Examination of Witnesses (Questions 60
- 79)
TUESDAY 13 JUNE 2000
MR JAMES
BARTY, PROFESSOR
IAIN BEGG,
MR ROGER
BOOTLE, PROFESSOR
WILLEM BUITER
AND DR
DANIEL GROS
60. You are aware that in their February conclusions
they did give themselves the power to review Member States' public
expenditure programmes?
(Professor Begg) Yes, but not in the sense of saying,
"Here is what you may spend money on".
61. What does reviewing Member States' public
expenditure programmes mean?
(Professor Buiter) In relation to the tax programmes,
it is just an elaboration of the stability of growth criteria.
It is a stabilisation story, not national priorities about the
size of the public sector issue.
62. Do you think peer pressure within ECOFIN
or within the Euro 11 or 12 is sufficient to bring about the degree
of economic policy coordination that might be required?
(Professor Buiter) That is a good question. I do not
know the answer to that. Logistically, even if everybody is willing
to coordinate the fiscal stance, it is much harder to get coordination
between one central authority amongst 11 or ten and a half national,
fiscal authorities, than in the United Kingdom, where you have
one on one interaction. Subject to the point of the logistics,
it can be done and will increasingly be done. The proposals to
give Euro 11 a greater voice in these stabilisation matters are
the logical outcome of this kind of thinking.
(Professor Begg) I think it is getting there very
slowly. There was a vacuum in the core of the EMU policy framework
when the Maastricht Treaty was drawn up which was the absence
of an explicit means of coordinating fiscal policy. With the Luxembourg,
Cardiff and Cologne processes, what political scientists call
the soft policy approach to all this—that is to say, there
is no Treaty base for it and there is no directive—but what
they are doing is engaging in these forms of bench marking and
coordination which are getting towards a coordinating mechanism
for the major design of policy, but it is not going to get into
the detail of which particular supply side policies the country
uses. Nor is it going to get into the detail of what public expenditure
programmes or taxation instruments are used. It is the grand,
strategic design of it.
Mr Davey
63. I would like to ask this question to all
of our witnesses. Do you agree with the OECD that the United Kingdom
has been converging in recent months with Euroland and that that
convergence is set to continue so that by the end of next year
it is likely that the Chancellor's first economic text on convergence
will have been met?
(Mr Bootle) No, I do not think I do agree, except
in a very superficial sense. The phrase used in the original document
which propounded the Chancellor's economic tests talked about
sustainable convergence. The word "sustainable" is very
important. We are not talking about certain macroeconomic variables
coming into alignment, whether they are going to cross over or
not. We are talking about something much deeper. However, one
would expect them to converge in that narrow sense as a precondition
for them to converge in a sustainable sense. To that degree, some
of them were a bit closer in that growth rates are reasonably
similar. There was a time when the United Kingdom was very much
faster. The inflation rates are also reasonably similar. Interest
rates having moved up strongly in the Eurozone recently are looking
as though they may have peaked or nearly peaked in the United
Kingdom. Arguably on the interest rate front too, there is something
like convergence. At the long end of the yield curve there has
been something like convergence for a long time. For all those
types of things there is something like superficial convergence
but I do not think it amounts to very much in that what one wants
is evidence that structures, institutions and practices, as well
as the movement of the economic cycle, make such a convergence
sustainable and not just something that will last a year or two.
If one focuses very narrowly on the question of interest rates,
there are several features here that are interactive. Our inflation
rate is very similar to the level in Euroland. In fact, it is
a good deal lower. This morning on the HICP measure I saw that
inflation fell even further to 0.5 per cent in Britain. Does anyone
seriously suppose that, if we had 4.25 per cent interest rates
in the United Kingdom, even without the fall in the exchange rate
that most advocates for joining the euro would suggest was a necessary
precondition, we would be at anything like this level of inflation?
I certainly would not. One puts together four per cent-ish interest
rates with an exchange rate at a plausible entry level, 2.70 or
so, and surely the apparent convergence with regard to inflation
would add up to divergence.
