Why the five economic tests?

2002 Cairncross Lecture, 4th December 2002


It is a great honour to be invited to give this twelfth annual Cairncross lecture.

I want to begin by paying tribute to Sir Alec Cairncross, in whose honour this lecture series is given. 

Sir Alec was not only a renowned economist and academic – Professor of Applied Economics at Glasgow, Master of St Peter’s College Oxford from 1969 to 1978 and then Chancellor of Glasgow University – but also a teacher, chronicler and historian – a writer of text books, diaries, memoirs and also historical dissections of key decisions in Britain’s twentieth century economic history.

I know of his skill as a teacher from personal – if indirect – experience: Sir Alec’s book “Britain’s Economic Prospects Reconsidered” was the first economics book I ever read, bought at a second hand book stall in mid-Wales on a holiday the summer before starting my A level economics course some twenty years ago. And having read it, I précised it and then handed it in – the first ever economics essay I ever wrote. I got a B- for that essay – sadly Sir Alec’s book was not really pertinent to the question about planned versus market economies that we had been asked to answer – but it was a memorable read, and I learned my lesson – always answer the question.

Sir Alec Cairncross is remembered, above all, as one of the finest public servants of the last century, an economist who could understand, analyse and make policy. He had a hugely varied career – in the Cabinet Office after the war, as an adviser to the World Bank, a member of the Radcliffe committee – and many other policy commissions in later life – but, most important, at the Treasury as Economic Adviser to the Government from 1961 until 1964 and between 1964 and 1969, the first head of the Government Economic Service – the GES – working closely alongside Robert Nield, the first Economic Adviser to the Treasury.

During his time at the Treasury, as the importance of economic analysis grew, so the number of economists working in government expanded exponentially  – from 22 when the GES was first formed – only four of whom were outside the Treasury – to around 200 when Sir Alec retired. In the years since then, the Government Economic Service has gone from strength to strength – under the leadership most recently of Sir Alan Budd and now Gus O’Donnell, Head of the GES and also the Treasury’s Permanent Secretary – with now nearly 800 economists working across Whitehall – often in senior policy roles.

I am sure that Sir Alec Cairncross would have been proud, too, not only of the wide range of Oxford economists now contributing to economic policymaking – including from St Peter’s, Dr Christine Greenhalgh, a regular contributor to our thinking and discussions at the Treasury, but also with Oxford economists on the Monetary Policy Committee, and heading up the Office of Fair Trading and the Competition Commission to mention a few.

It is appropriate that this lecture is jointly organised with the Institute of Contemporary British History. As Sir Alec will have experienced first hand, in the world of politics and policy, there is a spectrum which runs from today’s headlines, this weekend’s commentaries, through biography and memoir to historical record and analysis – a spectrum across which opinion and reportage becomes fact, truth and then record.

And while it is the luxury of historians to allow the years to pass, to wait for all the official records to be in the public domain, for all the memoirs to be written and the diaries to be published, policymakers do not have the time to wait -good policy has to be informed by an understanding of recent as well as more distant history. So it is the job of contemporary historians – and the Institute and all its scholars – to help distinguish truth from error, the partial from the comprehensive view, to help us draw the right conclusions from history – and avoid drawing the wrong ones.

Sir Alec Cairncross was a policymaker but also a contemporary historian of repute, a scholar determined that the observations we can draw from a proper understanding of history should be spelled out, learned and then applied. I hope, therefore, that he would have approved of the subject of this lecture tonight – “Why the five economic tests?”


To those of you who have come expecting some hint about future decisions of government policy, I am afraid that I am going to disappoint you – there is nothing new here this evening, on the page or between the lines. Instead, my purpose in this lecture, in setting out why I believe the government has taken and is taking the right approach to making the decision about British membership of single currency, is to show how we have learned the right lessons from our history.

As Sir Alec Cairncross wrote, in the final concluding paragraph of his 1983 study of this very subject entitled “Sterling in Decline”, written with the economic historian Barry Eichengreen:

“Nowhere is it so evident that circumstances have changed as in the attitudes of economists and politicians towards the role of the exchange rate in the management of the economy…. Perhaps when opinion about exchange rates has reached such a state of disarray, there are lessons to be learned from reviewing the record of the past.”

And drawing the right conclusions from our history is, indeed, of contemporary importance.

We have to draw the right conclusions from our history about the future of our country – and the right conclusion is that  – as the Prime Minister has said – Britain’s destiny is as a European power and that, on many economic issues, we best pursue our national interest by deepening co-operation with our European partners.

More than half of our trade is with the EU. Three million British jobs or more depend upon it. Europe gives us access to a wide and deep single market. By pooling our sovereignty in, for example, trade negotiations it gives Britain a greater say on issues of great economic importance to our country. Today the case for Europe must be not only that, working together, we can maintain peace but that, working together, we can maximise prosperity. As the Prime Minister said in his speech last week in Cardiff, “We should have more self confidence because we are a leading European power, always have been and always will be.”

And the decision on the Euro is the most important economic decision this generation will take.

As the Chancellor of the Exchequer, Gordon Brown, said in this year’s Mansion House speech, “Our decision on the euro is of immense, historic importance to the long term future of our economy and our country as a whole. It is perhaps the biggest peacetime economic decision we as a nation have to make.”

It is important because “to share a common monetary policy with other states does represent a major pooling of economic sovereignty” (1); and because the decision “is not just momentous but irreversible, affecting every industry and all people” (2). Unlike a decision to join a semi-fixed or fixed regime, or even a currency board arrangement, it cannot be reversed. So if entry happens, unlike previous exchange rate decisions in the last hundred years, there can be no changing of minds, no devaluation, and no exit either.

The government’s approach to making this decision was set out by the Chancellor in his statement to the House of Commons in October 1997 and by the Prime Minister’s statement to the House of Commons on the launch of the outline National Changeover Plan in February 1999. That approach is guided by four principles. Forgive me if this is familiar to you but I will briefly set them out.

