Speeches


BLOOMBERG DEBATE: 21 JANUARY 

The Test

The issue we are debating tonight is whether the UK economy has achieved sustainable convergence with the eurozone. 

Gordon Brown has described convergence as the `most critical’ of the five tests (HC Debs, col. 584, 27 October 1997). As the Treasury stated in its October 1997 assessment: `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. Joining before such convergence is secured would risk harming both’. 

Gordon Brown has said the economic case for joining the euro, as defined by the five tests, would need to be `clear and unambiguous’ (HC Debs, col. 584, 27 October 1997). That hurdle is a high one. Peter Mandelson, in his article in yesterday’s Times says `in economics there is never certainty’. Gus O’Donnell, now Permanent Secretary to the Treasury, said a year ago: ‘Economics can never be clear and unambiguous’ (The Times, 4 January 2002). 

The Governor-elect of the Bank of England, Mervyn King, has said `you need 200 or 300 years of data’ to see if business cycles have converged (27 May 1999, Select Committee on Education and Employment). 

These are not mere words. They must be taken seriously. They show what a high hurdle the Government has set itself if this test means what it says. And the test certainly should be taken seriously. As the Treasury’s Chief Economic Adviser, Ed Balls, said in a speech last month: `Unlike a decision to join a semi-fixed or fixed regime, or even a currency board arrangement, it cannot be reversed. So if entry happens, unlike previous exchange rate decisions in the last hundred years, there can be no changing of minds, no devaluation and no exit either’ (Oxford, 4 December 2002). 

It is against that background that convergence needs to be judged. In the Treasury’s own words, it has to be `sustainable and durable’. It is not enough if, at a particular moment in time, the UK’s growth rate or inflation rate are at similar levels to those in other European economies. This might be because our economies were like ships passing in the night, coming together for a moment before moving off in different directions. 

After all, even a broken clock tells the right time twice a day.

In fact, though, the evidence, as I shall show, simply does not support the proposition that convergence has taken place. 

Cyclical Convergence 

Much of Stephen King’s analysis focused on ‘cyclical convergence’ - the extent to which different economies are moving in tandem with one another so that they grow more strongly or less strongly together. 

This is, indeed, important. But in order to fulfil his remit to be neutral, he had to do two things. 

First he excluded Germany from much of his analysis. No doubt there have been specific circumstances involving Germany in the last decade. But there almost always are specific circumstances affecting one country or another. That is precisely why we should decide our economic policy and set our interest rates on what is best for Britain at any particular time, and not on attempting to do what’s best for 25 countries one or more than one of which is highly likely to be affected by specific circumstances at one time or another.

Growth 

He also showed a graph of growth rates, which he said showed that growth in the UK has been closer to the Eurozone’s than to America’s. 

But comparison of two series of numbers is not simply a question of putting them on a graph. Statisticians have a well-known technique which involves calculating a correlation co-efficient. This varies between 1 for variables that are perfectly correlated, through 0 where there is no correlation to -1 where there is perfect inverse correlation. 

The statisticians at ABN AMRO have done these calculations and they are shown on this chart. It shows the correlation of GDP growth in individual countries with (a) the US and (b) the Eurozone over the period 1991-2000. This demonstrates clearly that the UK economy is much more closely correlated with the US. 

If 1 indicates perfect correlation, the UK correlation with the US was 0.8. For France it was 0.5. For Italy it was 0.2. For Germany it was minus 0.5.

As to correlation with the Eurozone: for Italy and France 0.9; Germany 0.7; for the UK 0.1. 

We have expanded the analysis to include the whole period covered by Stephen King – 1980 to 2002. The results are very similar.

Again, if 1 indicates perfect correlation, the UK correlation with the US since 1980 has been 0.6. For France it was 0.2 and for Germany again negative.

As to correlation with the Eurozone: for Italy and France it has been 0.6; for Germany 0.8; for the UK less than 0.1.

This analysis of growth data over the last two decades shows we are much more closely correlated with the US than with the Eurozone.

Pricewaterhouse Coopers have said that that there has been some convergence – for example in growth rates - since 1998. But they also say that growth patterns started to diverge in the second and third quarters of 2002, with the possibility that divergence will widen further during 2003. 

John Hawksworth of PwC is reported as having said: `This evidence certainly does not prove that the convergence test has been met in a clear and unambiguous way’ (Financial Times, 8 January). 

Inflation and Interest Rates

In his article in the Times yesterday, Peter Mandelson said we are now a lot more convergent than in 1997, when the tests were last assessed. He used inflation as an example.

This is hardly a long enough period to assess long-term convergence. But let us take his claim head on. This is what has happened to inflation since 1997.

This is a classic example of the danger of treating momentary coincidence as long-term convergence, when all we are seeing is ships passing in the night. At the time of the introduction of the single currency in 1999, UK and Eurozone inflation rates were indeed almost identical. We can see what’s happened since.

Peter Mandelson’s article in yesterday’s Times also cited interest rates. But on the very same day the Financial Times noted that the gap between expected short-term interest rates in 2006 for Britain and the eurozone has widened from 0.25 percentage points to 0.5 points, since November. 

The fact is that there are always movements in such data either way, and a few years’ figures are not sufficient to conclude that convergence is occurring. Longer term data shows there certainly has not been the required convergence in our economic cycles. 

Structural Differences

Why not?

To help answer that we need to look at the other type of convergence - ‘structural convergence’. This concerns more fundamental features of the economy. If our economy is fundamentally different from other European countries, it will react in different ways to changing world conditions. 

Our labour market is still more flexible than that in other EU countries.

There are other differences too.

More people in the UK own their own homes and more have variable rate mortgages – so their disposable incomes are affected far more by changes in interest rates. 

The UK is also the only EU country that exports more oil than it imports. This means that if the price of oil goes up, there is more money coming into our economy and less going into other European economies, so the appropriate response to this kind of shock will be different. 

And the UK does more of its trade outside Europe than other countries do. That means that we will be more affected by an upturn or downturn in, say, the United States, and less affected by an upturn or downturn in continental Europe. 

In a recent report, Oxford Economic Forecasting examined how ‘asymmetric shocks’ – economic shocks that affect the UK in a different way to eurozone economies – would affect the UK both inside and outside the eurozone. Although the results varied for the different scenarios considered, they showed greater economic instability with the UK inside the eurozone than outside. 

So the evidence for convergence simply isn’t there. 

Conclusion

The reason why sustainable convergence is so important is that by entering the single currency we give up our right to set interest rates to suit our own circumstances. Instead the European Central Bank sets them for the circumstances in the eurozone as a whole. Interest rates are a very powerful economic tool. If they are set at the wrong rate for us, the damage this could do to jobs and livelihoods is huge. 

Peter Mandelson, in his article yesterday, wrote of the difficulty in setting a one size fits all interest rate for the UK. Why does he think it is easier to set one for the whole of the Eurozone? 

This problem already exists. Who would say that the current interest rate set by the ECB for the whole of the eurozone is the right rate for Germany, with its four million people out of work?

Without convergence between the UK economy and the eurozone these difficulties would be much worse.

So the Treasury is right to say that joining the single currency before sustainable and durable convergence is secured would risk harming growth and jobs. That sustainable and durable convergence has not been secured. So growth and jobs would be harmed. That is one of the reasons why joining the eurozone would be bad for Britain.

Rt Hon
Michael Howard QC MP