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Thursday, 16 May, 2002, 10:41 GMT 11:41 UK
Q&A: Understanding the five tests on the euro
The UK government says that if Britain is to join the euro it must meet five economic tests before a referendum would be called. BBC News Online looks at how each test might be judged.

What are the five economic tests, and why do they matter?

In October 1997, Gordon Brown outlined five economic tests by which the government would judge whether the UK economy would benefit from joining the euro, the single currency used by 12 European countries.

They include whether its introduction would be good for jobs, for foreign investment, and for the City, and whether the UK economy was marching in step with other European countries, and whether it had enough flexibility to adjust if it wasn't.

The government has said it will announce whether or not the UK meets the five economic tests by June 2003 - and if it does, it would recommend ask the country's voter to decide in a referendum whether to join the euro.

Are business cycles and economic structures compatible so that we and others could live comfortably with European interest rates on a permanent basis?

This is the key question as far as most economists are concerned.

That is because if the UK joins the euro, it loses control over interest rates, which are set for the whole eurozone by the European Central Bank (ECB) in Frankfurt.

If Britain were to go through a recession, while the rest of Europe was expanding, this could create problems for the UK economy (for example, if the ECB decided to raise interest rates to reduce inflationary pressures elsewhere).

On the ECB's council, the Bank of England would have just one vote - like the central banks of all other member states.

Many observers believe that the UK's economic cycle has moved closer to that of the eurozone over the past few years, and trade with the eurozone accounts for 60% of UK trade.

However, the UK seems to have weathered the global slowdown better than many eurozone countries, with growth in 2001 higher than that in Germany or France.

And some economists worry that the UK has a different economic structure than the rest of Europe - for example, the UK is a big exporter of North Sea oil and trades more with Asia and North America - and most people have mortgages with variable interest rates (as opposed to the fixed interest rates more common in Europe).

That means that the UK economy might react more strongly to changes in interest rates than the rest of Europe.

However, long term interest rates are now broadly similar in Germany and the UK, indicating that the financial markets believe the outlook for inflation in both countries is broadly similar.

If problems emerge, is there sufficient flexibility to deal with them?

The UK has the most flexible labour markets in Europe, since the governments of Margaret Thatcher reformed the country's labour laws.

That means that lower interest rates produce more jobs in Britain than elsewhere.

Unemployment in the eurozone is much higher than in the UK.

The lack of flexibility in the other eurozone countries could increase strains in the currency zone if there was a real economic crisis.

Although Britain has been pressing for changes in European labour markets, the process of change has been slow.

For example, only 0.4% of European citizens move to work in other EU countries each year.

In the United States, the high rates of migration between regions helps ease the adjustment when area is struck by a recession.

And prices around Europe still vary significantly, despite the single market and the single currency.

What impact would entry into the euro have on the UK's financial services industry?

The UK has Europe's largest financial services industry, with more jobs in this area than in manufacturing.

The City would broadly welcome euro entry, which would strengthen its position against European rivals like Frankfurt.

But the City of London can still make money by trading in euro-denominated government bonds even if the UK is out of the euro.

However, joining the euro could make the UK financial sector more vulnerable to takeover, for example in the abandoned plan for the London Stock Exchange to merge with the smaller Deutsche Börse of Germany.

And there are also those who worry that joining the eurozone might redirect investment streams, with investors finding it more attractive to put their money with firms on the continent than the UK.

Would joining the euro create better conditions for firms making long-term decisions to invest in Britain?

Almost certainly yes.

Britain has attracted the most inward investment in the EU, but recently many of the big multinationals like Toyota, Ford, and Nissan have begun to warn that they only invested in the UK because they assumed it would eventually join the euro.

The disadvantage for a firm that has invested in Britain is that fluctuating exchange rates, and especially the strength of sterling, has made their exports to the Continent uncompetitive.

Nissan, for example, whose most productive car plant in Europe is based in Sunderland, still cannot make a profit selling its cars to Europe at the current exchange rate.

Of course, if the UK joined the euro at the current exchange rate, then euro membership would not be so advantageous for these multinationals.

Would joining the euro promote higher growth, stability and a lasting increase in jobs?

This the broadest question, and the one that is most difficult to answer.

If there was convergence in economic cycles (the first condition) and flexibility in labour markets, then the gains of euro membership would probably outweigh the costs.

Recent economic research suggests that in the long run, monetary union could increase trade and growth by up to 20% - a big boost.

But the initial costs of converting to the euro could be expensive, especially for small shops, perhaps reducing UK GDP by 1-2%.

However, whether joining the euro would boost jobs and growth would partly depend on the exchange rate Britain joined at.

What about the exchange rate?

Although it is not one of the government's five economic tests, before it joins the euro the government would have to be very sure it was joining at a competitive exchange rate.

Otherwise, joining at too high an exchange rate could cost jobs as UK exports would not be competitive, and could lower UK GDP.

Most businesses, and many economists, believe that the pound is over-valued at the moment by between 10% and 30%.

It is currently trading at rate not much higher than when the UK left the exchange rate mechanism in 1992.

But lowering the value of the pound on international currency markets could be a difficult operation.

However, UK policy makers hoping that a long-awaited weakening of the US dollar, which would strengthen the euro, could have the side effect of reducing the pound's level against the single European currency.

The EU says the UK would be obliged to join the ERM for two years to establish a stable exchange rate before euro entry - but UK Treasury officials dispute this.

See also:

11 Jun 01 | Business
Pound must fall 10% for euro entry
08 Jun 01 | Business
Pound under political pressure
25 May 01 | Vote2001
Q&A: Britain and the ECB
30 May 01 | Vote2001
Bosses prepare for euro battle
24 May 01 | Vote2001
Is the UK ready for the euro?
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