First, in that statement, for the first time, the government declared its support for the principle of British membership of monetary union. Joining the Euro – the Chancellor said- can bring great potential benefits to the British economy – not just in terms of stability, lower long-term interest rates and reduced transaction costs but also from the boost to productivity and therefore real incomes from being more deeply integrated into the European single market. As Sir Alan Greenspan has remarked, if the US economy had had fifty currencies  – one for each state – for the last two hundred years it would be a less integrated and less productive economy today.

Second, that while joining the Euro clearly has constitutional implications, there is not a constitutional bar to membership – so long as joining a single currency is in the national economic interest and the economic case for doing so is clear and unambiguous. As the Prime Minister said in his Warsaw speech in October 2000, “I have said the political case for Britain being part of the single currency is strong. I don’t say political or constitutional issues aren’t important. They are. But to my mind, they aren’t an insuperable barrier. What does have to be overcome is the economic issue.”

Third, the basis for this decision as to whether there is a clear and unambiguous economic case is the Treasury’s detailed assessment of the five economic tests:

– Whether there can be sustainable convergence between Britain and the economies of a single currency;

– Whether there is sufficient flexibility to cope with economic change;

– The effect on investment;

– The impact on our financial services industry;

– Whether it is good for employment.

And fourth, given the constitutional significance and permanence, if on the basis of that assessment a decision to recommend joining is taken by the Government, that decision would then be put to a vote in Parliament and then to a referendum of the British people. Because, as with the EEC referendum in 1975 and, more recently referenda on establishment of the Scottish Parliament and the Welsh Assembly in 1997, the economic and political significance of this decision demands that we get popular consent for the economic case.

The Chancellor has said that if we recommend that Britain should join the single currency on the basis of a comprehensive and rigorous assessment of the five tests, then we can win a referendum and win it decisively.

In short, as Prime Minister Tony Blair said in this Labour party conference speech “We should only join the Euro if the economic tests are met. That is clear. But if the tests are passed we go for it.”

As you will know, back in 1997 we concluded that, on the basis of a detailed assessment of the five tests, it was not in this country’s interest to join in the first wave of EMU. But in order to allow a genuine choice in the future, the Chancellor said that it was essential that the Government and business prepare intensively during the last Parliament, so that Britain will be in a position to join a single currency, should we wish to, in this. We are committed to completing the second assessment of the five economic tests by June of next year. And, as the Chancellor explained in last year’s Mansion House speech, the Treasury is currently engaged in the necessary technical and preliminary work for the analysis of the five tests. Our commitment is to make a comprehensive and rigorous assessment  – and the scope of this preparatory work was set out in September in a memorandum to the Treasury Select Committee.

It is an understatement to say that the five tests are controversial. Some, who would rule out membership of the Euro in principle on constitutional grounds, say that this assessment of the national economic interest is, therefore, irrelevant. Others argue that the political case for membership is so compelling that the historical moment should be seized regardless of the economic case. And, all too often, commentators, doubting whether economics can rise to meet the challenge of the five tests assessment, fall back to the easy view that the decision on single currency will inevitably be made on political and not economic grounds.

I believe that Sir Alec Cairncross would have rejected the idea that economics and economic policymakers cannot rise to this challenge. He would have argued I am sure – if he were here today – that a decision of such magnitude has to be got right. But he would also point out, as he himself chronicled, that we do not have a good track record of making these decisions over the past century. And central to these past failures has been that politicians and policymakers paid insufficient attention to the economics in making key decisions and then paid a very heavy economic and political price when it all went badly wrong:

– the 1925 decision to return to the pre-first world war system of global fixed exchange rates backed by gold reserves – or, in short-hand, “the gold standard” – at the pre-war parity, followed by six years of stagnant growth, high unemployment, a national strike, the fall of the elected Labour government, the National government and forced devaluation;

– post-war re-entry to a fixed exchange rate system with the dollar in 1946 again at the pre-war parity and the decision of the government to reject devaluation, followed three years later by the forced devaluation of 1949;

– the decision of the incoming Labour government in 1964 to reject devaluation, followed three years later by forced devaluation of 1967, the resignation of the Chancellor, deflation, rising unemployment and retrenchment;

– and then, of course, the still painful memory of  September 16th 1992 and sterling’s ejection from European Exchange Rate Mechanism, less than two years after the decision to join the ERM and following the longest recession of the post-war period.

In an essay called “Reflections on economic ideas and government policy: 1939 and after”, in his 1996 collection entitled “Contributions to Contemporary Economic history”, Sir Alec Cairncross wrote “A case in which economic ideas have had far less influence than one might expect is exchange rate policy. If we take the two devaluations of 1949 and 1967, neither of them was decided upon as a result of a careful assessment of the pros and cons and a review of the likely consequences”.

Tonight in the spirit of Sir Alec’s essay, I will highlight four ‘reflections’ on this past history, with a particular historical focus on 1925 and the decision to re-enter the Gold Standard. And I will show how, in the approach that we are now taking to the five economic tests on the Euro, we have drawn the right conclusions from our history:

– we have ensured that economics, not politics, is the deciding factor on the timing and manner of any decision;

– we will make the decision  from a position of economic strength, not forced from weakness;

– we can, because of  the five tests assessment, base the decision on a proper economic assessment of the long run  economic case;

– and the five tests assessment will also make a full economic analysis of the economic consequences including any short-term transitional issues, so that the economic consequences are fully understood.

Many eminent scholars have analysed the history of the 1925 decision and the economic and political consequences – not only Cairncross and Eichengreen, but also Sayers, Moggridge, Dimsdale, Kynaston and Lord Skidelsky to name five more. And decades after these events, argument and debate still rages. Ongoing controversy is even more raw for the 1990-92 experience. “Politics and the Pound”, written by the Financial Times columnist Philip Stephens, is a fine piece of contemporary history – but there are still official papers to be released, memoirs to be written, biographies to be assessed and re-assessed.

Policy makers cannot wait for the passage of time. So this lecture sets out the historical context to the approach set out in the 1997 Euro statement. And while I am grateful to all the Treasury colleagues who have contributed to and commented on this lecture, all errors of analysis and interpretation are my own.

