Select Committee on Treasury Sixth Report


The changeover process

13. Eighteen months after their launch, Euro notes and coins have become an integral part of daily life in the eurozone. The completion of the changeover was accomplished at a time of considerable global uncertainty, in the aftermath of the events of September 11th. The Bank of England described the changeover as a "technical success greater than anyone could have anticipated"[12]. Mr Mike Rake of KPMG International told us that "contrary to all expectations it was introduced very efficiently and in a very smooth way"[13]. It is clear that the introduction of euro notes and coins across the eurozone was a logistical success.

14. There was some concern in the eurozone that traders would exploit the confusion of the changeover to increase prices. Indeed, a public opinion survey conducted by the Commission at the end of January 2003 found that 67% of the public felt that more often than not prices had been rounded upwards. Research by Eurostat[14] found that the contribution to inflation from the changeover process was a maximum of 0.2%[15]. One possible explanation suggested was that "shoppers take note mainly of the prices of frequently bought goods; a train ticket, a newspaper, a haircut. It was exactly these small ticket items that became more expensive"[16]. The Consumers' Association told us that "anecdotal evidence collected by consumer organisations in the first wave countries suggested that there have been some significant increases in prices, particularly for personal and leisure services. EU average figures do not of course show sector problems or individual abuses".[17] The Association also recognised that in the longer term "the greater ability of consumers to make price comparisons may force manufacturers and retailers, over time, to lower prices". While rounding up of prices was found to have no significant statistical effect on overall inflation, in a small minority of sectors there was some evidence of retailers taking advantage of the changeover to push up prices.

The European Central Bank

Strategy and objectives

15. Monetary policy in the eurozone is the responsibility of the European System of Central Banks (ESCB). This consists of the European Central Bank (ECB) and the National Central Banks of each of Member States of the European Union. The ECB is independent of national Governments and the European Commission. The responsibilities of the ECB are to set interest rates for the eurozone, and also to intervene in foreign exchange markets if required. Its primary objective, as defined under the Maastricht Treaty, is to "maintain price stability" in the eurozone.[18] The ECB is able to define what is meant by price stability, which has led the Bank to set its own objective for inflation in the eurozone. Without prejudice to the primary objective, the ECB shall also "support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community".[19]

16. The objectives of the Community are specified in Article 2 of the European Community treaty and include "a high level of employment" and "sustainable non­inflationary growth". Britain in Europe told us that the ECB's mandate was "broadly similar to the UK system introduced in 1997, where the [Bank of England's] mandate is to meet its inflation target and 'subject to that' to support the policies of HM Government for growth and employment".[20] A recent paper from the Centre for Economic Policy Research (CEPR) pointed out that, while the Treaty gave the ECB a double mandate, "the ECB fulfils its double mandate by reducing it to a single responsibility, a focus on price stability"[21]. Mr Wim Duisenberg, President of the ECB, has said in testimony to the European Parliament that "strictly following this mandate [of maintaining price stability] is the best contribution the ECB can make to supporting sustainable non­inflationary growth and a high level of employment in the euro area"[22]. The CEPR paper considered that "this view is not just narrow, but mistaken" and that "the practical issue is whether the ECB cannot engage in a more active policy of output stabilisation without endangering price stability".[23]

17. The ECB has chosen to define its mandate of price stability as being "year­on­year increases in the Harmonised Index of Consumer Prices (HICP) for the eurozone of below 2%" over the medium term. This objective was criticised by some witnesses as being unhelpfully low and 'asymmetrical' because the ECB attempts to keep inflation under 2%, whereas the Bank of England has a 'symmetrical' inflation target in that "deviations below the target are treated in the same way as deviations above the target"[24]. In regarding an undershooting of the target as being as important as an overshooting, the symmetrical approach guards against deflation as well as inflation, while also helping to "ensure that monetary policy not only delivers price stability but supports growth and employment"[25]. The TUC believed that the ECB's inflation objective should be "kept at 2% on HICP but set symmetrically with a range above and below the target. So for example a range of 1%-3% might be set"[26]. The ECB President has, however, countered accusations of a deflationary bias by stating that the ECB's overriding objective is maintaining price stability, "avoiding both inflation and deflation";[27] and the actions of the ECB in cutting rates while inflation is above 2% lend some support to this statement (see paragraph 19 below). The UK rate of inflation targeted by the Bank of England is measured by the retail price index RPIX. HICP inflation is around one percentage point lower than an equivalent measurement on RPIX, caused in part by major differences in coverage and in part by technical measurement issues.[28] In his Budget 2003 the Chancellor of the Exchequer announced an examination of the implications of adopting the Harmonised Index of Consumer Prices. This would bring the UK into line with all eurozone countries.

