Politics will be arbiter on UK euro entry

For years the British economy has been seen as a distant planet, revolving in a lonely orbit far from the course of continental Europe.

Now it seems that the two economies may be swinging into alignment. As Mr Wim Duisenberg, president of the European Central Bank, suggested this week, the idea of trying to link them with a single currency is looking increasingly possible.

Obstacles remain, but over the next few years, the convergence may be close enough to persuade the government to make the jump.

Despite all the British government's talk of five tests for joining the euro, there is only one really important economic question: would the benefits of transparency and certainty in creating a single market with a single currency be outweighed by the loss of flexibility in monetary policy?

The more Britain's economy falls into line with the euro zone, the lower the cost of losing flexibility in the exchange rate and interest rates, and hence the stronger the case for joining.

The Treasury has begun to devote some effort to this question, discussing it with outside economists, and has become guardedly positive about Britain's progress towards convergence.

Since the beginning of 1999, the continental recovery has become increasingly solid.

This year the euro zone should grow by a little over 3 per cent, while Britain will probably grow by a little under 3 per cent. Unemployment in the euro zone, although still considerably higher than in Britain, has begun to fall more rapidly.

Inflation on the internationally comparable measure is now higher in the euro zone than in Britain.

As the Organisation for Economic Co-operation and Development (OECD) put it earlier in the month, the British economy is certainly no more divergent from the economies of Europe's core than many countries that are already in the euro.

The problem is that this alignment of the real economies is being attained at a point where short-term interest rates, although closer than they were in 1997, are still 1.75 percentage points higher in Britain than in Europe.

Sterling too, although it has fallen back, is still some way above the level at which industry would be happy to fix it forever.

"If we locked in an exchange rate of €1.35 to the pound, and a repo rate of 4.25 per cent, our economy would probably not look like the euro area average, it would look more like the Republic of Ireland," says Mr Martin Weale of the National Institute for Economic and Social Research.

As Sir Eddie George, governor of the Bank of England, put it, convergence between the economies cannot simply be temporary, like "ships in the night". To live happily with a single currency, Britain and the countries of the euro zone must have economies that move broadly in line forever.

As Mr Mervyn King, the bank's deputy governor, has said, to know that the economies have converged in that sense we would have to wait for two or three hundred years.

But Lord Currie, professor of economics at the London Business School whose work on the euro was published by the Treasury in 1997, says some people have set impossibly demanding tests.

"We will never have perfect convergence; there can never be hard scientific evidence," he says.

"The question is will the British economy be significantly out of kilter with the euro area, and I don't think it will."

In the end, most economists would agree with Mr Duisenberg's assessment that the ultimate arbiters will be politics and psychology, not economics.

"The Treasury can do some analysis, but this is still a very political question," says Mr David Walton of Goldman Sachs.

"These economic tests will provide a bit of cover: if the politics are not right, then the government can hide behind the economics. But if the politics are right, then the economics won't stand in the way."