I am an economist and a policymaker but  – unlike Sir Alec  – not an accomplished historian. But if  – as I am sure Sir Alec would have agreed – contemporary policymakers lay themselves open to scrutiny and debate by the contemporary historians and commentators of their day, the result might be better policy decisions.

So, in that spirit, let me start with 1925.


While re-entry to the gold standard did not occur until April 1925, the decision to re-join the Gold Standard had effectively been taken some seven years earlier.

In the final months of the war in 1918, the Treasury and the Ministry for Reconstruction set up the Cunliffe Committee  – headed by Lord Cunliffe, former Governor of Bank of England and including Pigou, the Cambridge economist – to consider the problems of currency and foreign exchange during the reconstruction and “report upon the steps required to bring about the restoration of normal conditions in due course”. Its interim report in August 1918 concluded that sterling should re-join at the at the pre-war parity of £3 17s 10.5d (equivalent to $4.86), saying “… it is imperative that the conditions necessary to the maintenance of an effective gold standard should be restored without delay.”

But there was a delay. As wartime controls were eased, and pent-up demand was released, the economy experienced a considerable boom immediately after the war ended and – as the trade deficit widened, the value of sterling fell substantially. As fiscal policy was tightened, and interest rates were raised to slow demand and support sterling, boom turned to the 1921 slump – the steepest recorded recession in British economic history, as unemployment climbed from 1.4 per cent to 16.7 per cent within a year and whole sale prices fell sharply.

The deflationary policy stance brought British prices down towards American levels and put upwards pressure on the exchange rate. And the Bank of England felt able to reduce interest rates in the summer of 1922 to below US levels. But by the following summer, with sterling under downward pressure and monetary policy focussed on restoring the parity, rates were raised again. By 1924 UK rates were above US levels.

This monetary policy squeeze achieved its objective – sterling rose steadily from a low of $3.20 in February 1920 to $4.32 and then up to the pre-war parity of $4.86 in the ten months before the April 1925 decision to re-fix, a 32 per cent appreciation. After adjusting for what was, despite the post-slump deflation, the relative inflation of wholesale prices, which rose by 60 per cent in the UK between 1914 and 1925 compared to 40 per cent in the US, this translates to a real exchange rate appreciation of well over 10 per cent since 1914.

While it was Churchill who made the decision to join, it was his predecessor, Phillip Snowden, who in 1924, having announced that he would stand by the recommendations of the Cunliffe Committee, appointed a committee of experts to consider restoring the gold standard:  the Chamberlain-Bradbury Committee – chaired first by Austen Chamberlain MP and then by former Treasury Permanent Secretary Sir John Bradbury. (3)

Opinion amongst the experts giving evidence to the Committee was almost unanimously in favour of restoring the gold standard.  Three main arguments were put forward, as Lord Skidelsky records.  First that it would anchor the value of domestic money and prevent inflation.  Bank of England Governor Montagu Norman argued in his evidence that a return to the gold standard would prevent a “great borrowing by public authorities.”  Second, the return to gold was seen as necessary to revive world trade and Britain’s trading performance – the Federation of British Industries stated in their evidence that a “general return to [a] gold basis … would be greatly to our benefit.”  Finally, the City was near unanimous in the view that a return to gold was necessary to restore the City of London to its position as the world’s leading banker, and sterling to its position as the world’s leading currency. (4)

There was – with notable exceptions – little dissent. In its final February 1925 report, the Committee concluded that a return to gold at anything less than the pre-war parity “could not be seriously considered”.  The Committee concluded that, “there is, in our opinion, no alternative comparable with a return to the former gold parity of the sovereign”.  The Committee therefore recommended that: “the early return of the gold standard basis should forthwith be declared the irrevocable policy of His Majesty’s Government.” (5)

Churchill announced his decision in the Budget speech of 28 April 1925. From that moment on economic matters went badly wrong. Struggling under the strain of a strong exchange rate, set back by the General Strike the following year, growth was sluggish, industrial exports remained depressed and unemployment remained persistently high falling no lower than 9.7 per cent in 1927.

The Conservatives lost the 1929 election; Labour was re-elected as the Wall Street crash of that year impacted round the world. Two years later, with unemployment rising to 22 per cent, reserves diminishing fast, the Labour government collapsed in the face of demands for fiscal deflation to stem the tide, and the National Government led by the former Labour prime minister Ramsay MacDonald announced that sterling would be devalued – leaving scars deep in the political psyche of British economic policymaking which exist to this day.

My argument tonight is that there are four important conclusions to be drawn from this experience. I will take each one in turn.

The first reflection is that the government of 1925 did not ensure that economics, not politics, was the deciding factor on the timing and manner of decision.

The Cunliffe Committee report of 1918 concluded “In our opinion it is imperative that after the war the conditions necessary to the maintenance of an effective gold standard should be restored without delay.” This was taken as recommendation to re-join at the pre-war parity and was accepted by both the Treasury and the Bank of England.

Rejoining became a political imperative which dominated both the gold standard debate and the practice of economic policymaking from 1918 to 1925. From that time on, Britain’s standing in the world required re-entry at the 1914 rate. And interest rates were set to get sterling back to that level.

What started as a decision about economic policy – stability, trade and the role of the City – became a wider decision about politics and prestige. As Barry Eichengreen writes, the “decision to resurrect the pre-war parity was an instinctive reaction. The gold standard was a symbol of past economic glories, and there was a desire to turn the clock back to a time when Britain played a dominant role in international trade and finance.”

As Churchill says in his April Budget statement, “If we had not taken this action the whole of the rest of the British empire would have taken it without us, and it would have come to a gold standard, not on the basis of the pound sterling.  But a gold standard of the dollar.”

And for Churchill there was a further twist to the political timetable. The 1920 Gold and Silver Export Control Act, which extended war-time controls on the export of gold and silver for a further five year period, was set to expire at the end of 1925. Indeed, Churchill raised this point directly in his 1925 Budget speech, noting that “By the express decision of the Parliament of 1920 the Act which prohibits the exports was of a temporary character. That Act expires on the 31 December of the present year, and Great Britain would automatically revert to the pre-War free market for gold at that date. Now His majesty’s Government has been obliged to decide whether to renew or prolong that Act on the one hand or let it lapse on the other” So, for Churchill, the choice was to join and abolish the restrictions or admit failure and go to the House of Commons to seek a further extension.

