Professor Michael Wickens

3 JULY 2007

  Q67Chairman: Professor Wickens, welcome to the Committee. It is very good of you to come. I need to say to you that you are being recorded and some of this will appear on the website and that you will get a transcript of your evidence at the end of this. How would you like to do this? We have read your most recent paper, which you kindly sent us. Would you like to start with a general statement, or would you like us to start asking questions?

  Professor Wickens: Thank you, My Lord Chairman. Having sat on the other side of the table for about nine years with the Economic Affairs Committee, my experience is that if you give an opportunity to someone to make an opening statement they go on for ever and then they cover all the issues and there is no time left for the questions; so I think we should go straight to the questions.

  Chairman: Excellent; then we will do that.

  Q68  Lord Inglewood: Professor Wickens, do you think it is possible to have a monetary union without a fully functioning single market which has common taxes and labour market integration? In any event, do you think that Europe will not be able to reap the full benefits of currency unification unless you have those kinds of things?

  Professor Wickens: I think this is an excellent question that goes to the heart of the matter. One could spend perhaps the whole session discussing this. I think it is possible to have a monetary union without a fully functioning single market, but I think there are very few precedents. Perhaps as a result of this all members of the euro zone, and new members of the EU, are required by the EU to join the euro, to satisfy the Stability and Growth Pact and to enter into the single market, though there is now some question about the degree to which competition is required. I think that, nevertheless, and despite the fact that this is what has happened in the EU, it is possible to have a system which allows individual countries to make their own decisions. Obviously, for the UK, this is a very important issue. It does not seem to me that it is an issue which has been addressed by the EU, and it does not seem to me that the systems which the EU has developed make it easy to pursue one's own policies, and not to have common policies. There are two types of problems that we face; one is long term and one is short term. What we have seen in the long term is that the system is not functioning very well for individual countries; meanwhile it is performing very well at the aggregate level, and this is a bit of a conundrum. In the paper that I sent you I was trying to explore the implications of having a single currency. It is well-known that if you have a single currency then the interest rates which are set will be too high for low inflation countries, like Germany and France, and they will be too low for high inflation countries, like Ireland and Spain. As a result of this, of course, countries with high inflation and low real interest rates will find that capital is relatively cheap. There will then be an incentive to invest, and the increase in output is likely to put pressure on domestic resources and increase the inflation rate. The opposite occurs for countries which have low inflation, like Germany. If one looks at some of the figures, Ireland has had a 31% increase in its price level since 1999 and a 44% increase in its own output. If you take the opposite extreme, Germany, has had a 5% increase in prices and only an 11% increase in output. So if you look at individual countries there seems to be a problem, but if you look at the EU as a whole, one finds that the inflation rate is about on target and an average level of growth is produced, which is okay for some and not for others. The problem then is how one copes with a system which structurally seems to generate such internal imbalances, I think this is the question that we have to address. In my paper, I tried to answer the question usually put at this stage, which says that countries with high inflation and rising price levels are going to lose competitiveness, and if they lose competitiveness that means this is going to put a brake on their economic activity.

  Q69  Lord Cobbold: May I interrupt; were they not starting from a lower base and lower prices, and therefore just catching up rather than forging ahead?

  Professor Wickens: In fact, what one can show is that there is a very high correlation between the price level increases which have occurred over the eight or nine years, and the initial rate of inflation at which they went into the EU. So there is no sign of convergence in inflation. One might have expected that there would be convergence, and indeed one would expect that, if the system is sustainable in some sense, this convergence is required. What I find is that there has not been convergence, nor has there been divergence in inflation rates. The fact that there are different inflation rates and they are not converging has led to this loss of competitiveness, but the loss of competitiveness does not seem to be able to provide the necessary long-term stabilisation. I think this is the problem. It is not a problem that the ECB, for example, has been keen to address, because their remit, as we shall come on to later on in the questions, refers to the EU as a whole, or the Euro Zone as a whole. The long-run problem is how to deal with this.

  Q70  Lord Blackwell: Can you just explain that point about why the loss of competitiveness you think is not causing a brake on inflation in those areas?

  Professor Wickens: I think the loss of competitiveness is stopping inflation rates from diverging, but is not causing inflation rates to converge. The arguments of most people, and the argument of the President of the Bundesbank, have been that Germany's competitiveness is improving so fast that we are going to be benefiting from this. The evidence does not show that, and my theory, for what it is worth, does not show it either. In principle, one might expect this to happen, but it does not look as though it does. We need to find some system, some way of coping with this, otherwise we are going to run into long-term difficulties. There is another question. That is the long-term; and the short-term problem is that we have found as a result of giving up a single currency, that we have given up control over our own monetary policy, we have also given up control over our own exchange rate, and that means that all we are left with is fiscal policy. How can one use fiscal policy? The answer is that in the long term one cannot really use fiscal policy, so fiscal policy does not really provide us with a long-term solution; fiscal policy can only provide us with some short-term stabilisation possibilities. I will not develop that point now because I think it comes up in later questions, but I think this is something one needs to think about, the short-term flexibility which might be required for fiscal policy, which in my view is not there now.

