The five economic tests were designed by Chancellor Gordon Brown together with his assistant, Ed Balls back in 1997. The purpose is to assess whether UK is ready to join the Economic & Monetary Union (EMU) or not, therefore ditching the pound & adopt euro as its official currency
The UK Treasury is responsible for assessing the tests. It first did in October 1997. That time it was concluded that UK was neither sufficiently converged with the rest of EU nor sufficiently flexible to join as euro member. It is said that the first two tests are the most important which will eventually affect the outcome of the third & fifth test. The government then published the revised assessment in June 2003. The outcomes were broadly similar in many ways
What are those 5 economic tests?
(1) Convergence. To what extent UK’s business cycle have converged with those in EU? Is UK able to live comfortably with the euro interest rates on a permanent basis? What about inflation rate, unemployment or level of government’s debt? As a matter of fact, there are many incompatibilities
The UK Treasury is responsible for assessing the tests. It first did in October 1997. That time it was concluded that UK was neither sufficiently converged with the rest of EU nor sufficiently flexible to join as euro member. It is said that the first two tests are the most important which will eventually affect the outcome of the third & fifth test. The government then published the revised assessment in June 2003. The outcomes were broadly similar in many ways
What are those 5 economic tests?
(1) Convergence. To what extent UK’s business cycle have converged with those in EU? Is UK able to live comfortably with the euro interest rates on a permanent basis? What about inflation rate, unemployment or level of government’s debt? As a matter of fact, there are many incompatibilities
Source: tutor2u
Unemployment rate in UK is persistently lower than those in France, Germany & Spain due to the success of labour market reform embarked by Conservatives in the past. Before the crisis, UK economic growth was much higher than its major euro rivals. In terms of interest rates, if UK would have joined earlier, it would have to be adjusted downward accordingly to the single ECB interest rates. With already a rapid growth, lower interest rates will send UK economy to another boom & bust. Housing market is another major stumbling block. Most people in UK that time chose variable rate mortgages. With lower base rates, Britons will unnecessarily experience higher level of personal debts given the appetite for property market. The only minor convergence would be the inflation rate between euro & UK. This is because both adopted the targeted inflation rate of 2%, except that UK allows it to be within +/- 1%
(2) Flexibility. If problems emerge, is there sufficient flexibility to deal with them? This is another major hindrance of adopting the euro. First of all, UK will totally lose its control over monetary policy. It can no longer set interest rate that is in favour of its own economic fundamentals. It will have to bow to the interest rates set by ECB which is more often suitable for some, but not for many. This means fiscal policy is the most important tool now. However, according to the Growth & Stability Pact, a country should not incur budget deficit of more than 3% of its GDP. In a recession, blindly adhering to this will prove to be more curse than cure. We often heard countries that spend themselves out, not tighten their way out. Lastly, labour market will be less flexible. Firms will find it difficult to hire & fire given that traditionally euro countries give more power to labour unions than companies
(3) Investment. Would joining EMU create a better condition for firms making long-term decisions to invest in UK? The Treasury believes that a successful single currency market will turn UK into an attractive area with low inflation & therefore stability for firms to invest. Also investment could be boosted with reduction in transaction costs & elimination of exchange rate uncertainty. Being a single market will have greater elements of competitions due to transparent pricing & provide new opportunities for companies. However, this will only materialise if the convergence & flexibility criteria are met. Therefore, it fails the third assessment. Interestingly, UK has been very successful in attracting FDI & yet the largest even it stays out of euro
(4) Financial services. What impact would entry into EMU have on UK's financial services industry, particularly the London’s wholesale market? It is said that by joining euro, London’s position as the world largest financial centre will not be affected, given that it is already established as the world’s largest financial centre. It houses London Stock Exchange, London Metal exchange, Lloyds of London, Bank of England & many other prominent banks
(5) Growth & jobs. In summary, will joining EMU promote long lasting economic growth, stability & low unemployment? There is no clear evidence to this. However, we know that in order for these to be met, again the first two conditions will be the prime determinant. Critics argue that UK’s economic performance was much more impressive even it decided to stay out of euro
(2) Flexibility. If problems emerge, is there sufficient flexibility to deal with them? This is another major hindrance of adopting the euro. First of all, UK will totally lose its control over monetary policy. It can no longer set interest rate that is in favour of its own economic fundamentals. It will have to bow to the interest rates set by ECB which is more often suitable for some, but not for many. This means fiscal policy is the most important tool now. However, according to the Growth & Stability Pact, a country should not incur budget deficit of more than 3% of its GDP. In a recession, blindly adhering to this will prove to be more curse than cure. We often heard countries that spend themselves out, not tighten their way out. Lastly, labour market will be less flexible. Firms will find it difficult to hire & fire given that traditionally euro countries give more power to labour unions than companies
(3) Investment. Would joining EMU create a better condition for firms making long-term decisions to invest in UK? The Treasury believes that a successful single currency market will turn UK into an attractive area with low inflation & therefore stability for firms to invest. Also investment could be boosted with reduction in transaction costs & elimination of exchange rate uncertainty. Being a single market will have greater elements of competitions due to transparent pricing & provide new opportunities for companies. However, this will only materialise if the convergence & flexibility criteria are met. Therefore, it fails the third assessment. Interestingly, UK has been very successful in attracting FDI & yet the largest even it stays out of euro
(4) Financial services. What impact would entry into EMU have on UK's financial services industry, particularly the London’s wholesale market? It is said that by joining euro, London’s position as the world largest financial centre will not be affected, given that it is already established as the world’s largest financial centre. It houses London Stock Exchange, London Metal exchange, Lloyds of London, Bank of England & many other prominent banks
(5) Growth & jobs. In summary, will joining EMU promote long lasting economic growth, stability & low unemployment? There is no clear evidence to this. However, we know that in order for these to be met, again the first two conditions will be the prime determinant. Critics argue that UK’s economic performance was much more impressive even it decided to stay out of euro
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