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Sound sterling?
Gordon Brown's fiscal and monetary rules have given Britain a firm foundation for growth. Will he risk stability for the euro?
Gordon Brown's fiscal and monetary rules have given Britain a firm foundation for growth. Will he risk stability for the euro?
By Tom Buerkle
September 2002
Institutional Investor Magazine
Gordon Brown seems anything but a gambling man. When the leadership of Britain's Labour Party was up for grabs in the mid-1990s, a position Brown believed he was destined for, he abandoned his bid for the job and let his closest ally, Tony Blair, seize the prize and, ultimately, the prime ministership. Then, when Labour swept to power in 1997, as chancellor of the Exchequer he took control of British economic policy and frustrated his party's desire for a dramatic burst of social spending by opting for stability first. He gave the Bank of England independence and handed it control of monetary policy, and he set a tight fiscal policy to slash the deficit and please the bond market.
Now, after five years of steady growth, rising employment and low inflation, Brown has a sterling reputation, but he's preparing to risk it on two big bets. The first, just wagered, is to commit to the biggest sustained increase in government spending in more than 30 years. Brown unveiled plans in July to boost spending by more than 4 percent a year over the next four years in a bold attempt to rebuild the U.K.'s ailing health service, schools and road and rail networks. The need is real, but there is no guarantee that the money will actually transform public services or that Brown can finance the spending without tax increases. What's more, the plan will swell the public sector at a time when most European Union countries are trying to shrink theirs, putting Britain on a potential collision course with its EU partners.
The second, even larger bet must be placed by next June: Should Britain adopt the euro or rule it out for several more years? Cleverly, Brown gained an effective veto over the decision by laying down five economic tests for entry and establishing his Treasury as arbiter of the tests. The success of Brown's economic policies, particularly Bank of England independence, suggest that his answer to those tests should be no. The U.K., after all, has grown faster than the euro zone while staying outside monetary union. Entering it could put Brown's economic stability at risk.
But the euro is ultimately as much a political as an economic question. Is joining the currency essential to Britain's influence in Europe? Blair clearly thinks so and seems determined to lead Britain into economic and monetary union before leaving office. And so the question for Brown is, Can he best advance his ultimate ambition of succeeding Blair as prime minister by saying yes to the euro, or no, not now? The British public's current hostility toward joining the euro argues for waiting, but there's no guarantee that the conditions for Britain entering EMU -- or Brown entering 10 Downing Street -- will be better in four years.
In an interview with Institutional Investor, the 51-year-old Brown was characteristically noncommittal about the single currency, avoiding any hint of personal preference and stressing the primacy of his tests (see box, page 118). The decision on whether to adopt the euro will be one of the most important economic choices in British history, he says, and therefore it must be made "on the most rigorous and comprehensive and solid assessment that can be done."
But unlike Blair, who said recently that a decision to stay out of the euro on political grounds would be a "betrayal" of British interest, Brown shows little sign of enthusiasm for the single currency. By contrast, he displays real conviction when he touts his own economic record, noting Britain's low inflation, strong growth and buoyant employment -- 1 million jobs created in the past five years. He proudly proclaims himself to be a "fiscal disciplinarian" and insists that the sharp decline in debt in recent years makes his spending plans feasible -- and more sensible than the forced austerity of the euro zone's Stability and Growth Pact. "We gave ourselves a platform from which we could make the investments that are necessary for our future," he says. In short, Brown doesn't sound like a man eager to trade his unchallenged control over the world's fourth-largest economy for a seat at the table of the 12-nation euro group.
Brown developed a passion for politics from an early age. As an eight-year-old boy growing up in the small Scottish town of Kirkcaldy, he was allowed by his father to stay up until 1:30 a.m. to hear the results of the 1959 general election, which Labour lost to the Conservatives. At 20 he was elected student rector at the University of Edinburgh. "He eats and drinks politics," says Giles Radice, a Labour member of the House of Lords. "He is an obsessive." Along with a thirst for politics, Brown learned a strict moral code of individual responsibility and social compassion from his father, a Presbyterian minister and a socialist. When Brown married his longtime girlfriend, Sarah Macaulay, two years ago, he requested that donations be sent in lieu of gifts to two charities, Oxfam International and Christian Aid.
Elected to Parliament in 1983, Brown shared an office and formed a close friendship with another new Labour MP, Tony Blair. Frustrated by the party's marginalization, the two men developed a plan to make it electable by abandoning socialist dogma for market-oriented policies and rebranding the party as New Labour. Their relationship has since frayed -- a 1998 biography of Brown revealed his resentment at losing the party leadership to Blair, prompting a Blair confidant to complain about the chancellor's "psychological flaws" -- but their bond still explains Brown's enormous influence. "The strength of Gordon Brown is to do with his character and the way the prime minister has delegated authority to him," says Sir Alan Budd, a former Treasury economic adviser and one of Brown's first appointees to the Bank of England's Monetary Policy Committee. "He is extremely clever, and he is a very strong character."
Since World War II every Labour government has been undermined by an economic crisis of one kind or another. Harold Wilson devalued the pound in 1967, while James Callaghan had to turn to the International Monetary Fund for assistance in 1976. Even many of Brown's Conservative predecessors left office in disgrace. Nigel Lawson triggered an inflationary boom in the late 1980s by cutting taxes rashly, while Norman Lamont reaped the consequent bust. The U.K. suffered its worst postwar recession in the early 1990s, culminating in the humiliation of the pound's forced exit from the European Exchange Rate Mechanism in 1992, when George Soros and other speculators sold sterling massively.
By contrast, Brown's tenure has seen British inflation (1.5 percent), interest rates (4.76 percent yield on benchmark government ten-year bonds) and unemployment (3.1 percent) fall to the lowest levels in nearly 40 years. It's a tribute to his record that when he announced his dramatic spending plan in July -- a risky strategy given the weakness of the global economy -- U.K. financial markets and the pound showed nary a flicker of concern. "If we were in 1996 and you told me that Britain would have the lowest inflation in Europe, the lowest unemployment in Europe and the highest growth in Europe, I don't think businesspeople would have believed it," says Digby Jones, director-general of the Confederation of British Industry. "This government has been very successful in providing macroeconomic stability. It's an enormous plus."
Brown has enjoyed good fortune, inheriting an economy in its fifth year of a boom fueled by the 1992 devaluation. But he has made his own luck, too. He helped prevent the economy from overheating by keeping a tight lid on government spending in his first two years in office, while increases in spending last year countered the global slowdown and helped Britain avoid recession. Growth rebounded strongly in the second quarter and has averaged about 2.75 percent a year over the past five years, a faster rate than in the 12-nation euro zone. "Because public finances were sound, the chancellor was able to expand fiscal policy in a way that supported the economy years," says David Walton, chief European economist at Goldman Sachs International. "France and Germany don't have that leeway."
This reputation for economic competence is Brown's proudest legacy, and it reflects the influence of his closest aide, chief economic adviser Ed Balls. Balls, 35, studied economics at Harvard University under, among others, former U.S. Treasury secretary Lawrence Summers. He was struck by the fact that most U.S. economists, whatever their political persuasions, had abandoned the idea that policymakers could trade higher inflation for more jobs and instead preached the need for stability as the basis for sustainable growth. He was influenced by a paper Summers coauthored that demonstrated a strong link between central bank independence and low inflation.
"Labour in opposition never had the confidence to make economics a dividing line," Balls says. "I always figured you could have an ambitious and progressive agenda for social change only on the basis of having established a platform and a reputation for running the economy."
After Labour lost the 1992 election, Brown hired the young economist and began drawing on his U.S. connections. Balls arranged for Brown to meet with Summers during a visit to Washington. The two would become good friends. Brown also got to know former U.S. Treasury secretary Robert Rubin, who was instrumental in getting president Bill Clinton to make deficit reduction the top priority in a bid to please the bond market and bring down interest rates.
When Labour was elected in a landslide on May 1, 1997, Brown and Balls put their U.S. lessons to work quickly. Just five days later Brown stunned the British political world and financial markets by announcing that he was giving up control over British interest rates -- one of his biggest tools -- to a new Monetary Policy Committee of the Bank of England. It was given the job of keeping inflation at a target of 2.5 percent. Central bank independence was a political revolution for Britain -- the Conservatives didn't endorse the move until last year. Financial markets embraced the change overnight, though. Long-term interest rates fell as investors bet that an independent Bank of England would prove much more successful at controlling inflation.
