Select Committee on Treasury Sixth Report

The monetary transmission mechanism

73. The monetary transmission mechanism—the means through which changes in interest rates affect the wider economy—is the subject of one of the supporting studies. Oxford Economic Forecasting submitted a study concluding that "the UK is four times more sensitive to interest rate changes than the Eurozone and the different structure of its housing market and mortgage markets are an important component in that sensitivity".[125] In contrast, a recent study by the NIESR found that "the eurozone countries and the UK are similar to each other in terms of their overall interest rate sensitivity".[126] The European Commission economic paper found that following changes in interest rates "consumption in the UK was more affected than elsewhere but the impact on investment was smaller".[127] How the UK reacts to changes in eurozone interest rates is an important area for the Treasury to have examined during the assessment; this should include an assessment of the effect of interest rate changes on investment and consumption in the UK as well as in aggregate.

The exchange rate

74. The Treasury's 1997 assessment made little reference to the importance of the exchange rate. As part of the technical work for the forthcoming assessment a supporting study will be completed "Analysing different approaches to the sustainable real exchange rate—as this is a key indicator of convergence and of obvious importance to this and all of the tests".[128] The exchange rate is of critical importance for convergence: even if there is currently cyclical convergence, entering at an inappropriate exchange rate could cause economic performance to diverge. Locking in at an overvalued rate could create a long process of adjustment by low wage and price growth and higher unemployment. Similarly, going in at an undervalued level could lead to a period of above average inflation, which could damage competitiveness in the medium term. The essential question is whether the recent fall in the value of sterling against the euro provides an exchange rate that would avoid these difficulties if it were the basis of the UK joining the euro. The Treasury assessment must spell out how a sustainable real exchange rate for entry is to be determined.

The housing market

75. The housing market is the subject of one of the Treasury's supporting studies, informing the assessment of the convergence test. The Council of Mortgage Lenders (CML) told us that "the UK housing market is quite different from the rest of the eurozone because it combines a high level of owner occupancy, a high level of debt and a high proportion of variable rate mortgage finance".[129] UK mortgage rates and the level of mortgage payments therefore respond quickly to changes in interest rates, in contrast to the eurozone where a higher proportion of loans are taken out at fixed rates. Changes in interest rates affect both the disposable incomes of the homeowner (through a change in mortgage payments) and also the price of housing by making it more or less affordable. Miss Lea explained that changes in the eurozone interest rate would therefore have a "big impact on the housing market in this country and on personal consumption ¼ whereas this would not be the case in Germany".[130] The CML told us that "a switch from variable to fixed rates could protect borrowers against changes in interest rates" and "the take­up of fixed­rate mortgages can change quite dramatically over relatively short periods of time".[131] Figures supplied by the CML show the proportion of new loans at fixed rates has fallen from a high of around 50% in 1998 to 24% in 2002; this compares with around 57% in the EU in 1999. The Chancellor announced in the 2003 Budget a review of the factors underlying the low take­up of fixed rate mortgages in the UK.[132] An interim report is due by autumn 2003, and a comprehensive report with recommendations due by the time of Budget 2004.

76. The housing market in the UK has recently been through a period of high growth in prices. The Permanent Secretary to the Treasury has previously described the rate of growth in house prices as "unsustainable",[133] although the Treasury have argued that "there may well be structural reasons why house prices have increased permanently" meaning that actual price levels may be sustainable[134]. The Treasury have also previously acknowledged with regard to house price inflation that "although a slowing must come at some point, the longer it is delayed the greater the risk of a sharp correction".[135] The CML cautioned that lower interest rates stemming from euro entry could lead to further unsustainable rises in house prices, "this may increase the chances of an asset bubble developing and the potential for a sharp correction". However, the risk of a bubble developing and being followed by a sharp fall in house prices will depend, in part, on the economic outlook at the time that interest rates converge with lower European levels. Mr Weale drew attention to how different the situation in the housing market is from the 1980s when the large fall in house prices was caused by very high interest rates for a very long time and suggested that "no one is expecting that at the moment either inside or outside the eurozone".[136] The Republic of Ireland's housing market experienced similar buoyant conditions in the run up to their entrance to the euro but so far had managed to avoid a subsequent crash. Part of the reason for this is that price rises were moderated in the medium term due to a large rise in house building. There is a question as to whether the planning system could accommodate such an increase in housebuilding in the UK.

