Stephen King: The Chancellor has paved the way for eventual membership

As a lesson in expectation management, the Government's performance was admirable. We were led to believe that Gordon Brown's euro conclusions would be a case of "no, but..." And that's exactly what they were. But, then again, there was an unexpected change of emphasis.

Reading through the assessment of the five economic tests, the comments are generally rather cautious. We now know that the tests on investment and growth, stability and employment are, conditionally, passed and that the test on financial services is definitely passed. But the Chancellor continues to exercise caution in the two most critical tests, on convergence and flexibility. He said: "There remain structural differences with the euro area, some of which are significant, such as in the housing market." And "more can be done to ensure the UK economy is resilient to deal with the risks". He chose to fail us on both tests.

Yet the Chancellor's comments were rather more upbeat than the written word. Here was a Chancellor who appeared to be setting out a road-map, coming up with a variety of measures that, once taken, would enable the currently failed tests to be passed and could pave the way for a referendum and euro membership.

He chose to identify precisely the causes of current divergence and suggested that the Government could deliver the needed changes. He appeared to brush aside the issue of the appropriate entry rate for sterling. We may not be in the euro yet, but the path towards membership appears to be littered with fewer obstacles than before.

Mr Brown also seemed surprisingly upbeat about the potential benefits of membership. If carried out in the right way, euro entry could provide the UK economy with a significant bounty. The Chancellor suggested that this could be as much as £3bn per year, equivalent to an additional 0.25 per cent on the rate of economic growth. With this kind of result, the arguments in favour would appear to be considerably strengthened.

But the Chancellor could not bring himself to embrace the euro wholeheartedly. His concerns on convergence and flexibility are sufficient to rule out membership over the months ahead (he even used the exchange rate mechanism to highlight the perils associated with such ventures). So, from now on, much depends on his road-map and, in particular, his ability to identify and deliver the reforms needed to bring Britain and the rest of Europe closer.

Of these reforms, some are easier to deliver than others. Moving to the "harmonised" measure of inflation as the target for the Bank of England is an easy "win" for the Chancellor. This will happen at the time of the pre-Budget report this autumn and could, if we adopt an inflation target close to the European Central Bank's "less than 2 per cent", allow the Bank to cut rates just a little bit more than could be justified on the basis of the current inflation target.

Other reforms, though, could be more difficult. The housing market got a lot of attention in Mr Brown's speech. It is quite clear that the Treasury is very concerned about the sensitivity of the UK housing market to changes in short-term interest rates and, at the same time, the sensitivity of UK consumers to changes in the housing market. There may be no easy fix for this.

The Chancellor could legislate to encourage greater mortgage provision based on long-term interest rates, but this might be construed as interference in the market mechanisms that currently govern the mortgage market. Perhaps the easiest way to deliver reform would be for the UK to enter the euro, thereby exposing the rest of Europe to the mortgages with short-term interest rates dominant in Britain and exposing us to those with long-term interest rates available in the eurozone. But, in a Brownian world, that would be putting the cart before the horse.

Then there are the Chancellor's concerns about the way in which the eurozone runs its affairs. He clearly has a great deal of distaste for the so-called stability and growth pact, the fiscal discipline that many would argue is contributing to Germany's current economic woes. Mr Brown would rather see a eurozone where fiscal policy can be used to regulate the economic cycle. This view betrays some of Mr Brown's obvious unease with the project. Most economists would argue that monetary policy is far more precise than fiscal policy when it comes to cyclical regulation: being forced to use fiscal policy is perhaps too reminiscent of the "stop-go" policies of the 1960s. Mr Brown is also not keen on the European Central Bank, particularly the confusing ways in which it has described its inflation objective. Clearly, he believes there are better alternatives. Ironically, they might have been used had Britain been more enthusiastically "European" in the first place.

Overall, there's more enthusiasm that I would have expected, but the Chancellor has nevertheless been keen to dwell on many of the pitfalls. Could we join next year? Well, if Mr Brown really believes that he has identified the remaining constraints on membership and can remove them over the coming months, then perhaps the answer is "yes". But don't bank on it.

First, Mr Brown needs to shift the opinion polls. Second, he needs to achieve reform, not just in the UK but, according to his own assessment, in the rest of Europe as well. Third, there's the small matter of Europe's own economic performance. As Germany struggles with recession and deflation, Mr Brown may once again find himself turning to the other side of the Atlantic for economic inspiration.

Stephen King is managing director of economics at HSBC