Select Committee on Treasury Sixth Report


The assessment process

53. The Government has stated that, even leaving aside the political and constitutional issues involved in the decision, it would recommend joining only if the economic case was "clear and unambiguous". The assessment of the five economic tests laid down is the process by which the Government will come to a view about whether such a case has been made.

54. As announced in a paper submitted to this Committee in September 2002, examination of the tests is being underpinned by a number of supporting studies (discussed further below—see paragraphs 60-61).[86] The Chief Economic Adviser to the Treasury, Mr Ed Balls, emphasised the importance of this supporting analytical work in a speech in December 2002, stating that the five tests enabled the decision to be made "on a proper economic assessment of the long run economic case" and the economic consequences to be "fully understood"; he suggested that, arguably, other important economic decisions of the last century had not been made on the basis of a similarly thorough exercise.[87]

55. Some commentators have expressed some scepticism as to how far, in practice, the five tests can be decided along economic rather than political lines, given the political issues involved in, for example, the interaction between the SGP and national fiscal policies and the accountability of the ECB. But several witnesses emphasised the thoroughness of the analysis being attempted[88]. The Governor of the Bank of England told us that he was "absolutely convinced that [the assessment] will be a balanced assessment looking at the potential benefits and the potential disadvantages and it would go across all of [the] issues." [89] It will be for political and other observers alike to judge, when the assessment is announced, whether they are satisfied that the assessment has indeed been made on economic grounds. There will also be a question, as many have pointed out, as to whether the economic case for entry can ever be truly "clear and unambiguous"[90]. But we accept the need for a serious and in­depth analysis which will allow the Government to take a properly considered and researched decision on the economic consequences of joining the euro. At the same time, we recognise that an economic analysis is not a mechanistic exercise and that there will inevitably be an element of judgement involved in assessing the economic case for entry. It will be difficult for the results of the assessment to be totally unambiguous.

56. We discussed with the Chancellor the process by which the decision on whether to proceed to a referendum will be taken.[91] It will be for the Chancellor in the first instance to make the assessment of the five tests, once the supporting studies have been completed. The Cabinet will then make its decision. The assessment will be announced, and the supporting studies will be published at the time of the assessment, but not before. If the assessment is in favour of joining, a bill will be brought in to provide for a referendum; if the decision is not in favour of joining then an indication will be given as to the Government's policy in the new situation[92]. The Chancellor told us that in practice the decision rested with the Treasury, rather than the Cabinet or the Prime Minister:

"¼the Prime Minister has already said that the economic assessment made by the Treasury will be decisive. In other words, while in constitutional theory the Treasury makes the assessment and the Cabinet will make the decision, the Prime Minister said that in his view the decision should be made on the basis of whether the assessment recommends yes or no¼ In practice the Prime Minister has already made it clear that the economic assessment and the Treasury's recommendation will be decisive."[93]

He added that while the supporting studies were in preparation "Obviously the Prime Minister is involved in this process"[94] and that "we are drawing on a large range of expert advice and there will be occasions when members of the Number 10 staff have been involved".[95]

57. The decision that the supporting studies should not be published before the assessment is announced has been controversial. The Chancellor told us:

"The studies are intrinsic to the assessment; in other words, they are the technical work that backs up the assessment. Therefore the appropriate time to publish them is on the day and at the time of the assessment, not in advance of the assessment. It would be a mistake to believe that, either for reasons of market sensitivity or for reasons of completeness, we would be adding to the debate by publishing these individual studies in advance of assessment. They are intrinsic to the assessment and will be published at the time of the assessment."[96]

58. Mr Peter Riddell, of The Times, argued that this was bringing "both the analysis and the conclusions under the same umbrella of secrecy" and that there was no reason why "the analysis should not be released and discussed at an earlier date¼ We need an open debate now, before the assessment, not afterwards";[97] other witnesses took a similar line[98]. Mr John Monks, for the TUC, while not allowing himself to be pinned down specifically to calling for advance publication of the studies, said that the TUC would "certainly be asking for a more open process than the one that there is at the moment"[99]. The Chancellor's suggestion that the studies are market sensitive may not apply, for example, to academic and comparative work on other currency areas. It seems to us that non­publication of the supporting studies ahead of the announcement will have reduced the opportunity for informed public debate before the Government becomes committed to a particular judgement. It is now too late for the studies to be published before the assessment is made and announced, and we regret this.

The five tests and the supporting studies

59. The five economic tests which "must be met before any decision to join can be made"[100] are:

i)  Convergence: are business cycles and economic structures compatible so that we and others could live comfortably with euro interest rates on a permanent basis?

ii)  Flexibility: if problems emerge is there sufficient flexibility to deal with them?

iii)  Investment: would joining EMU create better conditions for firms making long­term decisions to invest in Britain?

iv)  Financial services and the City: what impact would entry into EMU have on the competitive position of the UK's financial services industry, particularly the City's wholesale markets?

v)  In summary, will joining EMU promote higher growth, stability and a lasting increase in jobs?