Politics determined the former course.

The second reflection is that the Government of the day made the decision not from a position of strength, but from weakness.

Indeed they had no alternative economic policy – no plan B.

Rocked by the 1920s slump and persistent high unemployment, Britain’s economic credibility and international standing was weakened. Getting back to parity as soon as possible became the symbol of renewed stability, credibility and the restoration of Britain’s place in the world.

And the advice to Snowden and Churchill from both the Treasury Permanent Secretary Otto Niemeyer and Bank of England Governor Montagu Norman was clear  – re-entry as soon as sterling could be got back to the pre-war parity was the only acceptable route to stability and credibility.

As Churchill said in his Budget speech of 28 April 1925:  “… A return to an effective Gold Standard has long been the settled and declared policy of this country … No responsible authority has advocated any other policy … no political party no previous … Chancellor of the Exchequer has challenged the principle of a reversion to the Gold Standard in international affairs at the earliest possible moment…”

Outside commentators, seeing no alternative, urged the government to end the uncertainty. By December 1924 the Economist was pushing for early entry, “It seems that in many respects we have at the moment a blend of sentiment and economic conditions which is unusually favourable to a return to parity. This combination of circumstances may not last, and for this reason we should like to feel that the authorities concerned are well prepared, should the developments of the near future be favourable, to take action and to take it quickly.”

Snowden, now in opposition, wrote himself in the Times in February 1925 “the world opinion in favour of the return to the gold basis is too overwhelming for any other course to be accepted for a long time to come.”

And the Economist in an April editorial, just before the decision, called on Mr Churchill to “remove an element of uncertainty by announcing the government’s intention in regard to gold”.

When the decision was finally made, the reaction was one of relief. Following the decision, ‘The Times’ declared that it had never doubted “that the best interests of the country would be served by returning to the Gold Standard as soon as the course became practicable and safe to do so.” (6) ‘The Economist’ expected it to offer: “…a definite broadening of the base of British commerce.” It went on to say that the new policy should be the subject of congratulation to the Chancellor and was the “crowning achievement of Montagu Norman.” (7)

There was, though, an alternative view. Both John Maynard Keynes, then Bursar and Fellow of King’s College Cambridge and regular columnist in the Manchester Guardian and Sunday Times,  and Lord McKenna, a former Chancellor and Chairman of the Midland Bank, appeared before the Chamberlain-Bradbury Committee to question the wisdom of the strategy of returning to gold at the pre-war parity.

But even though Keynes was clearly in a position to advocate a credible plan B, he was constrained by the authorities lack of desire for one and the risks of stepping too far outside the conventional wisdom.

As Lord Skidelsky records, Keynes “had outlined his alternative. He favoured independently managed national monetary systems; these would be consistent with de facto exchange rate stability over long periods. But he also understood that this was not practical politics; so he set himself the lesser aim of trying to ensure that the return to gold was brought about with the least disruption possible to the British economy. His general line in 1924 was one of ‘wait and see’.”

Keynes was not against fixing the pound at its pre-war parity with the dollar if circumstances justified; but he argued that it should not be an object of policy and was especially opposed to a deliberate policy of deflation to bring it about.

And in his evidence to the Chamberlain-Bradbury Committee in July 1924, Keynes did not argue that no attempt be made to restore gold at the old parity but instead that, by waiting until US inflation boosted UK competitiveness, re-entry would be more sustainable and less painful. In answer to a direct question from Chamberlain he replied: “My own belief is that the policy I advocate – price stability – would almost certainly lead to a restoration of the parity of the sovereign, because I find it hard to believe that American prices will not rise in time, unless they do improbable things…”

But he did foreshadow what was to come, arguing that a return to parity at the present time would require “a drastic credit restriction” and in addition would raise export prices so “that in a great many cases … our export trade would be absolutely cut from under our feet for the time being.” This analysis was based on the fact that the sterling dollar exchange rate at the time stood at a lower rate of $4.44, eighty eight per cent of its pre-war parity. Keynes thought that deflation on a scale necessary to get back to a competitive exchange rate  “would prove socially and politically impossible.” McKenna made a similar point in his evidence; “The attempt to force prices down when you have a million unemployed is unthinkable.”

Yet, as Skidlesky concludes, Keynes evidence to Committee was “hardly a robust attack on restoring the gold standard.”  This was, of course, still the young Keynes  – twelve years before the publication of the General Theory and, with almost the entire economic and political establishment taking a different view. So the case for delay and for a different approach, which he argued vociferously in the period after 1925, was put more tentatively in the run-up to the decision.

The third reflection is that they did not base the decision on a proper economic assessment of the long run  economic consequences.

In his April Budget statement, Churchill claimed, “There has never been a step of this character taken by any government which, so far from being marked by undue precipitancy, has been more characterised by design, forethought, careful and laborious preparation”.

But this statement does not, with the benefit of hindsight, ring true.

Yes, there had been two public investigations before the decision was taken.

But the Cunliffe committee, heavily influenced by a City constituency, had taken the need to rejoin at the pre-war parity as a given. The only question was how quickly the parity could be restored – and the Committee concluded “without delay”. Questioning the entry level, the timing or the implications for interest rates and the wider conduct of economic policy was not part of the Committee’s discourse. And this imperative was reflected in the remit of the Chamberlain-Bradbury committee  – set up to advise Snowden on “when and how the final step [of joining the gold standard] should be taken”. This Committee, three of whose members also served on the Cunliffe committee, did not give serious consideration to returning to gold at a lower parity, let alone whether joining at the earliest opportunity was actually in the national economic interest.

The Cambridge historian of the period Donald Moggridge is scathing about the lack of a proper economic assessment on the basis of his analysis of the government documents of the period. “The ‘Norman conquest of $4.86′” (8) – he says, referring to the of Governor of the Bank of England Montagu Norman, “was ultimately an act of faith an incompletely understood adjustment mechanism, undertaken for largely moral reasons.” While the Chamberlain-Bradbury committee did recognise that there would be a need for some further adjustment in British prices relative to those in America, he argued that the “decision and the surrounding advice rested much more on beliefs than analysis”, in particular the belief that American inflation rather British deflation would make the pre-war parity competitive for British industry and exporters.