77. We welcome the research announced in the Budget into factors influencing the take up of fixed rate mortgages, but regret that it will be too late to inform the assessment of the tests due to take place by June 2003.

The degree of convergence required for entry

78. Present members of EMU joined on the basis of satisfying broad convergence parameters set out in the Maastricht Treaty covering price stability; sustainability of government finances; long term interest rates and exchange rate stability (discussed further at paragraphs 97-98 below). For some years the UK has satisfied the Maastricht criteria, except membership of the ERM. The question now is how much further convergence there needs to be before normal economic forces, by a process of adaptation and adjustment, can be relied on to bring about sufficient convergence without jeopardy to growth and stability. To demand total convergence before joining EMU is likely to be an impossible condition to fulfil and indeed not all present EMU members fulfil it. The judgement of whether the present degree of convergence is enough for any adverse consequences of post entry adjustment to be outweighed by the benefits of membership is more political than economic.

Flexibility test

"If problems emerge is there sufficient flexibility to deal with them?"

79. Even if there is a high degree of convergence between the UK and eurozone economies, they may still react differently to future economic events. This test examines the mechanisms by which individual economies can adjust to mitigate the effects of an economic shock in the absence of changes in interest and exchange rates. The Chancellor drew attention to the experience of the United States where there are three mechanisms through which individual states adjust to shocks. These were "a very big central budget" which adjusts expenditure towards poorly performing regions; labour mobility where "people will move from one part of the single currency area to another, so if there are less jobs in Massachusetts they may move to California and the other way round"; and "the way labour markets work, particularly in terms of wages, and it is undoubtedly the case that in a single currency area you need greater flexibility for that single currency to work".[137] The Chancellor told us that the adjustment mechanism of a central budget was "not available for the European Union" and that US­type labour mobility did not happen in the EU.[138]

80. In practice labour market flexibility covers a range of questions. How rapidly do prices and wages adjust to a shock to demand? Can firms respond to changes in demand for their products by recruiting workers or making cutbacks? Are workers' skills flexible enough to enable them to change jobs and move to new industries? Also, are workers able to access training opportunities to improve their skills and productivity? Is there sufficient labour mobility—are people able to travel or move house to find jobs? Are there incentives that make work more attractive than remaining on benefits? Capital market flexibility is also important—can firms invest in areas of high unemployment, and are the workers productive and skilled enough to make such investment worthwhile?

81. We asked our witnesses what types of flexibility it was important for the UK to have if it was to join the euro. Mr Bootle interpreted the test as being "mainly about labour market flexibility" and "the ability of [the] wage and price structure to adjust".[139] To the TUC flexibility meant workers "being agile, ...capable of change, ...well rewarded, well trained and well educated and to adjust without their wages being adjusted downwards rapidly or their hours being chopped and cut around".[140] Mr Dicks regarded this as a symmetrical test requiring flexibility both for the UK and the eurozone.[141] The Chancellor confirmed this saying that the "test looks at whether there is sufficient flexibility to enable us to withstand shocks. In other words, it is movement in achieving greater flexibility that we have been looking for both in the UK economy and in the euro area."[142] Labour market flexibility is important for the UK economy, if it is to respond efficiently to shocks. We ask the Treasury to clarify and define the ways in which there has to be flexibility amongst the eurozone countries and the UK for this test to be passed. We note the Chancellor's statement in Budget 2003 in respect of achieving greater labour cost flexibility in the regions of the UK. We hope the Treasury assessment will say more about the context for this reform.