60. As part of the preliminary and technical work underpinning the assessment, a total of 18 supporting studies examining key issues relating to the tests are being undertaken by the Treasury. 14 studies were announced in the paper sent by the Chancellor to this Committee in September 2002:[101]

  • The monetary transmission mechanism
  • The housing market
  • National business cycles
  • The exchange rate
  • Labour markets
  • Adjustment mechanisms and how the UK economy responds to shocks
  • Using fiscal policy as a stabiliser
  • The cost of capital
  • Impact of joining the euro on business in the manufacturing and service sectors of the economy
  • Financial services and the City
  • Trade
  • The experience of the US as a monetary union
  • Fiscal and monetary policy in the eurozone, including the Stability and Growth Pact
  • Price differentials

61. Four additional studies were announced later:[102]

  • The transition to the euro
  • The exchange rate and macroeconomic adjustment
  • A selection of specially commissioned papers by international academics on aspects of British membership of the euro
  • The overall framework for the assessment of the five economic tests.

62. The tests seek to determine whether UK membership of the euro is in the national economic interest. The fifth test indicates that the Treasury will define this as whether joining the euro will "promote higher growth, stability and a lasting increase in jobs". The Treasury memorandum indicated that the five tests will judge the decision on UK membership of the euro "against the Government's central objective to raise the economy's sustainable rate of growth, and achieve rising prosperity through creating economic and employment opportunities for all".[103]

63. Joining the euro would have both advantages and disadvantages for the UK economy and the tests seek to examine these. The potential benefits have been described by the Chancellor as being "in terms of trade, transparency, costs and currency stability—and could help us create the conditions for higher and more productive investment and greater trade and business in Europe".[104] The 1997 assessment describes potential benefits in terms of reducing the structural level of unemployment, through increased competition, reduced volatility and increased market reform, and of increasing growth and investment, through increased intra­European trade, increased stability and greater price transparency.[105] The tests covering the effect on investment and on growth and jobs will seek to estimate the extent to which these benefits could be realised.

64. Balanced against these potential benefits is the fact that the single interest rate (referred to by some commentators as the 'one­size­fits­all' interest rate) set by the ECB might not be appropriate for the UK economy at all times. The first two tests, covering convergence and flexibility, examine whether this could pose problems for the UK economy. Countries adopting a common currency require a single interest rate, and the European Central Bank sets the interest rate for the eurozone on the basis of the overall performance of the economies in the eurozone. Without proper convergence and sufficient flexibility, inappropriate interest rates set by the ECB could increase the instability of the UK economy and outweigh any benefits to investment and growth from currency stability with the eurozone. A single interest rate is not always appropriate for each individual economy within the eurozone at all times. In some economies interest rates may be too low, leading to excesses of inflation, whereas in other economies interest rates may be too high leading to increased unemployment. However, some witnesses referred to the fact that the interest rates set by the MPC for the UK economy did not suit all sectors and regions within the UK.

The 'counterfactual' question ­ the consequences of remaining outside

65. The purpose of the five tests is to compare two different futures for the UK economy, one within and one outside the euro. Many witnesses stressed the importance of the assessment being forward-looking. Dr Diane Coyle told us that "there is an important omission from the framework. The tests look at the possible effects of euro entry. Yet there's no explicit recognition in the Treasury's statement that there will be a need to assess the counterfactual: what will happen if Britain stays out?"[106] Possible consequences from staying out include loss of foreign direct investment (FDI) and increased currency instability[107] and also loss of influence in design of the eurozone rules. The status quo may alter substantially. Many witnesses referred to the importance of assessing the tests in this way. The Chancellor confirmed that the consequences of not joining the euro would be taken into account in the assessment.[108] We note the importance of assessing the consequences of not joining the euro. One set of issues arises if the decision is taken to join. A different set of issues arises if the decision is taken not to join in the foreseeable future. Both scenarios bring new challenges to the UK economy. We therefore welcome the confirmation that this point is being taken into account in the Treasury's assessment.

