Stephen King: Timing of euro entry critical for long-term fiscal policy

Brown has stressed that euro membership has to be based on a long-term assessment of economic conditions

Lots of "jaw jaw" and hints of "war war" but, apart from Iraq, the other issue which is getting renewed attention is the euro. After days of wrangling, the TUC has given its support, however grudgingly, to current government policy on the single currency. Like the country at large, however, the TUC appears decidedly split on the issue: ask Bill Morris or Unison and you're unlikely to see a "thumbs-up" for euro entry.

Eurosceptics within the union movement don't appear to have the same concerns as those within, say, the Conservative Party. That, in itself, is a bit of an oddity. The union opposition appears to be based on fears associated with the level of public spending – a key issue for Unison – but it is difficult to see why Tory sceptics would sympathise with this line of thinking. There may be a lot of reasons to oppose euro entry but it is not at all clear that they form a mutually consistent pattern: the opposition is, in essence, fragmented.

The public spending concern is a straightforward issue and does present a significant quandary for the government. The eurozone stability pact is a pretty tough thing, designed to prevent countries from borrowing too much on Europe's capital markets. The aim is to stamp out residual inflationary concerns associated with overly loose fiscal policies and, at the same time, to prevent countries from being fiscal "free-riders" – borrowing heavily and, hence, driving up interest rates for everyone.

All of this sounds reasonable but there is an obvious catch from a UK perspective: the stability pact is tougher than Gordon Brown's own set of fiscal rules. According to the Chancellor, he can't borrow for the purposes of current spending (wages, unemployment benefits and the like) but he can borrow for capital spending (new hospitals, schools and so on). Of course, he can still do this within the framework of the euro but the limits are more tightly drawn. Weak economic growth – leading to falling tax revenues – could more easily throw the Chancellor's carefully laid plans for public sector capital spending off course – or, alternatively, could require tax increases to maintain them.

On top of all this, there is an additional concern with regard to fiscal policy. Currently, UK base rates are at 4 per cent whereas those in the euro area stand at 3.25 per cent (see first chart). Moreover, given what is happening in the eurozone at the moment – Germany, in particular, is in a real mess – there's a good chance that eurozone interest rates will come down further from current levels. On that basis, there will be a considerable gap between the level of rates that the Bank of England deems appropriate for Britain and the level of interest rates that the European Central Bank chooses to set for the eurozone.

This is not the first time that this problem has cropped up. After all, a lot of countries – Italy and Spain when the euro was first formed, Greece more recently – have found themselves cutting interest rates aggressively in the run-up to euro membership. The key difference, however, is that these countries were all tightening fiscal policy aggressively as they lowered interest rates so that they could just about meet the Maastricht convergence criteria. The tightening of fiscal policy may well have offset the potential expansionary effects of the reductions in interest rates, thus keeping their economies on the cyclical straight and narrow.

For the UK, the story doesn't appear to be quite so simple. The conventional view is that sterling needs to fall to a lower rate against the euro to be competitive over the medium term. Assuming, in addition, that euro rates are 1 per cent lower than those in the UK over the next couple of years, it's not difficult to argue that UK membership of the euro could imply a significant monetary stimulus. To avoid that stimulus turning into inflation – implying a loss of UK competitiveness against its eurozone neighbours – the Chancellor would have no choice other than to bring down government borrowing. And, if tax increases are off the agenda, suddenly his spending plans are under threat.

A reasonable defence against this argument is that the assumptions are either wrong or, alternatively, are too short term in nature to be relevant to a decision as momentous as euro membership. As Mr Brown has repeatedly stressed, any decision on euro membership has to be based on a long-term assessment of economic conditions.

That's all perfectly reasonable but I'm not sure that the short term and long term can be separated in an easy fashion. Short-term considerations primarily relate to levels for interest rates and currencies, all of which are subject to the vagaries of financial market ups and downs. The key question, however, is whether a short-term cyclical issue can have longer-term ramifications which, in turn, could affect the success or failure of entry into the euro.

As I outlined above, a key short-term concern might be the need to tighten fiscal policy in the light of rapid rate reductions and a lower exchange rate in the run-up to euro entry. But there are other short-term concerns that might ultimately work in the opposite direction and which could be more damaging to the euro project.

One such concern is housing. I'm going to make another key assumption here, namely that the UK housing market has entered bubble territory. A debatable point, perhaps, but one that is sufficient to demonstrate the relationship between the short and long term. If the housing market is a bubble, at some point it will have to burst, or at least deflate. Let's say that consumer spending has been well supported in the UK precisely because of the strength of the housing market (see second chart). On that basis, a fall in house prices would undermine the key area of strength in UK economic activity.

In itself, this may not be such a bad thing. But if, in the meantime, we have joined the euro, the policy options available to deal with this particular kind of short-term problem are likely to be rather limited. In a situation where domestic demand is deflated because of a fall in domestic asset prices, there are one or two useful things that can be done about it. First, if private demand is weak, it can be offset through a pick-up in public demand through an increase in government borrowing. Second, if domestic demand is weak, it can be offset through foreign demand via a fall in the exchange rate.

But if euro membership places a restriction on these policies, a short-term problem with house prices could turn into a long-term problem of insufficient demand. If the exchange rate cannot fall to accommodate an improvement in exports, the alternative is a period of domestic price weakness, sufficient to depress the "real" exchange rate. This, however, could prove to be a painful process. Try asking Germany, where the absence of domestic and external policy flexibility has left the economy on its knees.

The short-term/long-term relationship need not be an argument against joining the euro. However, if short-term factors can have an influence on long-term performance, the timing of euro entry becomes a critical issue. Clearly, the decision on whether or not to join the euro is one of the biggest that this country will ever take: yet the success of membership – at least in the first few years – could ultimately depend on the waxing and waning of short-term cyclical developments.

Stephen King is managing director of economics at HSBC.