Select Committee on Treasury Sixth Report


This Report

(a)    We fully recognise that the political issues will clearly form a major part—perhaps even a dominant part—of any referendum debate. But the political issues in themselves are not the subject of this report (paragraph 11).

(b)    Our intention has been to offer a significant, and balanced, contribution to the debate—so far as possible in relatively simple terms—about the economic implications of a decision to join, or not to join, the euro... We hope it will assist the debate for so long as joining the euro remains an issue (paragraph 12).

The changeover process

(c)    It is clear that the introduction of euro notes and coins across the eurozone was a logistical success (paragraph 13).

(d)    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. (paragraph 14).

European Central Bank

(e)    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 (paragraph 18).

(f)    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 (paragraph 21).

(g)    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. (paragraph 23).

(h)    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 (paragraph 24).

(i)    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 (paragraph 25).

(j)    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. (paragraph 28).

Stability and Growth Pact

(k)    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 (paragraph 34).

(l)    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 (paragraph 36).

(m)  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 (paragraph 38).

Performance of the eurozone economy

(n)    We agree that insufficient progress has been made in the eurozone in making labour markets more flexible (paragraph 44).

(o)    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. (paragraph 45).

(p)    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 long­term 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 (paragraph 47).

(q)    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 (paragraph 49).

Experiences of UK companies so far

(r)    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 (paragraph 52).

The assessment process

(s)    We accept the need for a serious and in­depth analysis which will allow the Government to take a properly considered and researched decision on the economic consequences of joining the euro. At the same time, we recognise that an economic analysis is not a mechanistic exercise and that there will inevitably be an element of judgement involved in assessing the economic case for entry. It will be difficult for the results of the assessment to be totally unambiguous (paragraph 55).

(t)    It seems to us that non­publication of the supporting studies ahead of the announcement will have reduced the opportunity for informed public debate before the Government becomes committed to a particular judgement. It is now too late for the studies to be published before the assessment is made and announced, and we regret this (paragraph 58).

The five tests and the supporting studies

(u)    We note the importance of assessing the consequences of not joining the euro. One set of issues arises if the decision is taken to join. A different set of issues arises if the decision is taken not to join in the foreseeable future. Both scenarios bring new challenges to the UK economy. We therefore welcome the confirmation that this point is being taken into account in the Treasury's assessment (paragraph 65).

(v)    When the tests were constructed in 1997 evidence concerning the present UK monetary arrangements and the eurozone (as a monetary union) was not available. We welcome the Treasury's examination of the experience of the eurozone so far as part of a number of the supporting studies. The eurozone countries now provide 12 case studies as to the effects of entering monetary union and we believe these provide important lessons for the UK. Equally, given six successful years of the new UK monetary framework, supporters of entry will have to demonstrate that entering the monetary union will be at least as beneficial as the UK framework that is to be abandoned (paragraph 68).

Convergence test

(w)  There has been substantial convergence between the UK and the eurozone economies since 1997. In some respects the level of convergence is greater than that between some of the eurozone members themselves before 1999. However, the Treasury assessment must include examination of whether convergence to date is cyclical or structural. It must also examine the implications of the recent imbalances in the economy for achieving sustainable and durable convergence and whether these imbalances would have arisen had the UK been in the eurozone from the outset (paragraph 72).

(x)    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 (paragraph 73).

(y)    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 (paragraph 74).

(z)    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 (paragraph 77).

Flexibility test

(aa)  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 (paragraph 81).

(bb)  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 (paragraph 82).

Investment test

(cc)  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 (paragraph 87).

(dd)  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 (paragraph 88).

City and financial services test

(ee)  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 (paragraph 90).

(ff)  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. (paragraph 91).

Growth, stability and jobs test

(gg)  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 (paragraph 93).

(hh)  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 (paragraph 95).

Maastricht criteria for entry

(ii)    We recommend that the Government should clarify whether they regard it as their policy to keep the deficit within the 3% limit required by the Maastricht treaty. We note that any deficit exceeding 3% on the treaty definition may preclude the UK from applying for membership of the euro (paragraph 98).

Exchange rate on entry

(jj)    It is of fundamental importance that entry to the euro, should this take place, is at a viable and appropriate exchange rate. Although there is no unanimity on what the precise appropriate rate would be, we note that a number of expert witnesses are now of the view that the exchange rate is close to such a rate (paragraph 100).

(kk)  We recognise the potential drawbacks of a process of entry involving a two year membership of ERM2. There is potential for the UK to provide leadership on this issue and to set out its preferred method of joining. Whatever the exact process were to be, it is important that the electorate knows, at least in approximate terms, the Government's view of an appropriate exchange rate range before they are asked to vote in a referendum (paragraph 101).

Influence of UK on reform

(ll)    In this period, when the eurozone's monetary policy and institutions are bedding in, there is clearly a greater 'window of opportunity' for British influence in negotiating reforms within the system, than would be the case later if there is a decision not to join the euro in the foreseeable future. The Government should continue to play an active role in the debate over reform of monetary and fiscal policy and structural reform. The analysis of the five tests and the accompanying studies will be of value to the eurozone states in this respect. Encouraging reform which improves the performance of the eurozone economy will also help to improve the performance of the UK's main export markets, whether or not the UK joins the euro (paragraph 104).

The present options

(mm)  Government (and then Parliament) now face a range of options [indicated in paragraphs 107-109]...We do not judge between these options, but we have sought in this Report to provide additional analysis and information on the implications of each option. The point we would emphasise is that while there are indeed political implications to each option (to which we have referred throughout this Report) it is of fundamental importance that the economic case for entry is met first of all if the UK is to enter the euro (paragraph 106 and 110).

Engaging the public: the challenge

(nn)  It should be the objective of the Government—and of other organisations and institutions involved, including the political parties and Parliament itself—to promote as full and as well informed a debate as possible ahead of any referendum. We should be seeking to maximise the level of participation in a referendum and to maximise the extent to which voters feel they have been given the information necessary to cast their vote, based on their knowledge of the issues involved (paragraph 112).

Public interest and increasing public understanding

(oo)  We recommend that, were there to be a referendum on the euro, provision for the Electoral Commission to encourage voter participation, and—as we discuss below—to provide objective information, should be included in the enabling legislation (paragraph 117).

(pp)  We conclude overall that there is a need and a desire among the public for a balanced source of information on the economic issues involved in a decision on whether to join the euro, ahead of any referendum. We recommend that the Government and the Electoral Commission give specific attention to examining ways of providing such information (paragraph 120).

(qq)  We consider that the role of the broadcast media in promoting informed and educative debate on the issues relating to the euro will be of particular importance during a referendum campaign. We have every confidence that broadcasters will recognise the significance of their treatment of the issue and will live up to their responsibilities. The BBC and other websites could play an invaluable role (paragraph 125).

(rr)  We accordingly recommend that, as part of their response to the recommendation in paragraph 120 above, the Government and the Electoral Commission, in consultation with the British political parties represented at Westminster and in the European Parliament, should examine ways in which a public information leaflet could be prepared and distributed to each household ahead of a referendum. The leaflet should include summary information on the key issues. It should also include website addresses for a range of other documentation and organisations (paragraph 129).

Issues of concern to the public

(ss)  The public information leaflet we have proposed will need to include information addressing the issues listed in paragraphs 132-134 above, if it is to be effective in responding to voters' concerns for information (paragraph 137).

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