"Are business cycles and economic structures
compatible so that we and others could live comfortably with euro
interest rates on a permanent basis?"
69. Convergence is one of the most significant of
the five tests. The Treasury stated, at the time of the first
assessment, that "we need to demonstrate sustainable and
durable convergence, before we can be sure that British membership
of EMU would be good for growth and jobs".
As already stated, if the UK joins the euro, responsibility for
fixing interest rates for the UK economy will pass to the European
Central Bank, which sets rates according to the economic conditions
in the eurozone as a whole. Although the UK would account for
around 20% of the eurozone economy and would have some input into
the determination of the rate through a seat on the Governing
Council of the ECB,
if the UK economy has not converged with the economies of the
eurozone then the interest rates set might be inappropriate for
the UK. This could lead to instability in the economy, and in
the short term to excessive inflation if interest rates were too
low or increased unemployment if interest rates were too high,
threatening a return to 'boom and bust'. What does convergence
mean in practice? The test divides convergence into two main issues
which seek to determine both whether the UK is currently converged
with the eurozone and also whether the convergence is capable
of being sustained. The first issue is whether the UK is at a
similar point in the economic business cycle to the eurozone economiesthis
is known as 'cyclical' convergence. The second issue is whether
the convergence is capable of being sustained, which will involve
analysing whether there is 'structural convergence'i.e.
whether the structures of the UK and eurozone economies are similar.
This will establish if there are particular features of the UK
economy that could lead it to react differently to changes in
eurozone interest rates or to other types of economic shock.
70. In a recent paper, HSBC examined the extent of
convergence between the UK and the eurozone economies. They concluded
that since the Treasury's 1997 assessment "the UK has become
more convergent" but that "part of this convergence
results from the pursuit of independent policies".
Goldman Sachs in recent research pointed out that "the key
test is whether the cycles would have been so well correlated
if interest rates [in the UK and the eurozone] had been held at
the same level and the exchange rate had been fixed".
HSBC also compared the performance of the UK economy with that
of the 11 eurozone countries if Germany is removed from the figures:
they concluded that "the UK is convergent not so much with
the eurozone as a whole but with the eurozone excluding Germany".
71. The recent imbalances that have developed in
the UK economy were seen as having implications for the convergence
test. UBS Warburg recently pointed out that while "the growth
rate of the UK economy has on average been similar" to that
of the eurozone "growth in UK consumer spending has remained
well above that" in the eurozone.
Goldman Sachs, in a recent paper, made a comparison with the ERM
period, suggesting that "declining imbalances and a depreciation
in the real exchange rate go handin hand. Inside the euro,
the real exchange rate could only fall if prices in the UK rise
less rapidly than the eurozonethis is only likely if the
UK grows more slowly than other eurozone countries for a prolonged
Mr Bootle told us that that he would be much more convinced that
convergence had been achieved if it was still in place following
a correction of the imbalances.
72. There was broad agreement amongst witnesses that
there had been some convergence between the UK and eurozone since
the Treasury's previous assessment in 1997. Mr Weale told us that
the economies were "much more converged than in 1997".
At the time of the previous assessment there was a difference
of around 4 percentage points in UK and eurozone interest rates
and the difference is currently 1.25 percentage points. Mr Taylor
believed that "we are more convergent, the question is whether
we are convergent enough".
Structural obstacles to sustainable convergence such as labour
markets, the housing sector, and trade linkages were identified,
although the importance of these was disputed by Britain in Europe.
Some witnesses believed that the act of joining the euro could
increase convergence. Professor Moore believed that "convergence
is a feature of countries that are already in monetary union,
it is not something that takes place beforehand".
There has been substantial convergence between the UK and the
eurozone economies since 1997. In some respects the level of convergence
is greater than that between some of the eurozone members themselves
before 1999. However, the Treasury assessment must include examination
of whether convergence to date is cyclical or structural. It must
also examine the implications of the recent imbalances in the
economy for achieving sustainable and durable convergence and
whether these imbalances would have arisen had the UK been in
the eurozone from the outset.