Euro entry must wait on a fruitful exchange rate

The Governor's message was simple: if you wanted to go to Euroland, you wouldn't start from here

If Gordon Brown was the one who mattered, Sir Edward George was the more illuminating. It was his Mansion House speech that explained the economics of Mr Brown's euro-victory over Mr Blair, and thus why a referendum on entry appeared to be retreating towards the Parliament after this. The Governor's message was simple: if you wanted to go to Euroland, you wouldn't start from here. Even if you saw monetary union as heaven on earth (which patently neither our Chancellor nor our Governor do), getting there in short order looked from Sir Edward's account as difficult as stuffing a camel through the needle's eye.

This has nothing to do with Mr Brown's five tests, on which, it seems, a lot of spreadsheets are to be filled over the next 18 months. It has everything to do with the exchange rate and an independent central bank.

When the Bank of England was given at least technical freedom, much was made of the idea that this would ease the transition to membership of the European Central Bank. Paradoxically, it actually makes that transition more difficult. But first: the exchange rate.

The problem with the pound is glaringly obvious. At the end of May (and the eve of the election) the pound's rate against the euro's main legacy currency was 3.28 Deutschmarks. You may recall that the "unsustainably" high exchange rate floor through which the pound crashed out of the European Exchange-Rate Mechanism in 1992 was a mere DM2.78.

Admittedly, much of the exchange-rate pressure at the time was actually coming through sterling's rate against the dollar, which was a good deal higher than it is today. Even so, the pound's "effective" exchange rate against its trading partners is today some 8 per cent higher than when we entered the ERM in 1990 (and allowing for relative movements in inflation since then, sterling's "real" exchange rate has risen far more than that).

Logic has told us (for ages) that we should be rising against the dollar and falling against the euro, but – as the Governor pointed out – logic has been slow in coming. The chart shows how perversely we have continued to move in the wrong direction.

Which means that our overvalued exchange rate, which has been steadily driving our external sector out of business, would have to drop by (say) 25 per cent against European currencies before the pro-membership arguments could even get to key stage one. And that is, of course, why post-election rumours of a quick rush to Euroland triggered a bit of sterling depreciation. Enter the Bank of England. A fall in the exchange rate (well, certainly, a fall of 25 per cent) would make it harder for the Monetary Policy Committee to hit its inflation target, just as the rise in sterling has contributed (well, actually, over-contributed) to the MPC's success.

If the Chancellor were to try actively to get to a "competitive" exchange rate within (say) two years, he would have to signal this intention to the MPC now. For the MPC must go on assuming we are not trying to enter until told otherwise, and – given the lags in monetary policy – it needs to be given plenty of warning.

This is where an independent Bank actually makes things trickier for the Chancellor. Before inflation targets and Bank independence, everything could be fudged. Now, if he wanted the MPC to massage the pound down, he would have to change the rules. For its given task is not to manage the exchange rate (as the Governor rather pointedly said at the Mansion House) but to hit the inflation target given to it by the Chancellor. As he also told his audience, if that's hard enough, trying to use interest rates to manage sterling is even harder. Since the beginning of this year, sterling has fallen against the dollar and risen against the euro, despite the fact that we have cut rates more than the European Central Bank but less than the Fed.

Of course, sterling may finally "adjust" (ie fall), naturally. And with a bump. This would not, however, make the policy dilemma go away. In the face of a falling exchange rate, either the Chancellor could raise the inflation target, or the Bank could raise interest rates. Britain would therefore be likely to arrive at a euro-ready exchange rate with either inflation or interest rates which look a sight less "convergent" than they do today.

This is the warning that (in somewhat different, but pretty bleak, terms) the Governor gave last Wednesday night. At present, we have massive internal economic divergence between a domestic boom and an export bust. To keep the economy growing at something close to its potential, the Government is pumping up demand, through higher spending on public services, while the high exchange rate keeps inflation under control by putting downward pressure on the price of traded goods. Were that control to snap (ie, the pound to fall), the Governor warned, we would have to check consumption "and we might find its momentum hard to stop". That is central bank lingo for a big hike in rates.

Can we guess what the political mood towards the euro would be at that point? On the one hand, we would have an exchange rate that the pro-euro lobbyists considered entry-ready, coupled with an interest rate squeeze. The prospect of lower rates inside monetary union might well feed business enthusiasm for entry. And a stronger euro (together with a new boss) might have repaired the ECB's present, pretty dismal, reputation. On the other hand, British interest rates would be high for a reason. It would not only be sceptics who would point to Ireland, and maybe Spain or Italy, and argue that lowering rates would blow our inflation control. The MPC might prove awkwardly frank. At the very least, its members might argue for tighter fiscal policy to compensate (as, indeed, might the euro's existing members).

The Government meanwhile would have its eye on an election seeming, by then, uncomfortably close. It would not want to upset voters by tightening fiscal policy. The Chancellor would have little difficulty tweaking his tests, to suggest that a few years of "stabilisation" at this lower exchange rate were required. Which explains why many senior businessmen have reached the point that they do not want to take sides in a euro war: they just want to be told, and told long enough in advance, what is the plot. As the sergeant said to the tongue-tied officer marching his troop towards the edge of the cliff: "Say something, Sir, if it's only goodbye." Well, "pro-euro realism" coupled with gubernatorial economics are a start; but these do not quite amount to Prime Ministerial words of command.

Sarah Hogg is chairman of Frontier Economics