Ten years after Gordon Brown decided the UK should stay outside the eurozone, imagine the alternative scenario …
A bigger boom, a bigger bust, no more euro ... and Nigel Farage in No. 10? Photograph: Corbis
Ten years ago this week, it was euro crunch time for Britain. Gordon Brown had promised an assessment of whether the UK met his five tests for entry into the single currency within two years of the 2001 election. He met the deadline almost to the day.
The conclusion was never really in doubt. Brown did not think the UK should join the single currency and the Treasury analysis provided him with strong arguments to fend off the much more enthusiastic Tony Blair.
Four of the five tests, including the two most important ones involving sustainable convergence and economic flexibility to withstand shocks, were failed. And that was that. Pro-euro cabinet members such as Charles Clarke and Patricia Hewitt grumbled that the decision had been a Treasury stitchup, but Brown's position was unassailable. Euro membership was off the agenda for the foreseeable future.
A jolly good thing too, of course. The euro has proved to be exactly the job-destroying, recession-creating, undemocratic monster the doubters always warned it would be. This was not the received wisdom on the left at the time, when to suggest that the euro would be supercharged monetarism, Thatcherism with knobs on, was deemed unseemly. People who liked the euro were civilised, supported the arts, went to Tuscany or the Dordogne for their holidays. People who didn't like the euro drove white vans decorated with the flag of St George.
Today, it is hard to find even the most fervent euro enthusiasts in the Liberal Democrat party arguing for UK membership of the single currency. Disillusionment with what was once called "the Project" is almost total in the face of grinding austerity, a double-dip recession that has already lasted 18 months and a jobless rate of 12.2% and rising.
Imagine for a moment that Nick Clegg, Ken Clarke and Tony Blair had triumphed back in 2003. Let's do one of Niall Ferguson's virtual history exercises and think through what would have happened had Brown been overruled and UK entry into the single currency fixed for 2005.
Stage one would have been the transition from the pound to the euro. The most important part of this process, to fix the right level for the pound to join at, proved quite a test for the new chancellor, Charles Clarke, the man chosen by Blair to replace Brown, who was now sitting on Labour's backbenches.
Sterling had already been overvalued in the early 2000s, with hot money attracted into London by a combination of relative high interest rates and a prolonged period of strong growth. The UK government feared that joining the euro at the wrong rate would penalise British manufacturers, while those already in the single currency were concerned that too cheap a rate for sterling entry would hand an added competitive advantage to the UK's strong financial services sector. Despite attempts by the new governor of the Bank of England, Mervyn King, to drive down the level of the pound, when the time came for the euro to be adopted it was clear that the exchange rate was too high. That, said Britain's new partners in the single currency, was the penalty paid for failing to join from the outset.
Stage two of the process would have been the bubble phase. Having ceded the right to conduct its own monetary policy, the UK had to accept the interest rate the European Central Bank (ECB) set for the eurozone as a whole. As one of the bigger members of the club, Britain carried weight at the discussions in Frankfurt, but monetary policy proved to be far too loose for a country already in the early stages of a housing boom and where the balance of trade was deteriorating year by year.
As in Spain and Ireland, a spectacular bubble developed in the housing market, fuelled by excessively low lending rates, an "anything goes" mentality among lenders and lax regulation. Even outside the euro, the UK had quite a boom going in the housing market in the mid-2000s. Inside, it would have been like the wild west.
When the crash came in 2007 it was a spectacular one. The financial markets imploded, the banks stopped lending and cheap credit dried up. The housing market collapsed, unemployment rose, tax receipts shrivelled and the government's budget deficit went through the roof. Speculation that the UK might leave the euro, as it had left the European exchange rate mechanism in 1992, meant investors demanded a high premium for holding UK government debt. Benchmark bond yields rose, first to 5%, then to 6%. When they hit 7%, Blair had no choice but to ask for help from the troika – the International Monetary Fund, the ECB and the EU.
Severe conditions were attached to the loan, the biggest the IMF had ever organised, including deep cuts in welfare and pensions and wage reductions across the public sector. Deprived of the safety valve of currency depreciation, Britain had no choice but to do what Spain, Greece, Ireland and Portugal were doing and drive down domestic costs to make the economy more competitive.
Unlike in Spain, Greece, Ireland and Portugal, however, there was no deep attachment in Britain to Europe as a political identity. Far from it. As a result, the buildup to the general election of 2010 was marked by street protests even more widespread and angry than the poll tax riots of 1990. The opposition Conservative party went into the campaign pledging a referendum on whether Britain should leave the euro and won by a landslide. The number of Labour MPs fell to under 100, its worst performance since the 1930s. Nigel Farage's UK Independence party made spectacular gains.
In the referendum that followed the election, the vote was overwhelmingly in favour of exit. The financial markets responded by selling the bonds of any other eurozone country struggling to cope with the rigours of austerity programmes demanded by the European commission in Brussels and the ECB in Frankfurt. By then, that meant pretty much every country apart from a hard core that included Germany, Austria and Finland.
The market turbulence caused by Britain's exit proved terminal for the euro. Bond yields rose sharply across the single currency as investors realised they had underpriced the risks of a country leaving the club. Outside the euro, life was not exactly a bed of roses for the UK, but after a deep and painful recession economic recovery began.
That, in short, is what would have happened had Blair won and Brown lost in 2003. The boom would have been bigger and so would the bust. Britain would have destroyed the euro on departure, and would now be on the point of leaving the EU altogether. The idea that Farage might be the next prime minister would be quite credible.