"It was a masterstroke, and it has worked out tremendously," says the MPC's Budd. "There's always a risk with a Labour government that the City would mistrust it. This was a very, very good way to neutralize the mistrust."
Brown demonstrated a fiscal conservatism to match his monetary stance. He laid down new rules that committed the government to balancing its current budget -- spending on welfare benefits, social programs like health and education and salaries -- over the economic cycle and borrowing only to finance capital investment in new roads, schools and other facilities. Brown also kept a tight grip on spending during his first two years while raising more than £8 billion ($12 billion) in new taxes to reduce the deficit and finance a jobs program for unemployed youths. The net result? Britain's budget swung from a deficit of more than 3 percent of gross domestic product when Brown took office to a surplus of more than 1 percent of GDP two years later. The national debt tumbled from nearly 44 percent of GDP in 1997 to about 30 percent today, the lowest of any major industrial country.
Brown always insisted that his fiscal prudence was for a larger purpose, however, and his latest budget and multiyear spending plan provided it. The budget in April raised spending by more than 4 percent in real terms and pushed the government's balance back into deficit after four years of surpluses. In July Brown unveiled a medium-term plan to raise spending by similar amounts over the following three years. Spending on the National Health Service will rise by 7.4 percent a year over the next four years, education will get 7.6 percent a year more and transportation a whopping 8.4 percent, as the government embarks on a £100 billion, ten-year renovation of Britain's creaking road and rail networks. For the chancellor the plan represents a definitive break with decades of cuts that he believes have worsened social inequality and undermined competitiveness. "Britain has for 20 or 30 years not invested properly in its transport, in its health, in its education, in science," he says. "That has been a huge barrier to our success as an economy."
But to pay for his big spending increases, Brown imposed a raft of new taxes that provoked a harsh response from the British business and financial community, which feared that he was undermining the foundations of the country's economic success. "The last budget was old Labour, tooth and claw," says Ruth Lea, director of policy at the Institute of Directors, a lobbying group of the U.K.'s top chief executives. "He really is raiding business coffers now." She believes Brown is eroding Britain's low-tax advantage by raising government spending to more than 41 percent of GDP in two years' time from 39 percent today and just 37 percent three years ago. That compares with 33 percent in the U.S., 49 percent in Germany and 53 percent in France.
Brown's biggest tax move was to increase national insurance contributions, or payroll taxes, by one point, to 11 percent, for both employees and employers. The move will cost business an extra £4 billion a year and stands in contrast to the trend in Europe, where most countries have been reducing payroll taxes to promote employment. "It shows a misunderstanding of business to tax job creation," says the CBI's Jones.
Brown also stunned the oil industry by raising taxes on North Sea producers by £600 million a year. Lord John Browne, group chief executive of BP and a frequent guest of Tony Blair at Downing Street, thinks the hike will undermine the confidence needed for long-term investments. "I don't think any other country in the world has increased production taxes in this way over the last ten years, with two exceptions -- Venezuela and Argentina," he said in a speech a few days after the budget was announced.
The chancellor also proposed changing the tax treatment of foreign banks by ending their ability to deduct interest on loans from their parents. The move is projected to raise £1 billion in 2003 and 2004. "This is the worst time to hit the wholesale markets with a tax," notes Angus MacLennan, senior executive vice president at Danske Bank and chairman of the Foreign Banks and Securities Houses Association. "There isn't a single financial institution today that isn't looking where to fit in, looking at their cost structure."
Treasury officials dismiss the warnings as overblown and point out that Britain continues to draw more foreign direct investment than any other EU member. "The test of the government on the economy is whether it's a good place to invest and create jobs," Balls says. "I think, in general, people look at the U.K. and say, This is a good place."
Brown's very first tax change continues to stoke controversy. In July 1997 he ended Britain's complex system of advance corporation tax payments, eliminating the ability of pension funds to claim £5 billion of refunds on taxes paid on corporate dividends. Brown contended then -- and still does -- that the change was offset by cuts in the corporate tax rate to 30 percent, from 33 percent. But in today's bear market, the loss of tax credits is a painful blow to pension funds. Many analysts believe the move has aggravated weakness in the U.K. stock market -- the Financial Times Stock Exchange 100 index has fallen by more than one third since its 1999 peak -- and prompted a number of major companies to replace defined benefit plans with defined contribution ones. The Treasury "didn't remotely consider that this was going to be quite such a big hit on pension funds, and it matters now because of the big drop in the market," says Angela Knight, head of an institutional investors lobby group, the Association of Private Client Investment Managers and Stockbrokers.
The shift to a more expansive budget policy at a time of heightened economic uncertainty clearly carries risks. Brown insists his plan is prudent because it is based on the assumption that the economy will grow by 2.5 percent a year, equal to its average postwar growth rate. But with the budget in deficit, Brown's margin for error is perceptibly narrower. The National Institute of Economic and Social Research, Britain's leading independent research outfit, recently predicted that tax revenues would come in below forecasts as a result of the economic slowdown, just as they exceeded expectations during the late 1990s boom. The institute said taxes would have to rise by the equivalent of 0.5 percent of GDP over the next four years and by a further 1 percent in future years to finance Brown's spending.
Whether Brown's largesse can produce dramatic improvements in Britain's health care, education and transportation networks is even more debatable. Health spending rose by more than 5 percent in the fiscal year that ended on March 31, but the number of operations performed by the NHS actually fell. Public sector unions have begun flexing their muscles, with local council workers striking in July for the first time in decades, raising the possibility that much of the spending will be eaten up by pay increases for teachers, nurses and police officers.
Brown's solution has been to draw up public service agreements -- no fewer than 130 of them -- that tie funding increases to government departments' ability to meet targets for everything from educational achievement to waiting times for seeing specialist doctors. The intent is clear. Money will come only if public employees change their inefficient work habits. But as any former central planner can attest, targets can have perverse effects. Labour promised in its first term to reduce the number of people waiting for hospital treatment, for example, only to see some hospitals delay care for people with life-threatening illnesses to focus on the larger number of patients with less urgent problems. "These are Soviet five-year plans, and they don't have a cat in hell's chance of working," says David Ruffley, a Conservative member of the House of Commons.
On international issues Brown has shown a similar penchant for rules and standards as well as for working with his American counterparts. He consulted closely with Rubin and Summers in the aftermath of Russia's debt default and the collapse of Long-Term Capital Management in 1998, and he helped to orchestrate an initial round of reforms to the international financial system. As head of the Group of Seven Finance ministers at the time, Brown pushed through an agreement in October 1998 calling on developing countries to publish timely and standardized information on foreign exchange reserves, budget balances and other economic data, and demanding closer cooperation among regulators through establishment of the Basel-based Financial Stability Forum. As chairman of the IMF's International Monetary and Financial Committee, Brown has pushed for collective action clauses in debt deals that would require private investors to participate in any sovereign debt restructuring.
Brown has shown an altruistic side. He was instrumental in getting the Group of Seven to agree to the HIPC plan of debt relief for heavily indebted poor countries in 1998, when Britain hosted the G-7 summit. He has also agreed to double Britain's aid budget to 0.4 percent of GDP by 2006. He calls for a new Marshall Plan under which developed countries would offer more aid and investment to developing countries that tackle corruption, pursue stable policies and open their economies to trade. It remains far from clear whether Brown can work as effectively on this agenda with current U.S. Treasury Secretary Paul O'Neill as he did with Rubin and Summers. Brown has cooperated with U.S. efforts to cut off financing to terrorists, but he talks more readily about "maximizing opportunity" in the developing world to combat the insecurities caused by globalization. He welcomes President George Bush's commitment to increase U.S. foreign aid by $5 billion a year (see IMF/World Bank, page 81) but acknowledged that U.S. tariffs on steel imports and higher subsidies in the recent farm bill were "a hindrance" to efforts to assist developing countries.
Ultimately, Brown will be judged by how he handles the biggest international economic issue facing him and Tony Blair -- whether to take Britain into the euro. The first clues should come next month, when Brown and Treasury officials are due to appear before the House of Commons Treasury Select Committee to discuss work on the tests, which the government has promised to complete by next June.
The five tests -- whether the U.K.'s economy has converged with the euro zone's, whether there is enough flexibility to cope with sudden shocks and whether the euro would be good for employment, for investment and for Britain's financial services industry -- are sensible enough. They are also inherently subjective and not likely to give the "clear and unambiguous" answer that Brown has demanded.
