Blair's Dilemma

Should he--and could he--coax Britons into the euro zone?

Rod Turner runs Whale Tankers Ltd., which employs 155 people in the Midlands town of Solihull building custom truck containers to haul toxic waste. The high exchange rate of sterling, which has risen 14% against the euro since the beginning of last year, has turned up the heat on Whale and many other British manufacturers. Still, Turner thinks joining the European single currency to escape the effects of the strong pound would be a big mistake. "We are doing very well outside," he says. "We have the lowest taxes, the lowest unemployment. Why take this leap into the unknown?"

Prime Minister Tony Blair would like to make that leap--if he thinks conditions are right. Fresh from a huge reelection win on June 7, Blair wants to go down in history as a great modernizer. And he thinks securing Britain's place in Europe is key to his legacy. He hears from Continental leaders and pro-European advisers that unless Britain adopts the single currency, it risks becoming marginalized outside an increasingly influential European Union. Yet Blair knows he would have to spend heavy political capital to persuade skeptical Britons to join. "Blair has a real dilemma," says Ruth Lea, policy director of the Institute of Directors, a business organization. "He wants to be at the heart of Europe, but he clearly can't be unless he goes into the euro."

Not surprisingly, the cautious Blair hasn't yet decided to give the euro a thumbs-up. He has promised to make a decision within two years on whether to recommend joining, and to hold a referendum if he decides "yes." Winning such a vote is a daunting challenge. Public sentiment against adopting the euro is running at between 2-to-1 and 3-to-1, and Blair's associates think losing a referendum could destroy his credibility as Prime Minister. "Our guess is that Labour will not be able to shift public opinion in favor of European Monetary Union entry early enough for Blair to call a referendum in the next couple of years," says Michael Saunders, an economist at Schroder Salomon Smith Barney in London. By then, the window will have likely closed until the next parliamentary elections.

CATBIRD SEAT. What's more, the economic case for entry into the euro is not overwhelming. The euro's advocates argue that high sterling is killing manufacturing and that foreign investors will throw in the towel if Blair does not join soon. But Britain's economic circumstances don't help them. Over the past five years, Britain has averaged 2.8% economic growth, vs. 1.8% for Germany. British unemployment at 3.1% is the envy of Europe. And Britain continues to lead its Continental rivals in attracting foreign investment.

There is also no evidence that being outside the euro zone has damaged the City of London as a financial center. In fact, having a corner on the market for sterling products may have given City financiers an edge to break into other markets. "Most of the myths put out [about not going into the euro] have proved not to be true," says Martin Gatto, chief financial officer of Somerfield PLC, a British supermarket chain.

Britain's economic reforms of recent years may have already reaped gains that joining the euro zone would have brought. Under Blair, Britain has an independent central bank that targets inflation. Chancellor of the Exchequer Gordon Brown has given Labour economic credibility by running fiscal surpluses. "Now that the U.K. has learned to run its economy properly, the gains of going in [to the euro] are not likely to be as great," says John Fitzgerald, research professor at Dublin's Economic & Social Research Institute.

While some British economists think Britain could adopt the euro without major disruption, others disagree. David Hillier and Adam Law, economists at Barclays Capital Inc., the investment banking unit of London's Barclays Bank, argue in a recent report that "the U.K. [cannot] live comfortably with euro interest rates," which are set by the European Central Bank. For example, Hillier says that if today's euro-zone interest rates of 4.5% were applied to Britain, inflation, now about 2.4%, would leap by up to one percentage point. "Our economy responds differently to changes in interest rates," he says. "That is a problem." Britain's more flexible labor and goods markets, and the higher percentage of adjustable-rate loans taken out, make its economy more sensitive to rate changes than those on the Continent.

Blair will be closely following the bitter battle to influence public opinion. The pro-euro campaign called Britain in Europe has enlisted such heavyweights as Unilever PLC Chairman Niall FitzGerald and British Airways PLC Chairman Colin Marshall. These boardroom chieftains are getting more vocal about the euro. "A lot of multinationals have been giving the government the benefit of the doubt. If they see prevarication, they will move investment elsewhere," says Chris Haskins, chairman of Northern Foods PLC, a Hull wholesaler with $2 billion in annual sales.

SKEPTICS UNLIMITED. The anti-euro camp, known as Business for Sterling, is less heavy on Establishment stars, but it is strong among people in small and midsize businesses. And some well-regarded young chief executives have been attracted to the "no" camp. One is Simon Wolfson, the 33-year-old chief executive designate of clothing retailer NEXT PLC. "It is not possible to effectively manage the whole economy of Europe," he says. "Certain regions of Europe will require higher interest rates to control inflation, while others will require lower." Europe's current performance--with low growth in Germany and inflation heating up in Ireland--reflects that, he adds.

Should Blair determine that omens are right to push the euro, a likely referendum date would be the fall of 2002. But Blair will have plenty of persuading to do--first of all with Brown, who is more skeptical about the euro than Blair. Then Blair would have to negotiate favorable terms of entry for Britain. Most analysts say sterling would have to come down at least 10% from its present level--one reason the currency has plunged recently.

Blair would also have to persuade Europeans to be accommodating about other details for Britain's entry. While politicians are unpredictable, there's a good chance the Europeans would oblige. Their own experiment with the euro might be a better bet with pesky sterling finessed. But Blair has some finessing of his own to do first.

By Stanley Reed in London

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