Stephen King: Brown's Budget buys him time to answer the euro question

There can be no doubt that euro membership could change the UK system of mortgage provision

Ooh, what a tease! On one level, Gordon Brown's Budget was a highly predictable affair: no change in fiscal policy and the usual questions about his growth assumptions – which, for the record, no longer look prudent on any reasonable interpretation.

On another level, however, the Chancellor offered all sorts of hints. These focused primarily on the UK's future position in the world economy. Should we seek to emulate the Americans, by raising the share of research and development expenditure within the UK economy? Should we steer clear of the euro, given the persistent weakness of the eurozone economy and its negative impact on the outlook for UK economic growth? Should we reform the housing market – both the supply of housing and the supply of mortgages – to bring us more into line with the eurozone (and, for that matter, the US)? Should the Government change the Bank of England's inflation target to bring us into line with the European Central Bank's own approach to inflation control?

These questions expose both the Chancellor's love affair with the American economic system and his need to show Number 10 that he is capable of taking practical steps towards membership of the euro if need be. At the outset, though, it's worth puncturing the Chancellor's interpretation of the American Dream. The Chancellor stated in his budget speech that "two-thirds of the productivity gap with America is due to the poorer quantity and quality of innovation. So it is a priority to raise R&D from today's 1.9 per cent of GDP towards America's 2.8 per cent."

I wouldn't argue with the UK's inability to innovate. The UK's persistent problems with productivity over the years are well documented and probably don't require repeating now. However, the idea that Britain's problems can be specifically attributed to a low rate of R&D expenditure seems bizarre. It's not that I'm questioning the Chancellor's figures: rather, I would simply observe that the US is not the only country to outstrip the UK on R&D expenditure. Other countries that have persistently outperformed include France, Germany and Japan. Yet, on the Chancellor's own figures, the UK productivity gap with France has narrowed considerably, the gap with Germany has all but disappeared and the UK now has better productivity performance than Japan.

My point is simple. Knowing that there are differences in R&D expenditure is interesting but these differences – on their own – cannot be used to explain differences in economic performance. It's a bit like saying that Manchester United are good because they've got some great players. To emulate their success, you simply have to acquire some great players yourself. Chelsea went down this route yet, although their performance has improved, they have still not achieved the success they originally craved. I should know: I'm a Chelsea supporter. The Chancellor is very fond of the measurement of "inputs", but I still think that insufficient attention is paid to the ways in which these inputs can be successfully combined.

What about our relationship with the eurozone? Apart from his desire to blame the eurozone for the UK's economic slowdown ("Looking forward, the largest repercussions for the British economy arise from the further fall in growth prospects for the euro area to around 1 per cent in 2003"), the Chancellor was happy to flag both the housing market and the inflation rate as areas for review. There are good reasons for doing so. We all know that the UK housing market booms and busts in ways that are not seen elsewhere in Europe and, for those that get excited about this sort of thing, the definition of inflation in the UK varies from that used elsewhere in Europe.

The Chancellor's housing market difficulty stems from a complete misdiagnosis of the problem back in 1997. When the Treasury's first convergence report on the euro came out, it said that "the continuation of low inflation should also help to make our housing market less speculative, reducing the influence of past volatility". If we've learnt anything at all in the intervening period, it's that inflation and house prices need not follow the same path.

This is where the Chancellor now has a bit of a problem. He may have achieved low inflation and it may be the case that UK inflation is broadly convergent with inflation in the rest of Europe. But if house prices can move in an independent fashion and push household balance sheets into unsustainable positions, the UK will face specific macroeconomic problems that perhaps would not be seen elsewhere in Europe.

The issue here is not so much one of home ownership as the ways in which homes are purchased. Other than Germany, the UK's owner-occupation rate is not dissimilar to the rest of Europe (see left-hand chart). One important difference is that the British tend to borrow a lot more to purchase houses whereas others either require bigger initial deposits or, alternatively, acquire houses through inheritance. A second important difference is the degree to which UK mortgages are linked to volatile short-term interest rates, whereas those elsewhere in Europe are linked more closely to long-term rates.

Professor David Miles from Imperial College, London, who has been asked to investigate the mortgage funding issue, will doubtless come up with a series of options for reform, all aimed at reducing the sensitivity of the UK housing market to changes in short-term interest rates.

As a start, the most obvious areas to investigate will be the US system – where Fannie Mae and others provide broad funding of mortgages at long-term rates – and the related pfandbriefe system in Germany. But there can be no doubt that euro membership itself could change the system of mortgage provision. With assets and liabilities in a common currency, British banks would be able to lend at shorter-term rates to borrowers elsewhere in Europe and, presumably, other European lenders would be able to lend at longer-term rates to people in Britain. In other words, it might be the case that euro membership itself could provide the market solution to an issue that is commonly regarded as an impediment to euro membership.

Finally, inflation. The right-hand chart shows the path for UK inflation on the basis of RPIX, the measure currently used by the Bank of England for inflation-targeting purposes, and also on the basis of the harmonised measure of inflation, using the approach adopted by the European Central Bank. On the harmonised measure, it looks as though Britain's inflation problem disappears altogether. Could it be that this significantly lower inflation rate would bring in its wake a much lower level of British short-term interest rates?

Unfortunately not. A persistently lower harmonised measure of inflation would require a persistently lower inflation target. If the RPIX target is 2.5 per cent, then the right-hand chart suggests the harmonised target should be 1.5 per cent which, oddly enough, is not a million miles away from the European Central Bank's current inflation target of less than 2 per cent.

So we're left with a situation where the Chancellor remains suspicious of Europe, maintains his love affair with the US but has opened up a series of reform options that would create a clearer path towards euro membership. When the Chancellor finally reveals the results of his five economic tests – by the beginning of June at the very latest – he may choose a "yes, but" answer. Yes, we have converged with Europe, but further changes to UK institutional arrangements – to be carried out at the Government's discretion – will still have to occur before euro entry can take place. What a wonderful way to buy some more time.

Stephen King is managing director of economics at HSBC.

stephen.king@hsbcib.com