Membership of the Euro would involve replacing with Euros and adopting a common EU monetary policy. Some argue the disadvantages of the Euro significantly outweigh advantages and therefore we should never join. The UK govt state they have no fundamental objection to joining but will only join when its 5 economic tests are met.

Govts Five Tests

1. Is there sustainable convergence between the UK and the EURO zone economies.

2. Is there sufficient flexibility to cope with problems as a member of EMU?

3. What effect would membership of the EURO have on investment

4. What effect would membership have on the UK financial service industry

5. What is the overall impact on growth, stability and jobs

The first test is whether there is sustainable convergence between the UK and the Euro zone. This is important for the successful implementation of a common monetary policy. For example if the UK was in a recession but other countries were growing interest rates will most likely be too high for the UK and therefore cause even lower output. At the moment it is argued that the German economy is in recession because the ECB has kept interest rates too high.

At the moment 02 / 2004 the UK is growing faster than the Euro zone and as a consequence interest rates are 2% higher than the ECB. Therefore if we joined now interest rates would fall from 4% to 2 % this could cause inflation to increase above the inflation target. This suggest this is not a good time to join.

However others argue that the UK economy has been stable and is ready. For example inflation has been low for the past 10 years and govt debt as a % of GDP is within the Maastricht criteria of less than 60% of GDP. Furthermore if the UK joins the EURO it is likely to speed up the process of convergence.

The second test is whether there is sufficient flexibility to cope with macro economic imbalances in the economy. This is important given that the UK will lose control over monetary policy. Critics argue that the growth and stability pact limit our ability to control fiscal policy. This states that the govt is not allowed to borrow more than 3% of GDP. However the UK has seen a decline in its fiscal position and therefore if there was a downturn in the economy we would have difficulties in increasing AD using fiscal policy. Also there is a degree of labour market immobility within the Euro zone this makes it more difficult to overcome geographical imbalance within the Euro area. E.g it is difficult for unemployed in Wales to move and find jobs in other parts of the EU.

Another concern about the UK economy is the nature of the housing market. IN the UK many households have variable fixed rate mortgages therefore the UK economy is more sensitive to interest rate changes than EU, therefore a common monetary policy would have a greater impact in the UK e.g. a cut in interest rates to 2% could cause another boom in the housing market which creates instability.

However if the UK could encourage a more stable housing market less affected by interest change it would make membership more easy, however this is unlikely to happen in the short term

However arguably the UK does meet the 3rd Test on net investment at the moment. Joining the Euro will make inward investment more attractive if the UK joins the EURO because we will eliminate transaction costs and reduce exchange rate instability. However critics of the Euro argue that the UK is not being left behind by remaining outside the EURO because investment and growth in the UK are still quite high. Therefore this benefit is perhaps not that significant.

The fourth test is about the impact on the UK financial sector. The govt has said that on this test there is a clear benefit from joining. Joining the Euro will help the London financial markets maintain its position as the leading European financial centre.

Another criteria to consider when joining the Euro is the exchange rate. IF the UK joins at a rate which is too high (e.g. ERM1990-1992) then the UK will be locked into a rate which makes our exports uncompetitive and lead to less exports. However although the is quite strong against the dollar it has weakened against the Euro and so is not too high. However it is sometimes difficult to measure the true level of a currency.

The fifth Test is about the overall impact on growth, stability and jobs. This really depends upon whether the UK has successfully convergence with the EU economies and will be able to cope with a common monetary policy. I would argue that the UK is currently unsuited to joining the Euro because its economic cycle is at a different stage and could therefore be harmed by a common monetary policy, this is exacerbated by the nature of the UK housing market which is very sensitive to changes in the interest rate. Also the benefits of the EURO membership such as increased investment and trade and perhaps not that significant compared to the loss of autonomy over macro economic policy. Staying out of the EURO has not harmed the UK economy fundamentals and therefore there is no convincing case for the UK to join either now or in the future.