DIRECTOR'S PERSPECTIVE

by Saruhan Hatipoglu sshatipoglu@beri.com

THE TRANSATLANTIC MIDWIFE:

Critical Decision Facing the United Kingdom

Full Time Job: The United Kingdom (U.K.) government is allocating twenty-four hours of unwavering attention to foreign relations every day and increasingly engaging in shuttle diplomacy as the priorities of its European "destiny" frequently clash with those of its largest ally in Washington, D.C.  Transatlantic relations with the European Union took a turn for the worse with the advent of the Bush presidency in 2000, and no signs of improvement are in sight during the next four years. 

With the imminent birth of new problems on the horizon, ranging from Iran to climate change, it seems that the U.K. government will take every measure to ease the pain and regulate the breathing rhythms of the United States and the European Union in the coming years.  However, its efforts do not have any guarantee of success and probably face a considerable chance of failure.  Not many will deny that the U.K. has an awkward role in this ordeal, and the government needs to make a choice soon between long-term political and economic union with its neighbors or short-term gains from replacing its European goals with the security of American strength and cooperation.  It is not possible to completely succeed in both of these objectives simultaneously.

Many episodes in this political sitcom have already taken place, but one of most recent is particularly striking.  The warning from the Pentagon to the European Union not to lift its arms embargo on China was delivered as a gift-wrapped Christmas present to Brussels.  The Pentagon was clear in its intention, stating that lack of adherence to this demand will inevitably curtail military technology cooperation between the transatlantic neighbors.  Here is the uncomfortable situation for the U.K.: only three months before this threat, the Blair government had secured a preferred status from the U.S. Congress, which facilitated Britain’s access to U.S. military technology.  Now, that decision can be nullified because the U.K., at least on paper, is still in the European Union, and any undertaking will also apply to the Blair government. 

The U.K. has been at a crossroads for some time now.  Although the logical path points to an eventual European Monetary Union (EMU) membership and deeper political and economic ties with Europe, economic realities and foreign policy differences currently dominate the concept of political integration with the Continent.  In the end, integration will occur only when Euroskeptics in the U.K. are convinced that benefits outweigh drawbacks.  Joining the EMU requires not only success in convincing the country's nationals but also taking a hard line against U.S. positions, when needed, to show solidarity with the European Union at such critical junctures as the war against Iraq and recent negotiations with Iran as well as issues ranging from human rights to global climate change. 

Time Has Come:  Decision time is already here, but mixed messages are being sent about the U.K.'s position on EMU.  Earlier last year, Prime Minister Tony Blair said, "The euro for me is an issue with a specific economic dimension because it is an economic union that you're joining.  Even though politically there is a case for joining, economically there isn't one at this time."   Simple.  Clear.  To the Point.  However, not too long ago, Secretary of State for Foreign and Commonwealth Affairs Jack Straw said that the decision to join the EMU is "almost all political."  The difference in opinion is not limited to these two individuals but rather engulfs the entire country.  Therefore, it is no surprise that the U.K. is divided on the issue of monetary union, which is a key emotional decision that will determine the future course of history in Europe.  But, no more time is left for foot dragging, and that is exactly what the government has been doing since June 2003 when it made its last official comment on the issue.

In March 2004, Chancellor of the Exchequer Gordon Brown stated that there would be no review process in 2004 until the time of the 2005 budget.  But, do not hold your breath for a positive review before the general elections because a favorable evaluation will translate into a referendum on this pivotal topic, and that is something that the Prime Minister is desperately trying to avoid: campaigning on the controversial euro adoption in a bitterly divided country.  Nonetheless, the U.K. needs to move on the issue because political alliances fray easily in Europe, and foreign policy decisions in London during the past four years have created real obstacles to trust.   

Not Passing All the Tests with Flying Colors: The Treasury identified five crucial tests in 1997 that the country would need to overcome to become a successful member of the EMU without jeopardizing its macroeconomic performance.  Namely, the issues at hand then and now are convergence, macroeconomic flexibility, investment continuity, health of the financial industry, and sustained employment and growth upon adopting the euro.  Based on results so far, it is fair to say that the country is not yet ready in economic terms to join the EMU, but it is not as far away as some public officials would like to claim.

