Test 1: convergence

Failed

The British economy has moved more closely in step with the eurozone over the past six years but is not yet ready to live with interest rates set by the European Central Bank, the Treasury declared yesterday.

Convergence with the eurozone, the first and most important of Gordon Brown's five tests, has been failed, the Treasury said in its 246-page assessment, because Britain and the eurozone are still too far apart.

"We cannot yet be confident that UK business cycles are sufficiently compatible with those of the euro area to allow the UK to live comfortably with euro area interest rates on a permanent basis," the Treasury concluded.

"While the extent of convergence with the euro area has significantly increased, the convergence test is not met."

The British economy has suffered greater booms and deeper busts than the eurozone economies over the past few decades.

While Mr Brown's decision to put the Bank of England in charge of setting interest rates in 1997 has tamed the worst of the stop-go cycle, the Treasury is worried that the British economy is still more volatile than other major European countries.

Mr Brown used his speech to underline the pernicious effects of Britain's love affair with bricks and mortar. "Most stop-go problems that Britain has suffered in the last 50 years have been led or influenced by the housing market," he said.

Soaraway house price inflation encouraged consumers to stack up ever higher mortgages and made the British economy extremely sensitive to changes in borrowing costs.

Although long-term problems such as the housing market remain a barrier, some of the short-term differences between Britain and the eurozone have narrowed since 1997.

"Over the last five years, the UK output gap cycle has been more highly correlated with the German cycle than with the US," the assessment said.

"Indeed, the UK now exhibits a greater degree of cyclical convergence than some EMU members demonstrated in the run-up to the start of EMU in 1999 and remains more convergent than a number of EMU countries today."

The gap between interest rates in Europe and Britain has narrowed from four percentage points in 1997 to one and three-quarter percentage points now.

Sterling has also fallen sharply against the euro and is close to the level many economists regard as compatible with entry into EMU.

The Treasury warns, however, that the costs of locking sterling against the euro at too high a rate would be considerable. "There may be permanent damage to the real economy, since trade opportunities might be permanently lost and resources devoted elsewhere."

Going in at too low a rate would be damaging as well, the Treasury said, because it would provoke an inflationary boom damaging Britain's competitiveness, which would have to be re-established by years of painfully low price rises.

"The adverse impact of going in at too high a rate, in terms of the impact on growth and jobs, is likely to be greater than the effects of going in at too low a rate."