A preliminary assessment by economists at London's South Bank University in June, for example, determined that Britain's economy had converged durably with that of the euro zone in terms of growth, inflation and interest rates. It also claimed that the exchange rate stability provided by the single currency would be positive for jobs and investment. "We think it's sufficiently clear to be a credible passing of the tests," says professor Iain Begg, one of the authors of the report.
A study by Oxford Economic Forecasting for the "no" campaign ahead of a referendum came up with an entirely different conclusion. It claimed that Britain would suffer more inside the euro zone than outside from shocks such as a rise in interest rates, an increase in oil prices or a fall in global equity prices.
"I can't believe anybody can seriously argue that the conduct of macroeconomic policy would be better if we joined the single European currency," says former Treasury and MPC official Budd. "We won't have the appropriate interest rates -- that's incontrovertible." But he adds that the tests are ultimately a political as well as economic judgment call.
One key factor in reaching their decision will be the pound's exchange rate. Sterling's strength against the euro in recent years has squeezed the country's manufacturers even as service industries have boomed. The result has been an unbalanced economy, with house prices and domestic consumption booming while the trade deficit has widened.
The pound's decline of nearly 10 percent against a resurgent euro this year has eased this concern, but only in part. Simon Wren-Lewis, an economist at Exeter University who has been commissioned by the Treasury to estimate the appropriate pound-euro exchange rate, came up with a figure roughly 20 percent below current levels in a study three years ago. "If we go in at the wrong exchange rate, we'd have another Black Wednesday on our hands," says Clive Soley, a senior Labour member of Parliament, referring to the day in 1992 when the pound was devalued.
Black Wednesday is a particularly haunting memory for two key advisers on the euro debate. Gus O'Donnell, the senior civil servant overseeing the euro tests, was John Major's press secretary at the time. Stephen Wall, Blair's adviser on EU affairs, was Major's private secretary and had to counsel him against resigning after the pound's devaluation. These and other Treasury veterans "still have scars" from the ERM debacle, says Jim Rollo, former chief economist at the Foreign Office.
A potentially bigger argument against the euro is the sheer success of Brown's policies. Britain joined the ERM in 1990 mainly because it couldn't achieve low inflation and stable growth on its own. By contrast, Brown's monetary and fiscal rules have contributed to Britain's best inflation and growth record in more than 30 years. "The better the British economy performs relative to the euro economy, the more difficult it will be for politicians to make the case for joining," says DeAnne Julius, a former member of the Bank of England's Monetary Policy Committee.
Brown has criticized the European Central Bank, claiming it is insufficiently accountable to the public and biased against growth. Many economists contend that the Bank of England's inflation target -- which deems undershooting the 2.5 percent objective to be as bad as overshooting it -- gives a clearer, pro-growth steer to policy than the ECB's aim of keeping inflation somewhere below 2 percent. "A lot of problems with the ECB are precisely because it doesn't do what the U.K. does," says economist Wren-Lewis. "There's no explicit inflation target. It's not symmetrical. There's a lack of transparency. It's a negative factor for joining EMU. We would be moving to an inferior model if we went to the European Central Bank."
Brown also has clashed with the EU over the Stability and Growth Pact, which requires countries using the euro to aim for a balanced budget and sets an absolute deficit ceiling of 3 percent of GDP. The European Commission, the EU agency that monitors the pact, issued a thinly veiled criticism of Brown earlier this year for pushing Britain's budget into deficit. Brown responded by attacking the pact as too rigid and urged that it take into account countries' debt levels and allow deficits to swing more with the ups and downs of the economic cycle.
Increasingly, his views are gaining ground. In July EU Finance ministers agreed to take cyclical effects into account when assessing compliance with the pact. And Pedro Solbes, the EU commissioner for economic and monetary affairs, has begun to acknowledge Brown's arguments on debt. Britain's so-called golden rule of allowing government borrowing for capital spending "has economic sense," Solbes tells II. He also acknowledges that Britain's low debt and lack of pension liabilities means that deficit spending could be appropriate as long as it is "a temporary, not a permanent, solution." The signs of a thaw were evident as Brown lauds the EU's policy aims in his own interview with this magazine. "There is nothing fundamentally at odds with the euro group's wish to have the same monetary and fiscal stability that we have got in Britain," he says. "And basically, you've got two potential routes to stability."
Notwithstanding such complimentary words, Brown's blunt tactics have fanned doubts among EU colleagues about his real intentions toward the euro. In February Brown announced before an EU Finance ministers' meeting that he would oppose a proposed reprimand of Germany over its budget deficit. The move killed the reprimand before the meeting began, casting doubt on the credibility of the Stability Pact, but it won favorable headlines in Britain's euro-skeptic newspapers. "I've become more and more convinced that he has only one agenda -- being prime minister of the United Kingdom," says one senior EU official, who spoke on condition of anonymity. "He has no European agenda."
In London, certainly, nobody doubts Brown's political ambition. "Obviously, Gordon wanted to be leader and would still like to be leader," says MP Soley. The real question is whether he will improve his prospects by saying yes or no to the euro tests before next June.
The current betting has to be for a no. Aside from an occasional pro-euro statement from Blair, the government has made little attempt to win public support for the euro. "The only policy you can be sure of is prevarication," says Gerald Holtham, chief investment officer of Morley Fund Management. Surveys show Britons remain as opposed to the euro today as they were when Labour came to power five years ago. Market & Opinion Research International, which conducts monthly polls of euro sentiment, found in July that only 35 percent of respondents would support euro entry even if the government urged it; 52 percent would oppose it. The negative balance matched the monthly average since November 1997.
"There's not going to be a referendum in the life of this Parliament," says Bob Worcester, an American who heads MORI and has been polling for Labour for nearly 30 years. "They can't win. It's too big a gap to close." Investors appear to agree. Analysts at Goldman Sachs International estimated recently that the cheap price of sterling forward call options at an exchange rate of less than 70 pence to the euro -- the rate at which most analysts expect Britain to enter the euro -- suggests investors believe the chances of entry in the next three years are less than one in three.
Given those risks, most analysts expect the government to defer a euro referendum and focus on Brown's budget objectives of fixing British hospitals, schools and roads, areas where voters trust Labour much more than the Conservatives. Even many Conservatives believe the government will opt to cruise to what looks like a third election victory in 2005 and only then go for a euro referendum, after which Blair could retire. "Brown doesn't want to derail the next election and his succession as prime minister," says the Conservatives' Ruffley. "I'd be amazed if he said the tests have been passed."
Of course there is a counterargument. Staying out of the euro for four or five years could mean tougher conditions upon eventual entry. Existing euro members are eager to gain Britain as a partner and might be amenable to waiving the required two-year period of exchange rate stability for the pound and instead negotiate a favorable entry rate. In 2006, however, as many as ten Eastern European countries are expected to be pushing for euro entry, making it harder for the EU to cut a sweet deal for Britain.
Blair, after all, clearly believes that Britain must join the euro to play a full role as a European power alongside France and Germany. It's a view shared by former prime minister John Major, who has told associates he believes British entry is inevitable in the next ten to 15 years. As one close adviser to the current prime minister puts it: "Tony Blair believes this is something that is in Britain's interest to do, and it's desirable to do it sooner rather than later. He is prepared to take some risks."
If Blair decides to go for the euro, many doubt that Brown could risk undermining him. "I don't see Brown succeeding without a successful Blair," MP Radice says. "Whether he likes it or not, they're linked intrinsically."
Some doubt that there is any tension between the two. The suggestion that the prime minister is strongly pro-euro while the chancellor is skeptical is a "political con trick" aimed at swinging voters if Brown comes out in favor of euro entry, says Michael Howard, the Conservatives' Treasury spokesman. If Labour remains strong in the polls next year and opinion begins to shift on the euro, "I believe they'll go for it," he says.
Brown can't keep people guessing much longer. Testing time is about to begin.
Testing time for Gordon Brown
The U.K.'s chancellor of the Exchequer achieved an enviable economic record for Britain by practicing fiscal discipline and steering clear of the euro. But now Gordon Brown is dramatically boosting government spending on health, transportation and edu-cation while preparing to decide whether to embrace the euro, provided five qualifying standards can be met. Is this any way for Brown to preserve his reputation -- and his shot at the prime ministership? Here the chancellor chats candidly with Institutional Investor European Editor Tom Buerkle.
Institutional Investor: The U.K. stock market was down again heavily today [July 24]. The Financial Times Stock Exchange index is below its 1997 level and, along with most other indexes, is nearly 50 percent below its peak. Is it fair to talk about a crisis of confidence in global capitalism?
