Joining the Euro – Meeting the Convergence

Countries wishing to join the single currency must meet the convergence criteria. The
four convergence criteria are explained below:

Stable prices: Inflation must not be more than 1.5 percentage points higher than the
average in the three member countries with best price stability, i.e. lowest inflation.
Stable exchange rate: The national currency must have been stable relative to
other EU currencies for a period of two years prior to entry into the monetary union
(ERMII entry).
Sound government finances:
a. Gross government debt must not exceed 60 per cent of GDP.
b. The annual government budget deficit must not be greater than 3 per cent of GDP.
Low interest rates: The 5-year government bond rate must not be more than 2
percentage points higher than in the three member countries where inflation is lowest.

Labour and the Euro - the 5 Economic Tests

A long-term decision
The Government's decision on EMU membership reflects what it believes is best for the
long-term economic interests of the British people and the performance of the UK
Source: Treasury Statement of Policy on the 5 Economic Tests, June 2003

Brown has outlined
five tests to be met before he will consider membership of the single

Economic convergence: This test revolves around the following question. Are UK
and Euro Zone business cycles and economic structures compatible so that we and others
could live comfortably with Euro interest rates on a permanent basis?

Economic flexibility: The second test considers whether there is sufficient flexibility
in the economy to cope with external shocks. This includes flexibility in the labour market
so that an adverse shock to output and demand in the economy does not lead to too
heavy a rise in unemployment.

Investment: This test focuses on whether membership of the single currency has a
beneficial effect on capital investment across many sectors of the economy. Would
joining EMU create better conditions for overseas firms making long-term decisions to
invest in Britain? Or can the UK do just as well by staying outside of the system?

The financial services industry: The fourth test is definitely not the most important
one! It considers the likely impact of Euro participation on the health of the UK's financial
services industry. Why a test for a single industry? Why not have tests for the fishing
sector or for coalmining?
5. Employment: The fifth and final test considers whether the Euro is good in the long
term for raising employment and reducing unemployment.

The Importance of Economic Convergence

The idea of convergence is perceived to be the single most important test against which
the UK government is assessing the costs and benefits of UK participation in the Euro.
Three different types of convergence can be identified:

Cyclical convergence: This considers the extent to which the economic cycles of the
UK and the Euro Zone have aligned.

Structural convergence: Here, economic structures in the UK and the Euro Area are
compared and the implications in terms of demand and supply-side shocks and their
impact on prices, output and jobs are assessed.

Endogenous convergence: Endogenous convergence describes the convergence
that may occur as a result of joining the Euro – for example the extent to which
in the labour market and price-setting in product markets might be
affected by being inside a single currency area.

Cyclical Convergence

The main indicators of cyclical convergence are

1. National output: The basic measure of convergence is the rate of real GDP growth.

Short-term nominal interest rates - differences in short-term interest rates
indicate disparities in either inflation targets or perceived inflationary pressures.

The output gap – this is the difference between actual and potential output. The
output gap is used as an indicator of future inflationary pressure and is often at the
forefront of decisions of central banks when setting interest rates to meet an inflation

Labour market conditions - labour market indicators would include the annual
growth of wages and earnings, the rate of unemployment and surveys of skills shortages
– reflecting the changing balance of labour demand and supply in an economy.

Long-term interest rates and inflation expectations – these indicate the success
and credibility of monetary policy. The long term rate of interest on ten year Government
bonds is widely perceived as the bond markets best forecast of inflation expectations for
a country going forward.

The exchange rate - a further important indicator of the state of the economy
because changes in the exchange rate can have a major effect on the pattern of demand
and short term growth.

Are the economic cycles of the UK and the Euro Zone aligned?

There is no guarantee that countries within the Euro Zone will see synchronisation
between their economic cycles. Indeed there is some evidence that cycles have
diverged within the single currency area since the Euro was fully launched at the end of
2001. For example the Spanish economy has grown quickly since 1999 whereas Germany
has been stuck in the slow lane of growth. One of the reasons for this is changes in the

real exchange rate
. Although countries inside the Euro Zone share a common interest
rate and have fixed nominal exchange rates between them, the real exchange rate can
vary quite a lot. A country with low inflation for example will become more competitive
over time and this should help to boost their export performance in trade in goods and
services with other Euro Zone nations.

