United we stand

It has been a difficult year for Europe. Publication of the draft European Union Constitution and the Treaty of Accession, enabling 10 new members to join in 2004, was overshadowed by continued economic weakness in the core European economies and a major political rift over war with Iraq. Worst of all, within weeks of Chancellor of the Exchequer Gordon Brown's "not yet" verdict on UK membership of the single European currency, voters in Sweden gave a resounding thumbs down to the euro.

The single currency is set to remain an ongoing source of uncertainty for UK business but at least the debate can now be backed by extensive analysis, after recent research by the Treasury.

The Treasury published the results of this research, UK Membership of the Single Currency in June, and its bottom line conclusion was that the euro could be of major economic benefit to the UK. It stated that European Monetary Union membership could significantly raise UK output and lead to a lasting increase in jobs in the long term. It argued that joining up would boost UK trade within Europe by up to 50% over 30 years which, by way of an associated rise in investment and increased competition, would stimulate stronger growth in productivity. Within a generation, it claimed, national income per head could be 9% up on what the UK would enjoy outside the euro - an extra £1700 per person.

The Treasury also concluded that the cost of living would drop if the UK joined the euro. It believes that without the complication of having to account for currency differences, consumers in a common currency zone would become more aware of the relative prices of goods across borders.

Price transparency could be bad news for businesses that previously relied on a favourable exchange rate to stay competitive. They would become exposed to the full weight of consumer power, forcing down prices.

This would mean the UK economy would have to move broadly in tandem with the other EU economies and would need to be able to respond to the shocks that knock economies off course. If these so-called convergence and flexibility conditions were not met, there would be no guarantee that the single interest rate set by the European Central Bank would always be right for the UK.

In fact, it could destabilise the economy, making it prone to periodic bouts of boom and bust.

Unfortunately, by the Treasury's own assessment, while the UK economy has been converging with the rest of Europe it still behaves very differently in many respects. In particular, UK consumers are more sensitive to interest rate changes because they are much more likely to finance housing with variable mortgages, rather than long-term fixed-rate deals.

In addition, the Treasury assessment highlighted the problems that would arise if the pound were to join the euro at too high or too low a rate.

It proposed 73p as the ideal entry rate and flagged up the need for a new form of fiscal fine tuning of the UK economy. The assessment showed how changes in public spending and/or taxation (especially VAT) would become a more significant means of regulating the economy once the UK was operating in the single currency.

As for flexibility, the absence of exchange rate adjustment within EMU would mean wages would have to move up and down easily, or workers move easily from occupation to occupation or region to region, in response to economic shocks. And, though the Treasury found that the UK is relatively flexible compared to the rest of the EU, its overall conclusion was that further progress was needed. Indeed, the Treasury assessment implies that any benefit from euro membership for jobs would arise primarily as a result of increased flexibility, which is desirable whether or not the UK joined.

On closer inspection, therefore, the Treasury assessment appears cool, if not sceptical, about the benefits of joining. However, the government nonetheless holds out the prospect that the UK could join eventually if steps are taken to promote both greater convergence and flexibility. It is pursuing a series of reforms designed to overcome the barriers.

EMU test

Eurosceptics argue that the real test of the euro is flexibility in EMU, and the operation of the fiscal Stability and Growth Pact that underpins it. The SGP is said to be too rigid to enable countries to cope with the loss of independent monetary policy - one result being that France and Germany have already flouted the rules. Not only does this potentially threaten the long-term stability of the euro, it clearly had some influence on the Swedish referendum outcome. Likewise, the so-called European Social Model, based on strong market regulation, is reckoned to hinder employment flexibility in the single economy.

These are legitimate concerns and they will continue to place a question mark over both the economic resilience of the EU and UK membership of the euro. EU economies will have to reform if they are to become flexible enough to operate a successful single currency, especially when the EU welcomes in new member states that need a substantial boost to productivity and jobs.