Stephen King: Opportunity knocks for Brown's grand euro design

Rather than the Growth and Stability Pact, we would end up with the Chancellor's Golden Rule

Opportunity knocks! Gordon Brown is probably facing the best chance he'll ever have of getting Britain into the euro. Ironically, this opportunity has arisen primarily because of the euro's manifest weaknesses, not because of a sudden recognition that the euro's institutional arrangements are superior to those in the UK. The Chancellor can now more easily join on his own terms. Think of the plaudits he would receive: "The great euro reformer"; "The euro saviour"; "New Labour, new euro."

The key point is this: Europe's leaders may finally have an appetite for reform. They have recognised – albeit grudgingly – that the euro is not working as well as it might. The European Central Bank may not have done a bad job so far – inflation has been quite well behaved and, although not directly its responsibility, recession has, for the most part, been avoided. There is, however, a lack of growth. Inflation remains stubbornly above the ECB's target range (defined as inflation of less than 2 per cent). And fiscal deficits are becoming a bigger and bigger headache.

Policy makers appear to be caught in a vortex. When growth is weak, they find themselves having to raise taxes and cut public spending. They find themselves unable to lower interest rates when it might feel right to do so. And they find themselves looking enviously across La Manche at a country that is enjoying a higher growth rate and, simultaneously, both a lower rate of inflation and big increases in public spending. "Please, Gordon," they say, "Come and join us and show us the true path of prudent economic management".

For the Chancellor, this could be a wonderful opportunity. He may not be so obviously pro-European as the Prime Minister but his caution relates in part to the institutional arrangements that govern the euro rather than the euro itself. For example, the Growth and Stability Pact is turning out to be a fairly draconian arrangement that would certainly stifle the Chancellor's plans for health and education. He might not want to join under the current arrangements but, if there is an opportunity for reform, membership could become a lot more attractive.

Imagine. Rather than the current Growth and Stability Pact, we would end up with the Chancellor's Golden Rule. The Golden Rule allows governments to borrow for capital spending purposes but not, over the medium term, for current spending: you can borrow to build hospitals, but you can't borrow to pay the doctors and nurses that have to fill those hospitals. Faced with this kind of rule, a lot of governments in the eurozone might find that their fiscal positions were not so bad after all.

Indeed, a quick look at the numbers for France and Germany suggests that a Golden Rule approach may make life easier. For Germany, removing public sector capital spending from the overall budget deficit gives only a very small deficit on current spending. In the Chancellor's medium-term framework, this really wouldn't require any immediate action. For France, removing public sector capital spending produces a current surplus of about 1 per cent of GDP. In other words, in a Brownian world, the French could happily loosen fiscal policy without complaint from any of their neighbours (see charts).

There are, however, a number of catches. First, the Chancellor's numbers take account of depreciation. If this were applied to France, the numbers wouldn't look anything like as good (and depreciation rates are open to manipulation by the Chancellor as he encounters his own fiscal difficulties). Secondly, there is the small matter of the Chancellor's other fiscal rule, which requires that the ratio of public debt to GDP should not exceed 40 per cent. For the UK, this has the potential – admittedly very low – to become a tricky constraint over the next few years but for the others, it's a much more immediate problem. Germany and France are already at about 60 per cent and the Italians are well over 100 per cent. Nor do these numbers sit easily with the Maastricht euro qualifying hurdle that supposedly requires that countries should have debt/GDP ratios of no more than 60 per cent.

These constraints do matter. The trouble with the Golden Rule is that it allows you to borrow whatever you want, so long as the funds raised are destined for capital spending projects. This provides a twin incentive for profligate governments: borrow a lot more than you should and, in addition, re-label a lot of current spending as capital spending. Suddenly, you're left with no fiscal discipline whatsoever.

Ideally, therefore, you need some sort of constraint on debt. Oddly enough, there already is one, and it's contained within the Maastricht Treaty. Article 104c states that "member states shall avoid excessive deficits". It goes on to say that a deficit that is excessive will partly depend on "whether the ratio of government debt to gross domestic product exceeds a reference value (defined in the protocols attached to the treaty as 60 per cent of GDP), unless the ratio is sufficiently diminishing and approaching the reference value at a satisfactory pace".

Why not simply interpret these comments over the course of the economic cycle? In other words, don't worry too much about what happens from one year to the next but make sure that those countries that do have relatively high debts fall into line over a period of time. The fines associated with excessive deficit procedures could still be adopted but they would not have to be triggered at the first sign of deficits hitting the 3 per cent of GDP limit that seems to haunt so many of Europe's finance ministers.

The third catch is the reaction of the ECB. The additional fiscal flexibility might suit some individual countries but it could be enough to give apoplexy to the ECB. The ECB has already been quite vociferous in its criticism of government commitment to fiscal reform and, doubtless, a new, more flexible, system would not be welcomed.

However, deals can always be reached. Why not give the ECB two choices? Either forget about fiscal consolidation altogether and have a ridiculously loose fiscal approach, or offer the Brownian option. And, in addition, why not say that the politicians will go for the Brownian version only on condition that the ECB changes its inflation target? It would, after all, be perfectly reasonably to point out that the ECB has not hit its inflation target for three years in a row: better, therefore, to come clean and simply shift to an inflation target of, say, between 1 and 3 per cent.

These changes would suit the British and could also suit a lot of other Europeans as well. The Germans could regard reform as a way of salvaging some economic success. The French would be happier to have the additional fiscal flexibility. And, for Europe as a whole, there would be a lot more room to manoeuvre.

All of this might, of course, turn out to be a completely bizarre fantasy with not a chance of coming true. There are also other difficulties that still need to be overcome, for example, finding a level of sterling that would keep both Germany and Britain happy. But something like it is not entirely implausible. British membership of the euro could be regarded as a vote of confidence from a sceptical nation. The removal of policy straitjackets could reduce the chances of going into a deflationary spiral. And, for Mr Brown, the prize would be a new European architecture that would satisfy both his domestic and his European ambitions. Hughie Green would be proud of him.

Stephen King is managing director of economics at HSBC.

stephen.king@hsbcib.com