  Q71  Lord Cobbold: How will fiscal policy cope in the long term?

  Professor Wickens: Governments provide public goods and these public goods have to be paid for. They are paid for, in the long run, out of taxes. In the short term, however, government expenditures might rise through unemployment payments, due to business cycles, and these expenditures can be paid for through debt. This is not, in fact, the view of the current Government; the current Government's view is that current expenditures should be financed from current taxes and that capital expenditures can be financed from debt. In my view, this is completely wrong. What one should do is use debt finance for temporary increases in expenditures, and use tax finance for permanent changes in expenditures. What is the role of fiscal policy? Fiscal policy can help provide public goods, it can help provide public capital, it can help generate productivity gains, and this has been a major plank of the UK Government's policy for a number of years, in trying to improve productivity. Unfortunately, the evidence is that it has not been very successful. Ideally, and this is what the Lisbon Agenda was all about: how to enable productivity gains to be made so that there can be catch-up and stability within the EU overall. My view is that this is a very difficult task for fiscal policy to achieve in the long term.

  Q72  Lord Blackwell: Can I just go back to these fiscal transfers, both the direction and the size. What is confusing me initially is, if you have a high inflation country with a low real interest rate, which is therefore expanding fast, you would expect that at some point that high inflation would mean that, the fact is, production will become uncompetitive, and that would mean that eventually the country would suffer high unemployment and therefore would need transfers to it from the other countries. I thought I understood from your paper that you run the other way round?

  Professor Wickens: Yes, indeed, and the view you have expressed I think is the standard view. That is why I wrote the paper: because it seemed to me that the evidence did not support the standard view. Thinking of Ronald Reagan's great statement about economics, that an economist is somebody who sees something working in practice and wonders if it will work in theory, I thought I ought to try to provide a theory which explained the evidence. Of course, there is a lot of ex post rationalisation, but the theory at least does explain the evidence, that inflation rates are not converging.

  Q73  Lord Blackwell: You would expect that countries like Germany would need to receive fiscal subsidies from Ireland and Spain, etc., because you would expect high unemployment in Germany?

  Professor Wickens: I do not really think that. What I think is that, for high inflation countries there has got to be some kind of inflation tax, which is used to help low inflation countries. This happens in the short term, because, if you take regions of the country, high activity in the South East and low activity in the other regions of the UK, typically results in more unemployment benefits in the low activity regions, and this comes from the tax revenues raised by the high activity regions. Within a country like the UK, and like the US, transfers do take place, and this is what one would expect to happen in the short term. I think the problem is a long-term problem and the long-term problem is much more difficult to deal with using fiscal policy, for the reasons I have tried to explain. We do not even have, currently, in the EU, a short-term stabilisation scheme that works; in fact, the amount of money which is provided by the EU for stabilisation is negligible, virtually zero.

  Q74  Lord Blackwell: Regardless of which countries it is and in which situation, depending on the theory or the facts, would you agree that the likelihood is that, as a result of differences in the structures of the economy and different exposure to the world, we will end up within areas under a similar interest rate, some areas that are less competitive and with higher unemployment rates than other areas? If that is the case, if I follow your argument, normally the political lid would be kept on that by transfers; without the possibility of transfers then you have a political conflict between the areas with high unemployment and the Central Bank. Am I extrapolating too far; is that what you were saying?

  Professor Wickens: No, I think that is a reasonable way of putting it. I would not disagree with most of that.

  Q75  Lord Kerr of Kinlochard: I agree entirely with Lord Blackwell. It is a perfectly reasonable way of putting it, but it is not the real world that the European Union lives in, because there is not going to be a big fiscal flywheel transferring resources. In the 1980s and the 1970s it was proposed that there should be, but the decision in the 1990s, reinforced in this decade, was that it was not going to happen. This is why, I think, Professor, you are not arguing there should be fiscal transfers, you are arguing that since there will not be fiscal transfers the monetary union is fragile; which brings me to whether it is not always true of monetary unions. I remember a previous Governor of the Bank of England getting in serious trouble for admitting that the monetary policy being practised by the Bank of England was sub-optimal for Newcastle.

  Professor Wickens: As, indeed, it is.