Brown: No. The key question you ask is, Are the economic fundamentals sound? If you look at the British economy, we have put in place a new regime for monetary and fiscal stability. We've got low inflation. We've got the fiscal position sound; we've cut debt very substantially. We've created a better competitive environment. And in our case, employment and growth are happening. You ask yourself whether you are able to withstand the ups and downs of the economic cycle better than you were ten or 20 years ago. And the answer is yes.
What can be done now to restore confidence in markets?
You've seen that the House of Commons has a statement on auditing and accounting practices. It is important to look at the changes necessary so we can be absolutely sure that we've done everything in our power to strengthen auditing and accounting. So we will do that. You'll find across America and across Europe that the same thing is happening, depending on different systems and different cultures. It's also important to say that we will pursue sound anti-inflation and sound pro-stability policies.
We're coming up on the anniversary of September 11. What does that day mean to you? Has the world really changed?
The world has changed hugely as a result of September 11. We're seeing both a maturer phase of globalization and also the insecurities that can arise in a global economy and a global society. And the insecurities include failed states, they include terrorist threats, they include the insecurities that can arise from the very process of globalization itself.
I admire the way America has been resilient after September 11. I've got a great respect for the way people facing tragedy, particularly, of course, in New York, responded by a resolution and a determination. And we stand full-square with the American government and the American people in fighting terrorism and will continue to do so. The response since September 11 -- for example, the measures I've been involved in to try to ensure that there's no real safe havens for terrorists trying to use the financial system -- has brought the world together. And there's been a degree of international cooperation on these issues that we haven't seen in the past. So as we remember September 11, there will be a huge sense of loss and a feeling of solidarity with the American people.
Equally, we understand that we are in a new world where we are aware both of the opportunities of globalization and of the insecurities that arise from it. The opportunities include the ability of companies and individuals who have got a skill or have got a product or have got an idea to market that product or that idea on a worldwide basis in a way that wasn't possible ten, 20, 30 years ago. There's global competition in just about every service and every product now. So there are great opportunities for people who've got ideas and who have got something to offer. But equally, there are insecurities that arise. We've got to be able to deal with that. In many ways we can minimize insecurities by maximizing opportunities. But equally, we've got to deal with the military and terrorist threats that can arise in a mobile society.
Last December in Washington you talked about the need for a new Marshall Plan, advancing social justice on a global scale. To borrow a phrase: "tough on terror, tough on the causes of terror." It's a bold vision. Are you disappointed at the follow-through?
There has been follow-through. The decision at Monterrey by the European governments to pledge over time $7 billion extra a year in aid and the decision by the American government to raise its development aid contribution by $5 billion a year meant that for the first time in perhaps 25 years, the decline in aid to the poorest countries has been reversed.
The Marshall Plan that I was talking about, the modern Marshall Plan, is essentially a new relationship, a new compact between developed and developing countries, wherein in return for the poorest countries entering the world economy and pursuing anticorruption, pro-stability, pro-trade, pro-investment policies, we are, as was Marshall in the 1940s, prepared to devote a substantial amount of resources to health, to education, to economic development, to antipoverty programs. And I do believe that Monterrey was an advance. And so, too, was the G-8 meeting where the African plan was agreed.
You've doubled your aid budget. The U.S. is still contributing much less on aid. The farm trade bill has been widely criticized. Are you concerned that the U.S. is doing its share?
The decision at Monterrey by President Bush to raise American aid was something that has been welcomed all over the world and therefore is something that all of us can build upon. It's true that any protectionist measures on the part of the richest countries will be seen as a hindrance to that process. But I'm of the view that in American history there have been periods where what may seem to be restrictive measures like the farm bill and the steel tariffs are the prelude to fast-track authority or some opening up of trade negotiations on a wider scale. And I think the Americans are committed to the Doha agenda, as is Europe. We can make progress on that.
The Treasury is getting ready to weigh the five euro tests. Some economists say it's a clear pass, some say not at all. How can the test results ever produce a clear and unambiguous answer?
The first thing to recognize is that this is one of the biggest decisions in economic policy that Britain has made. We're a very open trading economy, and we've got a history of stop-go in our economy. And therefore it's all the more important that whatever the decision we do make is made on the most rigorous and comprehensive and solid assessment that can be done. And that is what we're going to do. People have got to be patient and wait for the Treasury to complete its work. And we will publish not just the assessment itself but, of course, the individual papers that are going to make up that assessment. It would be premature to make conclusions at this stage.
In your recent Mansion House speech, you talked a lot about the exchange rate. Clearly, there's an imbalance in the economy between the service sector and the traded -- particularly the manufacturing -- sector. Do you think the pound needs to decline to correct some of these imbalances, and if so, can policy induce a decline?
I've never got myself in a position to speculate about the day-to-day movements of the currency. We want a stable and competitive pound that reflects the economic fundamentals of the economy. The important thing that I would come back to is the sound foundation on which our economic policy is based. And that's low inflation and a strong fiscal position.
Bank of England independence and your fiscal rules have worked beautifully. You've got the lowest inflation, the lowest interest rates in 40-odd years. The economy has grown pretty well through a difficult period. Why would you give this up?
The European Union is trying to find the same route to stability as we are. So there is nothing fundamentally at odds with the euro group's wish to have the same monetary and fiscal stability that we have. Basically, you've got two potential routes to stability. That's why we can see advantages in potentially lower long-term interest rates, currency transactions not being costly, the single market in Europe working better and to our advantage. We're in an area where we've got 50 percent of our trade. But of course the key question as far as the decision on the euro is concerned is whether the tests that I've set down on employment and financial services and investment can be met. Therefore the government has taken a decision that in principle we see great advantages in the euro; in practice we must meet these five tests.
Do you think the fact that your arrangements, your monetary and fiscal rules, have worked so well make it harder to make the case that euro entry is in Britain's interest?
We are happy that from a period when we didn't seem to have a regime for monetary and fiscal policy that was giving us the stability we wanted, either the low inflation or the fiscal disciplines, that we got it. But it doesn't change the position that I referred to earlier on, that there are two routes to stability: the one we are pursuing at the moment and through the euro. Don't underestimate the extent to which European governments of the 1990s reduced inflation and got the fiscal position under control as well.
You've criticized the Stability and Growth Pact for being too rigid. There's been some evolution recently to take into account the cyclical budget position. Is this a good move, and is it enough?
This is an ongoing discussion. We've reduced debt very substantially in Britain, from 44 percent of national income to 30 percent. Debt repayments as a percentage of our national income are now lower than at any time since 1915. So we are fiscal disciplinarians.
But equally, you need a stability and growth pact that makes sense over the economic cycle, that takes into account the different levels of debt sustainability that individual European countries have and also takes into account investment as distinct from consumption. Clearly, some economies in Europe have a level of underinvestment in their infrastructure that is itself a barrier to their economic efficiency. And people have argued that the Stability and Growth Pact does not take account of the distinction between consumption and investment.
Would the pact need to be modified? Is that a condition for Britain's euro entry?
The pact itself is a broader set of guidelines. The interpretation of the pact is what is being debated. There is no sixth test, no.
Do you accept that Britain would suffer economically and politically by staying out of the euro over the long term?
We've said that in principle there are benefits to the U.K. economy in joining. But we've also said that the assessment is designed to examine the employment effect, the investment effect, the effect on financial services. So we have got to be satisfied that these tests can be met. You want to press me to make further announcements, and I can't, because the work has still got to be completed.
In five years you've redistributed income significantly. You've also talked of the need to extend opportunity. How would you define your political philosophy?
As someone who believes in an economy that is efficient and a society that is fair. We're trying to build a Britain that is more enterprising and a Britain that is fair. And I believe that both enterprise and fairness really depend on there being more opportunity. More opportunity for people to start businesses, to see their enterprise flourish, to see their investments succeed. But equally, more fairness because people see that there is opportunity in the society.
Your first two years you stressed fiscal discipline -- some say excessively so. The latest budget is seen as a return to traditional Labour values -- tax and spend.
When people look at Britain, they will see that for 20 or 30 years we have not invested properly in transport, in health, in education, in science. That has been a huge barrier to our success as an economy. We needed to make these investments, and we're making them -- many in cooperation with the private sector. At every point I've made decisions about whether we can invest or not based on a foundation of sound fiscal discipline. By paying off very substantial amounts of debt in our first few years, we gave ourselves a platform from which to make the investments for our future. We couldn't have made these investments in 1997 or in 1998. We had to take the measures to correct our fiscal position first.
