EURO-X: A POLITICAL COUNTER-WEIGHT?

  64.    Mr George said there were some people who thought of Euro-X[14] as a political counter-weight to the ECB not in the sense that the members of Euro-X could run an alternative fiscal policy in the euro zone: they could not because they were all signed up to and bound by The Stability and Growth Pact[15], ("the stability pact"). The thought, rather, was that Euro-X might seek to exert pressure on the ECB to run a looser monetary policy than it might otherwise choose. He thought that the Treaty provisions for the protection of the independence of the ECB would ensure that any such attempt did not succeed (Q 56).

  65.    Herr von Wogau doubted whether Euro-X would be of lasting interest to the Finance Ministers who would find themselves repeating many of its discussions in Ecofin. He saw it more as a fig-leaf to solve "a certain problem"[16] (Q 161).

  66.    Mr Monks said that in the argument about the role of Euro-X the TUC had been more on the French side than the German side. The TUC wanted to see Euro-X as "a very important player", under the stability pact (Q 184). He saw the relationship between the ECB and Euro-X as "a rather creative mix". He would have liked the United Kingdom to be a member at the beginning when these relationships were being sorted out (Q 184). He accepted that Euro-X would not, by itself, be sufficient to promote employment but he noted that the Luxembourg Jobs Summit was giving a new impetus to the mechanisms of job creation in the EU (QQ 186-187).

COORDINATION OF ECONOMIC POLICY: MULTILATERAL SURVEILLANCE AND THREE POLICY ELEMENTS

Multilateral surveillance

  67.    Commissioner de Silguy reminded us that Article 103 of the Treaty required Member States of the Union to regard their economic policies "as a matter of common concern". Multi-lateral surveillance of each Member State's economic policy was a well-established practice. Each year the Commission proposed broad guidelines of the economic policies of the Member States and of the Community for adoption by Ecofin[17]. If a Member State deviated from the guidelines the Commission would draw the matter to the attention of the Council which may make a recommendation to the Member state concerned and may, acting by a qualified majority on a recommendation from the Commission, make its recommendations public. This multi-lateral surveillance applied to all Member States. Those within the euro zone were subject to the further discipline of the stability pact under which they were, ultimately, liable to financial sanctions which could be imposed by the Council (Q 130).

Three policy elements

  68.    Mr Turner drew an important distinction between two elements of fiscal policy and coordination which are sometimes not clearly and separately identified. One element, he said, was the national budget deficit or surplus. This element is to be constrained in the euro zone countries by the stability pact which limits national deficits and provides for deterrent financial penalties if the limits are broken other than in exceptional circumstances. The other and conceptually separate element, he said, was the harmonisation of tax policies and rates. While EMU was intended to affect the first element he saw the second as subject to different influences. The greater transparency of prices brought about by the single currency would, beneficially, increase competition and would, he said, stimulate market forces which might tend to reduce tax rate differentials although he noted that in the United States the sales tax rates and regimes continued to differ from State to State (Q 416). The immediately following paragraphs are concerned primarily with the first element of fiscal policy—the budgetary balance.

  69.    Sir Nigel Wicks took the view that the smooth functioning of the single currency would require a satisfactory mix between fiscal and monetary policy. He added that for these two policy elements to combine well there was a need to have a third—an efficient supply side (QQ 90, 102). He pointed out that all the Member States that wanted to join EMU had over the last few years moved their fiscal policies in the same direction: there had been a convergence of fiscal policy as a result of which eleven of the applicants had fiscal deficits of 3 per cent of GDP or less. The important question for him was whether this fiscal convergence could continue in a way which was conducive to the smooth functioning of the monetary union. The stability pact was intended to put some control on national deficits while still leaving some scope for automatic stabilisers to work: the national medium-term objective of fiscal balance or close to balance which had been accepted by the European Council would leave scope for a fiscal deficit of three per cent if the economy required that. Indeed, the stability pact allowed, in certain circumstances, a deficit in temporary excess of three per cent. This, he thought, made it possible for national fiscal policy to be tailored to the local economic conditions (QQ 91, 102). He accepted that in the monetary union, where there was a single monetary policy and where budget deficits were subject to the framework of the stability pact, the importance of a "flexible and subtle" supply side response was underlined (Q 102).

