Select Committee on Treasury Eighth Report


Performance of the Euro-area Economy

22. The rate of growth in the euro-area economy in 1999 was 2.4 per cent and is projected by the European Commission to be 3.4 per cent in 2000 and 3.1 per cent in 2001.[121] During the first eighteen months of Stage Three, the rate of inflation remained steady, around, or more often below, 2 per cent, and unemployment declined, from 10.4 per cent in January 1999 to 9.2 per cent in April 2000. Mr Barty believed that the euro-area had performed "reasonably well" since the commencement of Stage Three,[122] although the reasons for the increasing rate of economic growth were contested. Credit Lyonnais UK argued that it was attributable to cyclical factors,[123] although Professor Buiter disagreed, arguing that there had also been stimuli for economic growth from structural reforms, ECB monetary policy (which he described as being "conjunctionally appropriate" to the economic circumstances), and the external value of the euro.[124]

23. The effect on the euro-area economy of the depreciation of the external value of the euro was contested. By measuring trade as an average of imports and exports, the CEPS found that the euro-area economy was more open than either the US or Japan: in 1998 traded goods with the rest of the world accounted for 13 per cent of the euro-area's income, and on a broad measure of all current account transactions this figure rose to 21 per cent.[125] The TUC believed that the weakness of the euro's external value had therefore helped to "kick-start export industries" in economies such as Germany, and that the decline in the currency's value would not cause the ECB to raise interest rates.[126] However, the CBI argued that the external value of the euro mattered less to the euro-area economy than had the value of the legacy currencies to each Member State, because much of the foreign trade undertaken by euro-area countries now occurs within the same currency zone.[127] Professor Begg and Mr Ardy thought that the euro-area economy was "relatively closed" and, as a result, the decline in the external value of the euro had had "relatively little impact on consumer prices through imports" but net exports had been "boosted".[128] The support lent to the euro-area economy by the weak external value of the euro has been complemented by the ECB's interest rate policy. Deutsche Bank has calculated that the neutral level of interest rates in the euro-area is 4.5 per cent[129]—the key ECB refinancing rate has always been below this level (see Figure 3), indicating that in the first eighteen months of Stage Three the ECB's interest rate policy has been expansionary.


24. Ireland has experienced rates of economic growth and inflation well in excess of the euro-area average. Mr Barty suggested that Ireland, Spain and, to a lesser extent, Finland were set to eliminate their spare capacity at a faster rate than slower growth euro-area countries such as Germany and Italy.[130] Witnesses answered in different ways the questions of whether, despite current differences in the real economy, euro-area member states' economies were converging, and the consequences of such a development. The Institute of Directors argued that the euro-area economies were "disparate and show little signs of economic convergence", so making the selection of an appropriate interest rate by the ECB an "almost impossible task".[131] Mr Barty argued, however, that there did "appear to be some convergence" in terms of the growth rates and, to a lesser degree, the inflation rates of euro-area member states since 1998.[132] He noted "some worrying developments in Ireland", however, but believed that, at this stage, it was too early to draw definite conclusions.[133] The TUC agreed that it was too early to deduce the degree of economic convergence that had occurred since the start of Stage Three.[134] Looking ahead, Professor Buiter expected a greater degree of convergence as "one of the most important reasons for divergent cyclical behaviour is independent national monetary policies"; under the Third Stage of EMU, he added, "that particular impulse towards divergence is dead".[135]

25. The issue of convergence may be complicated if some economies grow faster and therefore 'catch-up' with the more advanced economies of the euro-area—Commissioner Solbes said it was those countries, such as Ireland and Spain, where this was apparently occurring which also had the highest rates of inflation in the euro-area.[136] Apparent divergences between euro-area member states caused by catching up may lead to greater convergence in the long-run, if not the short-run. Mr Barty argued that, even if inflationary pressures arise in less advanced euro-area countries, "this may not be undesirable" as it would allow price and wage levels to converge across the EU, provided these are justified by the rate of productivity.[137] If this condition does not hold, however, Professor Eltis warned that countries such as Ireland could lose their advantage as a "low cost country",[138] with adverse implications for future growth which could thereby hinder long-term convergence. The Governor of the Central Bank of Ireland recently warned that ECB monetary policy was "not well suited" to current economic conditions in Ireland, stating that this made the Irish economy "more vulnerable than before to overheating and the consequences of this—inflation and a loss of competitiveness".[139] Commissioner Solbes told us that he believed the currently high rates of inflation in Ireland were more a consequence of the policies of the Irish Government and the structure of the nation's economy.[140] Finally, it is open to debate as to whether complete convergence among euro-area member states is necessarily desirable—Mr Christopher Johnson, UK Adviser, Association for the Monetary Union of Europe, argued that "growth rates should not be completely synchronised, or inflationary booms will develop", believing that stability would be assisted if complete convergence was not achieved in the euro-area, a principle accepted by the Treasury.[141]