But behind the scenes in Whitehall, there was a real debate actively encouraged by the new Chancellor, Winston Churchill. Churchill was genuinely uncertain – evidenced by the famous agonising “Sunday morning reflections” memo that Churchill wrote to Niemeyer in February 1925.

In that memo Churchill worried that Keynes’ arguments had not been properly taken on board and that “The Governor allows himself to be perfectly happy in the spectacle of Britain possessing the finest credit in the world simultaneously with a million and quarter unemployed,” and concludes “I would rather see Finance less proud and Industry more content.”

Niemeyer replied at once.  The alternative to the return to Gold was, he argued, inflation; and with increasing inflation the credit of the country would be destroyed and money would “cease to be acceptable as value.” As inflation grew, wage demands would increase, and there would be grave industrial unrest. (9)

The final decision was made, according to Churchill’s Private Secretary P J  Grigg, at dinner at No 11 Downing Street on 17 March 1925, to which Churchill invited McKenna, Keynes, Niemeyer and Bradbury. Keynes made the case for delay, but, according to Grigg, he had an off night and lost the argument. And the dinner ended on a prophetic note. After Keynes faltering performance, Churchill concluded  ” … this isn’t entirely an economic matter; it is a political decision, for it involves proclaiming that we cannot, for the time being at any rate, complete the undertaking which we all proclaimed as necessary in 1918 and introduce legislation accordingly.” And then he turned to McKenna, the only other politician present, and asked him what decision he would take. McKenna, reading the writing on the wall, replied “There’s no escape; you have got to go back; but it will be hell.” (10)

The commitment had been made. There was no turning back.  

The fourth reflection is that, at the time, the government did not undertake a full economic analysis of the economic consequences including any short-term transitional issues so that the economic consequences were fully understood.

Because, with hindsight, for all the political commitment, and capital invested in the principle and politics of rejoining gold, the unsustainably strong exchange rate at which the sterling rejoined could not be sustained  – the prolonged periods of high interest rates and restrictive fiscal policy designed to deflate the price level and hold the parity took their toll on the wider economy.

Far from being in a fit state to re-enter the gold standard at its pre-war level, if anything, sterling needed to rejoin at a lower parity in real terms compared to 1914 in line with Britain’s reduced economic standing. Emerging from the First World War, Britain was a much weakened force in the international economy – forced to sell off many of its assets to finance the war effort, and with the structure of international trade and finance irredeemably changed, to Britain’s economic and political disadvantage.

But instead, because of the inflation of the immediate post war period, Sterling rejoined at a pre-war parity that, in real terms, meant that the sterling real exchange rate was overvalued relative to 1914. The result was depressed export growth from the early 1920s on, but also widespread deflationary pressure. As Milton Friedman and Anna Schwartz, in their 1963 Monetary History concluded, the “pre-war parity overvalued the pound by some 10% or so at the price level that prevailed in 1925… hence the successful return to gold at the pre-war parity required a further 10% deflation of domestic prices; the attempt to achieve further deflation produced instead stagflation and unemployment, from which Britain was unable to recover until it finally devalued the pound in 1931.”

Yet there is no evidence, from the historical record, that the risks to the economy of either the rate of entry or the need for high interest rates to achieve the necessary deflation to maintain the parity were analysed in any detail.  The emphasis is on long-term benefits plus an implicit belief that exchange rates once fixed were immutable.  Once this was accepted, the actual exchange rate chosen did not matter, for in the long run the system would adjust and adjust successfully. Other than Keynes and McKenna, no one really attempted to point out how long and difficult the short run might be.

It was not only the Treasury that underestimated the transitional costs. The Times business section in March 1925 wrote “the immediate effects may possibly be unpleasant, but it will tend to compel these readjustments that are necessary to restore our competitive power which otherwise might never be recovered”

But economic reality steadily became apparent as the decade progressed and the consequences of that 1925 decision – slower growth, dwindling reserves, pressure on the exchange rate parity – became steadily clearer. Keynes set the tone for the criticism that followed 1925, reprinting a series of articles written for the Nation and the Evening Standard in his ‘The Economic consequences of Mr Churchill.”

The pamphlet, written before the General Strike and coal miners strike, did not  – in line with his evidence to the Chamberlain-Bradbury committee argue “against the gold standard as such …[but] against having restored gold in conditions which required a substantial readjustment of all our money values.” But the rhetoric was now tougher. Churchill, he said, ‘was gravely misled by his experts.’ Sterling had joined the gold standard at about 10 per cent higher than price differentials warranted. Maintaining the parity required deflation. And “deflation … does not reduce wages automatically. It reduces them by causing unemployment.”

In retrospect, the historical verdict has nearly unanimously backed Keynes judgement of the time that the timing and manner of the return to the Gold Standard in 1925 was both mistaken and set off the chain of events which ended in ignominy for  British economic policy, the economic reputation of Churchill and his Permanent Secretary Otto Nieymeyer, and for the economic reputation of the government. For the economic crisis did not happen quickly. It was only six years later in 1931 that economic reality finally prevailed over political will and the inevitable devaluation finally occurred.

So having reflected on 1925 and the return to the Gold Standard, we conclude that the policy makers -politicians and Treasury officials alike – did not give proper priority to the economics; they made their decision from weakness rather than strength; and they never conducted a proper assessment of the long run and short term consequences of what they were proposing.  


The 1925 return to the Gold Standard ended in failure and devaluation. But it was not the last exchange rate crisis of the twentieth century – and judged by the process by which the decision was taken, it was far from being the worst.  For all their inadequacies, the Cunliffe and Chamberlain-Bradbury committees did produce reports before the decision was taken. No such analyses seemed to have been conducted in the comparable cases of the 1946 decision to adhere to the Bretton Woods agreement and peg sterling to the dollar – and subsequent devaluation; nor the 1964 decision by the incoming Wilson government to try to maintain the parity and the 1990 decision to enter the ERM.

