Test 1: Shock and flexibility

If problems emerge, is there sufficient flexibility to deal with them?

The assessment of the flexibility test is key to the overall assessment of the five tests. Flexibility is the ability to respond to economic change efficiently and quickly while safeguarding fairness.

Sufficient flexibility ensures that shocks do not have long-lasting effects and that high levels of output and employment are maintained. Flexibility ensures convergence is durable.

The economy continually needs to adjust to changing circumstances, affecting the competitiveness and profitability of the goods and services that it produces. The UK has experienced a number of such disturbances or shocks in recent years, some local, some global, including the foot and mouth crisis in early 2001, the IT boom in the late 1990s and the heightened uncertainty that followed the recent global slowdown.

A high degree of flexibility means the UK will be resilient in the face of such shocks and will minimise costs in terms of lost output and jobs. The central question in this test is, were the UK to enter EMU, if problems emerge is there sufficient flexibility to deal with them?

The 1997 assessment judged that the UK and EU as a whole needed to develop more flexibility, particularly in labour markets. This is why the UK Government has been at the forefront of promoting flexibility in both the UK and EU. Flexibility is now recognised as being even more important than it was in 1997.

If there were a high degree of convergence, then the degree of UK flexibility required, though still high, would be less. But the assessment of the convergence test is that there is not this degree of settled and sustainable convergence.

Inside EMU, loss of national monetary policy and the nominal sterling-euro exchange rate means that other adjustment mechanisms would have to work harder.

Wage and price adjustments are the most effective adjustment mechanisms available, but there is also a potentially enhanced role for fiscal policy.

UK labour market flexibility has improved markedly since 1997. Significant falls in overall unemployment and long-term unemployment have accompanied strong employment growth giving the UK one of the lowest levels of unemployment in the OECD, lower even than the US. The 1997 assessment observed that the UK already had a relatively high degree of employment flexibility. This has been maintained, as demonstrated by a high incidence of part-time employment and flexible working practices. Moreover, evidence since 1997 points to an underlying improvement in wage flexibility. However, important challenges remain in the UK to reduce inactivity and repeated spells of workless-ness and to enhance skill levels and improve mobility. Adjustment mechanisms have not been fully tested in recent years as the UK has had a relatively stable macroeconomic environment. If the UK decided to join EMU, wage movements would need to play a greater role in adjustment.

Wage flexibility would be more severely tested by a decision to join EMU, where price movements would need to play a greater role in adjustment to shocks. There are some signs that EMU membership has facilitated euro area wage flexibility. Because of its key role in adjustment, the level of real wage flexibility in the UK and the euro area poses a risk to successful UK membership of EMU. Budget 2003 announced the Government's intention to increase wage flexibility in the public-sector labour market through a stronger local and regional dimension to the setting of public-sector pay.

EMU membership puts a premium on the need for institutional structures to cope with shocks. Therefore, while the positive reforms to the institutional and policy framework in the UK suggest that recent improvements can be sustained, more progress on labour market reform would enhance flexibility in the UK and advance the Government's long-term goal of employment opportunities for all. In the context of EMU, it would also increase the durability of convergence between the UK and the euro area.

A decision to join EMU would increase the need for rapid price movements and would also make it necessary for firms to be able to respond effectively to shocks and adapt to the competitive opportunities that the single currency will bring. The UK has a reasonable degree of price flexibility with relative prices both rising and falling within the overall inflation aggregate. Moreover, the UK generally exhibits a competitive business environment and the Government is committed to further sharpening competition forces and improving opportunities for entrepreneurship. Since the 1997 assessment there has been much effort to promote competition at the EU level. The degree of competition and market flexibility falls short of what might be achievable as measured by the US.

Capital markets play an important role in stabilising the impact of shocks between regions in the United States, facilitated by highly integrated financial markets. Although cross-border risk sharing is not significant in Europe, greater financial market integration would enhance the scope for risk sharing across the EU, and bolster its role as an adjustment mechanism.

The experiences of EMU members illustrate the role that adjustment mechanisms can play, in particular regarding the implications of inflation differences within EMU.

