6 September 2002
PAPER FOR THE TREASURY COMMITTEE ON THE TREASURY'S APPROACH TO THE PRELIMINARY AND TECHNICAL WORK
Introduction
This paper has been produced to meet a request from the Chairman of the Treasury Committee, in his letter to the Chancellor of 8 July, asking for a paper from the Treasury by the first week of September as part of the inquiry the Committee is conducting into aspects of EMU.
Building on the Chancellor's speeches to the CBI on 4 November 2001 and at the Mansion House on 26 June 2002, this paper explains in more detail the importance, and content, of the preliminary and technical work that is now underway prior to the assessment of the five tests for UK membership of the single currency.
Policy
Government policy remains as set out by the Chancellor in his statement to Parliament in October 1997. The determining factor underpinning any Government decision is the national economic interest and whether the economic case is clear and unambiguous.
The Government has set out five economic tests which must be met before any decision to join can be made.
The five tests were set out in full in the Treasury assessment accompanying the statement made by the Chancellor in October 1997(1) . They are:
(1) Are business cycles and economic structures compatible so that we and others could live comfortably with euro interest rates on a permanent basis?
(2) If problems emerge is there sufficient flexibility to deal with them?
(3) Would joining EMU create better conditions for firms making long-term decisions to invest in Britain?
(4) What impact would entry into EMU have on the competitive position of the UK's financial services industry, particularly the City's wholesale markets?
(5) In summary, will joining EMU promote higher growth, stability and a lasting increase in jobs?
A comprehensive and rigorous assessment of the five tests will be made within two years of the start of this Parliament.
On the basis of the assessment, the Government will decide whether the five tests have been met. If a decision to recommend joining is taken by the Government, it will be put to a vote in Parliament and then to a referendum of the British people.
Preliminary and technical work
In his Mansion House speech in June 2001 the Chancellor explained that before the assessment of the tests was started, the Treasury would:
"?continue to do the necessary preliminary work for our analysis - technical work that is necessary to allow us to undertake the assessment within two years as promised."
This makes clear that the preliminary work will inform the assessment. IMF Executive Directors welcomed this approach in March 2002 at the concluding discussion to the latest Article IV consultation with the UK.
The scope of the necessary preliminary and technical work was set out in the original October 1997 assessment. Although there have been new developments since the 1997 assessment, the underlying issues to be analysed remain the same and the five tests themselves remain unchanged.
The Chancellor's 2002 Mansion House speech set out in more detail why each of the five tests are important and provide the right framework for assessing the national economic interest. It gave further detail on the preliminary and technical work, which this paper amplifies and which continues to evolve to take account of the latest technical research and analysis.
A number of supporting studies will be published encompassing the preliminary and technical work. As the Chancellor noted in his 2002 Mansion House speech, the supporting studies will cover key issues, which relate to particular tests but also apply to more than one test. When the assessment is complete, the detailed supporting studies will be published alongside, all to be subject to intensive public scrutiny and debate.
This paper gives more detail on the supporting studies to be published alongside the assessment.
Framework for the Five Tests
The five tests are a means of judging the decision on EMU membership 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.
The Government has consistently stressed that, in principle, there are benefits from membership which, if realised, could increase the level of potential GDP growth for the UK.
As the Chancellor reiterated in his 2002 Mansion House speech, "In principle British membership of a successful single currency offers us obvious benefits - 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."
The five tests provide a framework for robustly analysing the decision on EMU.
Often the tests are described as the Treasury's tests or the Government's tests, but neither description does justice to their critical role in assessing whether EMU membership is in the British national economic interest.
While the Maastricht criteria can judge convergence in the short term, the five tests go to the heart of what is required for the long-term future of the UK economy: they are the means of judging the decision on EMU membership against the Government's central objectives - full employment and high and sustainable rates of investment and growth.
As the Chancellor said in his 2002 Mansion House speech, being serious about the economics of the euro means being serious about the five economic tests.
1. Convergence Test
Under the convergence test, the preliminary and technical work will update the evidence presented in the 1997 assessment on the cyclical behaviour of the UK economy relative to that of the euro area countries and their relative responses to different shocks, both common and country specific (i.e. asymmetric) shocks.
The Treasury's October 1997 assessment stressed that "sustainable and durable convergence is the touchstone and without it we cannot reap the benefits of a successful EMU." As the conclusion of the 1997 assessment said "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."