The post-war government not only inherited an economy facing the challenge of readjustment to peacetime, it also inherited a commitment to rejoin the gold-backed standard at its  – now overvalued – pre-war parity. The Bretton Woods agreement of 1944 committed Britain, in broad terms, to a regime of stable (but not unchangeable) exchange rates and to the abolition of exchange controls. But as Lord Skidelsky highlights, a little noticed amendment to Article IV (section 1) of the Bretton Woods agreement laid down that par values of currencies should be expressed in terms of gold ‘or in terms of the US dollar of the weight and fineness in effect on 1 July 1944.’ (11) Hence the pound-dollar exchange rate was fixed at $4.03, the rate at which it had been pegged at the beginning of the Second World War.

Commitment to the pre-war parity was part of the Bretton Woods agreement. The policy failure was the subsequent political decision to resist, in the face of economic reality and US pressure, the case for devaluation. By 1949, with the exchange rate under pressure and reserves dwindling, Chancellor Stafford Cripps was warning Cabinet’s Economic Policy Committee (EPC) that: “within twelve months all our reserves will be gone … there might well be a complete collapse of sterling” (12) while in public he was telling the House of Commons “the Government has not the slightest intention of devaluing the pound.”

Just as Churchill had no alternative route to credibility other than to enter at the pre-war parity and just as the new Labour government in 1929 had no choice but to stick doggedly to it, Cripps neither had – nor allowed himself – an alternative route to credibility other than to make the same mistake. And while – assisted by the recently nationalised Bank of England – he did propose modest deflationary measures, much to the dismay of his Cabinet colleagues, Cripps knew that, while doing more would have been economically and politically highly damaging, these measures were not fit to the task of resisting what ultimately became a 30 per cent devaluation.

These first two observations – to let politics dominate the decision with no credible alternative route to stability – applied equally in the 1960s too. The economic situation in 1964, without the comfort of wartime controls, was if anything more pressing with demand accelerating and the deficit on the current account the highest since the immediate post war period. But the new Prime Minister Harold Wilson, scarred by his own experience of the 1949 devaluation, had learned, in retrospect, precisely the wrong lesson  – he was determined not to make the same mistake again and take “the easy way out” through devaluation. So, and against the advice of many though not all the government’s economic advisers, the new Government took a firm decision against devaluation the day after the election results were announced.  So “Harold Wilson (the Prime Minister), James Callaghan (the Chancellor) and George Brown (the Secretary of State for Economic Affairs) met at Number 10, and as William Armstrong (Permanent Secretary at the Treasury) recalls, “the devaluation decision was over in a flash – on Friday night.  There was no great debate.  Bang, it was done.” (13)

As in 1925 and 1946-49, so in 1964-67  – the third observation – the authorities did not make a proper analysis of the long-term economic consequences of the decision being taken. As Cairncross observes of 1967  “like Stafford Cripps in 1949, he [Wilson] had ruled out the possibility of devaluation without taking stock of the economic arguments for and against. From October 1964 onwards, no position paper setting out these arguments was ever asked for by ministers.”

And Caircross goes on to observe of the 1967 decision, “the debate in Whitehall was dominated by short-run considerations when it was arguable that the decisive favours were long term.”  He argues that that “there does not seem to have been a careful weighing of the pros and cons [of devaluation] by officials, much less at a meeting of ministers … [that] it was largely a matter of accident that $2.80 rather than $3.00 to the pound was the rate selected.”  Cairncross also note that “the significance of getting other countries to move simultaneously was rarely stressed … [and] the measures to accompany devaluation were considered separately and almost as an afterthought.”

So in both 1949 and 1967, the fourth historical reflection again applies  – in both cases, the consequences of the powerful short-term economic forces at work – unsustainable demand, diminishing reserves – were not appreciated early enough and acted upon decisively. Typical of the commentary of 1949, The Economist called the devaluation “no more than a confession of defeat by the Government” and said  “Ministers and the majority of their official advisers have been uncommonly stubborn in their refusal to face facts.”

Eighteen years later, the Economist produced an almost identical article writing that “…it was the inexorable pressure of facts alone that caused Mr Wilson and Mr Callaghan to eat so many of their past words; any dangers that now beset Britain … arise from the fact that their meal was in unconscionably delayed.” (14)


In the end, while the ignominy of devaluation, the loss of credibility and the savagery of newspaper commentary was similar in both cases, the biggest difference was the speed at which events took their toll. In 29 July 1949, with Cripps convalescing from illness in a Swiss sanatorium, the Cabinet met to decide that devaluation was necessary. Attlee then decided to write a letter to Cripps and dispatched Wilson, who was set to holiday nearby, to deliver it. Cripps insisted that no decision be made until he returned to London, which he did on August 18th and argued unsuccessfully for delay. The Cabinet confirmed its earlier decision on 29th August but the devaluation was not enacted until 18th September, nearly two months after the first Cabinet decision. By 1967, with deeper capital markets and fewer controls, events moved faster with just days to enact the decision to devalue and begin the slow process of once more rebuilding the credibility of British economic policy.

But twenty-five years later, with modern capital markets, new technology, and the abolition of all exchange controls, what took months in 1949 and days in 1967 took a matter of hours on September 16th 1992.

I am not tonight going to go through in great detail events which are both recent and I am sure familiar  – as well as chronicled by Philip Stephens.

But the four reflections on decision-making in the 1920s, 40s and 60s are also relevant to 1990.

With no comprehensive assessment of the economics ever conducted, politics again dominated economics on the timing and manner of the key decision, leading first to the decision to join the ERM being delayed and then being taken at the wrong time. Indeed, what began as a debate and then a row about economic policy and the policy of shadowing the D-Mark became by the summer of 1989 a row also about European policy and a demand for a political timetable for ERM entry.

At the June 1989 Madrid European Summit Margaret Thatcher came under pressure from the Chancellor Nigel Lawson and Geoffrey Howe, the Foreign Secretary, to announce a firm date for British membership of the ERM. But Mrs Thatcher refused to agree a date for entry. (15) The compromise was that the decision was to be made once certain economic conditions – the Madrid conditions – had been met, although different people had different views of what they actually were. It did not matter – the Madrid conditions were not met at the time of UK entry.

