When he reviewed the conclusions from the 'five economic tests' on UK membership of EMU the chancellor, Gordon Brown, made the significant observation that 'we have strengthened our commitment to and support for the principle of joining the euro'. He was effectively re-affirming the expectation that the UK will join the EMU in the foreseeable future, which may not be what many will have concluded from the results of the assessment.
Although there are still unsettled arguments around sovereignty and other political considerations, which will need to be addressed by the electorate within the context of a referendum, economics is much closer to the realities for businesses. My intention is to review the business issues arising from the assessment and the conclusions in relation to each test, the potential problems of delayed entry and the likely implications of the government's policy agenda for companies.
Convergence (Not yet …)
This is a key test for the government, unsurprisingly given the prominence of interest rates in the macroeconomic management of the UK economy. The Treasury assessment is that there has been significant progress on convergence, helped by the much greater stability of the UK economy in recent years.
Indeed, the degree of convergence that the UK has already achieved is greater than that of some of the original Eurozone countries in the run up to the start of EMU in 1999.
The UK is said presently to meet the Maastricht convergence criteria on all counts, including government deficit and debt, but some might argue that ongoing increases in public expenditure of approaching 10% do not sit well with the Stability and Growth Pact over any extended period of time. The obvious deduction, that taxes may have to rise significantly in the run-up to delayed UK entry, is not addressed but is clearly a concern.
Flexibility (Not quite …)
This test is focused on the labour and housing markets. On labour market flexibility, the conclusions are as much an admonishment to our EU partners on their lack of progress as a recognition that there remains more that can be done in the UK. The issue is an important one, since the government sees something of a trade-off between flexibility and the constraints on economic management that EMU represents.
Housing is a different kettle of fish and is regarded by the Treasury as a problem needing a solution, largely irrespective of EMU. The concern is that the volatility of housing and its importance to the economy can drive interest rate policy in directions not at ease with the perceived requirements of the wider economy. Conversely, interest rate management by the European Central Bank (ECB) inside EMU would have magnified effects in the UK, given the predominance of variable rate mortgages.
This could be a major issue for business, since if Eurozone interest rate policy should turn more interventionist, the consequences for the UK could well be highly damaging. However, this would be at odds with the ECB's brief, which is simply to manage inflation, and the diverse nature of the EU economy would make it very difficult to develop appropriate, commonly held objectives for intervention or to respond appropriately.
The implication is that UK entry is unlikely to lead to adverse policy risks, although there may be some loss of ability to manage economic cyclicality.
The conclusion is that EMU could reduce the cost of capital to firms through lower long-term interest rates and access to a larger financial market. This would particularly help smaller firms and should benefit SME productivity, by reversing a legacy of long-term under-investment and, over time encourage cross-border and foreign direct investment, reversing the diversion of investment funds to Eurozone destinations, such as France and Spain. The chart shows the recent development of this worrying trend.
Since investment decisions are rarely taken without reference to prior investments, internal and external synergies and infrastuctural considerations, it would take some time before this could be turned around. Conversely, delaying the decision could turn out to be much more damaging than anticipated, with uncertainty having a cumulative effect. One thing that business people try to avoid almost at any cost is uncertainty. Risk is one thing, not being able to assess that risk quite another.
Financial services (Yes)
The conclusion here was that entry would enhance the already strong competitive position of the UK's wholesale financial services sector. Retail financial services should remain competitive in either case but entry would enable the sector to leverage additional benefits from EU integration.
Here the business issues centre on the pace of integration and the lags and leeways associated with planning and preparation for entry by banks and other intermediaries. The costs, again particularly to SMEs, of delay and uncertainty arise as a result of the inability to access the full range of euro-based financial services, perhaps for several years.
Growth, stability and employment (Yes, but …)
Overall, the macroeconomic implications of entry are seen as overwhelmingly positive, with the potential to significantly raise UK output and drive a lasting increase in employment in the long term. Within EMU, the UK could benefit from a significant boost to potential output, albeit that this is subject to concerns about current Eurozone monetary policy, the need to reform the Stability and Growth Pact and the adoption of economic reforms to address the rigidities that bind the German economy, in particular.
However, all this is subject to the proviso that the UK still needs to put in place some of the building blocks for 'sustainable and durable' convergence inside EMU, which begs a number of questions, from the business point of view, in terms of the changes that will be required and what the business impacts might be.
The government has pointed to important new policy initiatives relating to housing and fiscal stabilisation. On housing, the Treasury is committed to addressing what it sees as market failure. Initiatives are expected to target the planning system, the supply of housing and housing finance, to increase the market's compatibility with the Eurozone. The exact nature of the changes will remain unclear until the studies commissioned to review the options report back. However, likely outcomes include an increase in house-building, which should at least benefit the construction industry.
The other major market to be focused on is the labour market, where the policy targets are improved wage flexibility in the public sector, skills improvement initiatives and deregulation, which may include relaxation of planning criteria to assist employers.
More controversial will be the potential business impacts of the envisaged fiscal stabilisation initiatives. Here, the intention is to identify short-term, discretionary fiscal policy measures, to be applied to manage the economy in a much more direct, hands-on way, as a counter to the loss of interest rates as a national instrument. The likelihood is that the focus will be on expenditure and transaction-based taxes of one sort or another.
The issue for business will be the trade-off between any increase in economic stability (the evidence from previous attempts at fiscal interventionism is mixed) and the uncertainties associated with short-term changes in taxation.