  82. With the loss of an independent monetary policy, a greater burden will be placed on fiscal policy to stabilise the economy and prevent swings in output in response to a shock. The No Campaign identified a number of drawbacks to using fiscal policy to stabilise output, including the speed with which discretionary fiscal policy can be used and whether the use of fiscal policy could interfere with long term priorities in promoting efficiency and welfare; Ms Janet Bush believed that there would be pressure for the EU to enlarge the central budget and to make transfers through the tax system between Member States.[143] Mr Taylor also thought that the eurozone might increase the pressures for tax harmonisation.[144] The Chancellor told us that he disagreed with those who said "that a successful single currency requires tax harmonisation or federal tax and spending arrangements"[145] and stated that the government opposed "tax harmonisation and ... qualified majority voting on taxes".[146] We note that taxes remain unharmonised in the highly integrated federal United States economy.[147] The Treasury assessment needs to set out clearly the Government's thinking on the relationship between monetary union and member state fiscal policy regimes and how it will deal with the extra pressure in a single currency for tax harmonisation and for an enlarged EU budget.

Investment test

"Would joining EMU create better conditions for firms making long­term decisions to invest in Britain?"

83. Encouraging investment to raise the long­term growth and productivity performance of the UK is a key part of the Government's objectives. This test examines "how EMU membership will affect public and private investment in general and foreign direct investment in particular".[148] If the UK joins the eurozone then some firms may be encouraged to increase their investment because they want to sell into the European markets and the absence of exchange rate risk enhances the attractiveness of locating in the UK. The degree of convergence and flexibility assessed in the UK will have a bearing on whether the overall effect on investment is positive.

84. ALSTOM told us about a number of possible benefits of eurozone membership including greater price and cost transparency and a removal of currency risk. Mr Paul Barron, Alstom's UK President, stated that for the UK part of the business "unlike all our European partners selling into the eurozone, we still have the currency fluctuation to deal with".[149] Unilever told us that "some investment decisions had already been influenced by the euro—and while it remains one factor among several, the uncertainty of the currency value equation will undoubtedly be a major influence in the future. In the long term, the continuing UK position outside the euro is likely to have a negative effect on Unilever's investment and employment levels in the UK".[150]

85. While the fact that reduced currency volatility with the eurozone would benefit trade and investment was not disputed, Miss Lea claimed that if the UK joined the euro our currency would be "more volatile" against the dollar than if we kept sterling,[151] although the significance of this effect was disputed by Britain in Europe.[152] Professor Rowthorn told us that "in terms of exchange rate stability ... the balance of advantage would depend in large measure on the relative importance of our trade with eurozone and non eurozone countries".[153]

86. The Treasury has said that "Evidence suggests that foreign direct investment into the UK can raise the productivity of UK firms through technology and skills spillovers. The preliminary and technical work is considering how EMU would affect FDI inflows to the UK".[154] The UK has a well established track record of attracting much higher levels of foreign direct investment than other countries in the EU. Several different sources of statistics were presented to us including those from Eurostat, Ernst & Young and the UN.[155] Dr Coyle told us that "it is impossible to draw strong conclusions about FDI flows given that they have suffered globally and that much UK inward investment has come from the US in the past. Nevertheless the UK's share of EU inward FDI has fallen".[156] Mr Bootle cautioned that that FDI is "imagined as being some foreign company moving to a greenfield site and building a car factory" whereas it is sometimes "essentially a financial transaction where a company is taking over another company's shares".[157] Ms Lea believed that swings in FDI had a lot to do with mergers and acquisitions and that figures could be distorted by big takeovers such as Vodafone's takeover of Mannesman[158] (which was was a factor in the large increase in Germany's share of intra European FDI to over 30% in 2000, from 10% in 1999). Dr Coyle believed that there will be a clearer picture of whether the UK's share of FDI has declined as a result of being outside the eurozone when global investment flows start to increase.