By Tom Buerkle
September 2002
Institutional Investor Magazine
Gordon Brown seems anything but a gambling man. When the leadership of Britain's Labour Party was up for grabs in the mid-1990s, a position Brown believed he was destined for, he abandoned his bid for the job and let his closest ally, Tony Blair, seize the prize and, ultimately, the prime ministership. Then, when Labour swept to power in 1997, as chancellor of the Exchequer he took control of British economic policy and frustrated his party's desire for a dramatic burst of social spending by opting for stability first. He gave the Bank of England independence and handed it control of monetary policy, and he set a tight fiscal policy to slash the deficit and please the bond market.
Now, after five years of steady growth, rising employment and low inflation, Brown has a sterling reputation, but he's preparing to risk it on two big bets. The first, just wagered, is to commit to the biggest sustained increase in government spending in more than 30 years. Brown unveiled plans in July to boost spending by more than 4 percent a year over the next four years in a bold attempt to rebuild the U.K.'s ailing health service, schools and road and rail networks. The need is real, but there is no guarantee that the money will actually transform public services or that Brown can finance the spending without tax increases. What's more, the plan will swell the public sector at a time when most European Union countries are trying to shrink theirs, putting Britain on a potential collision course with its EU partners.
The second, even larger bet must be placed by next June: Should Britain adopt the euro or rule it out for several more years? Cleverly, Brown gained an effective veto over the decision by laying down five economic tests for entry and establishing his Treasury as arbiter of the tests. The success of Brown's economic policies, particularly Bank of England independence, suggest that his answer to those tests should be no. The U.K., after all, has grown faster than the euro zone while staying outside monetary union. Entering it could put Brown's economic stability at risk.
But the euro is ultimately as much a political as an economic question. Is joining the currency essential to Britain's influence in Europe? Blair clearly thinks so and seems determined to lead Britain into economic and monetary union before leaving office. And so the question for Brown is, Can he best advance his ultimate ambition of succeeding Blair as prime minister by saying yes to the euro, or no, not now? The British public's current hostility toward joining the euro argues for waiting, but there's no guarantee that the conditions for Britain entering EMU -- or Brown entering 10 Downing Street -- will be better in four years.
In an interview with Institutional Investor, the 51-year-old Brown was characteristically noncommittal about the single currency, avoiding any hint of personal preference and stressing the primacy of his tests (see box, page 118). The decision on whether to adopt the euro will be one of the most important economic choices in British history, he says, and therefore it must be made "on the most rigorous and comprehensive and solid assessment that can be done."
But unlike Blair, who said recently that a decision to stay out of the euro on political grounds would be a "betrayal" of British interest, Brown shows little sign of enthusiasm for the single currency. By contrast, he displays real conviction when he touts his own economic record, noting Britain's low inflation, strong growth and buoyant employment -- 1 million jobs created in the past five years. He proudly proclaims himself to be a "fiscal disciplinarian" and insists that the sharp decline in debt in recent years makes his spending plans feasible -- and more sensible than the forced austerity of the euro zone's Stability and Growth Pact. "We gave ourselves a platform from which we could make the investments that are necessary for our future," he says. In short, Brown doesn't sound like a man eager to trade his unchallenged control over the world's fourth-largest economy for a seat at the table of the 12-nation euro group.
Brown developed a passion for politics from an early age. As an eight-year-old boy growing up in the small Scottish town of Kirkcaldy, he was allowed by his father to stay up until 1:30 a.m. to hear the results of the 1959 general election, which Labour lost to the Conservatives. At 20 he was elected student rector at the University of Edinburgh. "He eats and drinks politics," says Giles Radice, a Labour member of the House of Lords. "He is an obsessive." Along with a thirst for politics, Brown learned a strict moral code of individual responsibility and social compassion from his father, a Presbyterian minister and a socialist. When Brown married his longtime girlfriend, Sarah Macaulay, two years ago, he requested that donations be sent in lieu of gifts to two charities, Oxfam International and Christian Aid.
Elected to Parliament in 1983, Brown shared an office and formed a close friendship with another new Labour MP, Tony Blair. Frustrated by the party's marginalization, the two men developed a plan to make it electable by abandoning socialist dogma for market-oriented policies and rebranding the party as New Labour. Their relationship has since frayed -- a 1998 biography of Brown revealed his resentment at losing the party leadership to Blair, prompting a Blair confidant to complain about the chancellor's "psychological flaws" -- but their bond still explains Brown's enormous influence. "The strength of Gordon Brown is to do with his character and the way the prime minister has delegated authority to him," says Sir Alan Budd, a former Treasury economic adviser and one of Brown's first appointees to the Bank of England's Monetary Policy Committee. "He is extremely clever, and he is a very strong character."
Since World War II every Labour government has been undermined by an economic crisis of one kind or another. Harold Wilson devalued the pound in 1967, while James Callaghan had to turn to the International Monetary Fund for assistance in 1976. Even many of Brown's Conservative predecessors left office in disgrace. Nigel Lawson triggered an inflationary boom in the late 1980s by cutting taxes rashly, while Norman Lamont reaped the consequent bust. The U.K. suffered its worst postwar recession in the early 1990s, culminating in the humiliation of the pound's forced exit from the European Exchange Rate Mechanism in 1992, when George Soros and other speculators sold sterling massively.
By contrast, Brown's tenure has seen British inflation (1.5 percent), interest rates (4.76 percent yield on benchmark government ten-year bonds) and unemployment (3.1 percent) fall to the lowest levels in nearly 40 years. It's a tribute to his record that when he announced his dramatic spending plan in July -- a risky strategy given the weakness of the global economy -- U.K. financial markets and the pound showed nary a flicker of concern. "If we were in 1996 and you told me that Britain would have the lowest inflation in Europe, the lowest unemployment in Europe and the highest growth in Europe, I don't think businesspeople would have believed it," says Digby Jones, director-general of the Confederation of British Industry. "This government has been very successful in providing macroeconomic stability. It's an enormous plus."
Brown has enjoyed good fortune, inheriting an economy in its fifth year of a boom fueled by the 1992 devaluation. But he has made his own luck, too. He helped prevent the economy from overheating by keeping a tight lid on government spending in his first two years in office, while increases in spending last year countered the global slowdown and helped Britain avoid recession. Growth rebounded strongly in the second quarter and has averaged about 2.75 percent a year over the past five years, a faster rate than in the 12-nation euro zone. "Because public finances were sound, the chancellor was able to expand fiscal policy in a way that supported the economy years," says David Walton, chief European economist at Goldman Sachs International. "France and Germany don't have that leeway."
This reputation for economic competence is Brown's proudest legacy, and it reflects the influence of his closest aide, chief economic adviser Ed Balls. Balls, 35, studied economics at Harvard University under, among others, former U.S. Treasury secretary Lawrence Summers. He was struck by the fact that most U.S. economists, whatever their political persuasions, had abandoned the idea that policymakers could trade higher inflation for more jobs and instead preached the need for stability as the basis for sustainable growth. He was influenced by a paper Summers coauthored that demonstrated a strong link between central bank independence and low inflation.
"Labour in opposition never had the confidence to make economics a dividing line," Balls says. "I always figured you could have an ambitious and progressive agenda for social change only on the basis of having established a platform and a reputation for running the economy."
After Labour lost the 1992 election, Brown hired the young economist and began drawing on his U.S. connections. Balls arranged for Brown to meet with Summers during a visit to Washington. The two would become good friends. Brown also got to know former U.S. Treasury secretary Robert Rubin, who was instrumental in getting president Bill Clinton to make deficit reduction the top priority in a bid to please the bond market and bring down interest rates.
When Labour was elected in a landslide on May 1, 1997, Brown and Balls put their U.S. lessons to work quickly. Just five days later Brown stunned the British political world and financial markets by announcing that he was giving up control over British interest rates -- one of his biggest tools -- to a new Monetary Policy Committee of the Bank of England. It was given the job of keeping inflation at a target of 2.5 percent. Central bank independence was a political revolution for Britain -- the Conservatives didn't endorse the move until last year. Financial markets embraced the change overnight, though. Long-term interest rates fell as investors bet that an independent Bank of England would prove much more successful at controlling inflation.
"It was a masterstroke, and it has worked out tremendously," says the MPC's Budd. "There's always a risk with a Labour government that the City would mistrust it. This was a very, very good way to neutralize the mistrust."
