Britain faces D-day on EMU and referendum

The most important decision of the Blair premiership may well be taken in the next few months, when Britain is forced to come off the fence on the question of membership of the European single currency. There are still some hopeful souls who believe that a general postponement of the entire EMU project might be engineered, if not of the ultimate launch of euro notes and coins in 2002, then at least of the initial date of monetary union in 1999.

Remember that in the first three years of EMU, from 1999 to 2002, the European Central Bank will be fully operational, but domestic currency denominations will continue to circulate in each national economy. It has been suggested (by Walter Eltis among others) that this interim phase could prove extremely unstable, since it will allegedly have all of the fragility of a fixed exchange rate system, with none of the offsetting shock absorbers. Given these supposed disadvantages of the interim stage, the proposition is to shrink its length from three years to (say) one year, by delaying the launch of EMU until 2001. A further interesting wrinkle on this proposition is that the UK could provide the excuse for Germany and France to accept delay by offering to join EMU in 2001, thus allowing the entire EU to adopt the single currency simultaneously.

One problem with these ideas is that there is no longer much indication that the core members of EMU are looking for an excuse to delay. Certainly, the new French government is acting as if it has decided that EMU in 1999 is the least worst option it can choose. In Germany, where there was a major wobble in the spring and summer, nerves have now been steadied, and the French Socialists have been reluctantly accepted as suitable partners for the marriage. In all probability, if the Blair government suggested a two-year delay in order to allow the UK to join the first round, it would be met with an embarrassing rebuff.

Another problem with this approach is that the Eltis analysis of the flaws in the interim stage of the monetary union is far too pessimistic. Eltis makes two crucial claims, both of which are wrong. The first is that interest rates will not be able to diverge during the interim stage, so that the private sector will face no disincentive against holding all of its assets in "strong" currency denominations like the mark, while switching completely out of "weak" denominations like the lira. The second is that, if faced with this problem, the Bundesbank might not be willing to increase the supply of marks to match the extra demand as the stampede out of lira occurs. The result would be that the mark would have to be revalued - or, in other words, the single currency would explode before it was truly launched.

Neither of these claims is valid. The first is simply based on a misperception of how the interim stage will work - it will be perfectly possible for the interest rate on mark deposits to be lower than that on lira deposits during that stage, if that is required to equilibrate the market. Provided that the whole EMU enterprise has political credibility, then a relatively small interest differential should be enough to prevent the stampede into marks which Eltis fears. After all, why should the private sector choose to lose money by holding marks instead of lira, unless they become certain during the interim stage that the entire Maastricht process is imminently facing collapse?

The second claim is also invalid, provided that the Treaty stands. Under Maastricht, the Bundesbank will no longer be an independent central bank in the interim stage, but will instead be in the infinitely inferior position of an operating arm of the ECB. Therefore, should the Eltis stampede occur, the Bundesbank will be forced under its treaty obligations to issue exactly as many marks as are required to satisfy the demand for marks. Only by repudiating the Treaty could Germany do anything different. Since no one will expect this, the problems which Eltis foresees should not develop in the first place.

The lack of enthusiasm for any thoughts of delay was reinforced at the meeting of European finance ministers at the weekend, when "senior sources" from the UK were apparently acknowledging that it would be difficult for Britain to stay out of the single currency indefinitely. But entry in the first round still seems fraught with difficulties. As the graph shows, the cyclical divergence between the UK and continental Europe is still very wide, which makes it very hard even for the most enthusiastic proponents of EMU to support UK entry in 15 months' time.

Imagine what would happen to the overheating British economy if short- term interest rates were to decline to the EMU average of, say, 4 per cent by the end of next year. This, combined with the effects of depreciating sterling to its likely EMU entry rate of DM2.50-2.60 would surely unleash a 1988-style boom in this country.

Furthermore, there is really no knowing when the cyclical divergence between the UK and the Continent will be ironed out sufficiently to permit UK membership of the single currency. If all goes well both here and in the rest of Europe, it is possible that our economy will gradually slow down while others speed up in the next couple of years, with the two regions consequently meeting happily in mid-cycle activity rates (ie approximately zero output gaps) in a couple of years' time.

In this event, UK membership of EMU could become feasible later in this Parliament. But it is equally possible that the UK cycle will not come into line with the European cycle for many years, in which case premature entry into the single currency would simply invite a repeat of the ERM debacle.

Given this genuine uncertainty, it is not easy for the Government to make a watertight pre-commitment in the near future to join in EMU in two or three years' time. But a lesser option would be possible, in which the Government commits itself firmly to the principle of future membership, adopts a "convergence" programme of measures which prepares the economy for membership, and actively participates in decisions relating to the future of EMU.

This would minimise the loss of political influence in the EU which will undoubtedly happen if the UK remains outside the first round. But there would still be the little matter of the timing of the referendum to consider. Until now, it has seemed safe to assume that Tony Blair would want to leave open all of his options on referendum timing, so that he could opportunistically choose the right moment when it arises. But, given the extraordinary popularity of the Government, and the result in Scotland last Thursday, it may occur to the Prime Minister that an early referendum might be winnable, especially if British business comes off the fence fairly soon.

Nothing would give the inclusive Mr Blair greater pleasure than to align himself with British business, and then see his new combination defeat Mr Hague's isolationist Tory Party on the critical question of integration in Europe.