Stephen King: Brown likely to 'pass' when quizzed on joining euro

The fly in the ointment is likely to be the impact of lower rates on sterling

On Thursday, Gordon Brown will be quizzed by the Treasury Select Committee. His specialist subject will be "The UK and the euro". Unlike TV's Mastermind, however, the Chancellor will no doubt declare victory over his inquisitors if he fails to answer any of their questions.

Question 1: "Has the UK achieved sustainable convergence with countries in the eurozone?" Answer: "You'll have to await the outcome of the five economic tests."

Question 2: "Can the UK and others live with a single interest rate?" Answer: "You'll have to await the outcome of our economic tests."

Question 3: "At this stage, can you provide us with an assessment of the overall benefits of joining the euro?" Answer: "Pass."

"Mr Brown, you end this round with a total of no points with umpteen passes". Applause from Treasury officials as Mr Brown exits stage left.

Nevertheless, the Chancellor's appearance before the committee comes at an interesting time. For the first time since 1997, sterling has started to wobble. Since the end of January, sterling has fallen against a basket of major currencies by 3.8 per cent. Not the biggest of collapses by any means, but still a considerable decline. As the left-hand chart shows, sterling has been a haven of stability in recent years, so people are bound to sit up and take notice when there is a sudden shift in direction.

Why has sterling come under pressure? There are a number of plausible explanations. First and foremost, the euro has been in the ascendant, gaining at the expense of both sterling and the dollar. Some of sterling's weakness is, therefore, more a case of the euro's strength.

Second, the Bank of England's unexpected rate cut this month has led to a decisive shift downwards in expectations about UK interest rates.

Third, although many private-sector economists are concerned about the build-up of debt in the UK economy, some members of the Bank's Monetary Policy Committee seem happy to shrug off higher debt levels. As Kate Barker said last week, if the choice is between higher debt and lower growth, policy makers should normally opt for higher debt.

Lastly, the UK economy is wobbling: more signs of soggy housing activity and retail sales down sharply in January – although they had been up sharply in December.

What impact do these developments have on Britain's chances of joining the euro? Here are three obvious questions for the Treasury Select Committee to put, questions that might tease out the Treasury's real views on euro membership.

First, to what extent could signs of economic weakness make it more difficult for the UK to join the euro?

Although Mr Brown is unlikely to make any precise comments about the growth outlook for 2003, even the Bank of England has become more cautious in its assessment of the outlook. From most points of view, this would seem to be an undesirable result. But in the weird world of euro convergence, it could be argued that lower UK growth makes it easier to join the euro. The eurozone is going to struggle to grow by much more than 1 per cent this year, so anything in the UK that is a lot higher than that would create problems for monetary convergence. The weaker UK economic growth is, the more likely that UK rates can fall closer to those in the eurozone. The latest cut from the Bank of England narrowed the gap to 1 per cent and I suppose further downward surprises to activity in the UK could narrow the gap still further, although the ECB itself is likely to start cutting rates fairly soon.

The fly in the ointment is likely to be the impact of lower interest rates on sterling. Sterling's recent decline undoubtedly reflects the perception that interest rates are likely to fall further. And this leaves euro ambitions in a bit of a fix. Growth and interest rate convergence might be desirable but a sustained sterling decline would appear to be inconsistent with the Maastricht Treaty, which explicitly states that currencies should be trading within the normal Exchange Rate Mechanism bands of the good old European Monetary System. Should sterling fall a lot further, Britain would be clearly flouting this aspect of euro qualification (a theme to be continued in question three).

Second, how do your fiscal plans relate to the Stability and Growth Pact? There is an easy answer here. For the time being, the Chancellor can happily argue he will have a budget deficit that will be less than the 3 per cent of GDP limit that triggers the process of examination, castigation and eventual fines within the eurozone. At this point, however, the committee should be able to follow up with a couple of supplementaries.

First, the Chancellor has no plans for the time being to bring the budget back to balance over the medium term even though the Stability and Growth Pact demands this. Why not?

Second, suppose the global growth environment leads to more UK government revenue shortfalls, leaving Britain in a position whereby, through no fault of its own, the budget deficit could rise to, say, 3.5 or 4 per cent of GDP. Under that scenario, would the Chancellor act, raising taxes or cutting spending, or would he allow the automatic fiscal stabilisers to kick in? If the latter, would this not flout every rule in the Stability Pact book?

Third, do you welcome sterling's decline and how far could sterling fall before it would be too low to join?

It is fairly obvious the Chancellor can easily parry this question, arguing that sterling's value is a matter for the foreign exchange markets, not an issue for the Government. But this answer simply will not do. Discussions about the euro must take into account the entry rate. Unless the Government proclaims total indifference – in which case sterling could join at any one of the various levels seen over the past 10 years – there must surely be a view on a sterling "sweet spot" against the euro. The decline in sterling's value has, in many people's eyes, brought us closer to that spot. But, given, the precipitous sterling declines seen over the past couple of decades, sterling could just as easily undershoot this sweet spot.

The Government and, indeed, the Bank probably welcome sterling's fall, as it supports exporters at a time when there are the first few signs of weakness in domestic consumption. Moreover, it is likely that a fall in the exchange rate will represent an ongoing improvement in competitiveness that will not be eroded through higher domestic inflation in the UK relative to competing economies. But I reckon this rebalancing of the course of UK growth, although desirable, could be seen in the eurozone as a way of Britain locking in at a permanently very competitive exchange rate. Under these circumstances, what is right for Britain might not be right for the eurozone and, in particular, for Germany.

Ultimately, therefore, sterling and the fiscal position are the real puzzles. Britain's interests lie in a weaker currency which, in turn, should be a consequence of weaker – and more euro-convergent – growth in the UK, yet these interests may collide with views within the eurozone. And the Chancellor's interests lie in retaining fiscal flexibility: yet, by doing so, he could end up moving Britain further away from the fiscal requirements included in the Stability Pact and in the Maastricht Treaty itself.