Spurious indicators

In view of the rather limited and theoretically suspect set of indicators established by the Maastricht Treaty, the British Government adopted five supplementary tests which are claimed to be criteria for the decision whether EMU membership would be beneficial for Britain. These are:

(i) Whether there can be sustainable convergence between Britain and the economies of a single currency
In a dynamic global economy, it appears increasingly unlikely that the economies of countries can converge. Even if they did, differential productivity, technology and demand changes, together with the discovery of new process and commodities, will inevitably re-establish 'divergence'. Another difficulty is that the Treasury document slips between, and never precisely defines, two different interpretations of convergence. First cyclical, the belief that a single currency is only beneficial when the trade cycles of its members are synchronised, and second structural, the belief that a single currency is only beneficial when the national participants possess homogenous economic structures and international trading patterns. Although the two are inter-related, a determined government could potentially achieve 'cyclical convergence' over consecutive five-year parliaments through appropriate fiscal and monetary policy changes. In contrast, the more fundamental 'structural convergence' would require a focused longer-term strategy, potentially over generations. No government, nor the EU Commission, has ever devised, let alone implemented, such a complex programme and none appears to be immediately forthcoming. Moreover, if all EU economies achieved the easier target of synchronising the business cycle, the effect may be destabilising by its inducement of world inflations and recessions on a greater magnitude than previously experienced.

(ii) Whether there is sufficient flexibility to cope with economic change
A single currency cedes control over exchange rates and monetary policy. Therefore, without flexibility, future economic shocks are likely to impact negatively upon employment. Whilst the Treasury paper addresses significant dimensions of flexibility capable of national solutions, such as skills and long-term unemployment, it fails to confront directly the crucial issues for a single currency, i.e. labour mobility and price-wage flexibility across the EMU zone. It is precisely the absence of significant international labour mobility, restricted by language and cultural factors, together with the risk that wage differential transparency, enhanced by a single currency, will give rise to demands for wage equalisation between countries irrespective of productivity, thereby increasing wage rigidities.

(iii)The effect on investment & (v) whether it is good for employment
For both of these tests the Treasury argues that the single currency possesses the potential to enhance investment, employment and growth, but these benefits would only accrue if sufficient convergence and flexibility exist. However, the argument ignores the crucial role of British overseas investment, approximately 80% of whose destination is outside the EU, the potentially deflationary impact of the Maastricht convergence criteria and subsequent adherence to the Growth and Stability Pact, together with the establishment of price stability as the sole legal objective of the European Central Bank (ECB). Indeed, Bill Martin of United Bank Securities estimated that already 'EMU aspirants' suffered a deflation around 4.5% of GDP during the 1990s by pursuing the Maastricht criteria. Moreover, it appears that the Treasury fails to appreciate the enormity of any effective convergence and flexibility strategy. Tables 1.1 and 1.2 in the document show that the British and German economies have in fact steadily diverged; indeed since 1981 a negative correlation exists between their growth rates.

(iv) The impact on our financial services industry
A frequently cited danger for Britain remaining outside EMU is that posed to the City of London which is one of three major world financial centres. International financial services in Britain employ around 150,000 people, generating £10-£15 billion in annual invisible exports (Taylor, 1995). It is often asserted that, if the UK exercises its opt-out, London could lose its pre-eminence to Frankfurt or Paris, because Euro trading will be focused in the EMU area. However, international business within each time zone tends to gravitate towards a single location, this centralisation being propelled by a preference for deep, liquid markets, accommodating legal and tax frameworks, skilled labour and a cluster of supporting services including accountancy, law, software and telecommunications. The City possesses all these attributes, which any EU competitor would find hard to emulate. Hence, providing that complacency is avoided, the existence of such advantages should ensure the City's dominance even if Britain remains outside EMU.

When analysing EMU's consequences for the City of London, it is crucial to distinguish between its role as the premier European financial centre and its position in the world financial markets. The immediate effect of EMU will be a loss of intra-EU foreign exchange transactions, which can be compensated by an increased volume of Euro dealing that will concentrate in London just as French franc-US dollar business does currently. It would also be offset by greater dollar and yen trading against the Euro. A greater threat arises from the official bond market that will inevitably emerge from EMU, which the relevant authority will seek to retain inside the single currency area. However, without effective exchange controls, it will prove impossible to prevent global trading, so that a bond market will inevitably develop in London. Thus, so long as the City retains its competitive advantage, its European pre-eminence will remain even with Britain outside the EMU. Indeed, this constitutes an attraction as London falls outside the potentially restrictive arrangements required to sustain the Euro. Moreover, the City's international position in global markets, where business is growing fastest, would be jeopardised if EMU led to fiscal and political union, since it would become subject to greater regulation leading to its diminution to the benefit of New York and Tokyo. The conclusion therefore appears to be that a Britain outside EMU can provide a bridge between the USA and Europe so that the City of London's status, where the dollar and the Euro financial systems have their interface, is preserved.

In summary, the five tests selected by the UK Government undoubtedly extend the rather limited usefulness of the Maastricht convergence criteria and highlight a number of important issue for further analysis. However, they ultimately fail to meet the same requirements, namely the absence of a justification for reliance upon this specific set of indicators and the rejection of others. Moreover, the 'vague' nature of judging compliance with the 'five tests' impairs the clear and unambiguous establishment that a country is either well suited for EMU membership, or alternatively that its inclusion would weaken the union and hamper the effectiveness of its stabilisation policy mechanism. Consequently, a more extensive set of criteria is required in order to establish whether EU member states are ready to join EMU.