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Wednesday, May 28, 2003

To Join or Not to Join: That is the Question

It's decision time for the UK on those famous tests, and the political row is already brewing. Meanwhile a timely piece from Morgan Stanley GF summarising the five points and what are likely to be the main areas of contention. As they indicate real convergence has not been achieved, although it is not clear that this is due to divergence in policy. My feeling is that we need to wait a little yet to see what are the full effects of the 'one size fits all' constraint.

In his statement in October 1997, UK Chancellor Gordon Brown stated that the UK would only join EMU if the economic case for it is "clear and unambiguous". There are five economic tests to define if such a case can be made:

1. Sustainable convergence between Britain and the economies of the single currency.
2. Whether there is sufficient flexibility to cope with economic change.
3. The effect on investment.
4. The impact on the financial services industry.
5. Whether it is good for employment.

Interestingly, while the five convergence criteria set by the Maastricht Treaty only looked at nominal convergence, the UK tests also focus on real convergence. Considering both dimensions seems to us a sensible approach, as nominal convergence does not in itself (as Euroland has shown) guarantee real convergence. On the other hand, the Maastricht criteria were 'cleaner', assessing the actual situation in each economy before joining the single currency. In contrast, the latter three of the UK's tests try to evaluate the potential impact of EMU on the UK. This approach opens itself to criticism via the well-known ‘Lucas' critique’. Indeed, in his critique, Nobel prize winner Robert Lucas effectively warned against such tests, arguing that macroeconometric models being used to assess economic relationships are likely to be invalidated by structural changes (such as the UK joining EMU) and thus cannot be used to test the effect of these structural changes (such as the impact on UK investment of joining EMU).

We concentrate here on the first test, convergence. Our view is that a case for sustainable convergence of the UK economy with Euroland cannot be made at this stage. Nominal variables seem to have converged somewhat, but real variables have not. The measures used are explained in detail in the full report. In short, the nominal variables are inflation and long- and short-term interest rates, while the real variables are unemployment and domestic demand growth. Both the inflation and interest rate differentials diminished in the last decade. (Note, though, that the convergence in inflation itself explains part of the convergence in nominal interest rates.) On the other hand, standardised unemployment rates decoupled and domestic demand growth in the UK has consistently outperformed growth in Euroland since 1993, by an average of 1.6 pp per year.
Source: Morgan Stanley Global Economic Forum

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