There are some signs that EMU membership has facilitated euro area wage flexibility. As a large monetary union with a high degree of diversity between states, the US also shows the importance of a high degree of market flexibility and capital market integration.

But fiscal policy has generally not been counter-cyclical since the beginning of EMU, meaning it has generally not helped to counter periods of below or above trend growth. In 2000, when the euro area economy was growing at above-trend rates, the fiscal policy stance was expansionary in all three large euro area economies. Since the 1997 assessment there has been much effort to promote competition at the EU level. Despite progress, the degree of competition and market flexibility falls short of what might be achievable as measured by the US. Inside EMU, the adjustment process is very different to outside. The ECB also responds to the demand shock in the UK, but now only to the extent that it affects euro area-wide inflation.

Inside EMU, the euro area price level now effectively acts as an anchor for the UK price level. So the period of high inflation in the UK must be followed by a period of low inflation relative to the euro area. In the model this is achieved by a period where UK output is below potential. Overall, this process makes the adjustment path of inflation more cyclical and protracted.

These findings highlight the importance of wage and price flexibility in EMU, especially for shocks that require an adjustment in the relative price level between the UK and other countries. Wage and price flexibility is also important in facilitating adjustment in the UK.

Evidence detailed in the study, EMU and Labour Market Flexibility, points to an improvement in real wage flexibility in the UK.

Geographic mobility in the EU is much lower than in the US. The challenge of invigorating European labour markets is considerable. It is arguable whether recent improvements go beyond a purely cyclical effect or whether they would unwind if a large shock hit the European economy.

It is now recognised across Europe that to realise the full benefits of EMU membership requires more progress on a range of economic reform policies to enhance flexibility and resilience to shocks, particularly in labour markets. Europe as a whole needs to match the impressive flexibility record of some of the smaller EU member states.

A decision to join EMU would increase the need for rapid price and factor movements and would also make it necessary for firms to be able to respond effectively to shocks.

Since the 1997 assessment there has been much effort to promote competition at the EU level. Despite progress, the degree of competition and market flexibility falls short of what might be achievable as measured by the US. Any decision to join EMU would mark a substantial shift in the UK economic environment. With monetary policy no longer tailored for UK needs, the ability of the economy to respond to shocks would be reduced, all other things equal. This implies that the UK's hard won stability could be put at risk by creating greater volatility, with possible adverse effects on growth and employment.

There are policy requirements. Flexibility, the ability to respond to economic change efficiently and quickly in a way that maintains high employment, low inflation and unemployment, and continued growth in real incomes, ensures convergence is durable. Sufficient flexibility ensures shocks do not have long-lasting effects and high levels of output and employment are maintained.

In the labour market, the Government is continually working to enhance flexibility and in the product market, it has announced the full independence of the UK competition authorities. It is enhancing competition in specific markets, reforming the planning system to make it work more efficiently and introducing a package of deregulatory reforms to ease the burden of regulation on small business.

In the capital market, the Government will increase flexibility through reforms to improve access to finance for small enterprises with high growth potential and consultation on further reform to the corporation tax system. The degree of fiscal stabilisation may need to increase inside EMU where the absence of a UK-specific monetary policy may cause the degree of macroeconomic volatility to increase. The Treasury discussion paper, Fiscal Stabilisation and EMU, explores a number of policy options to make discretionary fiscal policy more effective for stabilisation purposes and strengthen the automatic stabilisers. The paper considers the reforms to the institutional framework that EMU membership would require to ensure an enhanced fiscal stabilisation policy operates symmetrically, credibly and transparently and which policy levers are likely to prove most effective. Credible policy options include a new symmetrical fiscal rule to trigger the Government to consider taking action, publishing a stabilisation report to enhance transparency, increasing the role of independent audit and specific fiscal instruments that could be used for the purposes of stabilisation.

A credible option would be a rule under which the Government would commit to a discretionary fiscal policy response under particular circumstances, for example if the forecast of the output gap exceeded a certain level, say plus or minus 1 or 1.5 per cent of GDP.