Two routes to stability

66. In one respect there has been a change of emphasis since the Treasury's 1997 assessment, reflecting the fact that the UK now has a number of years of experience of the post­1997 arrangements for setting monetary policy. The Chancellor observed that "there are two routes to stability, one from domestic monetary and fiscal arrangement and one from joining the ECB".[109] The No Campaign believed that, insofar as the new arrangements had already delivered (since 1997) lower long­term interest rates, this undermined the arguments that the UK still suffered from an inflation premium and that the increased credibility of the ECB could potentially allow lower interest rates without leading to higher inflation.[110] Professor Begg told us that he would never advocate "joining monetary union to get a better monetary policy" but that people making the case for entry considered that there were other benefits that could be obtained to offset the sharing of sovereignty and that the UK "might also be able to throw our weight behind improving the arrangements that currently exist" in the eurozone.[111] Some witnesses also cautioned that it would be wrong to be complacent about the superior performance of the UK's economic policy frameworks.[112]

67. Just as there is now evidence which was not available in 1997 about the domestic "route to stability", so also there is now evidence about the ECB "route". When the Treasury undertook its first assessment of the five economic tests in October 1997, there was still considerable speculation as to whether the euro would actually be introduced. The European Central Bank had yet to be established and the Stability and Growth Pact had only been introduced several months previously. The euro has now been in existence for over four years and the body of evidence of the effect of its introduction, while not yet substantial, is increasing. Many of the issues covered under the five tests can and should be supplemented by examining the experience of the eurozone so far. For example, to what extent is the euro promoting trade and investment amongst the countries in the eurozone? How are adjustment mechanisms operating in the eurozone in the face of a single interest rate set by the ECB? Are they allowing economies to regain their competitiveness and avoid sustained periods of low growth or high inflation? The extent to which convergence can occur between economies after joining the eurozone should also be examined. The Chancellor told us that "part of our assessment will include a view of what has happened since 1997" and that "there is quite a debate taking place in the EU about why the inflation rates in different countries have been diverging [and about] the level of growth overall".[113] Several witnesses thought that the assessment should also examine the reasons for the eurozone's recent poor performance in the face of the global slowdown and the extent to which the euro had contributed to these problems.

68. When the tests were constructed in 1997 evidence concerning the present UK monetary arrangements and the eurozone (as a monetary union) was not available. We welcome the Treasury's examination of the experience of the eurozone so far as part of a number of the supporting studies. The eurozone countries now provide 12 case studies as to the effects of entering monetary union and we believe these provide important lessons for the UK. Equally, given six successful years of the new UK monetary framework, supporters of entry will have to demonstrate that entering the monetary union will be at least as beneficial as the UK framework that is to be abandoned.

Convergence test

"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".[114] 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,[115] 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 economies—this 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".[116] 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".[117] 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".[118]

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.[119] 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 eurozone—this is only likely if the UK grows more slowly than other eurozone countries for a prolonged period".[120] 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.[121]

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".[122] 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".[123] 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".[124] 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.

86   Appendix 1: The Treasury's approach to the preliminary and technical work 6 September 2002 Back

87   Cairncross Lecture, 4 December 2002 Back

88   For example, Miss Lea (for the Institute of Directors) Q 338 Back

89   Q 1208 Back

90   See for example Q 74 [Mr Peter Riddell] Back

91   Qq 1002-1033; see also Q 66 [Mr Stephens, Mr Riddell] Back

92   Q 1025 Back

93   Q 1011 Back

94   Q 1026 Back

95   Q 1028 Back

96   Q 1002 Back

97   Ev 15 (para 7); see also Qq 54,73 Back

98   Q 73 [Dr Coyle, Mr Stephens] Back

99   Qq 206-207 Back

100   Appendix 1: The Treasury's approach to the preliminary and technical work, 6 September 2002 Back

101   ibid Back

102   Q 999 Back

103   Appendix 1: The Treasury's approach to the preliminary and technical work 6 September 2002 Back

104   ibid Back

105   HM Treasury: UK membership of the single currency - An assessment of the five economic tests (October 1997) Back

106   Ev 17 Back

107   Q 78 Back

108   Qq 1046, 1058ff. Back

109   Q 1045 Back

110   Ev 71, 103 Back

111   Q 298 Back

112   In our Report on the 2002 Pre-Budget Report we noted that while the Monetary Policy Committee's record of achieving its inflation targets since 1997 was good, it was possible that this could be associated with continuing sectoral imbalances, and we recommended that the Treasury and the Bank of England should undertake a joint review of the process (Second Report of Session 2002-03, The 2002 Pre-Budget Report, HC 159, para 30) Back

113   Q 1044 Back

114   HM Treasury: UK membership of the single currency-An assessment of the five economic tests October 1997 p 8 Back

115   Subject to the eventual impact of a rotation system following enlargement, discussed above. Back

116   The UK's Euro Challenge, HSBC, January 2003 Back

117   Can the UK achieve a smooth transition to EMU? Goldman Sachs, February 2003 Back

118   The UK's Euro Challenge, HSBC, January 2003 Back

119   Preparations for EMU, UBS Warburg, October 2002 Back

120   Can the UK achieve a smooth transition to EMU? Goldman Sachs, February 2003 Back

121   Q 315 Back

122   Q 315 Back

123   Q 374 Back

124   Q 800 Back

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