  70.    Mr Volcker pointed out forcibly that the idea that in the United States, or in Japan, there had been effective coordination between fiscal and monetary policy was wrong. The political situation had been generally confused. He added that in the United Kingdom, until the recent arrangements for operational independence of the Bank of England were brought in, there had been institutional arrangements that theoretically ensured coordination, but "they did not necessarily ensure a better policy result" (Q 439). Mr Gordon Brown made the same point by saying "when one person was responsible for monetary and fiscal policy in the United Kingdom it was not a system that, despite what might seem to be great and obvious coordination, worked to best effect" (Q 515).

  71.    Mr George thought that the coordination of monetary policy, in the hands of the ECB, and fiscal policy, in the hands of national authorities, could certainly be made to work in EMU. He saw the stability pact as a constraint on individual countries and, therefore, on the overall budgetary deficit position. He thought the pact was a realistic way of addressing the current position in Europe where there was no single fiscal authority across the Union (Q 54).

The stability pact: policy on budget deficits

  72.    The stability pact is the chosen mechanism in the euro zone for the restraint of national budget deficits. The key questions about this mechanism, we thought, were posed by Professor Goodhart who asked himself, in the initial years of the operation of the ESCB, "How will the stability pact work? Will it be accepted? Will it put undue pressures on the conditions in individual countries?" His less than re-assuring answer was "we do not know" (Q 16). Other witnesses, whose views are given in the following paragraphs, were less firmly agnostic.

  73.    Mr Gordon Brown said there was a genuine determination on the part of Member States to pursue policies of fiscal stability. Governments had learned that if economic policy was not built from a platform of both monetary and fiscal stability the reaction in the capital markets would be such, and the penalties so great, that the government's economic policy would be in danger. There was, therefore, "an intellectual commitment to monetary and fiscal stability" that had developed over the years (Q 498). Asked whether there had really been a change of heart by politicians towards running up large budget deficits, Sir Nigel Wicks asserted that over the last decade there had been a profound change of attitude to fiscal policy in all the G7 and OECD countries. No longer was it thought that there was no need to worry about deficits of 4 or 5 per cent—that "growth and a bit of inflation would look after that". Politicians had realised that they did not win many votes by going to the electorate and saying "My fastest expanding programme is government debt interest". Sir Nigel thought that "the spirit of the age" was pointing Member States towards responsible policies and that the process of striving to meet the Maastricht convergence criteria had helped.

  74.    Herr Regling said that even politicians who thought in terms of electoral cycles and not as long-term economists realised that the debt levels of the last twenty years could not continue. The world was not as it had been in the 1960s when countries started with low debt levels, a young population and a belief that running big deficits could do a lot of good for the economy. All this had changed: there were higher levels of national debt and ageing populations. He thought the commitment at the conclusion of the stability pact "to respect the medium-term budgetary objective of close to balance or in surplus" was a wise one. He would not be worried at all if it happened sooner rather than later (Q 317).

  75.    Commissioner de Silguy appeared to encapsulate the views common to the Finance Ministries when he said that "these days in Europe you really have what we might describe as a stability culture" (Q 131).

  76.    As an example of a country with a budgetary performance transformed from what it had been, Sir Nigel Wicks cited Italy: the country was now running a primary surplus (revenue higher than spending, excluding debt interest payments) of 6 per cent or so and had been running a similarly good primary surplus for the last few years (Q 110). He drew a distinction between the effect in the future of a high debt to GDP ratio and a high deficit ratio. He said that the debt ratios of themselves would not affect monetary conditions whereas high deficit ratios would: this was the justification for the stability pact which would operate in EMU (Q 112). He saw a different justification for the inclusion of a debt ratio in the convergence criteria: it was thought by those who drafted the Treaty that it would put pressure on a Member State to avoid getting into a position where it would find it difficult to service its debt. This criterion was seen as supporting the no-bail out provisions in the Treaty[18] which prohibited the Community or a Member State from assuming the commitments of a third Member State or its public authorities (Q 112-113).

