Curiouser and curiouser: Britain in euroland

There has always been something Alice in Wonderlandish about Britain's relationship with the exchange rate mechanism, the system set up in the 1980s to reduce exchange rate volatility in what was then the European community. Remember Black Wednesday, when the pound fell out of the ERM under John Major's government?

Latterly, however, it would make the Mad Hatter's tea party look logical.

Here's the plot. If Britain wants to sign up for the euro, then it not only has to satisfy the chancellor's five tests, the single currency club has five of its own, too.

Most - the level of public sector debt, the budget deficit, interest and inflation rates - would be a pushover for Gordon Brown's economy. But the fifth is much trickier.

Under the rules, wannabe eurozone members have to join the ERM at a central rate against (these days) the euro, and spend two years there without having to either devalue or revalue. All in the name of stability and convergence.

The British authorities, however, are having none of this. Why should they? Black Wednesday cost the Conservative party its reputation for economic competence and at least one, perhaps two, general elections.

Besides, currencies can demonstrate exchange rate stability without rejoining the ERM.

The problem is the pound. The consensus view is that sterling is too strong against the euro to allow Britain to join the eurozone without crippling what is left of the British manufacturing industry.

Instead of the current rate of around 62p to the euro, something in the region of 68p would be more appropriate. The government has set its face, rightly, against talking down the value of the pound. While any increased likelihood of Britain swapping sterling for the single currency would push the pound down on the foreign exchange market, sterling would probably not drop as far as is deemed necessary.

If it did, then sterling would be demonstrating the kind of instability that would have the central bankers in Frankfurt tutting in concern.

One way out of the dilemma in this Mad Hatter world, of course, is to rejoin the ERM, which was tweaked in 1993 when the system was on the point of collapse. Under the new rules, sterling would be able to fluctuate by 15% without breaking the ERM qualification rule.

So, in fact, there is plenty of scope for the pound to move to an industry-competitive rate. Nor could anyone complain that by allowing the pound to fall the government was trying to steal a competitiveness march on British industry's European rivals.

No doubt those who wish to see Britain join the ranks of eurozone members will hope the awkward question of the exchange rate will be solved by a rally in the euro itself. It may be, as politicians and central bankers among the 12-nation zone insist, that the euro is undervalued.

Its recovery, however, could be quite some time coming. In the meantime, Britain would best be able to achieve the level of currency instability needed to make eurozone membership an economic reality by joining a system designed to impose exchange rate stability. More tea anyone?