Brown demonstrated a fiscal conservatism to match his monetary stance. He laid down new rules that committed the government to balancing its current budget -- spending on welfare benefits, social programs like health and education and salaries -- over the economic cycle and borrowing only to finance capital investment in new roads, schools and other facilities. Brown also kept a tight grip on spending during his first two years while raising more than £8 billion ($12 billion) in new taxes to reduce the deficit and finance a jobs program for unemployed youths. The net result? Britain's budget swung from a deficit of more than 3 percent of gross domestic product when Brown took office to a surplus of more than 1 percent of GDP two years later. The national debt tumbled from nearly 44 percent of GDP in 1997 to about 30 percent today, the lowest of any major industrial country.
Brown always insisted that his fiscal prudence was for a larger purpose, however, and his latest budget and multiyear spending plan provided it. The budget in April raised spending by more than 4 percent in real terms and pushed the government's balance back into deficit after four years of surpluses. In July Brown unveiled a medium-term plan to raise spending by similar amounts over the following three years. Spending on the National Health Service will rise by 7.4 percent a year over the next four years, education will get 7.6 percent a year more and transportation a whopping 8.4 percent, as the government embarks on a £100 billion, ten-year renovation of Britain's creaking road and rail networks. For the chancellor the plan represents a definitive break with decades of cuts that he believes have worsened social inequality and undermined competitiveness. "Britain has for 20 or 30 years not invested properly in its transport, in its health, in its education, in science," he says. "That has been a huge barrier to our success as an economy."
But to pay for his big spending increases, Brown imposed a raft of new taxes that provoked a harsh response from the British business and financial community, which feared that he was undermining the foundations of the country's economic success. "The last budget was old Labour, tooth and claw," says Ruth Lea, director of policy at the Institute of Directors, a lobbying group of the U.K.'s top chief executives. "He really is raiding business coffers now." She believes Brown is eroding Britain's low-tax advantage by raising government spending to more than 41 percent of GDP in two years' time from 39 percent today and just 37 percent three years ago. That compares with 33 percent in the U.S., 49 percent in Germany and 53 percent in France.
Brown's biggest tax move was to increase national insurance contributions, or payroll taxes, by one point, to 11 percent, for both employees and employers. The move will cost business an extra £4 billion a year and stands in contrast to the trend in Europe, where most countries have been reducing payroll taxes to promote employment. "It shows a misunderstanding of business to tax job creation," says the CBI's Jones.
Brown also stunned the oil industry by raising taxes on North Sea producers by £600 million a year. Lord John Browne, group chief executive of BP and a frequent guest of Tony Blair at Downing Street, thinks the hike will undermine the confidence needed for long-term investments. "I don't think any other country in the world has increased production taxes in this way over the last ten years, with two exceptions -- Venezuela and Argentina," he said in a speech a few days after the budget was announced.
The chancellor also proposed changing the tax treatment of foreign banks by ending their ability to deduct interest on loans from their parents. The move is projected to raise £1 billion in 2003 and 2004. "This is the worst time to hit the wholesale markets with a tax," notes Angus MacLennan, senior executive vice president at Danske Bank and chairman of the Foreign Banks and Securities Houses Association. "There isn't a single financial institution today that isn't looking where to fit in, looking at their cost structure."
Treasury officials dismiss the warnings as overblown and point out that Britain continues to draw more foreign direct investment than any other EU member. "The test of the government on the economy is whether it's a good place to invest and create jobs," Balls says. "I think, in general, people look at the U.K. and say, This is a good place."
Brown's very first tax change continues to stoke controversy. In July 1997 he ended Britain's complex system of advance corporation tax payments, eliminating the ability of pension funds to claim £5 billion of refunds on taxes paid on corporate dividends. Brown contended then -- and still does -- that the change was offset by cuts in the corporate tax rate to 30 percent, from 33 percent. But in today's bear market, the loss of tax credits is a painful blow to pension funds. Many analysts believe the move has aggravated weakness in the U.K. stock market -- the Financial Times Stock Exchange 100 index has fallen by more than one third since its 1999 peak -- and prompted a number of major companies to replace defined benefit plans with defined contribution ones. The Treasury "didn't remotely consider that this was going to be quite such a big hit on pension funds, and it matters now because of the big drop in the market," says Angela Knight, head of an institutional investors lobby group, the Association of Private Client Investment Managers and Stockbrokers.
The shift to a more expansive budget policy at a time of heightened economic uncertainty clearly carries risks. Brown insists his plan is prudent because it is based on the assumption that the economy will grow by 2.5 percent a year, equal to its average postwar growth rate. But with the budget in deficit, Brown's margin for error is perceptibly narrower. The National Institute of Economic and Social Research, Britain's leading independent research outfit, recently predicted that tax revenues would come in below forecasts as a result of the economic slowdown, just as they exceeded expectations during the late 1990s boom. The institute said taxes would have to rise by the equivalent of 0.5 percent of GDP over the next four years and by a further 1 percent in future years to finance Brown's spending.
Whether Brown's largesse can produce dramatic improvements in Britain's health care, education and transportation networks is even more debatable. Health spending rose by more than 5 percent in the fiscal year that ended on March 31, but the number of operations performed by the NHS actually fell. Public sector unions have begun flexing their muscles, with local council workers striking in July for the first time in decades, raising the possibility that much of the spending will be eaten up by pay increases for teachers, nurses and police officers.
Brown's solution has been to draw up public service agreements -- no fewer than 130 of them -- that tie funding increases to government departments' ability to meet targets for everything from educational achievement to waiting times for seeing specialist doctors. The intent is clear. Money will come only if public employees change their inefficient work habits. But as any former central planner can attest, targets can have perverse effects. Labour promised in its first term to reduce the number of people waiting for hospital treatment, for example, only to see some hospitals delay care for people with life-threatening illnesses to focus on the larger number of patients with less urgent problems. "These are Soviet five-year plans, and they don't have a cat in hell's chance of working," says David Ruffley, a Conservative member of the House of Commons.
On international issues Brown has shown a similar penchant for rules and standards as well as for working with his American counterparts. He consulted closely with Rubin and Summers in the aftermath of Russia's debt default and the collapse of Long-Term Capital Management in 1998, and he helped to orchestrate an initial round of reforms to the international financial system. As head of the Group of Seven Finance ministers at the time, Brown pushed through an agreement in October 1998 calling on developing countries to publish timely and standardized information on foreign exchange reserves, budget balances and other economic data, and demanding closer cooperation among regulators through establishment of the Basel-based Financial Stability Forum. As chairman of the IMF's International Monetary and Financial Committee, Brown has pushed for collective action clauses in debt deals that would require private investors to participate in any sovereign debt restructuring.
Brown has shown an altruistic side. He was instrumental in getting the Group of Seven to agree to the HIPC plan of debt relief for heavily indebted poor countries in 1998, when Britain hosted the G-7 summit. He has also agreed to double Britain's aid budget to 0.4 percent of GDP by 2006. He calls for a new Marshall Plan under which developed countries would offer more aid and investment to developing countries that tackle corruption, pursue stable policies and open their economies to trade. It remains far from clear whether Brown can work as effectively on this agenda with current U.S. Treasury Secretary Paul O'Neill as he did with Rubin and Summers. Brown has cooperated with U.S. efforts to cut off financing to terrorists, but he talks more readily about "maximizing opportunity" in the developing world to combat the insecurities caused by globalization. He welcomes President George Bush's commitment to increase U.S. foreign aid by $5 billion a year (see IMF/World Bank, page 81) but acknowledged that U.S. tariffs on steel imports and higher subsidies in the recent farm bill were "a hindrance" to efforts to assist developing countries.
Ultimately, Brown will be judged by how he handles the biggest international economic issue facing him and Tony Blair -- whether to take Britain into the euro. The first clues should come next month, when Brown and Treasury officials are due to appear before the House of Commons Treasury Select Committee to discuss work on the tests, which the government has promised to complete by next June.
The five tests -- whether the U.K.'s economy has converged with the euro zone's, whether there is enough flexibility to cope with sudden shocks and whether the euro would be good for employment, for investment and for Britain's financial services industry -- are sensible enough. They are also inherently subjective and not likely to give the "clear and unambiguous" answer that Brown has demanded.
A preliminary assessment by economists at London's South Bank University in June, for example, determined that Britain's economy had converged durably with that of the euro zone in terms of growth, inflation and interest rates. It also claimed that the exchange rate stability provided by the single currency would be positive for jobs and investment. "We think it's sufficiently clear to be a credible passing of the tests," says professor Iain Begg, one of the authors of the report.