  77.    Sir Nigel Wicks said that market pressures in the direction of sound fiscal and monetary policy would still be in place after the start of Stage 3 of EMU on 1 January 1999: they were not simply a product of the strong political wish to meet the convergence criteria and qualify for entry to Stage 3. Politicians had also appreciated that a poor fiscal position curtailed their ability to take fiscal action when it was desirable: they were at the mercy of the international financial markets. If, however, a country was running an excessive deficit, this would not be a matter for the ECB but for the Council (QQ 103-105, 122). Dr Duisenberg agreed and said that where a country was found to have an excessive deficit, he expected the ECB to do nothing "except exert peer pressure" on the country concerned (Q 205).

  78.    Sir Nigel Wicks saw more drastic consequences following an excessive deficit: he said he would expect a country displaying "unneighbourly fiscal behaviour" to be subject to a "very considerable amount of political and other pressures to follow the requirements of the stability pact". Some of this dialogue would be in private but some could be in public. Discipline would be exerted by the rest of the Council members who would not wish the pressure on resources in the errant Member State to be allowed to spill over into their own countries. M Trichet, Governor of the Banque de France, said that small countries would be particularly eager to exert discipline over a large country because the spill-over effect would be greater the bigger the country (Q 473). Sir Nigel thought that any Member State which refused to honour its budgetary commitments would find itself in a very difficult position in Community business generally (QQ 103-105). He went so far as to say that he could see circumstances in which a Member State "would actually be compelled to pay the fines" imposed under the stability pact (QQ 103, 119).

  79.    Mr Gordon Brown rejected the suggestion that the stability pact was little more than a voluntary arrangement. He said there was a degree of compulsion implied by the sanctions that could be imposed, although he thought the sanctions "would be used in limited circumstances, if at all." In his view the stability pact was "not something you can take or leave". It was something that "binds the members of the euro together". He added that he thought that the pact embodied a fiscal policy "that most sensible economies are now pursuing" (QQ 504, 530).

  80.    Challenged on what would happen if a Member State refused to pay a financial penalty imposed under the stability pact, Commissioner de Silguy said that the purpose of the pact was to set up a mechanism which would strengthen the hand of a government in resisting calls to run an excessive deficit: he said the provision for penalties should be seen "as a dissuasive instrument" (Q 149). Herr Regling made the same point by saying that the penalties were there "in order to be pre-emptive" and act as a deterrent (QQ 305-306).

  81.    Mr George took a more sceptical view of the likely effectiveness of the stability pact. He thought that in its operation there might be some scope for "fudge": countries might be reluctant to apply discipline, thinking that they might be the victim next time (Q 64).

  82.    Professor Goodhart was asked how the ECB would react and how the stability pact would operate if a major country increased its public expenditure significantly in response to domestic political pressures. He explained that the ECB would decide whether it was necessary to revise its future inflation forecast for the euro zone as a whole and whether, therefore, it should change the interest rates for the euro zone. In operating the stability pact, there would be some lapse of time before the deficit figures were shown to have broken the pact limits and a further time during which the errant country would be urged to get back within these limits. Only after that would the financial penalties come into play. There was, therefore, scope for overwhelming political concerns to have a temporary influence. He thought that in a euro zone of, say, eleven countries the interest rate increase necessary to offset a fiscal expansion even in one of the larger countries and to maintain the desired rate of inflation over the whole area "would actually be pretty small" (Q 33). In response to a suggestion that in these circumstances the errant country, "the villain of the piece", would suffer no more than the other countries in the euro zone from the increased interest rates, Professor Goodhart said that economic effects from one country or region spilt over into others "all the time" even without a common currency. He cited the present East Asian crisis which was having the effect of reducing the prospective exports of the United Kingdom and other European countries. It was also reducing the likelihood and extent of interest rate increases (Q 41).