(Professor Buiter) The usual measures of convergence
have shown, since the start of 1999, that the gaps between the
United Kingdom and the average of Euroland have diminished. These
kinds of score cards are so transitory that I would not personally
pay much attention to them. Nothing is ever going to be in sync,
perfectly or lastingly. The only question is what is the magnitude
of the likely deviations and what are the mechanisms for dealing
with them once the monetary instrument is thrown away? It is true
however that, since one of the most important reasons for divergent
cyclical behaviour is independent, national monetary policies,
the data we are going to get are always going to give an overblown
view of the underlying degree of divergence that can be expected
following monetary union. Once you throw the monetary key away,
that particular impulse towards divergence is dead. There will
be sector specific shocks that impact on different nations differentially.
Yes, the OECD is right but it is also not very interesting. The
real issue is not are we at the same point or even: are we likely
to be ships passing in the night, but rather: even though we know
we are ships passing in the night how far away are we going to
be before the gaps close up again. I think it is basically a non-issue.
Chairman
64. It is the Chancellor's major economic test
actually.
(Professor Buiter) The kind of convergence we will
have following monetary union will be sufficient to operate the
Common Monetary Policy efficiently without adverse impacts to
the British economy. Clearly, if we had joined earlier, we would
not have had the current level of interest rates. I think this
is something that will be judged appropriately when the political
will is there and not until then.
Mr Davey
65. It is a question of political will rather
than some economic test?
(Professor Buiter) Yes.
(Professor Begg) I think it is interesting that in
an OECD report of 160-odd pages there are two paragraphs on convergence
which have grabbed all the headlines. It is based essentially
on their examination of what are called output gaps. Output gaps
are a particularly tricky concept because there are two different
ways of measuring them. Some of you might think it is peculiar
that you can have a positive output gap. In other words, your
economy is operating above potential, which is what projections
for 2001 that I have in front of me show from the OECD. The United
Kingdom is projected next year, 2001, to have an output gap of
0.9 of a percentage point and the Euro area 0.8. In the narrow
terms in which this debate has been couched, that is plainly convergence.
They are at the same points in the economic cycle. However, I
do question whether the notion of an economic cycle is quite so
useful as it used to be in the past when it coincided quite closely
with parliamentary cycles. What we now find is that the United
Kingdom economy has been through two cycles in the last 20 years,
the first starting in 1981 going to 1990, the second starting
roughly in 1992 and continuing. We do not have the deterministic
four or five year cycles we used to have. Whether this means that
the Chancellor has succeeded in achieving his abolition of boom
and bust or not is a question I leave to the Committee. There
is an interesting paradox that a government which tells us it
has abolished boom and bust is relying on boom or bust as an argument
for not entering the euro. In other words, the cyclical test is
being used for something which no longer seems to be relevant.
I would also commend to your attention a notion, using another
of the Chancellor's favourites words, "endogenous",
of endogenous convergence. What tends to happen once countries
join the currency area is that other aspects of their economy
other than their monetary policy tend to change. Would any of
you have believed that Ireland or Spain today would have the combination
of growth rate and inflation rate that they have? I doubt it.
What has happened is that the labour market institutions in those
countries have adapted quite considerably as a result of membership
of the single currency. That is putting a downward pressure on
the inflation rate. It seems to me that convergence is something
that happens not just before you join a monetary union but also
afterwards and as a direct result of joining.
(Mr Barty) I would slightly disagree with some of
what Professor Begg has said, in particular the idea that you
can rely on some endogenous convergence after you have entered.
You would have to be quite closely converged before you would
consider entering. One of the things I would definitely agree
with that Mr Bootle said is that, if you had put the United Kingdom
and the Euro area on the same monetary stance since the start
of monetary union, there is no way that we would have converged.