A study by Oxford Economic Forecasting for the "no" campaign ahead of a referendum came up with an entirely different conclusion. It claimed that Britain would suffer more inside the euro zone than outside from shocks such as a rise in interest rates, an increase in oil prices or a fall in global equity prices.
"I can't believe anybody can seriously argue that the conduct of macroeconomic policy would be better if we joined the single European currency," says former Treasury and MPC official Budd. "We won't have the appropriate interest rates -- that's incontrovertible." But he adds that the tests are ultimately a political as well as economic judgment call.
One key factor in reaching their decision will be the pound's exchange rate. Sterling's strength against the euro in recent years has squeezed the country's manufacturers even as service industries have boomed. The result has been an unbalanced economy, with house prices and domestic consumption booming while the trade deficit has widened.
The pound's decline of nearly 10 percent against a resurgent euro this year has eased this concern, but only in part. Simon Wren-Lewis, an economist at Exeter University who has been commissioned by the Treasury to estimate the appropriate pound-euro exchange rate, came up with a figure roughly 20 percent below current levels in a study three years ago. "If we go in at the wrong exchange rate, we'd have another Black Wednesday on our hands," says Clive Soley, a senior Labour member of Parliament, referring to the day in 1992 when the pound was devalued.
Black Wednesday is a particularly haunting memory for two key advisers on the euro debate. Gus O'Donnell, the senior civil servant overseeing the euro tests, was John Major's press secretary at the time. Stephen Wall, Blair's adviser on EU affairs, was Major's private secretary and had to counsel him against resigning after the pound's devaluation. These and other Treasury veterans "still have scars" from the ERM debacle, says Jim Rollo, former chief economist at the Foreign Office.
A potentially bigger argument against the euro is the sheer success of Brown's policies. Britain joined the ERM in 1990 mainly because it couldn't achieve low inflation and stable growth on its own. By contrast, Brown's monetary and fiscal rules have contributed to Britain's best inflation and growth record in more than 30 years. "The better the British economy performs relative to the euro economy, the more difficult it will be for politicians to make the case for joining," says DeAnne Julius, a former member of the Bank of England's Monetary Policy Committee.
Brown has criticized the European Central Bank, claiming it is insufficiently accountable to the public and biased against growth. Many economists contend that the Bank of England's inflation target -- which deems undershooting the 2.5 percent objective to be as bad as overshooting it -- gives a clearer, pro-growth steer to policy than the ECB's aim of keeping inflation somewhere below 2 percent. "A lot of problems with the ECB are precisely because it doesn't do what the U.K. does," says economist Wren-Lewis. "There's no explicit inflation target. It's not symmetrical. There's a lack of transparency. It's a negative factor for joining EMU. We would be moving to an inferior model if we went to the European Central Bank."
Brown also has clashed with the EU over the Stability and Growth Pact, which requires countries using the euro to aim for a balanced budget and sets an absolute deficit ceiling of 3 percent of GDP. The European Commission, the EU agency that monitors the pact, issued a thinly veiled criticism of Brown earlier this year for pushing Britain's budget into deficit. Brown responded by attacking the pact as too rigid and urged that it take into account countries' debt levels and allow deficits to swing more with the ups and downs of the economic cycle.
Increasingly, his views are gaining ground. In July EU Finance ministers agreed to take cyclical effects into account when assessing compliance with the pact. And Pedro Solbes, the EU commissioner for economic and monetary affairs, has begun to acknowledge Brown's arguments on debt. Britain's so-called golden rule of allowing government borrowing for capital spending "has economic sense," Solbes tells II. He also acknowledges that Britain's low debt and lack of pension liabilities means that deficit spending could be appropriate as long as it is "a temporary, not a permanent, solution." The signs of a thaw were evident as Brown lauds the EU's policy aims in his own interview with this magazine. "There is nothing fundamentally at odds with the euro group's wish to have the same monetary and fiscal stability that we have got in Britain," he says. "And basically, you've got two potential routes to stability."
Notwithstanding such complimentary words, Brown's blunt tactics have fanned doubts among EU colleagues about his real intentions toward the euro. In February Brown announced before an EU Finance ministers' meeting that he would oppose a proposed reprimand of Germany over its budget deficit. The move killed the reprimand before the meeting began, casting doubt on the credibility of the Stability Pact, but it won favorable headlines in Britain's euro-skeptic newspapers. "I've become more and more convinced that he has only one agenda -- being prime minister of the United Kingdom," says one senior EU official, who spoke on condition of anonymity. "He has no European agenda."
In London, certainly, nobody doubts Brown's political ambition. "Obviously, Gordon wanted to be leader and would still like to be leader," says MP Soley. The real question is whether he will improve his prospects by saying yes or no to the euro tests before next June.
The current betting has to be for a no. Aside from an occasional pro-euro statement from Blair, the government has made little attempt to win public support for the euro. "The only policy you can be sure of is prevarication," says Gerald Holtham, chief investment officer of Morley Fund Management. Surveys show Britons remain as opposed to the euro today as they were when Labour came to power five years ago. Market & Opinion Research International, which conducts monthly polls of euro sentiment, found in July that only 35 percent of respondents would support euro entry even if the government urged it; 52 percent would oppose it. The negative balance matched the monthly average since November 1997.
"There's not going to be a referendum in the life of this Parliament," says Bob Worcester, an American who heads MORI and has been polling for Labour for nearly 30 years. "They can't win. It's too big a gap to close." Investors appear to agree. Analysts at Goldman Sachs International estimated recently that the cheap price of sterling forward call options at an exchange rate of less than 70 pence to the euro -- the rate at which most analysts expect Britain to enter the euro -- suggests investors believe the chances of entry in the next three years are less than one in three.
Given those risks, most analysts expect the government to defer a euro referendum and focus on Brown's budget objectives of fixing British hospitals, schools and roads, areas where voters trust Labour much more than the Conservatives. Even many Conservatives believe the government will opt to cruise to what looks like a third election victory in 2005 and only then go for a euro referendum, after which Blair could retire. "Brown doesn't want to derail the next election and his succession as prime minister," says the Conservatives' Ruffley. "I'd be amazed if he said the tests have been passed."
Of course there is a counterargument. Staying out of the euro for four or five years could mean tougher conditions upon eventual entry. Existing euro members are eager to gain Britain as a partner and might be amenable to waiving the required two-year period of exchange rate stability for the pound and instead negotiate a favorable entry rate. In 2006, however, as many as ten Eastern European countries are expected to be pushing for euro entry, making it harder for the EU to cut a sweet deal for Britain.
Blair, after all, clearly believes that Britain must join the euro to play a full role as a European power alongside France and Germany. It's a view shared by former prime minister John Major, who has told associates he believes British entry is inevitable in the next ten to 15 years. As one close adviser to the current prime minister puts it: "Tony Blair believes this is something that is in Britain's interest to do, and it's desirable to do it sooner rather than later. He is prepared to take some risks."
If Blair decides to go for the euro, many doubt that Brown could risk undermining him. "I don't see Brown succeeding without a successful Blair," MP Radice says. "Whether he likes it or not, they're linked intrinsically."
Some doubt that there is any tension between the two. The suggestion that the prime minister is strongly pro-euro while the chancellor is skeptical is a "political con trick" aimed at swinging voters if Brown comes out in favor of euro entry, says Michael Howard, the Conservatives' Treasury spokesman. If Labour remains strong in the polls next year and opinion begins to shift on the euro, "I believe they'll go for it," he says.
Brown can't keep people guessing much longer. Testing time is about to begin.
Testing time for Gordon Brown
The U.K.'s chancellor of the Exchequer achieved an enviable economic record for Britain by practicing fiscal discipline and steering clear of the euro. But now Gordon Brown is dramatically boosting government spending on health, transportation and edu-cation while preparing to decide whether to embrace the euro, provided five qualifying standards can be met. Is this any way for Brown to preserve his reputation -- and his shot at the prime ministership? Here the chancellor chats candidly with Institutional Investor European Editor Tom Buerkle.
Institutional Investor: The U.K. stock market was down again heavily today [July 24]. The Financial Times Stock Exchange index is below its 1997 level and, along with most other indexes, is nearly 50 percent below its peak. Is it fair to talk about a crisis of confidence in global capitalism?