The 1997 assessment went on to spell out that sustainable convergence means that the British economy:
- Has converged with Europe;
- Can demonstrably be shown to have converged;
- That this convergence is capable of being sustained; and
- That there is sufficient flexibility to adapt to change and unexpected economic events.
As the Chancellor said in his 2002 Mansion House speech, the Treasury's preliminary work in this area includes study of the output gap, inflation, interest rates and the real effective exchange rate, to analyse not just short-term cyclical factors but also long-term structural issues to assess whether convergence is sustainable and durable.
To that effect, there are a number of supporting analyses - part of the technical and preliminary work - of key features of the UK and euro area economies that might be a source of asymmetric cyclical responses in the future. These will be published at the same time as the assessment, and include studies:
- Assessing whether the monetary transmission mechanism differs substantively in the UK compared with the euro area. This study will examine what the main channels of monetary transmission are. It will consider whether there are institutional or structural features which suggest the UK transmission mechanism could differ significantly from those of the euro area economies; whether the empirical evidence suggests that the transmission mechanism is different in the UK; and how the UK transmission mechanism would be affected if the UK were to join the single currency.
- Assessing the behaviour of the housing market, and its impact on consumption. This study will focus on the evidence for the claim that the structure of the housing markets and housing finance in the UK is substantially different to that in the euro area. If they are different, the study will look at the reasons for specific UK characteristics, both on the demand side and supply side; whether the differences between the UK and euro area would persist if the UK were to join the single currency; and whether the features of the UK market are sufficiently distinctive to affect sustained convergence if we were to adopt the euro.
- Reviewing and updating various empirical studies of national business cycles, including what drives them and how they respond to different economic shocks. This study will concentrate on what the stylised facts are concerning the relative magnitude and sychronicity of UK and euro area cycles. It will look at the extent to which past differences between the cycles have been caused by different underlying shocks, and the extent to which they appear to have been caused by differences in monetary policy stance and / or exchange rate shocks. Also, the study will examine what is meant by the distinction between core and periphery euro area economies; and how robust these results are to a change in policy regime, such as UK adoption of the single currency.
- Analysing different approaches to the sustainable real exchange rate - as this is a key indicator of convergence and of obvious importance to this and all of the tests.
The preliminary and technical work under the convergence test is also revisiting and deepening analysis of a range of relevant issues which were highlighted in the 1997 assessment including: trade and investment linkages, the sectoral composition of output, and generally analysing whether there are structural differences which could lead to the UK reacting asymmetrically to a single euro area monetary policy.
2. Flexibility Test
The second test concerns the degree of flexibility in the UK and euro area economies and, as the 1997 assessment made clear, it is closely related to the convergence test.
A high degree of convergence does not eliminate shocks and changes to the internal and external economic environment. So the work leading to the assessment of the second test - the flexibility test - is focussed on building up a foundation for evaluating how alternative adjustment mechanisms within EMU will help the economy adjust given a single European interest rate set to maintain euro area price stability.
Even with a high degree of sustainable convergence, individual economies will continue to be affected by shocks and changes to the internal and external economic environment. So the preliminary work for the flexibility test is compiling evidence on the mechanisms by which labour, capital and product markets adjust, how well and how quickly they work, and the extent to which the mechanisms differ across countries. It will look at the example of the US as well as the euro area and will consider the role played by labour and capital mobility, as well as wage and price flexibility, in allowing economies to adjust to changes in the economic environment.
Work is going forward to develop a framework to analyse this evidence, distinguishing between obstacles to greater flexibility in response to disturbances, as well as assessing the characteristics of more flexible markets and the improved outcomes these deliver in the longer term. In this way a more structured assessment can be made not just of flexibility in individual markets but also how markets can interact and evolve and what this implies for the priorities for making a success of EMU.
This work is informed by the UK's agenda to make progress on EU economic reform, as detailed in the Government's recent White Paper (2).