18. In order to achieve price stability, the ECB has adopted a 'two­pillar' strategy to inform its decisions on setting interest rates for the eurozone. The first pillar refers to money supply growth (M3), for which the ECB has set a reference value for annual growth of 4.5%. The second pillar consists of a broadly based assessment of the outlook for price development and the risks to price stability in the eurozone, which has been likened to an 'inflation forecast'. There was some criticism from witnesses of the ECB's monetary pillar. The National Institute of Economic and Social Research told us that "monetary growth continues to exceed the ECB's target, risking bringing it into disrepute in much the same way as happened to UK monetary targets in the 1980s"[29]. The CEPR believed that "the problem with the first pillar was not that it had greatly contaminated interest rate decisions, but rather that it had clouded the ECB's communication strategy"[30]. The money growth pillar has an unwarranted prominence in the ECB's monetary framework, though in practice it appears to be disregarded in setting interest rates. This tends to undermine the overall credibility of its monetary framework.

19. The charts below show money growth, inflation and interest rates in the eurozone:

20. The ECB has so far changed its key refinancing interest rate fourteen times, as shown in the above graph. Rates were initially cut in the autumn of 1999 in reaction to the East Asian crisis, and they were then raised during the first half of 2000 as oil and food price rises combined with the depreciation of the euro to push up inflation. As signs of the world economic slowdown began to materialise the ECB cut rates by 0.25% in May and August 2001, followed by a further 0.5% cut after the events of September 11th. The rate was then kept at this level for over a year before a further 0.5% cut in December 2002, and a further 0.25% cut in March 2003. Our witnesses thought that overall the ECB had done an adequate job in controlling inflation although cuts in interest rates in 2001/2 may have came too late in the face of deteriorating economic conditions. Mr Alan Wood, Chief Executive of Siemens in the UK, thought that the ECB had done a "good job of meeting the remit that they were given"[31]. Dr Diane Coyle told us that while the ECB "would almost certainly have done better to cut [rates] faster during 2002, this is a judgement made with the benefit of hindsight. And the core measure of inflation ¼ averaged 2.6% during the first half of 2002, which also helps explain the slow policy reaction"[32]. The ECB has continued to cut interest rates although inflation stubbornly remains above 2%, indicating to some that they do take growth into account and that the target is more symmetrical than it appears. There has been some divergence in inflation rates of the individual countries since 1999 and this was seen as making the ECB's job more difficult. Miss Ruth Lea, of the Institute of Directors, thought the ECB had "done a reasonable job", but the fact that—on her analysis—there was not proper convergence within the eurozone was making their task "impossible".

21. The President of the ECB has announced "a serious assessment and evaluation of our monetary strategy" in the course of the first half of 2003. In testimony to the European Parliament he added that "after four years of practice with our monetary policy strategy [... we consider] that it is the appropriate time to take stock of our experience so far and to reflect on the various elements of our strategy"[33]. We welcome the ECB's review of its monetary policy framework. The framework should be strengthened by the introduction of a symmetrical inflation target. This would not require a great policy change on the part of the ECB, but would provide a better match between its announced strategy and its actions. The ECB would benefit from a less prominent role for the monetary growth pillar, although it should still monitor developments in order to inform its decision making.

Transparency, openness and accountability

22. Since its inception, the ECB has presented annual reports to the European Parliament, the European Council and the Commission. A monthly report is published and, from December 2000, this has included twice yearly projections of inflation and economic growth in the eurozone. The President of the ECB appears four times a year before the Committee on Economic and Monetary Affairs of the European Parliament. Witnesses felt that the ECB had made some improvements in the area of openness. The Chancellor told us that the ECB was a "far more transparent organisation now than it was a few years ago".[34] Sir Edward George and the Chancellor both contrasted favourably the procedure of the ECB of explaining each decision at a press conference on the same day, with that of the Bank of England, where it is explained two weeks later with the publication of minutes of the MPC's meeting.

23. One important difference identified by Sir Edward is that the Bank of England publishes the results of the votes at MPC meetings, whereas the ECB "operate by consensus and do not publish votes"[35]. Publication of the voting record of individual MPC members improves accountability, and individual members have to be ready to justify their position (for instance in evidence to this Committee at our regular hearings on the Bank's Inflation Reports). Members of the ECB Governing Council are mandated to consider the performance of the eurozone as a whole and not national situations when making their interest rate decisions. Some witnesses argued that publication of the votes could invite political pressure on the individual National Central Bankers to vote along national lines rather than considering the appropriate rate for the eurozone as a whole, a view to which Sir Edward George gave some support[36]. We welcome the publication of economic projections by the ECB, but believe they should increase the frequency of publication to 4 times per year, as there can be significant change in the outlook over six months. More frequent publication would help the Bank to provide a clearer and more transparent explanation for their decisions.

