In his first real gamble as U.K. prime minister,

Tony Blair

last week launched a currency changeover plan that could make it possible for Britain to adopt the euro as early as 2004.

Readying Britain's economy, and its equally unpredictable people, for the changeover will not be easy -- even for a polished populist like Blair. Polls show that the public is still opposed to entering the eurozone by a significant margin.

Any sign that the U.K. is not willing to fit into the prime minister's tidy timetable would rock the country's markets. And it could even cause the sort of upheaval that accompanied the pound's ejection in 1992 from the

Exchange Rate Mechanism

, or ERM, the precursor to the European single currency.

The changeover plan envisions Britain abolishing sterling a mere three years after gaining approval in a referendum, which would likely be held soon after the next general election. The governing

Labour Party

, which Blair leads, is expected to call the election in 2001 -- and opinion polls currently suggest it will win hands down. The leadership of the

Conservative Party

opposes the changeover plan.

Pounding Ahead

In four years, Blair needs sterling, inflation and interest rates to be at levels that would ensure a smooth transition to the euro. But setting all three to desired levels is the economic equivalent of having one's cake and eating it, too. Or -- like the British monarch -- celebrating two birthdays every year.

Any country aiming to adopt the euro must see its interest rates converge with the key interest rate in euroland. In addition, before joining, its currency should trade at a consistently stable exchange rate vs. the euro for a period of two years or more.

How easy is that? If, in the run-up to Britain's joining the eurozone, rates are rapidly reduced, this could put upward pressure on inflation.

If so, the

Bank of England

, given a substantial amount of independence by the Blair government, would want to

raise

rates in order to secure its inflation target, currently 2.5% per year.

This possible tension was not lost on the Bank of England last week. Its governor, Eddie George, told a

House of Commons

committee that adopting the euro could create "a potential conflict" with the Bank of England's attempts to meet its inflation target.

The City of London is clear on this point, too. "Until the mandate of the MPC

Monetary Policy Committee of the Bank of England is changed, it will set rates to meet the inflation target, regardless of whether that widens the gap with Europe," says Peter Warburton, adviser on U.K. economics to

Flemings

in London.

Blair and Gordon Brown, the chancellor of the

Exchequer

, might not want to rush things; doing so could backfire in the same way it did in the late '80s under

Margaret Thatcher's

finance minister,

Nigel Lawson

.

The ERM Nightmare -- Again?

In his bid to get the pound into the ERM, Lawson caused a blowout in inflation by keeping rates and the pound too low. The subsequent policy response caused the U.K. to enter the ERM at too high an exchange rate. Overly high interest rates were needed to defend this level. These caused a deep recession that sapped the government's will to keep defending the pound.

George Soros

sensed a weakening in the government's resolve -- and, in a now-legendary move, bet that the pound would be taken out of the ERM, which, of course, it was.

With that ugly train of events still very much in people's minds, it seems unlikely that Blair would risk moving too fast. However, he and Brown, drunk on euro-enthusiasm, may make mistakes similar to those made by Lawson, who, until the ERM debacle, was thought too clever to try and defy the markets.

But euroskeptics should be careful not to draw too many parallels between now and the late '80s. The economic winds are now more favorable for a British entry into the eurozone.

The differences between the U.K.'s economic conditions and Europe's are much smaller this time around. Currently, the British key short rate is 5.5%, vs. the eurozone's 3%. The year-on-year harmonized U.K. inflation rate, the measure used for comparisons between EU countries, was 1.6% at the end of December, against 0.8% for euroland as a whole.

But will this closeness still exist in two or three years' time? Perhaps not. Yes, the Bank of England and most private-sector economists expect inflation to stay subdued over the next two years. But inflationary pressure is predicted to start picking up around 2001, just as debate over British entry heats up. And if this week's big drop in U.K. bond prices is a sign that the market thinks inflation is not such a distant threat anymore, then the Bank of England may have to hike rates much earlier than expected.

Bashing Brussels

Then Blair has to tackle the politics of joining the euro. A recent poll for

The Guardian

newspaper found that 52% of the respondents would vote against the euro in a referendum, with 36% voting "yes" and 12% registering as "don't knows."

British businesses are not sold on the idea, either. Fifty-five percent of all medium-sized and small businesses recently polled by

The Sunday Telegraph

said they wanted to "wait and see" how the euro did before supporting British membership. Just under 20% objected to the euro, while 26% were in favor of joining.

Of course, Blair, a formidable communicator, is hoping to use the next few years to woo Britain out of its euroskepticism.

But he'll have to contend with the British media. While they are not as uniformly euroskeptical as some believe, they love to ridicule Brussels when EU leaders do controversial things -- like recently pressing for EU-wide harmonization of certain taxes. Unfortunately for Blair, the EU is likely to come up with lampoonable plans for further integration that will only serve to confirm British fears that Brussels wants more and more power.

At a June summit in Cologne, EU leaders are expected to announce the first step toward European political union. These measures will require national parliaments or governments to hand over certain decision-making powers to EU institutions. It's not clear how far-reaching they'll be in the early stages. But the German government wants to have a full-fledged EU treaty on political integration ready for an intergovernmental conference in 2001 -- the most likely year of the U.K. election. If the EU comes up with an aggressive set of political measures, then Blair could be forced on the defensive by a euroskeptical Conservative Party.

European politics have toppled many a postwar prime minister. Blair may be no exception.