I thought the OECD report was particularly badly worded. They
said there would still be a gap in terms of interest rates but
that could quickly be eliminated if the United Kingdom entered
monetary union, without referring to what the implications of
that reduction of gap in interest rates would mean. They also
mentioned the exchange rate and the exchange rate, to my mind,
is a major problem for the United Kingdom going into monetary
union in the near future. The currency is still significantly
overvalued, despite the recent decline. The monetary policy stance
run by the Bank of England over the last year has been much, much
tighter than that run by the ECB. Whilst on a superficial level,
if you look at rates of inflation, rates of growth, output gaps,
however you define them, bond yields, you can say the United Kingdom
is much more converged with the Euro area, to ignore the fact
that the monetary policy settings have been completely different
misses the point altogether.
66. I think it is interesting that our four
witnesses have not agreed with the OECD report and I would tend
to agree with our witnesses, that the United Kingdom is not terribly
well converged, not sustainably, but given that it is the Chancellor
of the Exchequer's first test—and presumably if the current
government wins the next election it will be one of the tests
that is applied for the United Kingdom membership—what would
each of you again think that the Chancellor needs to do to try
to promote greater convergence? What policies should he be pursuing?
(Mr Barty) There are two very clear areas that you
need to address. One is the short term interest rate sensitivity
of the United Kingdom economy. I fundamentally disagree with those
who say that the main reason the United Kingdom's cycle is out
of line with the rest of Europe is differences in our trade patterns.
Frankly, the differences in our trade patterns are not that significantly
different from those in the rest of Europe to make that much difference
to our economic cycle. We are just much more sensitive to short
term interest rates. That is partly a historical phenomenon. Our
mortgage debt has been primarily funded at short term interest
rates and our corporate debt also, so when there is an adjustment
in interest rates in the United Kingdom the transmission mechanism
is much more aggressive than it is elsewhere. To this day, the
Bank of England is still worried about the housing market, where
house price inflation is 15 per cent and we have short rates of
six.
67. We need more standard banks, do we?
(Mr Barty) That is one route. Certainly in the mortgage
market, you have to extend the duration of the interest rate agreements
which govern mortgage interest rates. Although there has been
a move towards more fixing of mortgage payments, in the United
Kingdom you need to be quite careful of that because a lot of
those fixed agreements are for one, two or three years; whereas
in continental Europe they are for 15 years or plus. If the United
Kingdom wants to make a success of entry into the monetary union,
you would have to move much further down that route. The government
could address that probably several fold. It could certainly make
it, from a regulatory angle, much more advantageous for mortgage
lenders to offer fixed rate mortgages, which is not the case at
the moment. There is still a bias from their perspective to offer
floating rate mortgages. On the currency side, the government's
line that we need to ensure economic stability and then economic
stability will bring currency stability does not wash. If you
look at what is happening in the US, the US has a great record
on having macroeconomic stability. The Fed, over the last decade,
has delivered very sensible growth rates, very low inflation,
the fiscal side has been a lot better and the dollar continues
to oscillate substantially against the euro. If we are going to
offer sensible, sustainable convergence, you have to either change
the Bank of England's mandate in order to ensure that you shadow
the euro more effectively, or even consider joining ERM2. I find
it bizarre that a government that says it is prepared to take
the United Kingdom into a single currency is not prepared to enter
an exchange rate mechanism where you have fluctuation bands of
plus or minus 15 per cent against the central rate. If you cannot
be prepared to tolerate the economic requirements of shadowing
even such a loose environment, to fix the exchange rate in perpetuity
is very odd indeed.
(Professor Begg) When you opened this question, you
asserted that we all agreed the OECD is wrong. I do not think
the OECD is that far wrong. The British economy is much more convergent
with the Euro area now than it was three years ago. If the projections
have any validity to them in saying that the Euro area output
gap will become positive over the next year, the implication is
that the ECB will have to be tightening monetary policy at the
time when it has perhaps reached a plateau in the United Kingdom.
Monetary policies will therefore converge much more than they
have up to now over the next year or two. As for the exchange
rate, the pound/euro exchange rate has already fallen nearly ten
per cent since its peak. I think another five or so points, taking
it to somewhere in the region between 1.45 and 1.50, would be
tolerable for joining a single currency. It is much less of a
gap to be overcome than it was in the past on both these counts.
