests the eurozone will have to pass before it qualifies for sterling to become a member. We are promised a report on reform in more detail this week but, meanwhile, here is the "five test" version.

These tests are, first, reform of the stability and growth pact that takes into account the economic cycle, debt sustainability and public investment, more like the new fiscal framework the Chancellor announced yesterday.

The second would be reform of the European Central Bank, probably with an inflation target that is symmetrical in that the curbs on undershooting are as strong as those on overshooting, and with a remit that has more of a bias towards growth.

The third is the acceptance of tax competition rather than tax harmonisation. This goes further than the notion of a national veto on tax changes; it would enshrine the principle that it is good for countries to compete against each other to develop a more attractive tax system.

Four would be reform of the Common Agricultural Policy, which the Chancellor believes is one of the key barriers to further trade liberalisation and does particular harm to less-developed countries, whose products are in effect shut out of European markets.

And finally, there is reform of European labour markets, which the Chancellor believes is the main reason why the eurozone has nearly double the level of unemployment of the UK.

That would indeed be the "programme of European economic reform" that the Chancellor referred to at the end of his speech yesterday. It would also help clear the path to the "fully effective transatlantic economic partnership between Europe and the USA" that the Chancellor called for early in the speech. That would indeed be radical - a free trade area joining Nafta and the EU - much more radical than the matter of whether the time is ever right for Britain to adopt the euro.