26. Structural reform has assumed a greater importance for euro-area member countries because of the loss of monetary policy independence and the limitations placed on fiscal policy (see paragraph 28). Professor Buiter was confident that the pace of structural reform within the euro-area was progressing well.[142] The Economic Secretary said that progress was being made in the EU on supply side reform and cited the positive role of the UK in promoting such policies.[143] The pace of reform, she hoped, would be "at least maintained and possibly accelerated" following the Lisbon summit; she argued that the flexibility of the EU economy was important in order for it to be able to compete globally in the future.[144] In Germany, we were briefed on the German Government's plans for tax reform, which are now coming to fruition, although we were told that further progress in structural reform was required. The OECD, however, recently noted that "the benefits of product and capital market integration in facilitating the conduct of macroeconomic policy may remain limited unless the process of integration spreads to labour markets".[145] In relation to labour market flexibility, Business for Sterling said that "only 1.5 per cent of EU citizens even live outside their own country, despite free movements of persons under the EU Treaties",[146] and, in oral evidence, witnesses debated the extent to which there now existed a free market in managerial staff in the EU.[147] Mr Barty argued that while such microeconomic reforms can increase an economy's flexibility and its ability to adjust to macroeconomic problems, it may not necessarily lead to greater convergence or stability, citing the example of financial market liberalisation.[148] There are some indications that the commencement of Stage Three of EMU has been accompanied by some structural reform in the euro-area. We agree with the Treasury, who said that the pace of structural reform in the euro-area should be "at least maintained and possibly accelerated".[149]


27. Adjustment mechanisms within and between euro-area countries may also help promote stability. Those countries participating in Stage Three of EMU have lost autonomy over two national adjustment mechanisms, interest rates and the exchange rate. Witnesses debated whether, in the interests of stability, there was scope for a greater role for the EU in coordinating fiscal policy. Professor Begg advocated a "top down fiscal stabilisation" approach,[150] which he defined as a new centralised European taxation system, on a limited scale.[151] This, Professor Begg argued, would be similar to the US system of federal transfer of welfare benefits, which is used to limit downturns and upswings in states' economies and could be achieved with a budget of about 0.4 per cent of EU GDP.[152] Professor Buiter, however, disagreed with the need for such a body, instead arguing that such a stabilisation function could continue to be undertaken by national, or even sub-national, authorities either through automatic fiscal stabilisers, or discretionary fiscal policy measures. The Paymaster General denied that the EU was progressing towards a "totally harmonised united system" of fiscal policy, rather than a system of cooperation in certain areas, which she insisted was the way forward.[153]

28. Co-ordination of EU fiscal policy is presently achieved, to a degree, by the Stability and Growth Pact and the Broad Economic Policy Guidelines. The Pact states that, while maintaining the reference value for government deficits of three per cent of national GDP, euro-area member states shall seek "sound budgetary positions close to balance or in surplus".[154] Mr Forder warned that the fiscal restrictions placed on euro-area member states, in particular the three per cent limit, "imposes tight constraints on borrowing. Historical experience suggests that the deficits which are contemplated will not be sufficient to alleviate economic downturns".[155] In contrast, countries experiencing periods of high and even unsustainable growth, Credit Lyonnais UK argued, were under no obligation as a result of the Pact to tighten fiscal policy or take other appropriate action.[156] Corus argued that, when public finances are balanced or in surplus, "tightening fiscal policy seems to be difficult for politicians" meaning that "it will probably take some time before the right policy mix per country is implemented".[157] The Guidelines set out a number of "general orientations" to all EU countries and for the EU as a whole, as well as country-specific recommendations.[158] Professor Begg observed that the Maastricht Treaty did not explicitly create a mechanism for fiscal policy coordination, and that the EU had sought to address this issue by taking a "soft policy approach" (i.e one not enshrined in a Treaty or directives).[159] While the Guidelines encourage cooperation, Professor Buiter speculated that peer pressure alone might be sufficient to encourage coordination.[160] The Economic Secretary explained that the importance of the Guidelines was to encourage structural economic reform in the EU and, although they were non-binding, the Minister said there had been "a lot of progress" in this direction as a result of them.[161] Miss Johnson denied, however, that the European Commission could determine whether EU countries changed their tax rates.[162]