Although, for Nigel Lawson, ERM membership was primarily a route to domestic stability and not a stepping stone to monetary union, he did refer to wider political considerations in his resignation speech later in 1989: “Full United Kingdom membership of the EMS … would signally enhance the credibility our anti-inflationary resolve in general and the role of exchange rate discipline in particular and thus underpin the medium-term financial strategy… there is also a vital political dimension … I have little doubt that we [Britain] will not be able to exert … influence effectively and successfully provide … leadership, as long as we remain outside the EMS. So for economic and political reasons alike, it is important we seek the earliest practicable time to join.” (16)

As Nigel Lawson’s replacement as Chancellor, John Major, records in his memoirs, “Both the Foreign secretary Douglas Hurd and I were repeatedly pressed to join by our European partners. Their pleas echoed concerns about the domination of the Deutschmark. Bonn and Paris were seen as too close…and sterling’s entry into the ERM would weaken this domination.”  Recording a meeting with the Prime Minister in March 1990 on the forthcoming December IGC on EMU, ” at which many propositions unpalatable to Britain would be discussed”, he records “Our exclusion from the ERM was making us bystanders in this debate.”

In the end, as the clamour for ERM entry grew through 1990, Margaret Thatcher records that she lost the political argument. “Only at my meeting with John Major, on Wednesday 13 June did I eventually say that I would not resist joining the ERM…Although the terms I had laid out had not been fully met, I had too few allies left to resist and win the day.” (17)

Second, in 1990, the decision was again taken from a position of weakness rather than strength, with seemingly no credible alternative route to stability available. With the collapse of the Medium Term Financial Strategy, the failure of money targeting, the contradictions of Lawson exchange rate targeting and by 1990 inflation in double figures again, the credibility of policy was badly damaged and the search was on a for a credible nominal anchor for policy which the ERM appeared to provide.

Nigel Lawson’s memoirs record that he did propose central bank independence as a means of buttressing the ERM commitment – but the Prime Minister would not agree. John Major records that he considered a number of options aside from joining the ERM, (credit controls, tighter fiscal stance, inflation targeting), but decided that membership offered the best anchor for the government’s economic policy: “…had there been another route open to us, endorsed as ERM membership was, by business groups and commentators, I would have been delighted.  But there was not … we had to bring down inflation … the ERM, with its emphasis on exchange rate stability, was no panacea, but it looked to me like the best – if not the only way forward.”

John Major also noted that while “Margaret [Thatcher] shied away from it [ERM] … neither she nor anyone else was putting forward a serious alternative course of action.” (18)

It was this lack of a credible alternative at the time that led the CBI to welcome the decision to join saying “it was delighted by both moves [the interest rate cut and joining the ERM] …joining the ERM would bring much greater predictability for UK businesses in quoting for export orders … [and] would help sustain business confidence in a difficult economic climate.” And there was positive press reaction. The FT described the decision as “both politically and economically shrewdly timed.” The paper noted that, in reference to the Madrid Conditions:  “It was impossible for sterling to enter the ERM in the near future, after having achieved convergence of underlying inflation upon rates in major ERM countries.  Entry has to be a way to achieve that convergence.” (19)

The Times was more cautious presenting the decision as a triumph of politics over economics warning that “Britain is once again flying by the seat of its pants. ” (20) And William Keegan, in the ‘Observer’, actually foresaw the future devaluation, writing a week after entry:  “I cannot for one moment believe that the exchange rate will hold for more than two years, and advise the Labour Party and Thatcher’s potential successors to be wary of making commitments that they will be unlikely to honour.” (21)

Third, while the full papers from the period have, of course, yet to be published, there is little to suggest, from the evidence so far, that there was a proper economic assessment either of the long-term economic consequences – the likelihood that the ERM would deliver stability, the economic consequences of German unification, the sustainability of the real exchange rate, the ability of the UK economy to live with high interest rates.

Indeed, as John Major records in his memoirs, the timing of entry was partly shaped by uncertainty over the likely course of the Gulf war. ” [In August 1990] it seemed to be that much depended on how things turned out in the Gulf. If it became a long drawn-out affair, then the case for early ERM entry was strong, since we would be better placed to handle turbulence within the protection of the mechanism than our own. But if the war was to be short I felt we would be right to stay out until it ended, Margaret agreed: since there was no immediate solution in sight, the crisis in the Gulf would not stop us joining, and we were back on course.”

And fourth, with hindsight, once more a British government underestimated the short-term transitional costs of their decision. Progressively, as the months passed by, the reality of the decision became apparent. GDP dropped in real terms by almost 2 per cent between the first and second halves of 1990. House prices collapsed and manufacturing output fell by 5% within 9 months. Excluding North Sea oil national output fell for 7 successive quarters between the summer of 1990 and spring 1992. Unemployment increased from 1.6 million in mid 1990 to 2.6 million in early 1992.

As Phillip Stephens,  – all too aware of the parallels with the past – concludes in his history of the period that:  “The most important error … was the elevation of the exchange rate parity into a badge of pride…. ensuring that when defeat came it was devastating….. By 1992 the exchange rate had once again become an end of policy rather than a means.” (22)

And we have determined to learn from the 1990 mistake too  – as the Prime Minster Tony Blair made clear when questioned about the Euro during last year’s General Election Campaign: “In principle, I believe it is the right thing for Britain. But in practice, we must not repeat the mistakes of the Exchange Rate Mechanism and join under the wrong economic conditions.”


I said at the start that we have taken these historical reflections on board in our approach to the decision on the Euro as set out in the Chancellor’s statement to the House of Commons in October 1997. Let me repeat again:

First, the principle. In contrast with the de-facto commitment already made in 1918 to rejoin the Gold standard, in 1997 a clear principle was established. As the Chancellor said in his 2001 Mansion House speech, “British membership of a successful single currency offers us obvious benefits – in terms of trade, transparency, costs and currency stability. And membership of a successful single currency could help us create the conditions for higher and more productive investment and greater trade and business in Europe.”