That is, if the economy were expected to grow considerably above or below trend, the Government would respond symmetrically to large forecast positive or negative output gaps.

The Government could also retain the flexibility not to act if there was a strong case against discretionary fiscal policy action. In either case, the Government could be required to write an open letter to Parliament explaining its actions.

Fiscal policy has the potential to support market adjustment mechanisms inside EMU. But enhanced stabilisation mechanisms would need to meet a range of criteria to ensure their worth and be implemented when the under standing of the mechanisms by which fiscal policy affects the real economy has increased.

The most promising instruments for fiscal stabilisation policy would appear to be expenditure taxes, which could be relatively effective at stabilising output, with limited undesirable impacts on incentives, the supply side or the overall equity of the tax system.

Fiscal instruments could also help reduce volatility in the housing market in the same way that the automatic stabilisers operate in the economy on aggregate, as well as potentially providing an additional discretionary stabilisation tool.

Regions in a currency union can in theory also borrow from each other; countries suffering from an adverse shock can borrow from the rest of the monetary union - fiscal federalism. The lack of potential for fiscal federalism among euro area countries in comparison with the US is sometimes cited as a reason why EMU will not be able to function as effectively as a monetary union.

Greater fiscal federalism is unnecessary if regions within a monetary union already have a high degree of stabilisation at the regional level. The EMU study Policy Frameworks in the UK and EMU notes that euro area countries already have considerable scope for stabilisation at the national level, making greater use of a federal function unnecessary.

All European countries have embarked on an ambitious programme to reform labour, product and capital markets. However, it is important to make more progress at the European level.The less progress on flexibility that is achieved in the EU, the greater the premium on a high level of flexibility in the UK economy.

SHOCK AND FLEXIBILITY: THE MAIN POINTS

* UK labour market flexibility has improved markedly since 1997 and unemployment is lower even than in the US.

* More can be done to ensure the UK economy is resilient to deal with the risks identified in the convergence test and the challenges of EMU membership.

* Greater flexibility in the UK and throughout the euro area would minimise output and employment instability, helping to ensure that convergence was durable and that the potential benefits of EMU could be fully realised.

BACKGROUND PAPER: EXCHANGE RATES

Sterling fell sharply yesterday after the Treasury published a study on its five economic tests that implied a substantial devaluation would be needed for Britain to join the single currency.

The paper, by Professor Simon Wren-Lewis, a renowned currency expert, rather than the Treasury, gave a range of 1.175 and 1.33 to the pound. This is equivalent to 75p and 85p to the euro and is far weaker than the rate of 70.41p just before the figure was published.

The euro soared by more than a penny to 71.41p within 20 minutes of the announcement, before easing to 71p. Sterling fell by more than two cents against the dollar, to $1.6428, before paring losses to $1.65.

But the paper saidother studies focusing on a weaker exchange rate might be "outdated". "Recent trends in UK trade appear to have been more favourable than they assume," Professor Wren-Lewis said. He said the pound could join the single currency at 1.37 to the pound or 73p to the euro based on a new model of sustainable current account deficits in the UK, US and the eurozone. This would require a further fall of 5 per cent in the pound on top of the 8 per cent devaluation so far this year.

Although a sustainable exchange rate is not part of the five tests, the Treasury in effect endorsed the 73p figure by omitting any other assumption. A spokesman said: "Our objective for the exchange rate remains a stable and competitive pound in the medium term and we don't comment on the current or the future level of sterling." Michael Hume, an economist at Lehman Brothers, which last week published an important study saying the UK should join the euro, said 73p was about right. "Estimates of a 75p to 85p range might be used by the Government to argue for a slightly lower exchange rate in the event of negotiations for entry," Mr Hume said.

The exchange rate is crucial, as membership of monetary union would fix one of the mechanisms that can normally be adjusted in the case of economic shock. Locking in at too low an exchange rate can trigger a rise in inflation as firms find they can compete better with rivals in the monetary union - as Ireland found. Likewise too high a rate can lead to lower growth - as in Germany.

By Philip Thornton