24. While it appears that to date formal votes have not been necessary, this may not be possible as the eurozone expands. The ECB should start publishing the voting figures (keeping the votes of individuals confidential), since the figures would indicate changes in policy stance, thereby improving transparency.

25. The TUC also suggested that the interest rate setting process would be improved if the inflation target was set not by the ECB itself but by the European Council.[37] Such a move could help to address perceptions that the process lacks any political accountability. There is a clear opportunity for introducing a mechanism for greater democratic political accountability to the process by which the inflation target is set. We consider that this decision properly rests with ECOFIN.

Interest rate decision making body

26. Monetary policy decisions are the responsibility of the ECB's Governing Council, which currently consists of the governors of the 12 eurozone National Central Banks and also the six members of the executive board of the ECB. In our predecessor Committee's last report on the euro it was noted that reform of the Governing Council could be an "important issue"[38] before enlargement of the eurozone took place. Two arguments were put forward in evidence as to why reform was necessary prior to enlargement. First, a decision-making body which, following enlargement, could include up to 30 members was seen as being "too many for efficient decision making"[39]. Secondly, an enlarged Governing Council run on the principle of 'one member one vote' could result in a situation where a coalition of smaller countries could effectively control the monetary policy decisions of the ECB, despite only accounting for little more than 20% of eurozone GDP. The need for reform of the Governing Council was recognised in the Nice Treaty (which paved the way for enlargement of the EU). The Treaty allowed reform of the voting procedures of the ECB to be approved by the European Council on a proposal from either the Commission or the ECB itself.[40]

27. The ECB put forward a recommendation for reform of the voting procedures in the Governing Council on 20th December 2002. In essence, the proposal envisaged that the voting numbers on the Governing Council would not rise above 21, which (with 6 seats taken by the members of the Executive Board) meant that the number of national central bank representatives should not rise above 15. The 15 places would be allotted on a rotation system based on three groups of countries ranked according to size. The five largest countries (France, Germany, Italy, Spain United Kingdom) would form the first group and would have 4 seats, meaning that each country's central bank would have a vote for four out of five rotation periods (the length of which has not been decided); the smaller countries in the second and third groups would have correspondingly shorter periods with a vote. Professor Francesco Giavazzi believed that the national central bankers were "simply the wrong group of individuals to propose new voting rules for the ECB" and that it "was inevitable that they would come up with a set of rules that preserves their current rights, rather than proposing the most efficient mechanism for setting interest rates in the eurozone". He went on to say "One of the problems with the current council—which includes 18 members, 12 NCB governors plus the six Executive Board members—is already its size. This has sometimes already produced a status quo bias, that is in the decision to keep interest rates unchanged simply because it proved too difficult to agree on the change".[41] He also identified a number of drawbacks with the scheme in that it capped the number of voting Council members at a level that was far too high, and also violated the principle of ECB statutes, which prescribe that the National Central Bank Governors sit on the Governing Council as individual experts, not as representatives of their own countries. Professor David Begg agreed with this, stating that "one of the good things the ECB has done has been to downplay the nation state, they have mainly focussed on eurozone aggregates in forming their decisions" and that it was "unhelpful" that the rotation system emphasized the nationality as the basis for who had a vote at any one time. Mr Daniel Gros, Director of the Centre for European Policy Studies (CEPS), also pointed out in a recent CEPS paper that "all members of the Governing Council (with and without voting power) will continue to sit at the table and have the right to participate in the discussion. The ECB's proposal thus does not solve the problem of the excessive size of the forum".[42]

28. Sir Edward George told us that there may be pressure for the ECB to "move to something which is perhaps more efficient over time" but that "The issue is whether now is the right stage at which to exclude national representation on the policy making body". Professor Giavazzi put forward a solution where the "Executive Board should be joined by five independent experts to form the Monetary Committee that makes interest rate decisions, with the Governors bringing important information of local conditions but not making decisions"[43]. The solution of a small committee was also endorsed by Professor Begg. In its opinion on reform of the voting procedures the European Commission drew attention to the fact that the Nice Treaty "imposes important constraints and limitations which prevented the ECB from considering more comprehensive reform of its Governing structure"[44]. Mr Regling told us that "they were only asked to change Article 10.2 of the ECB protocol which talks about voting procedures" and that the ECB therefore "did not have the mandate" to put forward a more radical proposal. However, the ECB's proposals for reform of its structure on enlargement have now been agreed. We agree with the Commission that the ECB was prevented from considering alternative proposals for reform of its voting procedures (for example, the introduction of a separate committee based on the Executive Board for setting rates) due to the limitations of the enabling clause in the Nice Treaty. We do not think that the proposals put forward by the ECB are the optimal solution to the problems posed by enlargement. It is regrettable that such an important decision on reform was taken so quickly and with limited debate. We recommend that reform of the Governing Council prior to enlargement needs to be re­considered urgently, under a broader remit allowing changes to the structure of the ECB. We consider such reform important for the credibility and operational effectiveness of any enlarged ECB. We think the prospect of UK exclusion from 20% of ECB interest rate votes could prove to be an obstacle to entry.