ROOM FOR MANOEUVRE: WITHIN THE STABILITY PACT, SUPPLY SIDE MEASURES AND COUNTER CYCLICAL MEASURES

  83.    The preceding paragraphs have been largely concerned with evidence on whether the stability pact will be observed, or whether it will be flouted by countries running excessive deficits and whether financial penalties will be imposed. Of equal importance is whether observance of the stability pact will leave sufficient room for manoeuvre in a Member State to deal with cyclical strains and regional shocks affecting it more adversely than other countries in the euro zone. A separate issue, but one closely related to economic performance, is the extent to which the supply side can—to use Sir Nigel Wicks' words[19]—give a "flexible and subtle" response.

  84.    Professor Goodhart said that many of the countries likely to be in the euro zone were big enough to be able to manage for themselves a great deal of the stabilisation desirable over the economic cycle (Q 20). Dr Duisenberg pointed out that under the stability pact there was still scope for the automatic stabilisers to work: the room for manoeuvre was around 3 percentage points of GDP. He said that in the Netherlands, which was the country he knew better than others, over the last 50 years the maximum cyclically-caused variation in the public deficit had never exceeded 2 percentage points of GDP. He saw, therefore, the 3 per cent scope as adequate, based on past experience (Q 213). Mr Wolf, too, thought that for the larger countries, at least, their own national budgets and their capacity to tax would remain large enough for them to handle their own cyclical stabilisation needs themselves (Q 396).

  85.    Mr Turner pointed out that the scope for countries to use the room for manoeuvre allowed to budget deficits under the stability pact would be maximised if there was a low level of public debt. Where a country had a high level of public debt there was less room for manoeuvre before concern about national credit worthiness would set in. His point implicitly emphasised the importance of the goal set out in the stability pact of countries having budgets over the economic cycle close to balance or in surplus (Q 420).

  86.    Mr Volcker cast doubt generally on the flexibility of fiscal policy: he said that critics of the single currency seemed to have in mind some text book system of flexible adjustments of fiscal policy and exchange rates that "do not exist in practice". He said that fiscal policy was "pretty much frozen in every country". It was also hard to change exchange rates without making more problems than were solved. Budget deficits or surpluses "do not work very flexibly" but there was an illusion that changes in exchange rates or in the fiscal balance could "rescue you in a political sense while damaging the prospects for doing the structural things that you have to do sooner or later". Mr Volcker saw the single currency and the constraints on the fiscal balances as a political spur to make these necessary structural changes. He said he was told that there would have to be major structural reforms in Europe, with or without the single currency. His belief was that the single currency was going to facilitate rather than thwart the process of structural change (QQ 439, 446).

  87.    Mr Martin Wolf said that most economists now thought that fine tuning of fiscal and monetary policy was a game "not really worth the candle". Monetary policy was, however, a better fine tuning instrument than fiscal policy because it was relatively effective in a modern economy with a liberalised financial system and could be adjusted more frequently than fiscal policy (Q 390).

  88.    Commissioner de Silguy pointed out that in addition to the scope for fiscal flexibility within the stability pact there were other ways available to deal with shocks at the regional level, which were, he said more frequent than shocks at the national level. Regional crises could be addressed by state aids and other measures available to the national government (Q 131). The Commissioner said that in the ability to deal with regional shocks the move to the single currency "was not a leap in the dark". He said there was a framework and panoply of instruments which could be used (Q 131).

