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Dr. Cable: The hon. Lady has helpfully put her finger on the underlying fallacy in what the Government are trying to achieve, which helps me to make my point more strongly. I understand current Government policy to involve, as she says, pursuing a series of objectives which will hopefully land us at precisely the right exchange rate when it is politically convenient to enter EMU.

Theory and practice do not add up. It has been clear in the past few months, and for a much longer period before that, that foreign exchange markets do not work as the Government believe them to work. Government policy holds that, providing that interest rates are gradually cut to European levels over the next few years, the British exchange rate with the euro will gradually glide down to a convenient rate, but we know that foreign exchange markets do not work in that way. The Governor of the Bank of England admitted that last week, when he said that he was perplexed about what was happening to the exchange rate and did not understand the mechanism. That was a confession not of incompetence but of a lack of understanding.

Mr. David Ruffley (Bury St. Edmunds): Will the hon. Gentleman tell the House whether the Liberal Democrats have an exchange rate objective, and if not, why not?

Dr. Cable: Yes, I shall suggest how we might pursue an exchange rate objective, and that is the purpose of this part of my speech. I shall suggest not that we should pursue a single interest rate, which I think is what the hon. Gentleman wants me to say, but that we need a policy commitment on the exchange rate. He is right to imply that there is a basic point of logic in this matter, and I shall try to suggest how that objective might usefully be pursued.

The problem remains--this reinforces the point made by the hon. Member for Redditch (Jacqui Smith)--that the Government are hoping that interest rate cuts will gradually glide to a level that will enable British manufacturers to be competitive indefinitely, but we know from the workings of foreign exchange markets that that simply does not happen. There is a danger that, without a more proactive policy, we shall be landed with an exchange rate that is totally uncompetitive and inappropriate.

In those circumstances, the Government may well have fulfilled all their five tests and have the political mandate from a referendum, but we would have the wrong exchange rate. One lesson that we should have learned

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from the period of the exchange rate mechanism--our analysis of that corresponds with the views of some Conservative sceptics--is that if we are entering such a project, the exchange rate must be right.

How do we then resolve the problem--I am responding to the question asked by the hon. Member for Bury St. Edmunds (Mr. Ruffley)--of having an exchange rate objective? It cannot be done simply be sticking one's finger in the air, picking up an exchange rate and saying that it will be appropriate for ever. That would be absurd, and I do not begin to suggest it. However, we must do more than take the totally passive approach adopted by the Government.

There are two elements to the issue. First, the Government must widen their imagination and think in terms of broad bands, within which the exchange rate can fluctuate, rather than single points. We remember that in the old ERM, there was potential for fluctuation by 15 per cent., which gave a good deal more freedom of manoeuvre than the previous Government allowed themselves. Bands would make the problem of fluctuation more manageable.

The second step that the Government could take--they could do so now--would be to begin consultation with industry, academics and politicians of different parties to try to establish what would be a comfortable, sustainable competitive exchange rate or range of rates. Within this Parliament, there has been one example of the Government dealing rather neatly with such an economic problem, when they had the task of fixing a minimum wage. That is interference in the market and could have gone badly wrong, but the Government took soundings, did economic analysis and came up with a recommendation that was detached from them but which they could none the less adopt.

I suggest that the Government should now initiate consultation and reports on relative prices, technical measures, purchasing power parity and a sustainable exchange rate, about which there are many studies. They could then come up with a recommendation for an appropriate level or range of exchange rates. That would have several advantages. It might, for example, influence the market, although we do not know that. It would certainly be very reassuring to British industry, which would know that the Government were seriously concerned about the stability and competitiveness of the exchange rate and were not leaving it to pure chance. Most important, it would provide the Government with some political ammunition--when we eventually have to set the exchange rate within EMU, it will be a political process decided partly by the level that other members of the European Union think appropriate. We would be seen to have undertaken a proper scientific exercise, looking carefully at what exchange rate range was appropriate for the UK. That is the kind of early process that the Government could helpfully set in train. It would involve not setting a fixed objective but setting in train a process of creative thinking about the problem.