You also asked what the United Kingdom government needs to do.
I think pretty much steady as she goes. There is not much that
has to be adjusted macroeconomically in the United Kingdom to
continue the pace of convergence that we have seen over the last
couple of years. The United Kingdom is projected to grow slightly
more slowly than the Euro area. As it does, they will both catch
up towards full capacity utilisation and that will be a form of
convergence.
(Professor Buiter) I do not believe there is much
that can be done or necessarily needs to be done to promote convergence.
What convergence we are going to get is already substantively
there and it is enough. The structural similarities between the
United Kingdom and the continental European economies are much
more important than the differences. Specifically, I deny the
relevance or even the existence of significant difference in short
term interest sensitivities of Euroland vis a vis the United Kingdom.
There are always references to stories about the housing market
especially, but it is not in the data. The IMF has exhaustively
studied this. There is no evidence that economic activity responds
more sensitively to short term interest rates in Euroland, or
indeed in the US, then in the United Kingdom. Note that the US
has had a very sensitive response of economic activity to short
term interest rates for many years, even during the years when
the only mortgage you could get there was a 25 year mortgage.
There are many ways in which monetary policy gets transmitted.
It is different in Euroland but there is no evidence that the
United Kingdom is uniquely interest sensitive. You have to expect
that, after some of the sensible reforms of discrimination against
certain financial instruments take hold, the structure of housing
markets and housing finance will converge more but that is not
a precondition. What would help convergence is the creation of
a confident expectation of membership in the not too distant future.
If that is accompanied by clear hints that that membership, when
it is negotiated between Britain and its European partners, will
not be at anything like the current rate but south of it, that
would take care of the serious problem of how to get there from
here. Whether this requires formally entering into an ERM2 arrangement,
which will require negotiation of the central rate in the first
place—and the central rate will inevitably become, as it
did for the first 11 entrants, the actual entry rate—may
be a bridge too far. It is clear that once membership looms very
directly, once the political commitment has been made, the mandate
of the Monetary Policy Committee will have to be changed because
you cannot have an independent, national inflation target and
a floating exchange rate when you are steering towards membership
in a common currency. In the short run, I think, steady as she
goes. Our policies are not structurally divergent from the objectives
of monetary and fiscal policy in Euroland and the best thing to
do is to create confident expectation in the market as a whole
that membership will come and in the not too distant future.
68. You disagree with Mr Barty in respect of
interest rate sensitivity in the housing market but you did agree
with him on the exchange rate being a very important test of economic
convergence. Would you say that is the key test of economic convergence
even though the Chancellor does not actually put it in those terms?
(Professor Buiter) I do not think it makes a lot of
sense to join a currency union at an exchange rate that is way
out of line and that you will spend ten years working off as a
result. That is so clear both here and in Euroland that I do not
think it will be an insurmountable issue. The details will be
argued over ferociously but, just as everybody here agrees that
sterling is overvalued, everyone in Euroland, including the ECB
and the Council of Ministers, talks about the chronic undervaluation
of the euro.
69. Is that the key test of economic convergence?
(Professor Buiter) No. It is an important test that
has to be met for it to be a politically acceptable package. You
only will get there if you have made a commitment, if you want
to get there. The horse has to be in front of the cart rather
than behind it.
(Mr Bootle) What can the Chancellor do? Since the
government was elected, I have argued that if it was serious about
preparing Britain for the euro the major macro policy it could
pursue is to have run a much tighter fiscal policy than it has.
This is by no means dependable but it seems to me in direction
at least the way in which you could aim to have a lower level
of interest rates closer to the level operated in Euroland and
also, on the balance of arguments, it would have helped to restrain
pressure on the pound. For all sorts of understandable reasons,
that was not to be. I think one should treat it now as effectively
a closed door. The thing that remains is taking a more active
line on the question of getting Britain to the right exchange
rate and discovering what that exchange rate is, an issue on which
I would very much disagree with Professor Begg, who stressed the
possibility of converging after membership. He held out the example
of some countries like Ireland which had delivered a remarkably
good performance in the circumstances. It is true that there is
something of that which can occur. However, I am very struck by
the fact that it is not the way that France went about it. What
France did was actually to prepare for the euro for ten years.