The Fiscal Stability and Growth Pact

The European fiscal stability and growth pact was created in 1996 in an attempt to make
EU fiscal policy sustainable. The pact was intended to provide a check on the government
finances of many of the relatively smaller and poorer member states such as Ireland,
Spain, Portugal and Greece, but the main problems have been with larger economies
such as France, Italy and Germany where budget deficit problems have become acute.

The terms of the fiscal stability pact
o The original pact imposed a 3% ceiling on annual government budget deficits as a % of
o Over the medium term, European Government had to seek
to balance their
o The EU Commission could impose cash fines (sanctions) if budget deficit limits were
o This more or less ruled out the use of fiscal policy to deliver a huge fiscal stimulus to an
economy where output is well below potential and where unemployment is rising.

The aim of the pact was to discourage reckless government borrowing in a single country
that may push up interest rates across the whole area. By the autumn of 2003 it became
clear that the fiscal stability and growth pact was coming under enormous pressure – the
reason was that several countries were breaching the terms of the pact and ignoring the
threat of sanctions. Portugal was the first country to exceed the budget deficit limits of
the pact in 2001 (having come perilously close in 2000) and Germany followed suit in
2001. France and Italy have also run budget deficits above the permitted levels. As we
can see from the chart below, taking an aggregate of all of the countries inside the Euro
Zone, the budget deficits have been very close to the three per cent mark in the last
three years although not as bad as they were during the recessionary years of the early

Why have budget deficits increased within the Euro Zone?

The main reason is the slowdown in economic growth that has led to a slower growth
of tax revenues (from direct and indirect taxes) and led to increasing pressure on state
welfare benefits. Persistently high unemployment (much of it long-term and structural)
has added to government spending and reduced the level of tax receipts. Consumer
spending and company profits have also been weak in many EZ countries. This has
caused a downturn in tax revenues from indirect taxes and corporation taxation.
The budget deficit inevitably worsens when economies experience downturns – and in this
sense much of the fiscal deficit problems facing EZ countries are
cyclical rather than
structural. However there are some longer-term factors putting pressure on
government finances. A large percentage of unemployment in the EU is thought to be
structural. Secondly many European countries are facing up to the long-term impact of an
ageing population that threatens to increase future government liabilities in supporting
state pensions.

Criticisms of the Fiscal Stability Pact

1. Fixed rules creates a fiscal straight-jacket: The main criticism of the fiscal
stability pact was that it provided a straight-jacket for countries that wanted the freedom
to run an expansionary fiscal policy at times of prolonged economic weakness – e.g.
rising unemployment, low business and consumer confidence and a negative output gap.
Gordon Brown has argued on a number of occasions that the stability pact rules are “too
rigid” and must be applied with more flexibility if they are to be effective.

No adjustment for the business cycle: The budget deficit ceiling makes no
adjustment for the effect of fluctuations in the economic cycle. A fiscal rule expressed
over the cycle would mean that a government still has room to allow the automatic
stabilisers to operate - such as increased government spending on unemployment
benefits – in order to dampen fluctuations in real GDP and unemployment resulting for
example from external economic shocks.

Structural reforms cost money: Another criticism is that some countries are
running larger than permitted fiscal deficits because their governments are committed to
supply-side reforms, improvements in national infrastructure – all of which costs money
in the short term but which should bring long term economic benefits for the whole of the
European Union.
Debt to GDP ratios may be more important: The pact did not take into account for
each nation, the ratio of public debt to GDP. Expressing fiscal rules in this way might have
provided a country like Germany, whose public (government) debt is 60% of GDP,
compared with over 100% in Italy, more room to support its economy by boosting
government spending (e.g. higher state investment in public services).