Select Committee on Treasury Sixth Report

Implementation of the Pact

31. If a country has a deficit that exceeds the 3% of GDP threshold then the 'excess deficit procedure' is launched. The Commission prepares a report. Acting on the Commission's report the Council decides by qualified majority voting whether an excess deficit exists. If it does then it can recommend that the country take corrective action to bring the situation to an end within a specified period of time. If the Member State concerned persistently fails to put in place the Council's recommendations, then the Council may decide to apply one of a number of sanctions, ultimately leading to fines for non­compliance lasting at least two years. There is provision under the Treaty for a deficit over 3% not to be regarded as excessive if the deficit is only "exceptional and temporary".[49] Countries like the UK that remain outside the eurozone are also subject to the SGP but only 'endeavour' to avoid excess deficits and are not subject to sanctions if they fail to do so.

32. Many witnesses referred to the importance of 'automatic stabilisers'. This is the process through which, during an economic expansion, higher incomes lead to increased income and corporation tax receipts and at the same time lower unemployment leads to reduced social security payments. During an economic slowdown or recession the opposite happens: government tax revenue is reduced and more has to be spent on social security payments. The overall effect reduces the government deficit during a period of high growth and raises the deficit during an economic slowdown. Automatic stabilisers help to reduce the volatility of the economy over the cycle by boosting demand when growth is slow and reducing aggregate demand when the economy is growing quickly.

33. Eight of the twelve eurozone countries achieved the objective of a budget 'close to balance or in surplus' by the year 2001. Germany, France, Italy and Portugal failed to reach this objective and have continued to have difficulties since then. To some extent, as some witnesses[50] and people to whom we spoke during our visit to Frankfurt suggested, countries' current difficulties in complying with the requirements of the Pact stemmed from a failure to strengthen their fiscal position in earlier years when the economy was performing better. Following the announcement that the budget deficit in Portugal had increased to 4.1% of GDP in 2001, the ECOFIN Council on 5 November 2002 declared that an excess deficit existed in Portugal. The Portuguese Government declared its firm commitment to reducing their deficit below the 3% target in 2002, reducing the deficit to 2.7%. At the ECOFIN Council of 21 January 2003, it was decided that an excessive deficit existed in Germany in 2002, following an outturn figure of 3.6%. An early warning was also sent to France with a view to preventing an excessive deficit occurring in 2003. The Council concluded that the French projection of growth was optimistic and that there was a danger that the deficit would breach the reference value in 2003. The French Government has shown little desire to reduce the deficit for 2003 in the face of weak economic conditions: the Prime Minister, Mr Jean­Pierre Raffarin, was quoted as saying "When growth is uncertain you do not lower spending more than necessary—that would depress the economic climate even further".[51] Goldman Sachs recently contrasted the fortunes of the three countries that had been subject to the excess deficit procedure: "Germany and France allowed their budget deficits to breach the 3% limit [in 2002]. Portugal by contrast embarked on a hefty fiscal contraction to reduce its deficit below 3%. During the second half of 2002, French and German GDP grew at an annualised rate of 1.25%, Portuguese GDP declined at an annualised rate of 4.5%".[52] All three countries illustrate the possible consequences of failure to address significant deficits in good time. However, Portugal, which adhered to the stability and growth pact, suffered more severe economic penalties than Germany and France which did not adhere to it.

34. The TUC believed "that the Pact has put too much emphasis on stability and not enough on growth" and that more flexibility should be allowed in the event of growth of less than 1%[53]. Professor Begg suggested in respect of reform of the Pact that there is "a need for medium­term fiscal rectitude ¼ The question is whether there is any way to combine the reaffirmation of that with some operational structure which provides more short­term flexibility"[54]. The Governor of the Bank of England took a similar line, saying that "you obviously have to accept a commitment to fiscal sustainability in the medium and long term but ¼, in an environment of weak demand, you must let the fiscal stabilisers operate and not have an artificial cut­off point" and that "applying 3 percent absolutely rigidly would be unwise".[55] We recognise the fact that the countries now exceeding the 3% deficit limit of the Stability and Growth Pact would not now be doing so if they had addressed structural fiscal weaknesses before the present downturn. However, tightening fiscal policy at this stage in the cycle could further exacerbate the downturn in the eurozone. We conclude that a Treaty interpretation allowing countries with relatively low overall debt levels to exceed the 3% limit during a cyclical downturn is essential. Governments should, however, take advantage of any increase in economic growth to reduce structural deficits. As growth in the eurozone recovers it is important for those countries with significant structural deficits to achieve an enduring strengthening in the fiscal position. Medium term fiscal sustainability should remain the goal, but if it does not allow flexibility the SGP will lose credibility and jeopardise the ultimate objective. It is important that the discipline of overall fiscal policy expressed in the Stability and Growth Pact remains firm so that breaches of it do not become a way of avoiding the structural reform needed for long term sustainable growth.