Brown: No. The key question you ask is, Are the economic fundamentals sound? If you look at the British economy, we have put in place a new regime for monetary and fiscal stability. We've got low inflation. We've got the fiscal position sound; we've cut debt very substantially. We've created a better competitive environment. And in our case, employment and growth are happening. You ask yourself whether you are able to withstand the ups and downs of the economic cycle better than you were ten or 20 years ago. And the answer is yes.
What can be done now to restore confidence in markets?
You've seen that the House of Commons has a statement on auditing and accounting practices. It is important to look at the changes necessary so we can be absolutely sure that we've done everything in our power to strengthen auditing and accounting. So we will do that. You'll find across America and across Europe that the same thing is happening, depending on different systems and different cultures. It's also important to say that we will pursue sound anti-inflation and sound pro-stability policies.
We're coming up on the anniversary of September 11. What does that day mean to you? Has the world really changed?
The world has changed hugely as a result of September 11. We're seeing both a maturer phase of globalization and also the insecurities that can arise in a global economy and a global society. And the insecurities include failed states, they include terrorist threats, they include the insecurities that can arise from the very process of globalization itself.
I admire the way America has been resilient after September 11. I've got a great respect for the way people facing tragedy, particularly, of course, in New York, responded by a resolution and a determination. And we stand full-square with the American government and the American people in fighting terrorism and will continue to do so. The response since September 11 -- for example, the measures I've been involved in to try to ensure that there's no real safe havens for terrorists trying to use the financial system -- has brought the world together. And there's been a degree of international cooperation on these issues that we haven't seen in the past. So as we remember September 11, there will be a huge sense of loss and a feeling of solidarity with the American people.
Equally, we understand that we are in a new world where we are aware both of the opportunities of globalization and of the insecurities that arise from it. The opportunities include the ability of companies and individuals who have got a skill or have got a product or have got an idea to market that product or that idea on a worldwide basis in a way that wasn't possible ten, 20, 30 years ago. There's global competition in just about every service and every product now. So there are great opportunities for people who've got ideas and who have got something to offer. But equally, there are insecurities that arise. We've got to be able to deal with that. In many ways we can minimize insecurities by maximizing opportunities. But equally, we've got to deal with the military and terrorist threats that can arise in a mobile society.
Last December in Washington you talked about the need for a new Marshall Plan, advancing social justice on a global scale. To borrow a phrase: "tough on terror, tough on the causes of terror." It's a bold vision. Are you disappointed at the follow-through?
There has been follow-through. The decision at Monterrey by the European governments to pledge over time $7 billion extra a year in aid and the decision by the American government to raise its development aid contribution by $5 billion a year meant that for the first time in perhaps 25 years, the decline in aid to the poorest countries has been reversed.
The Marshall Plan that I was talking about, the modern Marshall Plan, is essentially a new relationship, a new compact between developed and developing countries, wherein in return for the poorest countries entering the world economy and pursuing anticorruption, pro-stability, pro-trade, pro-investment policies, we are, as was Marshall in the 1940s, prepared to devote a substantial amount of resources to health, to education, to economic development, to antipoverty programs. And I do believe that Monterrey was an advance. And so, too, was the G-8 meeting where the African plan was agreed.
You've doubled your aid budget. The U.S. is still contributing much less on aid. The farm trade bill has been widely criticized. Are you concerned that the U.S. is doing its share?
The decision at Monterrey by President Bush to raise American aid was something that has been welcomed all over the world and therefore is something that all of us can build upon. It's true that any protectionist measures on the part of the richest countries will be seen as a hindrance to that process. But I'm of the view that in American history there have been periods where what may seem to be restrictive measures like the farm bill and the steel tariffs are the prelude to fast-track authority or some opening up of trade negotiations on a wider scale. And I think the Americans are committed to the Doha agenda, as is Europe. We can make progress on that.
The Treasury is getting ready to weigh the five euro tests. Some economists say it's a clear pass, some say not at all. How can the test results ever produce a clear and unambiguous answer?
The first thing to recognize is that this is one of the biggest decisions in economic policy that Britain has made. We're a very open trading economy, and we've got a history of stop-go in our economy. And therefore it's all the more important that whatever the decision we do make is made on the most rigorous and comprehensive and solid assessment that can be done. And that is what we're going to do. People have got to be patient and wait for the Treasury to complete its work. And we will publish not just the assessment itself but, of course, the individual papers that are going to make up that assessment. It would be premature to make conclusions at this stage.
In your recent Mansion House speech, you talked a lot about the exchange rate. Clearly, there's an imbalance in the economy between the service sector and the traded -- particularly the manufacturing -- sector. Do you think the pound needs to decline to correct some of these imbalances, and if so, can policy induce a decline?
I've never got myself in a position to speculate about the day-to-day movements of the currency. We want a stable and competitive pound that reflects the economic fundamentals of the economy. The important thing that I would come back to is the sound foundation on which our economic policy is based. And that's low inflation and a strong fiscal position.
Bank of England independence and your fiscal rules have worked beautifully. You've got the lowest inflation, the lowest interest rates in 40-odd years. The economy has grown pretty well through a difficult period. Why would you give this up?
The European Union is trying to find the same route to stability as we are. So there is nothing fundamentally at odds with the euro group's wish to have the same monetary and fiscal stability that we have. Basically, you've got two potential routes to stability. That's why we can see advantages in potentially lower long-term interest rates, currency transactions not being costly, the single market in Europe working better and to our advantage. We're in an area where we've got 50 percent of our trade. But of course the key question as far as the decision on the euro is concerned is whether the tests that I've set down on employment and financial services and investment can be met. Therefore the government has taken a decision that in principle we see great advantages in the euro; in practice we must meet these five tests.
Do you think the fact that your arrangements, your monetary and fiscal rules, have worked so well make it harder to make the case that euro entry is in Britain's interest?
We are happy that from a period when we didn't seem to have a regime for monetary and fiscal policy that was giving us the stability we wanted, either the low inflation or the fiscal disciplines, that we got it. But it doesn't change the position that I referred to earlier on, that there are two routes to stability: the one we are pursuing at the moment and through the euro. Don't underestimate the extent to which European governments of the 1990s reduced inflation and got the fiscal position under control as well.
You've criticized the Stability and Growth Pact for being too rigid. There's been some evolution recently to take into account the cyclical budget position. Is this a good move, and is it enough?
This is an ongoing discussion. We've reduced debt very substantially in Britain, from 44 percent of national income to 30 percent. Debt repayments as a percentage of our national income are now lower than at any time since 1915. So we are fiscal disciplinarians.
But equally, you need a stability and growth pact that makes sense over the economic cycle, that takes into account the different levels of debt sustainability that individual European countries have and also takes into account investment as distinct from consumption. Clearly, some economies in Europe have a level of underinvestment in their infrastructure that is itself a barrier to their economic efficiency. And people have argued that the Stability and Growth Pact does not take account of the distinction between consumption and investment.
Would the pact need to be modified? Is that a condition for Britain's euro entry?
The pact itself is a broader set of guidelines. The interpretation of the pact is what is being debated. There is no sixth test, no.
Do you accept that Britain would suffer economically and politically by staying out of the euro over the long term?
We've said that in principle there are benefits to the U.K. economy in joining. But we've also said that the assessment is designed to examine the employment effect, the investment effect, the effect on financial services. So we have got to be satisfied that these tests can be met. You want to press me to make further announcements, and I can't, because the work has still got to be completed.
In five years you've redistributed income significantly. You've also talked of the need to extend opportunity. How would you define your political philosophy?
As someone who believes in an economy that is efficient and a society that is fair. We're trying to build a Britain that is more enterprising and a Britain that is fair. And I believe that both enterprise and fairness really depend on there being more opportunity. More opportunity for people to start businesses, to see their enterprise flourish, to see their investments succeed. But equally, more fairness because people see that there is opportunity in the society.
Your first two years you stressed fiscal discipline -- some say excessively so. The latest budget is seen as a return to traditional Labour values -- tax and spend.
When people look at Britain, they will see that for 20 or 30 years we have not invested properly in transport, in health, in education, in science. That has been a huge barrier to our success as an economy. We needed to make these investments, and we're making them -- many in cooperation with the private sector. At every point I've made decisions about whether we can invest or not based on a foundation of sound fiscal discipline. By paying off very substantial amounts of debt in our first few years, we gave ourselves a platform from which to make the investments for our future. We couldn't have made these investments in 1997 or in 1998. We had to take the measures to correct our fiscal position first.