87. Membership of the single currency is likely to provide the conditions for more and better investment if there has been sufficient convergence between the UK and the eurozone and sufficient flexibility exists. In this way the third test is to some extent a consequence of whether the first two tests have been satisfied. We received evidence from a number of firms that over time investment decisions would increasingly favour the eurozone at the expense of the UK. The assessment must cover the extent to which volatility against the dollar could be increased if the UK joined the eurozone and what effect this could have on inward investment to the eurozone from the US. The accuracy and significance of the large volume of inward investment statistics needs to be assessed, if possible with the effects of mergers and acquisitions identified and separated out.

Public Investment

88. The Treasury's paper to the Committee indicated that, under the heading of the investment test, the assessment will be examining the "potential impact ¼ on public sector investment" of the UK joining the euro.[159] As discussed in paragraph 30, the UK governs public expenditure through the Chancellor's fiscal rules, while also being subject to the Stability and Growth Pact (but not to its penalties). The No Campaign told us that "The golden rule distinguishes between capital (investment) and current (short­term) spending. It ... lets the Government borrow to invest".[160] The TGWU were concerned that "the imposition of the rigid Pact on the UK economy during this Parliament would place severe downward pressure on the promised investment in public services".[161] The Chancellor referred to the ongoing debate over reform of the Pact and told us that people were coming to accept the importance of debt levels being taken into account and of investment being distinct from consumption.[162] We welcome the examination within the assessment of whether the Stability and Growth Pact would place any constraints on the level of public investment in excess of those of the Government's fiscal rules. While the recent proposals allow a temporary deviation in the short term from the close to balance requirement to fund public investment, it is important to estimate whether investment projections in Budget 2003 could be constrained because overall deficits would breach the 3% limit of the Stability and Growth Pact.

City and financial services test

"What impact would entry into EMU have on the competitive position of the UK's financial services industry, particularly the City's wholesale markets?"

89. The Treasury has stated that "given the importance of the financial sector to the UK both in terms of employment and indivisible earnings, it is vital that the decision on whether to join the single currency does not damage the sector's competitiveness".[163] The assessment of the five tests in 1997 concluded that "EMU offers benefits to the UK financial sector whether the UK is in or out. But the benefits and the opportunities from the single currency will probably be easier to tap from within the eurozone".[164] Mr Lascelles of the Centre for the Study of Financial Innovation told us that "non­membership of the eurozone has not damaged the City in any way" and that "fears at the time of the euro launch that the City would lose out to continental centres, particularly Frankfurt, ... have not materialised."[165] Mr Rake believed that the threat to the City from the UK being outside the eurozone was "long­term rather than short­term" but that in the "increasingly competitive environment, remaining outside the euro risks putting the City at a unique disadvantage to its European competitors".[166]

90. Sir Martin Jacomb stated that "whether we join the euro or not is not the major threat to the City of London" and that more important was the threat of "over­regulation ... [and] over­taxation".[167] A recent survey commissioned by the Corporation of London was surprised to find the "low ranking of the euro­membership issue as a factor affecting the potential location of banking activity in London. There are several strategic concerns relating to London as a centre of financial activity, but UK Eurozone membership is way down the list".[168] Mr Rake believed that outside the eurozone the City could face a disadvantage from a lack of influence over financial regulation. However, Mr Lascelles believed that it was unlikely that eurozone members would pass any regulation that would discriminate against the City as this would violate the principles of the single market. The London Stock Exchange told us that "Stamp duty levied on UK equities harms the competitive position of the City of London. A combination of euro entry together with stamp duty would further disadvantage London¼" and that "the Government needs to begin the process of phasing out the tax¼before possible euro entry".[169] Many witnesses stated that the financial services sector had not yet been adversely affected by being outside the eurozone, but that it would wrong to be complacent about the position of the City as Europe's dominant financial centre. We believe that as well as assessing the recent performance of the financial services industry the test also needs to reflect a forward looking approach examining both potential opportunities and threats. It is also important to examine any possible effect on the UK's influence on European financial regulation from being outside the eurozone.