The U.K. has already met three of the five criteria. For example, investment activity will not be adversely affected by the EMU membership.  Quite the contrary, it will increase without the adverse impact of exchange rate fluctuations.  Furthermore, the U.K. will maintain and consolidate its leadership in the world of finance as it has done throughout modern history.  London will continue to serve as the heart of Europe's financial activity.  Finally, an accurate forecast for maintaining a stable growth path and robust job creation upon joining the EMU is implausible because that aspect of membership will be tested only after the eventual adoption of the euro.

Convergence and flexibility are the two real challenges facing the U.K.  Flexibility issues will improve rapidly as they have been during the past seven years.  It is fair to argue that the U.K. has better labor flexibility today than it did when the five test criteria were introduced.  Convergence, then, is the primary issue to be managed, and the government faces considerable challenges in reducing one significant structural difference with its neighbors to be in the EMU family.     

Put Your "House" in Order:   The housing market is the key factor threatening the convergence process.  Differences between the European Union and U.K. housing industry are so striking that potential accession to the EMU today would cause trouble for the country’s macro-economy and its consumers, who have been increasingly enjoying wealth accrued from real estate ownership.  First, housing equity has become a major source of consumer wealth in the U.K.  In the past three years, net housing equity withdrawal rose to 4.0%-4.5% of disposable income.  Historical statistics reveal that this type of withdrawal constituted 3.0% of disposable income during the past 20 years in the U.K., while in Germany, France and Italy net investment in housing exceeded net borrowing secured against housing.  To clarify, not withdrawing but investing in housing grew by about 6.0% during the 20 years in these three countries.  High property prices have encouraged U.K. consumers to engage in equity withdrawals as housing prices rose 40.6% during 2002-2004.  The annual rate of increase is lower than the 17.6% rise last year but is still an extremely high rate of growth and poses substantial profit opportunities for U.K. consumers, which have been disappointed by the stagnant stock market.  And that opportunity will be relinquished if the U.K. enters in the EMU today.

In Europe, particularly among EMU countries, housing and mortgage markets exhibit substantial variations, which result in different pricing behavior.  For example, house price inflation in the U.K. rose 3.3%/year during 1971-2001, highest among the EU countries (with the exception of Spain).  Germany (West only) experienced an increase of 0.1% while France, Italy and Denmark had a price growth of 1.2%, 1.5%, and 1.3%, respectively during that period.  This significant historical difference explains why housing is a better investment opportunity in the U.K.  Consumers feel richer, and the last thing they would like to do is to trade it away for EMU membership, particularly at a time when the outlook for equity investment and stock markets is uncertain.

But, the U.K. has a real opportunity now.  Housing prices are showing signs of stabilizing with the rate of increase in decline.  In fact, in November 2004, prices decreased at its fastest pace since end of 1992.  The stock of unsold properties also expanded 9.0% last year.  In addition, gross mortgage lending contracted 13.0% in December compared to the 2003 period.  The government will need to adopt measures, including making it more difficult for households to obtain mortgages, to bring the market in line with that of the EMU countries.  The housing market is the single economic obstacle threatening convergence.  The Blair government must facilitate the process and, even more challenging, sell the idea to its people.

Conclusion:  Tony Blair will soon have to face what he already knows: his country's future lies with deepening economic and political ties on the Continent.  His administration is aware of this fact, but convincing the people will prove difficult.  Moving away from being soul mates with the U.S. will also have repercussions, but it is a short-term sacrifice for long-term political stability, unity, and strength in Europe.  It is certain that the U.K. will not take steps toward EMU accession before the general elections, but time is critical and a stabilizing housing market is an opportunity.

The world is facing trying times today, and in the field of foreign affairs, the U.K. will need to stand firm with its neighbors and strengthen European influence in the global platform.  "There is at least one thing worse than fighting with allies - And that is to fight without them," said Sir Winston Churchill.  With global political repercussions from the chaos in Iraq, the potential nuclear threat from Iran, expected terrorist activity at the doorsteps of Europe, and a variety of economic challenges brought about by lingering uncertainty, Sir Winston’s statement rings even louder today, and Mr. Blair needs to listen to it.

DIRECTOR'S PERSPECTIVE Last Updated September 2004