Second, joining the Euro has constitutional implications, but there need be no constitutional bar, so long as the economic case is clear and unambiguous.

Third, the basis for this decision as to whether there is a clear and unambiguous economic case is the Treasury’s detailed assessment of the five economic tests.

And fourth, if on the basis of that assessment a decision to recommend joining is taken by the Government, that decision would then be put to a vote in Parliament and then to a referendum of the British people.

The decision about the Euro is, of course, materially different to these historic experiences. The Euro is a permanent monetary union, not a fixed or semi-fixed exchange rate regime. It does not, therefore, suffer from the same pressures that can undermine such fixed exchange rates systems – real or speculative pressures that have plagued British economic policy so often in the past. In a monetary union, convergence will, in the end, be realised. In principle, countries can choose whether they converge from the inside or before they join based on assessing the balance of benefits, costs and risks of the options. But for Britain – a large open economy with a history of instability, the Chancellor’s 1997 statement says that to meet the first test “convergence must be capable of being sustained and likely to be sustained – in other words, we must demonstrate a settled period of convergence.”

But still, with this important caveat in mind, let me show how, in designing this approach to the Euro decision, we have reflected on these past historical events in order, this time, to get it right.

First, the 1997 statement set out the principled case for membership of the Euro but ensured economics  – and the judgement as to whether the economic case is clear and unambiguous – set the timetable and determine whether we join. As the Chancellor said in his 2002 Mansion House speech, “If the tests are met then I believe we should join.  If the tests are not met, we should not.  The tests are decisive.  There is no hidden agenda: only a resolution to make the right long term decisions for Britain in the national economic interest.”

So we did not in 1997 repeat the historic mistake  – particularly from 1925 and 1990 – of setting a political timetable for entry, and then anchoring the government’s credibility in the decision coming out a particular way, thereby prejudging the economic assessment.

As the Prime Minister said in his Warsaw speech in 2000, “Joining prematurely simply on political grounds, without the economic conditions being right, would be a mistake. Hence our position: in principle in favour; in practice the economic tests must be met. We cannot and will not take risks with Britain’s economic strength. The principle is real, the tests are real.”

Second, we have used the period since the 1997 decision to establish a credible platform of economic stability for Britain based on clear long term goals, clear procedural rules and maximum openness and transparency. From the outset – with independence of the Bank of England and the government’s new fiscal framework – we have set out to ensure that the decision on entry to the Euro is made from a position of economic strength and not weakness.

So – unlike too often in the past where past governments made a decision on a political timetable to make or maintain a fixed or semi-fixed exchange rate as the only available route to stability and credibility – this time we can make the choice on the basis of the national economic interest.

Third, the commitment to the five tests assessment ensures that the decision will be made on the basis of a comprehensive and rigorous assessment of the long-term economic case – an assessment which will be published in full when the government makes its recommendations.

As the Chancellor said in his Mansion House speech, “To join without a proper, full assessment of the five tests could, in my view, prejudice our stability, risk repeating past failures of exchange rate management, and could return us to the days of stop-go at the expense of our ambitions for high investment, full employment and high and sustained levels of growth.”

With at least fourteen supporting studies to be published alongside the main assessment, the scope of the technical and preliminary work sets out both the scale and the range of issues which will be examined in the assessment and subject to intensive public scrutiny and debate.

Central to the assessment is an analysis of the long-term gains and the importance of achieving sustainable and durable convergence. As the Mansion House speech and Treasury’s note to the Treasury Select Committee made clear, the preliminary work in this area includes our study of the output gap, inflation, interest rates and the real effective exchange rate, housing and consumption and adjustment mechanisms as we analyse not just short term cyclical factors but also long term structural issues to assess whether convergence is sustainable and durable.

As the Financial Times commentator Martin Wolf wrote recently, “Never can the British Government have made a comparably detailed analysis of any policy decision.” (23)

And fourth the five tests assessment also ensures, with a full economic analysis of the economic consequences including any short-term transitional issues, that the economic consequences are fully understood.

It is because we have given proper weight to economics, are approaching the decisions we have to make from strength not weakness, and are conducting a proper assessment of the long run and of the short-term consequences that we can make the right decision 

The observation I make is not that it is wrong to make commitments – political commitments, principled commitments – but that decision requires a proper assessment of the long-term economic case and the short-term transition. Getting the politics right demands that we get the economics right. So the right conclusion is the basis on which the government is proceeding: that it makes sense to commit to joining in principle, but the practical decision requires the hard and detailed work we are doing.


This then is the case for the five economic tests and the government’s considered and cautious approach to the single currency  – what the Chancellor has called Pro-Euro realism:

“Pro-Euro  – because, as we said in 1997, we believe that -in principle – membership of the Euro can bring benefits to Britain.

Realist because to short-cut or fudge the assessment, and to join in the wrong way or on the wrong basis without rigorously ensuring the tests are met, would not be in the national interest.”

Some find it easy to dismiss the significance of the five tests – and the idea that economic analysis can genuinely shape historic policy decisions in advance. And of course, as contemporary historians will record, it is not always easy to raise issues of policy and long-term analysis above the din of contemporary politics.

But the reason why the five tests are so important is because they ensure that a proper and long term economic assessment of the national economic interest will precede an irreversible decision of great long-term economic and therefore political significance. As Prime Minister Tony Blair has said “they are not window dressing for political appearances”

 That is why it is essential that the government is held to account for the rigour of the analysis and soundness of that assessment of the national economic interest and by the judgements of, first contemporary, historians in the years to come.

Historians understand this. And Sir Alec Cairncross understood this too. I hope – given his emphasis on theory, history and the close relationship between economics and politics – he would think we were approaching the decision in the right way.  And if he was asked tonight to pre-judge the five tests assessment and say whether we should join, my guess is that he would say he first wanted to examine the results of the assessment and the Treasury’s technical and preliminary work

In the past this was not possible because, as Sir Alec reflected in that 1996 essay, past decisions were not made “as a result of a careful assessment of the pros and cons and a review of the likely consequences”. This time we are doing that careful economic assessment of the pros and cons. That is why we have the five economic tests.

Thank you.