Reform of the Pact

35. There have been calls for reform of the Pact from many quarters. We have noted some suggestions in the previous paragraph. Professor Michael Moore, of Queen's University, Belfast, advocated scrapping the Pact with the exception of the target of medium term fiscal sustainability.[56] Professor Anton Muscatelli, of the University of Glasgow, recognised one criticism of the Pact in that "it gives too much emphasis to deficits and too little emphasis to debt sustainability".[57] Some have commented that the Pact is asymmetrical in not establishing any mechanism to encourage governments to improve underlying structural deficits when their cyclical fiscal position is healthy.

36. Recognising some of the growing criticism of the Pact, the Commission put forward a number of proposals to improve its implementation.[58] Mr Regling described the proposals as intended to make the Pact "a little more sophisticated and more country specific", by allowing small temporary deviations from the 'close to balance or in surplus' rule over the cycle where the deviation is to finance a particular policy initiative with a long­term benefit for the economy, and allowing more permanent deviations from the rule where a country had a long­term healthy financial situation. He thought it possible that "the UK might fall into this category where we would consider more permanent small deviation as appropriate".[59] The proposals include measurement of the fiscal balance, for the purpose of assessing adherence to the 'close to balance or in surplus' rule, in cyclically adjusted terms. The proposals have no direct effect on the basic 3% limit, because that is set in the Treaty (rather than the Pact) and any change to it would require a Treaty amendment. ECOFIN, in its broad endorsement of the Commission proposals, noted "areas where further improvements could be made or clarification was needed with regard to an effective application of the Stability and Growth Pact. A pragmatic approach seems appropriate which, while abiding by the Pact's rules, could take reasonable account of specific situations." The ECOFIN proposals were adopted by the European Council on 20­21 March. It remains to be seen how far the reforms in the interpretation of the Pact agreed at the March European Council will work in practice, and we believe the promised reforms must be closely monitored to see if they do indeed deliver greater flexibility. We note the principle that there should be more flexibility to take into account the specific situation of individual countries. This could allow higher levels of spending where debt sustainability was not a problem. We note that the Treaty requires classifications to meet the definitions of European integrated economic accounts and that these are monitored by an independent committee convened by Eurostat. It is equally important, however, that individual countries are not allowed to escape the rules of the Pact by artificial reclassification of their accounts or other adjusted accounting.

37. Reforms could go further, for example in the treatment of investment spending. Professor Francesco Giavazzi noted that "There is no attempt [or only a] very mild attempt in the Commission proposal to make the point that current expenditure is very different from investment expenditure and should be treated very differently in the ¼ accounts";[60] he noted also that in the "second part of the 90s, public investment in the euro area has fallen (as a share of GDP)".[61] The ability to provide for appropriate levels of public investment is important for the UK and other euro countries, and it is particularly important also for the accession countries which need to improve their infrastructure to EU standards. Mr Regling told us that "investment can also be financed through normal tax revenues" and that this does not necessarily "mean higher taxation—it could also mean a restructuring of the budget on the expenditure side; less current expenditure and more investment expenditure". Though true that must not mean a bias against borrowing for investment if resulting debt levels are sustainable.

38. The UK Government agrees with the principle of a strong SGP founded on sensible fiscal policy coordination. The Government supports a "prudent interpretation of the disciplines of the stability and growth pact [that takes] into account the economic cycle, sustainability of debt and the important role of public investment".[62] The Government has also stated that the proposals made by the Commission and adopted at the Council meeting of 21-22 March are "in line with key aspects of the UK's prudent interpretation of the Stability and Growth Pact".[63] We support the Government's view of the need for a prudent interpretation of the Stability and Growth Pact taking account of the economic cycle, sustainability of debt and the important role of public investment. We recommend that the Government should set out at the time of its euro decision its views on exactly how this interpretation could be achieved within the existing framework and how far the Council's recent reforms are from meeting these requirements.