Stability and Growth Pact

29. Members of the euro have an interest in a stable and orderly monetary union. One possible source of instability is excessive government borrowing by one of the individual countries within the eurozone. Excessive government borrowing in one country could lead to increasing inflation and interest rates, thereby imposing costs on all countries within the zone. In an extreme case a heavily indebted country might default on its debt and impose costs on all eurozone members. It is also argued that reducing government debt and deficits will help member states prepare for the future budgetary costs of aging populations. The Stability and Growth Pact (SGP)[45] establishes a framework within which members of the European Union have agreed to coordinate their fiscal policies. The Pact requires member states to keep budgets "close to balance or in surplus" over the medium term. Under the Pact countries are also required to observe the two reference values laid down in the Maastricht treaty; these are that government deficits should not exceed 3% of GDP and public debt should not exceed 60% of GDP. The Pact is complemented by the Broad Economic Policy Guidelines (BEPG), which are general guidelines for the conduct of economic policy within the Union, agreed annually by the European Council on the basis of a report from ECOFIN (which acts on the basis of a recommendation from the Commission).[46]

30. The UK Government has also recognised the importance of medium­term fiscal sustainability. It has set two fiscal rules that it will endeavour to meet to ensure that it accomplishes this primary objective. The golden rule states that 'over the economic cycle, the government will borrow only to invest and not to fund current spending'; the sustainable investment rule states that 'over the economic cycle, public debt as a proportion of GDP will be held at a stable and prudent level', which has been defined as a level of net debt below 40% of GDP. The TGWU believed that "the UK's self imposed 'golden rule' is a far more flexible and investment focused fiscal framework".[47] Mr Ian Brinkley, of the TUC, pointed out that in some areas the UK's fiscal framework imposes a tighter regime than the SGP, noting that "the rule on public debt applied by the Chancellor is more rigorous than the one ¼ applied under the Pact" and that the UK rule implies "roughly 45% on European definitions and the Pact says 60%".[48]

12   Bank of England, Practical issues arising from the euro, May 2002, p6 Back

13   Q 114 Back

14   Eurostat is the statistical office of the European Commission Back

15   Eurostat press release, 16 July Back

16   Centre for European Reform, The euro and prices, January 2003, p 3 Back

17   Appendix 6 Back

18   Treaty on European Union: Protocol on the Statute of the ESCB and of the ECB Article 2 Back

19   Treaty establishing the European Communities (TEC), Article 105 Back

20   Appendix 4 Back

21   CEPR Surviving the Slowdown: Monitoring the ECB 4 2002 p12 Back

22   Testimony to the European Parliament Committee on Economic and Monetary Affairs, 8 October 2002 Back

23   CEPR Surviging the Slowdown: Monitoring the ECB 4 2002 p 12 Back

24   HM Treasury Reforming Britain's Economic and Financial policy 2002 page 47 Back

25   HM Treasury Reforming Britain's Economic and Financial policy 2002 page 47 Back

26   Ev 55 Back

27   Testimony to European Parliament Committee on Economic and Monetary Affairs, 17 February 2003 Back

28   The main differences are that HICP is calculated using a geometric rather than arithmetic mean and excludes housing costs. For March 2003, inflation measured on RPIX was 3%, compared to 1.6% on HICP. Back

29   Ev 137, para 27 Back

30   CEPR Surviving the Slowdown: Monitoring the ECB 4 December 2002 p 2 Back

31   Q 414 Back

32   Ev 16 Back

33   Testimony to the European Parliament Committee on Economic and Monetary Affairs, 17 February 2003 Back

34   Q 1087 Back

35   Q 1172 Back

36   Q 1172 Back

37   Ev 55 Back

38   Eighth Report of Session 1999-2000, Economic and Monetary Union, HC 573 Back

39   Ev 197 Back

40   Treaty of Nice, amending the Treaty on European Union, the Treaties establishing the European Communities and certain related acts Back

41   Ev 198 Back

42   Reforming the composition of the ECB Governing Council in view of enlargement-How not to do it! Briefing paper for European Parliament Economic and Monetary Affairs Committee, February 2003 Back

43   Q 538 Back

44   European Commission press release, 19 February 2003 Back

45   The Stability and Growth Pact is contained in a European Council Resolution of 17 June 1997 and in Council Regulations 1466/97 and 1467/97: see paper by HM Treasury (Appendix 3). Back

46   TEC Article 99 Back

47   Ev 180 Back

48   Q 214 Back

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