Mr. Forth: Has the hon. Gentleman thought what the result of that process might be? Let us suppose that the process took place and that there were agreement on the ideal exchange rate from the UK's point of view, if we were ever stupid enough to adopt the euro. Would not that signal to our partners what our negotiating position would be? What does the hon. Gentleman think would be

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the reaction if our partners did not allow us to join at anything like that rate but insisted on one that could damage the UK's interests?

Dr. Cable: The second point is the crucial one. I do not understand the right hon. Gentleman's problems with it. Surely it is right that the British should signal in advance what we perceive our national interest to be. In the case of the exchange rate, it is not an uncompetitive one such as we have had in recent months; nor is it one that is provocatively cheap, which would trigger domestic inflation. It seems perfectly right that we should be transparent about this.

I am also effectively suggesting--it may be surprising to hear this from a Liberal Democrat--another test of convergence. That test should be the exchange rate. We believe strongly that EMU would benefit Britain but, equally, we believe that it should be done the right way and at the right exchange rate. It would be disastrous to enter in the wrong way and at the wrong exchange rate. I am suggesting a hurdle, or test, which the Government have not yet set themselves but which they should satisfy. If that were done, there would be a much greater prospect of our meeting our negotiating objectives in Europe and of our carrying British public opinion, especially industrial opinion, with us. I am therefore suggesting another test that the process of convergence would have to meet, and I am not inhibited in doing so.

Mr. Ruffley: Does that mean that the Liberal Democrat party is advocating shadowing the euro?

Dr. Cable: No, I am not suggesting that we shadow the euro. I did not mention shadowing the euro, and the Government have ruled it out. I am suggesting that we establish a process to define explicitly what an appropriate band of exchange rates would be when we eventually enter the EMU mechanism. It could take place through a gradual process of crawling, through shadowing or many other ways. All I am suggesting is that instead of there being an empty core at the heart of the Government's economic policy, we address the issue explicitly for political and economic reasons.

Mr. Laurence Robertson (Tewkesbury): Does not the hon. Gentleman remember the pain caused to people with mortgages and businesses in this country when, yes,the Conservative Government tried to shadow the deutschmark and to remain in the exchange rate mechanism? Does not he remember that when we entered there were DM2.95 to the pound, and that the rate then dropped before regaining that level? Does he accept that it was not the rate that was wrong but the system?

Dr. Cable: We shall simply have to disagree on that point. It was the rate that was fundamentally wrong. However, the hon. Gentleman has raised an important issue relating to the third aspect on which I make a suggestion to the Minister, which is how we deal with the problem of mortgages. Before the hon. Member for Buckingham (Mr. Bercow) jumps to his feet, I hope that he will allow me to finish this point. I have been fairly generous in allowing interventions.

How we handle mortgages and the housing market is important. It has been brought home to me clearly inthe discussions that I have had with business that the

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Government have not focused as clearly as they should have on what the changeover plan should be. It was clear from Lord Simon's address yesterday to the Treasury Select Committee that the Government have scarcely begun to think about it. It is a serious problem that needs to be addressed as part of the changeover.

The problem, as critics of EMU point out, is essentially that if there is a common interest rate across Europe, we encounter the potential one-size-fits-all problem. However, that is not a fixed item; it can be dealt with, and we can try to manage it. Clearly, manufacturing industry is less sensitive to interest rates if companies are dependent on equity and have securitised bonds and do not rely on buying on short-term interest finance. In the housing market, the one-size-fits-all monetary policy could be dealt with if house purchasers were much less dependent than they are today on variable interest mortgages.

If we are to join EMU, there is a broad national interest in trying to make sure that the British housing market is much less dependent on variable interest rate mortgages. We can see from the Irish example, which involves a similar housing market structure to that of the UK, that, unless we address this problem, there is the potential to enter a period of booms and slumps, which is avoidable.

Why have the Government not tackled the mortgage issue in their changeover plan? I suspect that the reason is that it is not in the interests of the banks and building societies that they do so. If we move to a system of fixed interest mortgages, the banks then carry interest rate risk, which they do not at present--they simply pass it on to their customers. It will require a powerful Government initiative to make that change.

I suggest that the Government begin to think of opening discussions with banks and building societies about how rapidly they can move to a system based predominantly on long-term fixed interest mortgages rather than variable mortgages, and perhaps to think about how the regulatory system has to change to accommodate that.

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