Performance of the eurozone economy


39. The following graph shows the outturn and forecasts for economic growth in the UK and the eurozone for 1997-2004:

Sources: HM Treasury, Budget 2003, chart B5, p226, 2003/2004 midpoint of forecast range; European Commission, Spring Economic Forecasts April 2003, table 0.1, p3

40. In the four years since the introduction of the euro, the annual rate of growth of the eurozone economy has averaged 2.2%. This compares with annual growth averaging 2.4% for the UK over the same period. Within the eurozone there were significant divergences in growth rates between countries, with average annual growth performance over the period ranging from 8.8% in Ireland to 1.4% in Germany. Mr Regling told us that "when you look at the period 1999-2002, there were two good years and two bad years but this was also true for many other countries around the world." However, the downturn of eurozone economic growth during the world slowdown in 2001 and in the aftermath of September 11th was significantly more pronounced than that in the UK. European growth was led by exports, while domestic demand remained weak in the larger countries. In contrast in the UK domestic demand has been the driver of economic growth. Unemployment in the eurozone has fallen from 10.2% in 1998 to 8.5% at the beginning of 2003. The record on employment growth for the eurozone as a whole has been good, particularly amongst the smaller eurozone members.

41. Mr Regling identified one of the benefits of the euro as removing the currency fluctuations between the participating members, thus contributing to stability. He contrasted the experiences since the introduction of the euro with those of 1995, when there were "tremendous intra­European exchange rate variations" and noted that "independent estimates done afterwards that the German economy was affected by about 1% less real growth in the year 1995".[64] The TUC drew attention to the higher levels of workplace productivity in the eurozone than in the UK and stated that if "the UK was part of the eurozone it would rank 10th out of 13 in terms of overall economic prosperity (GDP per capita) and workplace productivity levels"[65]. Miss Lea and Mr Martin Taylor suggested that UK productivity on an output per head basis was lower primarily because the lower labour costs compared to continental economies made it sensible for businesses to opt for more labour intensity rather than capital intensity,[66] though clearly greater capital investment would indeed be a boost to productivity.

42. As for the effect on trade between countries, Mr Rake took the view that, by removing the national currency barriers to trade, "the creation of the euro has led to a rapid increase in cross­border trade in the eurozone, while Britain's trade with Europe has stagnated." He cited Eurostat figures indicating a 3% average rise in trade within euro countries and a 0.4% fall in UK trade with the EU,[67] though the No Campaign argued that these figures were misleading since they were based on trade as a percentage of GDP rather than measured by volume.[68]

Structural reform

43. With the advent of the euro structural reform has assumed a greater importance for eurozone members for encouraging economic growth. With internal exchange rates within the eurozone abolished, a greater burden of adjustment falls on product and labour markets, which need to be flexible to facilitate this adjustment. The IMF has noted that "to maximise the benefits from the introduction of the euro, it will be important to move forward with structural reforms".[69] At the Lisbon meeting of the European Council in March 2000 Europe's leaders set out a ten year strategy to make the EU "the world's most dynamic and competitive economy". As part of the Lisbon strategy a number of targets and objectives were set covering areas such as labour markets and employment, research and innovation, and further liberalisation of product and financial markets. Mr Regling told us that it is important to recognise that "there had been some progress" towards these targets "but not enough". He acknowledged that "there is less progress on labour market deregulation, making the labour markets more flexible, particularly in some countries."[70] He also stated that the Commission takes the view that "the low growth environment that we have at the moment should not be an excuse not to do the reforms that we consider necessary".[71]

44. The Chancellor regarded the economic reform agenda as "absolutely critical to the future of European Union"[72]. The Government recently published a White Paper on economic reform in Europe and the progress that was being made towards the Lisbon Objectives[73]. This identified that of the different areas of the Lisbon strategy there had been clear progress in six areas including employment, research and innovation and energy markets, 12 others were listed as work in progress, and there was limited progress in three areas. In a foreword to the paper the Prime Minister wrote that "Many countries have made impressive progress in cutting unemployment. But the EU's Member States are still not doing enough to tackle the fundamental barriers to job creation".[74] We agree that insufficient progress has been made in the eurozone in making labour markets more flexible.