  89.    Mr Turner saw a case for fiscal transfers which would flow from country A to country B when A was above trend growth and B below and which would flow in the reverse direction when their positions relative to their own growth trends were reversed. He saw such flows as requiring no net addition to the EC Budget although he conceded that it was "quite difficult to imagine the institutional structure which would achieve these flows". He offered no prescription but thought more consideration was required (Q 419). Mr Wolf thought that some of the smaller countries might need some help with countercyclical problems (Q 396). Mr Lea, Assistant General Secretary, Trades Union Congress, said that in the case of a shock affecting one country particularly it could perhaps be dealt with by "some special drawing right, something like that" (Q 197). Professor Goodhart said that his personal position was that it would be highly desirable, on presentational grounds, for some "fairly token transfer" to be made from the Community Budget to a country suffering an adverse shock (QQ 20, 40). He accepted, however, that it had become politically unacceptable to the paymasters of the Community, principally the Germans, to pay a higher proportion of their GDP into the Community Budget (Q 25). Commissioner de Silguy, asked whether the Community Budget might expand and be used as a means of counter-cyclical stabilisation, replied "No, to put it bluntly". He quoted figures to show that those countries which had made the biggest efforts to control deficits and inflation had achieved the highest rates of growth. In his view the whole system rested "on sound economic policy and budgetary stringency. It is a culture of stability." (QQ 145-146).

  90.    Mr John Monks, General Secretary of the Trades Union Congress, emphasised the importance of flexible labour markets as part of the supply-side ability to respond to shocks. Mr Volcker said that there was less labour mobility in the EU than one would like and than in the United States (Q 456). Mr Monks made a similar point but he pointed out that labour within the EU was more mobile, particularly among the younger and better educated groups, than it was often thought to be. He also cited the statistic that a year or so ago there were some 50,000 British and Irish building workers in Berlin. He drew the conclusion that the tight monetary policy, which he expected there to be in the euro zone, would need to be balanced by active measures to promote jobs. He said that the United Kingdom could not be criticised for lack of flexibility in its labour markets but that the country came low in terms of adaptability of the work force, technological innovation and time taken to bring new products successfully to market (Q 180).

  91.    Mr Gordon Brown emphasised that monetary union "would work better if accompanied by economic reforms to the labour markets, product markets and capital markets". He described "the ultimate test of a successful single currency" as "whether it delivers growth and high employment". For him the key factors for achieving these objectives were "stability and the willingness to undertake economic reform" (Q 496).

EXCHANGE RATE POLICY

  92.    In considering whether the exchange rate policy of the ECB with regard to third or non-participating countries would or should be one of "benign neglect", Dr Duisenberg said that the exchange rate would not be neglected but it would not be the primary aim of monetary policy. He pointed out, as did several of our other witnesses, that the countries in the euro zone would be less sensitive or vulnerable to exchange rate movements than was the case with individual Member States at the present. He said that for the likely participating countries the share of exports in GDP, excluding the intra-euro zone trade, would collectively be around 10 per cent—a figure similar to that for both the United States and Japan.

  93.    Dr Duisenberg reminded us that the European Council had decided that only in "exceptional circumstances", similar to those that in the past had led to the Plaza and the Louvre Agreements, would the Council issue "general orientations" on external exchange rate policy. Even then, it would be for the ECB to execute such a decision which, according to Dr Duisenberg, it would only be prepared to do "if that policy decision was not to interfere with its primary aim of achieving internal euro-wide price stability" (Q 199).

  94.    Mr Volcker expected that the exchange rate between the euro to the dollar would be determined by the perceptions even more than by the reality of the strength and vitality of the two economies. His concern was that these currencies would be volatile in relation to each other. He thought this could raise broad political questions about cooperation between the two societies: it could lead to more rather than fewer trade disputes and questions about relative burdens of security (Q 457).

INTERNATIONAL ASPECTS OF MONETARY POLICY

  95.    In international fora affecting the euro it was accepted that the ECB would need to be represented, Sir Nigel Wicks said (Q 128). Herr Regling and Mr George were agreed that where the G7 were talking about exchange rate movements the President of the ECB should participate (QQ 75,346).