29. French Finance Minister, Laurent Fabius, is reported to have called recently for the euro-11 group of finance ministers, which meets informally before European Council of Finance Ministers (ECOFIN) meetings, to be given a stronger role, although it is not yet clear what that role might be.[163] The role of the euro-11 group of finance ministers was seen by Professor Buiter as facilitating the coordination of fiscal policy with monetary policy in the euro-area.[164] He envisaged the euro-11 group usurping many of the functions of ECOFIN, including consideration of issues such as EU financial market integration.[165] Professor Begg agreed, pointing out that euro-11 had only been established because ECOFIN was unable to fulfil its original role because not all EU states were participating in Stage Three of EMU.[166] The Economic Secretary offered reassurance that nothing had changed the agreement of the 1997 Luxembourg Council that the euro-11 group would only "meet informally ... to discuss issues connected with their shared specific responsibilities for the single currency",[167] a point reiterated by the Chancellor.[168] Mr O'Donnell, of HM Treasury, added that, if the euro-11 group attempted to usurp ECOFIN, "the governing procedures where vetoes hold will all be governed by ECOFIN procedures, so there is no change to that whatsoever".[169] There is clearly a potential for conflict between ECOFIN and the euro-area group. Although the formal role of ECOFIN is clear, the euro-area group may increasingly shape the economic agenda. The British Government will need to ensure that, while the UK remains outside EMU, the euro-area group does not usurp the role of ECOFIN in shaping economic policy.

121   Spring 2000: Economic Forecasts 1999-2001, European Commission, 11 Apr 00; and see Q573 for the Chancellor's comments Back

122   Ev, p15 Back

123   App 27 Back

124   Qq2, 46 Back

125   Quo Vadis Euro?, pp44-5 Back

126   Ev, p78 paragraph 2.2 Back

127   Ev, p71 Back

128   Ev, p4 Back

129   The neutral interest rate is not directly observable and can only be estimated. Deutsche Bank's estimation of the ECB's neutral rate was based on the Taylor Rule, which calculates the neutral interest rate based on the difference between the actual rate of inflation and the central bank's target, the output gap, and the reference level for the 3-month nominal rate of interest Back

130   Q4 Back

131   Ev, p76 Back

132   Ev, p15 Back

133   Ev, p18 Back

134   Ev, p78 paragraph 3.3 Back

135   Q63 Back

136   Q104 Back

137   Ev, p15 Back

138   App 19 Back

139   Statement to the Irish Parliament's Joint Committee on European Affairs, Maurice O'Connell, Governor of the Central Bank of Ireland, Dublin, 23 Feb 00 Back

140   Q115 Back

141   App 5, paragraph 9; UK Membership of the Single Currency: An Assessment of the Five Economic Tests, HM Treasury, Oct 97, (hereafter Five Tests) paragraph 1.27 Back

142   Q5 Back

143   Q462  Back

144   Q463 Back

145   EMU: One Year On, OECD Policy Brief, Feb 00, p9 Back

146   App 16, paragraph 16 Back

147   Qq181-90 Back

148   Q47 Back

149   Q463 Back

150   Q48 Back

151   Q49 Back

152   Q48 Back

153   Q381; also see the Chancellor Qq589-603 Back

154   Resolution of the European Council on the Stability and Growth Pact, European Council, Amsterdam, 17 Jun 97 Back

155   App 23, paragraph 19 Back

156   App 27 Back

157   App 6 Back

158   Monthly Report, European Central Bank, Jul 00, p29 Back

159   Q62 Back

160   Q62 Back

161   Qq422-425 Back

162   Q430 Back

163   For instance see BBC Online Reports of 30 May and 17 Jul 00; and Daily Telegraph, 9 May 00 Back

164   Q53 and Q80 Back

165   Qq82-3 Back

166   Q86 Back

167   Q402; Presidency Conclusions, Luxembourg European Council, 12 Dec 97, paragraph 44 Back

168   Qq604-5, 607 Back

169   Q409 Back

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