A key area, as reflected in the 1997 assessment, is the behaviour of the labour market, including the degree of wage and employment flexibility. The 1997 assessment concluded that, in labour markets particularly, the UK had not yet achieved sufficient flexibility to meet the challenges of EMU membership. EMU membership would also place a greater premium on the success of domestic instruments of policy as an adjustment tool, in particular, fiscal policy and fiscal frameworks. In view of these priorities, supporting studies will be published on the following:
- The role of labour markets - and how labour mobility might complement movement in wages and prices. This study will consider, in particular, what we mean by labour market flexibility in the context of the EMU decision; what the relevant characteristics are of a flexible labour market; and what institutional features promote or hinder labour market flexibility. It will also look at whether UK labour market performance since 1997 indicates that the UK labour market now has sufficient flexibility to function effectively as part of the single currency, how UK flexibility compares with existing euro area economies and whether adoption of the single currency would encourage or discourage labour market flexibility.
- How the various adjustment mechanisms might operate for the UK including how the economy responds to different shocks, modelling how, in an environment in which UK interest rates were the same as euro area ones and there was a fixed nominal exchange rate with other euro area economies, the UK economy would respond to shocks, particularly asymmetric shocks. It will also look at how market mechanisms and fiscal policy can compensate and what the implications would be for output and inflation if the UK were to join the single currency.
- Fiscal policy as a stabiliser. Further work will include looking at the role of the automatic stabilisers and the potential for strengthening them, and the potential for use of discretionary fiscal policy instruments, focusing on issues such as: the advantages and disadvantages of using fiscal policy as a demand management tool; whether the use of fiscal policy for macroeconomic stabilisation should be confined to "automatic" stabilisers; and how the stabilisation properties of the existing UK fiscal arrangements compare with other countries.
3. Investment Test
Sustainable convergence - through cyclical convergence and a high degree of flexibility - must be accompanied by microeconomic benefits to ensure rising productivity and rising trend growth.
Economic theory and empirical evidence both show that investment in capital is a key driver of productivity, growth and overall economic performance.
As a result of long-term under investment, the UK today is significantly less capital intensive than its major competitors, contributing to the productivity gap.
The Government's strategy for closing the productivity gap has two broad strands: maintaining macroeconomic stability to help businesses and individuals plan for the future, and implementing microeconomic reforms to remove the barriers that prevent markets from functioning efficiently. These microeconomic reforms include encouraging investment to improve the UK's stock of physical capital in every sector and industry.
It is crucial that the EMU decision contributes to the Government's strategy for encouraging investment. The analysis will consider both how the impact of EMU on the stability of the macroeconomic environment will affect investment, and the impact of EMU on the key microeconomic drivers of investment, such as the cost of capital.
So for the third test - the investment test - the preliminary work includes, as in 1997, examining how EMU membership will affect public and private investment in general and foreign direct investment in particular.
Firms will decide to invest if the expected returns from the investment exceed the cost of the investment and the stability of the macroeconomic environment is a key factor affecting expected returns.
One of the key drivers of the cost of investment is the cost of capital. Macroeconomic stability is a key influence of the cost of capital, as lenders will typically require a higher rate of return to compensate them for the risk of inflation. The size and liquidity of financial markets will also affect the cost of capital.
Evidence suggests that foreign direct investment into the UK can raise the productivity of UK firms through technology and skills spillovers. The preliminary and technical work is considering how EMU would affect FDI inflows to the UK. One important issue is whether exchange rate volatility constrains FDI.
Increasing market integration in the EU, of which EMU is a part, could lead to significant industrial restructuring, as firms adapt to an evolving market and new competitive pressures. This could have important implications for the pattern of industrial location in the EU, which the preliminary and technical work is considering.
Because of the importance of the EMU decision for business in the UK and its contribution to investment, productivity and growth, more detailed studies will be published on:
- The cost of capital. This study will focus on the main determinants of the cost of capital for firms, as well as looking at how EMU has affected the cost of capital for firms from the euro area countries and how the cost of capital for UK firms would be affected were the UK to join the single currency.
- The impact of EMU on business in different manufacturing and service sectors of the UK economy. This study will examine how certain features of single currency membership - such as the elimination of exchange rate volatility and foreign exchange transaction costs for trade within the currency area, and increased price transparency between national economies within the common currency area - impact on firm behaviour. For example, it will examine the extent to which EMU will cause firms to relocate or to change their scale of operations and whether there is any evidence of such changes already happening in the existing euro area.
The preliminary and technical work is also considering the potential impact of EMU on public sector investment.
4. Financial Services Test
The UK has a significant comparative advantage in wholesale financial services and, on most measures, the City is by some distance the pre-eminent financial centre in Europe.
