COUNTERFACTUAL history is a fashionable discipline. Now the Treasury has pitched in with its contribution to the genre. It rewinds the clock to Gordon Brown's first verdict in 1997 and changes the answer to yes. So Britain joins the euro with the other 11 founder members at the start of 1999. How would the economy have fared inside rather than outside the euro area?
Initially, the champagne corks would have been popping. Interest rates would have dropped by four percentage points to the lower level set in the euro area. The stimulus to the economy would have pushed growth in 2000 up to a heady 5.5%.
But the millennium party would have generated a long hangover. Excess demand would have pushed inflation up to nearly 5% and it would have stayed high over the past three years. This would have made the economy less and less competitive.
Outside the euro area, a loss of competitiveness can be quickly regained by a fall in the exchange rate. Inside, it has to be grindingly restored through a protracted period of lower inflation and slower growth.
The Treasury's counterfactual history is self-serving: it vindicates the decision Gordon Brown took in 1997. But it also illustrates why it is so important to ensure that the economy is as convergent as possible with the euro area before signing up to membership. The less that interest rates have to fall, the smaller the shock.
The simulation also demonstrates why it is so important to join at the right exchange rate. Once Britain gives up its independent monetary policy, adjustment to shocks will occur through changes in the real exchange rate—the market rate adjusted for prices at home and in Europe. If Britain were to join at too high a market rate this would require a subsequent painful adjustment of lower inflation to bring the real exchange rate into line.
The Treasury published an independent estimate of a sustainable exchange rate for joining the euro: Simon Wren-Lewis, an economist at Exeter Unversity, says around euro1.37. Until its recent fall the pound was much more expensive, but now, at euro1.42, it is close.
This article appeared in the Britain section of the print edition under the headline "What if Britain had joined in 1999?"