Given all the uncertainties, the first best solution is to ensure economic conditions are sustainable at entry: this minimises the risk of a difficult and prolonged adjustment once locked into EMU.The experience of present euro area members illustrates the importance of transition issues. In terms of nominal interest rates and exchange rates, Germany and France experienced a fairly smooth transition: interest rates converged two years before entry and no exchange rate revaluations were made in the years before January 1999.In contrast, Ireland and Greece experienced fairly pronounced transitions to EMU. ” Since the start of EMU, relatively low inflation in Germany has led to a significant fall in the real effective exchange rate.At the start of EMU, Ireland and the Netherlands were in more cyclically advanced positions, with both experiencing positive and rising output gaps. In contrast, both Germany and France had slightly negative gaps that were closing.

Since 1999, Ireland and the Netherlands have experienced a more pronounced cycle than Germany or France.The conclusion of the convergence test is that there has been been significant progress on cyclical convergence since 1997. Financial markets and the forecasts by international organisations suggest that monetary conditions need to remain tighter in the UK than in the euro area into the medium term.But the UK now exhibits a greater degree of cyclical convergence than some EMU members demonstrated in the run-up to the start of EMU in 1999, and while some EMU countries still demonstrate substantially more cyclical convergence than the UK, some demonstrate substantially less. In terms of industrial specialisation the UK is quite similar at the aggregate level to other large EU countries.Distinct supply and demand features of the UK housing market mean that both the relationship between house prices and household consumption, and the underlying rate of real house price growth, are stronger in the UK than in the euro area. The structure of the UK mortgage market is such that UK households are more sensitive to interest rates, which has implications for the transmission of monetary policy.Analysis of monetary transmission suggests the UK may be more sensitive to monetary policy through some channels, and less sensitive through others: the pass-through of interest rate changes from official rates to bank lending rates is faster in the UK [and] the household sector in the UK may react more strongly to interest rate changes than in euro area countries.The UK is potentially more sensitive to monetary policy through its impact on the exchange rate; but there is little to suggest that the corporate sector in the UK will react more strongly than in the euro area. The UK’s relatively low levels of nominal wage rigidity will tend to reduce the impact of monetary policy on output.The process by which membership of EMU encourages convergence gives grounds for optimism about the future compatibility of UK structures, including housing. In addition, there are significant future uncertainties in the present economic and political climate, for example, trends in global financial markets, in the US dollar and euro and in the relative growth paths of the UK and the euro area.All these suggest there are clear risks associated with transition to EMU membership at present and emphasise the importance of sustainable and durable convergence and increasing the flexibility of the economy through the measures the Government is setting out.Alongside settled and sustainable convergence, there needs to be sufficient flexibility to ensure the economy can respond and adjust quickly to divergences which emerge, minimising the adverse impact on growth, stability and employment. The question of whether convergence and flexibility together provide the necessary degree of sustainable and durable convergence is answered after the assessment of the flexibility test.The overall conclusion [is that] there has been significant progress on convergence since 1997, which marks a break with the UK’s history of divergence and reflects greater stability of the UK economy and global trends towards integration.Indeed, the UK now exhibits a greater degree of cyclical convergence than some EMU members demonstrated in the run-up to the start of EMU in 1999 and remains more convergent than several EMU countries today.But there remain structural differences with the euro area, some of which are significant, such as in the housing market.

Because of the risks these factors pose, and the fact that any dynamic changes would take time to come through, we cannot yet be confident that UK business cycles are sufficiently compatible with those of the euro area to allow the UK to live comfortably with euro area interest rates on a permanent basis.Overall, at present, while the extent of convergence with the euro area has significantly increased, the convergence test is not met. The Government is committed to building on the platform of stability and has announced a wide-ranging, forward-looking policy agenda to deliver high levels of output and employment. This will help to make the economy more convergent with the euro area for the future.The policy requirements [will be approached by] the Government’s announcement of its intention in the next pre-Budget report to give the Bank of England a symmetric inflation target, as measured by the harmonised index of consumer prices, [which] will improve the quality of the UK inflation target and will also help ensure inflation expectations in the UK remain in line with those of the euro area.The Government is committed to a comprehensive programme to improve the functioning of the housing market. It is undertaking further significant changes in the planning system, supply of housing and housing finance to tackle market failures, increase the responsiveness of supply to demand and reduce national and regional price volatility. These measures will increase the housing market’s compatibility with the euro area, encouraging greater convergence over time.On the supply side, the Government requires new regional spatial strategies to take account of volatility in the housing market and promote macroeconomic stability as part of delivering sustainable development. Background Paper: Prices

BACKGROUND PAPER: PRICES
The Treasury believes the effect of euro entry on UK prices would be “limited” at changeover; some would not change but total convergence would take “many years”.Its paper, Prices and EMU, examines the history of single currencies, the euro and its impact since it was introduced.Short-term costs associated with entry would be transitional and less significant than the longer-term effects, the paper believes. In theory, reduced barriers to trade should cause prices to converge until eventually they are identical across the region, adjusted for the cost of transport and other trade.

The elimination of currency costs and exchange-rate risk ought to boost trade and competition, putting further pressure on prices across the region.But, in practice, EMU would not remove other barriers that limit price convergence. “Significant variations in prices could be expected to remain within the euro area, particularly in sectors which are less exposed to trade,” the paper says.Prices in Britain are significantly more expensive than the EU average, peaking at some 19 per cent higher in 2000. Since, the price differential has fallen to 8 per cent in January 2003, reflecting the sharp depreciation of sterling against the euro. Over the same period, France and Germany have become cheaper, and Italy has remained relatively cheap.The Treasury says regional price differentials are strongly supported by local labour costs and taxes, which would not be affected by joining the euro. The paper found house price growth had been stronger in the UK than in the larger eurozone countries, partly in response to the low level of house building in the UK.Almost three quarters of Britons own their homes while the two largest euro economies – Germany and France – have owner-occupation rates below 60 per cent. It said the high levels of mortgage debt in the UK and the dominance of variable rate mortgages implied that British households were more sensitive to interest rate changes than their continental counterparts.UK mortgage debt totals 60 per cent of GDP, well above the EU average.Six out of 10 mortgages in the UK are on a variable rate, a stark contrast to Germany where 80 per cent of homeowners are on fixed mortgages with a duration of at least five years. The Chancellor acknowledged this issue in the Budget in April when he commissioned Professor David Miles of Imperial College London to look at the feasibility of establishing a market for longer-term mortgages.Yesterday’s study also focused on the issue of mortgage equity withdrawal, when homeowners take out a second mortgage to cash in on the rising value of their home.