A number of other European countries, including the Netherlands,
were quite closely converged with the leading Euroland economy,
namely Germany. One can think of all sorts of reasons why one
might want to do that. In the French case I think this is particularly
important because although no one can know what exactly the right
exchange rate is, if indeed there is such a thing, in the French
case they could be sure—and so could the Germans be sure—given
the ten years that at least the rate at which the two currencies
were fixed could not be grossly wrong because of the experience.
We are not in that situation. I think it is simply incredible
that the Chancellor should take the current stance under which
the exchange rate has been down at 2.16 against the Mark, up to
3.45, all over the shop, with people arguing for a vast range
of different possible entry rates and then to suppose that some
time after the election there will be a referendum without a discovery
process, without an experience of Britain being linked closely
within a reasonable range to the euro—suddenly the thing
is foisted upon us. That is the critical issue: discovering what
the appropriate exchange rate is, within reasonable bounds, and
seeing if you can live with it.
Mr Plaskitt
70. How do we do that? We have had this quite
dramatic oscillation in sterling against the DM and the euro.
Clearly you have to get some degree of sustainable stability in
the exchange rate in the run up to joining membership. Can we
do it with the Bank of England's present remit as to how it controls
monetary policy, or do we have to give them a new remit? Do you
think, Mr Barty, we have to add perhaps a second pillar and say
it has now got an exchange rate job as well? Otherwise, how is
it done?
(Mr Barty) I tend to agree with Roger Bootle in that
you have to try and find the appropriate level of exchange rate,
fix it and see if you can live with it. At some point, that will
mean changing the Bank of England's mandate, I think.
71. In what way?
(Mr Barty) Because you would join ERM2, but you would
not know what the right central rate is. By the way, there have
been cases where people have adjusted their central rates prior
to entry. Greece is one; Ireland is another. You do not have to
stick with the central rate once you go in. One way or another,
you would have to say the Bank of England would have to take more
notice of the exchange rate than it currently has. Since we left
the ERM, we have fluctuated enormously against either the Deutschmark
or subsequently the euro. I do not know where Professor Begg gets
his idea that five per cent more would be enough. I do not think
anyone has a clue. The range of sensible equilibrium exchange
rate estimates that I have seen for sterling in Deutschmark terms
is from about 2.50 to 3 Deutschemarks. That is a huge range. The
only way you can basically try and discover that is to say to
the Bank of England at some point, once we are convinced that
we have inflation down to a sustainable level, "Now you have
to try and target the exchange rate as well". That could
be in a wide enough range to not massively limit the Bank of England
but you do have to go down that route. If we do not have stability
of the exchange rate, I do not understand how we can be confident
that we can go in at a certain level of sterling against the euro
and make it work.
72. Are they compatible objectives? If we achieve
price stability at round about the current exchange rate and then
say to the bank, "Now you have to get down to that exchange
rate but you are not to compromise price stability", is it
possible?
(Mr Barty) You have to be very careful. One of the
two targets would have to have precedence over the other. You
cannot have two targets and one instrument. You could ask the
Bank of England to take more weight from the exchange rate than
it has done up to now. To have a situation where the currency
fluctuated as much as it has, and it is only very recently that
the Bank of England has got so concerned about the level of sterling,
when we did get up to 3.40-ish against the Deutschmark, that it
forced them to stop raising interest rates. That shows that their
primary focus, quite sensibly, has been totally on the inflation
target. My contention would be that at the moment, if we had a
very different level of exchange rate, we would have much different
levels of interest rates. Some of the OECD stuff published last
week is an inappropriate gauge. It is not easy to do this, but
if you want to go down the route into monetary union you do have
to think about the exchange rate as well as inflation.
73. Given all the years of volatility, how long
do you think it will take, following the point at which you change
the rules, before you could demonstrate relative stability in
the exchange rate sufficient for you to be ready to join the euro?