Given the importance of the financial sector to the UK both in terms of employment and invisible earnings, it is vital that the decision on whether to join the single currency does not damage the sector's competitiveness.
The last five tests assessment in October 1997 concluded that "in summary, EMU offers benefits to the UK financial sector, whether the UK is in or out. But the benefits and the opportunities from the single currency will probably be easier to tap from within the euro zone."
The dynamic nature of the sector means there is no room for complacency, so the preliminary work for the financial services test will include a detailed analysis of the effect of the single currency on financial services, including monitoring the changes that have occurred in this sector in the UK and the euro area since the start of the single currency in 1999.
A number of factors make the UK an attractive place for the financial industry to locate, such as a favourable tax and regulatory environment, a large pool of skilled labour, and large and liquid capital markets. The decision on EMU must ensure that the UK remains an attractive location for financial services.
The preliminary work therefore includes a supporting analysis that will consider:
- The drivers of the location of activity in the financial services sector, and the changes which have taken place since the start of EMU. This study will examine questions such as what determines the location of financial markets and, more specifically, what are the factors that have encouraged the clustering of financial services in the UK and especially the City of London, but also regional centres such as Edinburgh. It will also look at the factors that might threaten to unwind such clusters, what trends are currently affecting the distribution of financial service activity, and what this suggests for the future distribution of activity.
5. Growth, Stability and Jobs Test
The fifth test, the employment test, assesses, as stated in 1997, whether EMU will "promote higher growth, stability and a lasting increase in jobs." So the preliminary and technical analysis is - as in 1997 - analysing the potential benefits of EMU for the longer-term performance of the economy. The assessment will compare these against the potential costs of joining EMU.
In order to ensure that the assessment is comprehensive and rigorous, as announced in the Mansion House speech, a number of supporting studies will be produced relating to the fifth test, but also with relevance to the other tests, which will look in detail at:
- The likely impact of EMU on UK external trade with the euro area and the rest of the world. This study will consider the range of estimates for the influence of monetary union on trade and assess the econometric studies that suggest the effects on trade could be very large. It will also examine what the data suggest has been the experience of the euro area economies since the formation of the single currency.
- What lessons can be learned from the experience of the US as a monetary union. The US economy is broadly similar to the euro area in terms of overall size of market, and in terms of its balance between domestic and foreign demand. Some of the issues that this study will look at include: the extent of regional divergence within the US; how large and how persistent regional divergences are in key measures such as output, inflation rates and unemployment rates; how different US regions adjust to asymmetric shocks with the same interest rate; and the role of relative price changes, factor mobility and fiscal policy in resolving regional divergences. It will also consider the evidence for the potential benefits of a single currency area such as increased trade, competition and productivity. And look at the extent of regional divergences in fiscal policy in the US.
- The robustness of the arrangements for macroeconomic stability - including the Stability and Growth Pact - and their contribution to overall economic performance. This study will look at the current arrangements for fiscal policy, monetary policy, and policy coordination in the euro area - how they deal with shocks, and how they contribute to the credibility and conduct of economic policy.
A study will also be published on:
- Price differentials. This study will examine what impact joining EMU might have on UK prices, what explains relative price level movements between European economies in the 1990's and what has happened to euro area prices since the introduction of the euro - whether they have converged and how euro area price dispersion compares with dispersion in other monetary unions such as the US.
Conclusion
As the Chancellor said in his 2002 Mansion House speech, to join EMU without a proper, full assessment of the five tests could prejudice the UK's stability, risk repeating past failures, and return the UK to the days of stop-go at the expense of the Government's ambitions for high investment, full employment and high and sustained levels of growth.
A long-term approach to these vital questions is necessary because of the distinctive nature of the UK economy - a large economy in the European Union, with strong trading and investment links with the US and institutions which have traditionally been more global in outlook - and also because of the stop-go nature of the UK's economic policy history.
This note has set out in detail why each of the five tests are important and the right framework for assessing the national economic interest. It has also explained the importance of the preliminary and technical work that is now under way prior to the assessment. When the assessment is complete, the detailed supporting studies - highlighted in this note - will be published alongside, all to be subject to intensive public scrutiny and debate.
HM Treasury
6 September 2002
1 HM Treasury (1997) "UK Membership of the Single Currency: An Assessment of the Five Economic Tests".
2 HM Treasury (2002), "Realising Europe's Potential: Economic Reform in Europe".
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