The Economist

Britain and EMU

Rumours of greater cabinet sympathy for Europe’s single currency have changed neither the politics nor the economics of monetary union

IT WAS a curious episode. “Cabinet shifts towards EMU”, declared the Financial Times on September 26th, in an article laced with quotes from an unnamed minister. The idea that the government had become more sympathetic to Britain’s membership of Europe’s monetary union sent financial markets haywire. Down went sterling that day, losing six pfennigs against the D-mark before regaining some of the losses. Up went the stockmarket, by more than 3%. And up went the price of British government bonds (gilts).

Then came the denials. “Nonsense on top of speculation,” averred the chancellor of the exchequer, Gordon Brown. Ministers from the EMU-phile Mr Brown to the EMU-phobe foreign secretary, Robin Cook, insisted that since the general election nothing in the government’s position had changed. Britain is highly unlikely to join the single currency in the first wave in January 1999. Joining two or three years later is a possibility—but only after a referendum or a general election. And Mr Brown still insists that the government will consider five tests, set out in a speech in July: the effect of EMU on firms’ investment in Britain; its effect on the financial-services industry; whether the business cycles in Britain and other European countries are aligned; whether there is sufficient “flexibility” in European economies; and EMU’s implications for economic growth and jobs.

Even so, the rumour was enough to excite the financial markets, and especially that for gilts. The reason? After monetary union, there will be a common interest rate across EMU countries. Thus there is already barely the width of a cigarette paper between the yields on, say, ten-year French government bonds and their German equivalents, bunds. And as the likelihood that Italy and Spain will qualify for EMU has risen, their bond yields have fallen closer to Germany’s: Italy’s ten-year bonds yield less than 70 basis points (hundredths of a percentage point) more than bunds; the Spanish spread is about 40 points. The convergence of gilt and bund yields now looks to be under way. The gap in ten-year yields, 111 basis points on September 25th, has fallen to below 90 points.

This still leaves a puzzle: why should the market react now, when nothing much of substance has changed? After all, says David Mackie, an economist at J.P. Morgan, an investment bank, it was the general election result which represented “a huge shift in the probability of our getting into EMU”. Tony Blair’s referendum promise notwithstanding, the Labour Party always looked more likely to join the single currency than the Euro-riven Conservatives. But for some reason “the gilts market never priced in that shift.”

Moreover, some economists argue that gilts had been looking cheap regardless of the politics of EMU. Geoffrey Dicks of NatWest Markets points out that the government has kept a tight hold of public borrowing, restricting the supply of gilts, and that inflation has stayed low, reducing the risk of holding gilts. That made it hard to explain why gilts should yield so much more than Italian or Spanish bonds. The FT’s story, it seems, was simply the catalyst for a change that was overdue.

If the politics of Britain’s EMU entry have changed little in the past week, the same is true for its economics. Most of Mr Brown’s five tests are vague enough not to matter. At least one, however, clearly rules out quick entry. The British economy is running close to capacity; continental Europe still has plenty of slack. The two need, and have, different monetary policies: British official short-term interest rates are 7%, and are generally expected to rise again this year; Germany’s are only 3%. Cutting British rates to European levels would set inflation racing. It will probably be a couple of years at least before Britain’s economy could be in line. And at DM2.85 or so most economists think the pound overvalued, despite its fall in recent weeks: DM2.60 is regarded as a more likely entry point. Roughly, that is the rate the market now expects in 2000 or 2001.

If the government does decide to try to push Britain into EMU, however, the economic “tests” will be less than half the battle. Since the election, Mr Blair has enjoyed plenty of adulation from the popular press—not least from the top-selling and bulldog-Eurosceptic Sun newspaper. The Sun’s reaction to the story of rising cabinet EMU-philia was thunderous: the government, it said, “is prepared to fly in the face of public opinion . . . It is willing to sacrifice our ability to control our own destiny.” If, through the Financial Times, a minister was trying to test the political wind, he or she got an answer: a gale warning.

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