 "WILL IT WORK?"

  96.    To most of our witnesses we put a very general series of questions on the lines of "Can the single currency work? Will it work? Could it all go seriously wrong?". We recognised that the questions were imprecise and that the answers which could only be sketched with a broad brush would necessarily be subjective; but as an indicator of mood we found the answers illuminating. In broad terms, our witnesses fell into two groups. Those from the continent tended to take the line which was encapsulated by Commissioner de Silguy who said, "I hope it will work. I am sure it will. All the ingredients are there. It depends on people's will. The Ministers' political will." (Q 139). Herr Regling expressed a similar hopeful view when he said "Lots of things can go wrong but that is political life" and "I am quite confident privately that it will work. There will always be problems but it will work" (QQ 325,348). Our British witnesses, by and large, were less confident. They tended to see possible problems rather than their solutions. Mr Wolf exemplified this less optimistic mood when he said (in the context of differential shocks, although the context is less important than the attitude displayed by the comments): "Let us imagine a situation—I am not saying this will happen often, it may never happen . . . I think in the last resort you have to hope this does not happen" (Q 403). Mr Turner, however, speaking from the knowledge of the views of his CBI members, and looking at this issue in terms of national advantage, took a more hopeful line. He, with several other witnesses, noted that the achievements of the last few years in terms of convergence were far greater than anyone would have forecast five years ago: fourteen countries now had price stability in the sense of inflation rates of 2 per cent or less and the fifteenth country had an inflation rate of below 5 per cent. His members believed[20] that, provided the conditions for British entry were right, the balance of arguments was in favour of British entry at the appropriate time (Q 422).

  97.    Herr Regling said that total collapse of the monetary union was not feared by the German people. They were fearful of such things as the level of inflation in the next few years and whether the countries joining EMU would implement the necessary structural reforms so that unemployment went down (Q 302). He thought the project of monetary union was now feasible because it was the culmination of a process of economic integration which had been going on in Europe since the early 1950s. Since the Maastricht treaty there had been a wide range of technical preparations. He was confident that at the technical level the ECB would be able to operate. He acknowledged, however, that there would remain two main issues with which countries would have to continue to deal: first, the process of fiscal adjustment and second, the problem of structural reforms (Q 302).

  98.    It was common ground among our witnesses that the sustainability of convergence was a crucial factor in how well the single currency system would work. Herr Regling pointed out to us the "remarkable" convergence that had already taken place on inflation—fourteen out of the fifteen countries in the EU now have inflation rates below two per cent, on interest rates and on the stability of exchange rates. He accepted that fiscal convergence was "not quite as convincing" as monetary convergence (Q 313).

15   The Stability and Growth pact was adopted by the Council in 1997. It consists of three elements: one a Council Regulation which aims to strengthen the surveillance and coordination of Member States' economic policies, a second Council Regulation which aims to speed up and clarify the implementation of the excessive deficits procedure and a Resolution of the European Council in which the Member States agreed on firm political guidance in order to implement the Treaty and the pact strictly. A Note by the Specialist Adviser on the pact is at Appendix 4. Back

16   We assumed that this cryptic remark was a diplomatic reference to the wish of the French government to be seen to be doing something to counteract fears that the ECB might be insensitive to the needs of the real economy. Back

17   The process involves elaborate consultation between the Commission, Ecofin and the European Council before coming back to Ecofin. The Commission initiates the process by making a recommendation to Ecofin which by qualified majority formulates a draft for the broad guidelines which is reported to the European Council which, on the basis of this report discusses a conclusion on the basis of which Ecofin adopts a recommendation setting out the broad guidelines. Back

18   Article 104b. Back

19   See paragraph 69 above (Q 102). Back

20   Mr Turner said that the bulk of his members favoured the CBI line: probably 60 or 70 per cent were in that broad bulk (Q 423). Back