45. Miss Lea told us that "it is not just the national governments of the eurozone countries that have to address this problem. I would like to see the Commission itself address the problems of labour market inflexibility".[75] Mr Philip Stephens told us that the ECB also has a role to play in encouraging structural reform and that the key thing is that "the bargain is struck between the ECB and Governments that trades flexibility in labour, product and capital markets offered by the Governments in return for lower interest rates"[76]. The Centre for European Reform, which issues a 'scorecard' for progress against the Lisbon objectives, suggested in its most recent report that, while Denmark, Sweden and Finland already met most of the Lisbon targets and a second tier of countries (which included the UK) were making "good progress", the "eurozone's three largest economies—France, Germany and Italy—have so far made little attempt to fulfil their Lisbon promises, particularly labour market and pension reforms" and that these three countries risked "becoming a drag on the entire EU".[77] Structural reform is vital if the eurozone is to gain the full benefits of the single currency. With the loss of monetary policy independence, reform in individual countries must play an increasing role in stimulating growth and reducing unemployment. We acknowledge that there has been progress in some areas, but are concerned that progress appears to be slow. The current weak economic conditions should not be an excuse for the pace of reform remaining slow. We welcome the contribution of the UK Government towards encouraging structural reform. The ECB, the Commission and the Governments of the Member States should work together to ensure that the promised reforms are actually delivered as quickly as possible.


46. The growth and unemployment performance of the German economy has been significantly worse than the eurozone averages. The average growth rate over the years 1999-2002 was 1.4%, compared to a eurozone average of 2.2%. There was some debate as to the reasons for this underperformance. Several witnesses commented on the fact that interest rates were too high for the German economy as a consequence of the 'one­size fits-all' monetary policy of the ECB. Mr Geoffrey Dicks, of the Royal Bank of Scotland, recognised that Germany was "going to suffer in terms of growth and rising unemployment from the strictures of the Stability and Growth Pact" as they are forced at a time of cyclical weakness and rising unemployment into a fiscal tightening, while acknowledging along with many other witnesses that Germany would not be facing this problem if it had taken advantage of better times to reduce its budget deficit. Mr William Keegan, of The Observer, regarded "a reduction in government spending in Germany a time like this [as] the 'economics of the madhouse'."[78] The TUC believed that "Much of the under­performance of the German economy can be traced back to the economic after­shocks of reunification." Reunification brought an extra 16 million people, with a highly inadequate economic infrastructure, into a country with a population of around 63 million. Mr Regling quoted an EC report which concluded that of Germany's underperformance "half the problem comes from reunification and the other half comes from the lack of structural reforms".[79]

47. Many witnesses thought that Germany had locked itself to the euro at an overvalued exchange rate, which meant that manufacturing costs in Germany were much higher than elsewhere in the European Union. Mr Anatole Kaletsky, of The Times, drew attention to figures from the US Bureau for Labour Statistics that manufacturing labour costs in France were "about 30% cheaper" than Germany. Lower inflation was seen as a natural adjustment process. Mr Roger Bootle, of Capital Economics, argued that while "it is by no means the ultimate root of Germany's problems" there is a sense in which being in the euro "blocks off some of the more comfortable exits"[80]. Many witnesses referred to structural problems with the German economy, particularly with regard to the flexibility of labour markets, which acted as a barrier to job creation. There was some disagreement as to the effect which the euro would have on solving these problems. Mr Rake of KPMG believed that over time the euro would help "correct these issues"[81] whereas Mr Hamish McRae, of The Independent, believed that it "it will be hard for other structural reforms to be put in place in such a tight fiscal and monetary regime"[82]. Mr Keegan drew attention to the higher productivity of the German economy relative to Britain and stated that "In the short run I would not be putting my money on the German economy but in the medium to long run I would not be pessimistic".[83] Witnesses put forward a number of explanations for the recent under­performance of the German economy and the extent to which they were caused or made worse by the euro. Many stated that the problems of the German economy were long term in nature and related to the after effects of reunification. There was a broad consensus that Germany entered the euro at an overvalued exchange rate—though the current account is now returning to substantial surplus. All witnesses questioned on the subject referred to the fact that structural reforms are necessary if Germany is to correct its underperformance.