  Q76  Lord Kerr of Kinlochard: This is life, and in any entity the policy practised with the aim of being in the interests of the average, or the generality, will produce difficulties somewhere in the periphery. I am puzzled why you call your paper Is the Euro Sustainable? because the implication of that question, given that you talk about the fragility of any monetary union, is that you think it is not sustainable. It seems to me we live in a grey world; we will not have the fiscal transfers, we will not have an unsticky labour market overnight, we will have an imperfect economic distribution of the effects of central policy on the union. That is life. We live in an imperfect world. Am I wrong?

  Professor Wickens: I agree with all of that. The only thing I would add is that one has to calculate the cost involved, and the cost may be very high. I think this is the question: how much is a country willing to pay in order to belong to a system which is not otherwise ideal for it. I think this is the problem which has been facing the UK for a long time, and by staying out of the euro it has tried to get the benefits of a single market without the costs of an inappropriate monetary policy. Newcastle, unfortunately, does not have the opportunity to do that, but we wait to see whether Scotland acquires it.

  Q77  Lord Kerr of Kinlochard: Is not that a sort of reductio ad absurdum? The idea of a monetary frontier at Gretna Green seems to me to be totally absurd, speaking as a Scotsman. You are not seriously arguing that we should contemplate going for smaller monetary units, are you?

  Professor Wickens: No. I am just picking up your point. I do not think the euro will collapse. I think that countries will be willing to pay the cost of being in the euro. So I agree with you entirely that it is not a realistic view to hold—that the euro will collapse. My paper, with the title Is the Euro Sustainable? was really to ask the question what are the problems with the euro and what does one need to do in order that, as we all believe, it will be sustainable. If I gave a question like "the euro is sustainable", no-one would be very interested, I suspect.

  Q78  Chairman: I think the question we are trying to tackle is what can be done to increase mobility of labour and capital within the euro zone to help restore equilibrium after shocks; one of the questions we are trying to tackle. Presumably you believe that there are things which can be done?

  Professor Wickens: Yes. May I return, just to add one more thing which relates to this question. We have been talking about the long term but I think the short term is also very important and we have not really talked about the short term. If I may, I would like just to comment on the Stability and Growth Pact. I think the Stability and Growth Pact is completely inappropriate, and one of the problems that the EU has, in my view, is it is neither necessary nor sufficient. It is not necessary because it is perfectly possible to have much higher levels of debt, as we have seen in Italy and Belgium, without there being any downside for the rest of the community, in terms of generating inflation or of excessive unemployment. It is not sufficient because we need to have a criterion which is more forward-looking. What we need to do, effectively, is be convinced that governments can pay off their debts. If the markets are convinced that governments can pay off their debts, it does not really matter what the size of the debt is. What we observe in the SGP is these rigid rules which say that deficits cannot exceed 3% and debts cannot exceed 60%. In fact, over half the original members of the EU have debts greater than 60% and yet nobody says that this is likely to bring down the EU. The recent changes to the Stability and Growth Pact have required that governments which have deficits in excess of 3% have got to bring them down, what is it, half a per cent of GDP per annum; but this is only likely to make matters worse for countries which suffer a shock and need to have higher deficits in the short term in order to stabilise their economies. It seems to me that there are great difficulties in tackling long-term problems, but most of the short-term problems we are seeing can be solved by recasting the Stability and Growth Pact in a way which is consistent with the general principles of fiscal finance. I think this is a problem which the EU must address, and the recent changes it made to the Stability and Growth Pact have not helped at all in this.

  Q79  Lord Cobbold: Surely that is the purpose of the Stability and Growth Pact, to provide some club rules for those members of the single currency for their fiscal policies? Once they are prevented from devaluing their currency, competitive devaluation for debt, surely then they rely on fiscal policy and the Stability and Growth Pact gives the rules of the game?

  Professor Wickens: Do we really need rules of this sort? The problem is, because you have given up your monetary instruments and you have given up your exchange rate instrument, how are you going to manage your economy? The only way you can do that is to have a more flexible fiscal policy, and that flexible fiscal policy requires you to allow intermittent stabilisers to work in terms of dealing with negative shocks. This requires higher deficits, possibly. The constraint on the deficits that we have now may slow down, and even prevent, the return to some sort of full employment. In addition, if one has a debt criterion which says that debt may not rise above 60% then that means one is unable to spend more in the short term and finance it by borrowing. I think the fact that there is a rule, in a way, is neither here nor there. What worries me more is that it is a bad rule. I do not mind having a good rule but the Stability and Growth Pact is not a good rule; we need a different rule, and the UK needs a different rule too.