91. The National Changeover Plan envisaged 4 months between a Government decision to join and a referendum, and then a further transition period of 24 to 30 months following the referendum. The Governor of the Bank of England felt that the City and the Bank "were as well prepared as we can be at this point".[170] Standard Life's experience of the euro conversion in Ireland led them to believe that they would " need three years to prepare for converting our UK data".[171] Mr Paul Richards from the Bank stated that most banks "would start to implement their preparations on a government decision to recommend entry and not wait until a referendum".[172] Witnesses from the financial services sector told us that they needed at least three years to prepare their UK operations for any changeover to the euro. We note that under the current National Changeover Plan this would mean they would have to begin preparations immediately following a Government decision to recommend entry and not wait until the result of any referendum.

Growth, stability and jobs test

"In summary, will joining EMU promote higher growth, stability and a lasting increase in jobs?"

92. This, the final and most fundamental test, will draw on all the preceding analysis to assess whether joining the euro would overall be good for growth and jobs. The technical analysis "is—as in 1997—analysing the potential benefits of EMU for the longer term performance of the economy. The assessment will compare these against the potential costs of joining".[173] As noted above, we believe it is important to recognise that remaining outside the euro has costs as well as benefits and that this test should be assessed against a scenario of the possible future performance of the UK economy outside the eurozone.

93. Britain in Europe told us that "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"; they drew attention to figures from Eurostat, showing that between 1998 and 2001 EU trade as a proportion of GDP increased for France and Germany, while it declined for the UK. The No Campaign preferred measures looking at the volume of trade, which they claimed showed "British exports to the eurozone have grown faster than the euro members' exports to each other".[174] The relative merits of empirical studies covering the effect of monetary unions on trade between member countries were discussed.[175] Britain in Europe referred to a recent paper from the Inter-American Development Bank which estimated that the impact on trade amongst eurozone member countries was 5%-10%.[176] Mr Bootle believed that while "there was no doubt that being in a monetary union should boost trade" there remain questions about the magnitude of these effects.[177] As part of the assessment the Treasury plans to undertake a supporting study assessing the likely impact of UK membership of the euro on "UK external trade with the euro area and the rest of the world" and to "consider the range of estimates for the influence of monetary union on trade and assess the econometric studies that suggest the effects on trade could be very large". As the Treasury itself admits, this crucial fifth test rests on judgements about long term effects. They cannot be known with certainty in advance. The assessment is therefore a judgement and the balance of evidence which informs it needs to be clearly set out.

The experience of the US & Canada

94. The US economy is of a similar size to the eurozone economy and has long been operating as a monetary union. The Treasury plans to examine "what lessons can be learned from the experience of the US as a monetary union", including "how different regions respond to asymmetric shocks with the same interest rate and the role of relative price changes, factor mobility and fiscal policy in resolving regional divergences".[178] Sir Martin Jacomb suggested that there may also be a parallel between the positions of the UK and Canada, both existing on the edge of large monetary unions.[179] Professor Begg made reference to a study examining the effect on trade of the Canadian border,[180] and the relative merits and demerits of this study were discussed in submissions from Britain in Europe and the No Campaign. Professor Laidler from the University of Toronto submitted two papers on the subject of Canada joining in a monetary union with the US. Both papers stressed the importance of the political element in any decision about international monetary integration, particularly those appertaining to the political accountability of the monetary authorities including the capacity to influence "the goals of monetary policy and the means whereby the relevant authorities pursue those goals". We welcome the examination of the experience of the US as a monetary union. There may also be something to be learned from the experience of Canada.

