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Thursday, 25 April, 2002, 23:17 GMT 00:17 UK
Gordon's next challenge
Gordon Brown now has to decide on whether the UK should join the euro


Now that the Budget is out of the way, the Chancellor can turn his full attention to the question of the UK's euro membership. .

He has pledged to say by the middle of next year whether he believes that the UK meets the economic tests that he has set as a prerequisite for membership.

But many economists believe that the nature of Mr Brown's latest Budget, which is relying on faster economic growth as well as higher taxes to finance a big expansion of public spending, may be incompatible with a push towards early euro entry.

Following eurozone rules could limit the Chancellor's plans to boost public spending and lead to lower growth.

Bank of England vs. ECB

One reason that Mr Brown may be reluctant to join the euro is the relative performance of the Bank of England and the European Central Bank.

According to Professor David Begg of the Centre for Economic Policy Research, in a new research report, the ECB performed relatively well in last year's global economic slowdown by reducing interest rates, especially after September 11.

But the UK's Bank of England performed even better, "flawlessly", according to Professor Begg, cutting interest rates earlier, and helping to ensure that the UK had the highest growth rate last year among the major industrial countries.

According to Professor Begg, the ECB's problems stem from a lack of credibility in the markets, which makes it difficult for them to cut interest rates too aggressively for fear that they would not be reversed.

That is one of the reasons why European growth has been slower than in the UK - and Mr Brown might well prefer to have the independent Bank of England managing interest rates if the UK economy got into difficulties, given the importance of high economic growth to his strategy.

The mandate of the ECB emphasises price stability as its sole goal.

Unlike the Bank of England, the ECB does not have a "symmetrical" inflation target., so it is not forced to cut interest rates if inflation is too low as well as raising them if inflation is too high.

Budget constraints

Another problem for the Chancellor is the Stability and Growth Pact, which limits the size of budget deficits in eurozone countries to 3% of GDP and pledges them to move towards balanced budgets.

Mr Brown has already clashed with the European Commission and said he would follow the "prudent interpretation" of the stability pact, which takes into account the UK's lower public pension payments, its low overall debt, and the need for further investment in public infrastructure.

Professor Begg says that the Growth and Stability Pact rules are a "fourth order solution" to the problem of financial stability, and far less desirable than the Chancellor's rules which allows borrowing for extra spending on investment.

He suggested that Europe might need to move towards a more subtle interpretation of the pact, in which the situation of individual countries was taken into account - for example, whether they were in a recession or at least a slowdown, where they were growing below their potential.

Problems with the pound

Another problem for the Chancellor, if he were to desire early euro entry, would be the high value of the pound against the euro.

Most observers believe that the pound would have to weaken before membership in order to ensure that British manufacturing industry was more competitive.

One way to lower the value of the pound would be to cut UK interest rates, making it less attractive to hold money in sterling.

However, the growing Budget deficit makes it more likely that the Bank of England will raise interest rates to ensure that the economy does not overheat - thus strengthening the pound further.

Some economists, however, believe that as UK growth slows down, the pound will eventually weaken.

Conflict with business

Mr Brown's Budget stance has won praise from the unions, but has drawn the ire of business, which is facing a 4bn increase in National Insurance payments to help fund the health service.

Yet it is the business community whom the government has been relying on to sell the benefits to euro membership to a still-sceptical public.

The cooling of Labour and business relations will make this strategy more difficult.

It may be no coincidence that the CBI, the main employers organisation, has decided not to hold any more members' polls on the desirability of euro membership until the government has decided on entry.

In this Budget, Mr Brown has reinforced the impression that he is the main architect of Labour's domestic policy agenda.

It would not be surprising if Mr Brown is now reluctant to put a European straightjacket on his freedom of manoeuvre.

Surviving the Economic Slowdown: Monitoring the European Central Bank, by David Begg, Fabio Canova, Paul De Grauwe, Antonio Fatas, and Philip Lowe, is published by CEPR


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24 Apr 02 | Business
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