(Mr Barty) It is very difficult to put an exact time
frame on it but certainly years rather than months. I would personally
say at least a couple of years to see what the effect of a certain
exchange rate would be. Here we are, 18 months into monetary union,
and none of the economists at this table can honestly say whether
we think there has been divergence or convergence amongst the
Euro zone economies since we started.
(Professor Buiter) I do not want anybody to go into
a demonstration that we can manage the exchange rate outside the
euro. What is required is a transition, if Britain is to join
the euro, from the current level of exchange rate to a more sensible
level. It does not require you to demonstrate that you can manage
the exchange rate in ERM2 for some years' time. We have to get
out of that box. These interim regimes are bad news. Our current
monetary arrangements in this country are the best arrangements
for managing independent monetary policy with no expectation of
joining. It is the wrong arrangement for managing monetary policy
with an expectation of joining. It should not have two nominal
targets ever. If the Chancellor and the government decide that
joining is going to be a serious objective, then the exchange
rate has to become the overriding nominal target. You cannot be
a little bit pregnant in these things. You have to do it seriously
and have a formal change in the mandate.
Mr Fallon
74. Given Mr Barty's assumption of, say, a two
year transition—you are the experts—what rate would
you joint at, Roger Bootle?
(Mr Bootle) The 64,000 euro question. I would have
to give a range. Something probably between 2.60 and 2.90.
75. Professor Buiter?
(Professor Buiter) I do not want to venture a guess
at this stage.
(Professor Begg) Ideally, somewhere between 1.40 euros
and 1.45.
76. Could we have that in Deutschmarks?
(Professor Begg) Not off the cuff.
(Mr Barty) It is 2.80-2.90.
Chairman
77. Professor Buiter, I presume the reason why
you have not give us an answer is that you have recently been
a member of the MPC?
(Professor Buiter) Yes.
(Mr Barty) In the document I submitted, I said a broad
range guess is somewhere between 2.60 and 2.80. I would probably
be towards the top end of that range but I think it is impossible
to put an exact number on it.
Mr Fallon
78. Can we move on now to the inclusion of Greece
and the drachma into the system from next January? The ECB I think
slightly qualified that inclusion in their report by questioning
whether the drachma would have the capacity to meet the conditions
on a sustained basis. Do you share that concern?
(Professor Begg) The Greek government has been working
very hard since 1996 to join the EMU. It has gradually brought
the aspects of the economy that were out of line into what seems
to be in line. The exchange rate stability has been one of the
advantages of that policy because it has not been all over the
place the way it used to be in the eighties. It is not a big difficulty
for the drachma joining because there is strong political commitment
behind it. Anyone who looks at the accession of Greece to the
single currency and says, "This is a destabilising feature"
is simply ignoring the arithmetic, which is that the Greek economy
is around one percentage point of the EU total. That does not
alter monetary policy. You are adding the equivalent of a couple
of Isle of Wights to the United Kingdom economy and that will
never change things.
(Mr Barty) It has been a fairly rapid convergence
for Greece and the jury is going to be out on exactly how they
cope once they are inside the monetary union, but they have made
tremendous progress on convergence. I would agree with Professor
Begg that Greece is, what, 1.5 per cent of the EU GDP. That is
relatively small. It is not going to make a major difference to
the Euro area. The United Kingdom is a very different situation.
We are somewhere between 15 and 17 per cent of the EU GDP so if
we went into the euro and we were inappropriately positioned it
would be much more significant.
79. Is it suggested that just because an economy
is very small it should somehow be exempted from complying with
the rules under a sustained basis?
(Professor Buiter) No. The argument that they have
not exhibited durable, sustainable exchange rate stability is
again getting it backwards. You join the monetary union because
that is the best way, the only sure way, of getting currency stability.
To ask for a capability to demonstrate it on a durable basis before
you join is quite silly. The fundamentals are right. The budgetary
situation, the underlying inflationary pressures, the adherence
to the general rules and norms of the Common Market game are ready.
They will get their exchange rate stability, extremely sustainably,
once they are part of the euro.
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