The Stability and Growth Pact and the European Central Bank

95. If the UK joins the eurozone then, as previously discussed, the European Central Bank will be responsible for setting the interest rates applicable for the UK. Similarly fiscal policy will become subject to the Stability and Growth Pact. An important part of the assessment of the effect of euro entry on the UK economy will be how these frameworks operate and comparing them with the monetary and fiscal frameworks currently in place in the UK. One of the Treasury's supporting studies will examine "the current arrangements for fiscal policy, monetary policy, and policy coordination in eurozone ­ how they deal with shocks, and how they contribute to the credibility and conduct of economic policy".[181] Since the Treasury announced this study, there have been changes to the Stability and Growth Pact, and the announcement of a review by the European Central Bank of its monetary policy framework. The Chancellor, during his appearance before the Committee on 27 February, told us that he expected to be clear "about the next steps that the ECB are taking in the conduct of monetary policy and what they are proposing as a result of the review in the next few weeks".[182] We recognise that, while much of the current round of reforms is largely agreed, there is a need for continuing evolution in the reform process and any assessment of the European Central Bank and the Stability and Growth Pact will be in essence 'aiming at a moving target'. If the assessment of the five economic tests is announced prior to the completion of the review of its monetary policy framework by the ECB, then the Treasury should publish a supplementary study examining any significant changes made.

125   No Campaign Press Release 2 March 2003, reporting on paper by Oxford Economic Forecasting The housing market and the monetary transmission mechanism in the UK, in and out of EMU, February 2003. Back

126   NIESR: Designing and choosing macroeconomic frameworks: the position of the UK after 4 years of the Euro (Ray Barrell and Martin Weale) November 2002 Back

127   European Commission: European Economic Papers No. 178 October 2002 Back

128   Appendix 1: The Treasury's approach to the preliminary and technical work, 6 September 2002. Back

129   Appendix 7, para 4 Back

130   Q 379 Back

131   Appendix 7 Back

132   Budget 2003, HC (2002-03) 500, para 2.79 Back

133   Q 71 in evidence to this Committee's Second Report of Session 2002-03, HC 159 Back

134   Pre-Budget Report 2002, Cm 5664 (para A70) Back

135   Appendix 7, para 15 Back

136   Q 316 Back

137   Qq 1136-1137 Back

138   Qq 1136-1137 Back

139   Q 317 Back

140   Q 188 Back

141   Q 317 Back

142   Q 1139 Back

143   Qq 252- 255 Back

144   Qq 374-375 Back

145   Q 999 Back

146   Q 1041 Back

147   See also paper on fiscal transfer payments in the USA by Professor H Scobie (Appendix 8) Back

148   Appendix 1 The Treasury's approach to the preliminary and technical work, 6 September 2002 Back

149   Q 369 Back

150   Appendix 22 Back

151   Q 345; see also evidence from Professor Minford Q 490 Back

152   Britain in Europe further memorandum (see List of Memoranda p 68) Back

153   Appendix 24 Back

154   Appendix 1 The Treasury's approach to the preliminary and technical work, 6 September 2002 Back

155   See for example Ev 16 (Dr Coyle), Ev 45 (Mr Rake), Ev 63 (No Campaign), Appendix 4 (Britain in Europe) Back

156   Ev 16 Back

157   Q 318 Back

158   Q 409 Back

159   Appendix 1: The Treasury's approach to the preliminary and technical work, 6 September 2002 Back

160   Ev 106 Back

161   Ev 174 Back

162   Q 1086 Back

163   Appendix 1: The Treaury's approach to the preliminary and technical work, 6 September 2002 Back

164   HM Treasury: UK membership of the single currency - An assessment of the five economic tests October 1997, p 35 Back

165   Appendix 5 Back

166   Ev 45-46 Back

167   Q 116 Back

168   The Impact on the City of UK Eurozone Membership: The Banking Industry - press release 2, December 2002 Back

169   Appendix 13, paras 6.1- 6.2 Back

170   Q 1151 Back

171   See List of Memoranda p 68 Back

172   Q 1152 Back

173   Appendix 1: The Treasury's approach to the preliminary and technical work, 6 September 2002 Back

174   Ev 118 Back

175   Q 319, Ev 123-124 Back

176   Appendix 4 Back

177   Q 319 Back

178   Appendix 1: The Treasury's approach to the preliminary and technical work, 6 September 2002 Back

179   Q 154 (see also Q 330 [Mr Weale]) Back

180   Q 330 Back

181   Appendix 1: The Treasury's approach to the preliminary and technical work, 6 September 2002 Back

182   Q 1126 Back

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