48. The smaller eurozone countries have typically outperformed the central countries. This has particularly been true in the case of the Republic of Ireland which has grown at an average annual rate of nearly 9% over the years 1999-2002—over four times the eurozone average. Irish unemployment is now at 4.4%, at a lower level than in the UK, having fallen from 12% in 1995. The lower interest rates available to Ireland as a member of the eurozone were partly responsible for the elimination of this spare capacity within the Irish economy. The economy began to overheat in 1999, which led to increased inflation, initially exacerbated by the fall in the value of the euro, which pushed up import prices due directly to the large proportion of Irish imports that come from outside the eurozone (in particular, around 37% from the UK). Many of those to whom we spoke referred to the potential benefit to the Republic of British membership of the euro, in terms of reduced exchange rate volatility. Inflation has now moderated slightly, falling from 6% in late 2000 to 4.9% in March 2003, although it is still the highest in the eurozone.

49. As part of this inquiry the Committee visited Dublin to examine the performance of the Irish economy. We were particularly interested in the performance of the Irish housing market since this is similar in structure to that of the UK, with a significant proportion of debt at a variable rate. The reduction in interest rates led to rapid growth in house prices in the years leading up to the introduction of the euro, with annual increases peaking at 30% in 1998. However in the years following the introduction of the euro the rate of growth moderated, without leading to substantial falls. This moderation was partly due to the increased supply of housing, with housebuilding activity rising by 50% over the past five years. The Irish economy has benefited from being part of the eurozone in terms of gaining a credible monetary policy and the elimination of exchange rate fluctuations against other eurozone members. However, excessive inflation could lead to a loss of competitiveness in the longer run if not matched by productivity improvements. There may be a particular danger of this following the appreciation in the value of the euro against sterling and the dollar, especially if the UK remains outside the eurozone.

Experience of UK companies so far

50. While the UK remains outside the eurozone, many British firms trading with Europe deal with the single currency on a regular basis. ALSTOM already saw one benefit of the single currency as "reducing the complexity and financial costs ... of transactions throughout the eurozone".[84]. The Engineering Employers' Federation told us that of respondents to their survey "over six in ten companies" were conducting some of their invoicing or purchasing in euros.[85]

51. The Committee visited Northern Ireland to examine the UK's land border with the eurozone. Ms Gault of the Northern Ireland Hotels Federation told us that her members would be "dealing with dual currency all along the border" although she highlighted the problem for marketing hotels in Northern Ireland. The Committee also visited the border town of Newry and witnessed the arrangements for dual circulation of sterling and the euro. The euro was increasingly in use as a currency of invoicing in Newry, a role that the punt did not have previously. Many retailers used the euros they accepted to pay suppliers throughout the eurozone, not only in the Republic but also further afield in Germany and Italy. Some employees were paid in euros.

52. Extensive use is of course also being made of the euro by individuals travelling to eurozone countries. It is clear that, both at the level of international businesses and at local level, UK businesses and citizens are adjusting comfortably to use of the euro. While UK firms are finding it relatively easy to adopt operational strategies for living with the euro while the UK remains outside the zone, longer term issues affecting location and investment may well be contingent on knowing where government policy is headed. UK companies need to see the analysis of the five tests to provide such clarification.

49   Under the Pact, a deficit is automatically regarded as temporary if output fell by over 2% in the year in question, and may be regarded as temporary if output fell by 0.75-2% Back

50   See for example Q 296 [Mr Martin Weale] Back

51   Financial Times "France refuses to take steps to curb budget deficit" 25 February 2003 Back

52   Goldman Sachs, European Weekly analyst 28 March 2003 Back

53   Ev 53 Back

54   Q 301 Back

55   Qq 1182, 1195 Back

56   Qq 802, 805 Back

57   Q 561 Back

58   Strengthening the co-ordination of budgetary policies European Commission communication, 21 November 2002 Back

59   Qq 464-5 Back

60   Q 488 Back

61   Ev 199 Back

62   Appendix 3, para 24 Back

63   HC Deb, 14 March 2003, col 491W Back

64   Q 461 Back

65   Ev 50 Back

66   Q 366 Back

67   Ev 32 Back

68   Ev 73 Back

69   IMF World Economic Outlook, April 2002, p 25 Back

70   Q 474 Back

71   Q 475 Back

72   Q 1139 Back

73   HM Treasury Meeting the Challenge: Economic Reform in Europe February 2003 Back

74   ibid (Foreword) Back

75   Q 387 Back

76   Q 71 Back

77   Centre for European Reform Press Release 10 March 2003 Back

78   Q 48 Back

79   Q 477 Back

80   Q 298 Back

81   Q 114 Back

82   Ev 1 Back

83   Q 32 Back

84   Ev 154, para 10 Back

85   Engineering Employers' Federation: Manufacturing and the euro-any change? 2002 Back

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