Foreign Affairs Committee - Minutes of EvidenceHC 87

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Oral Evidence

Taken before the Foreign Affairs Committee

on Tuesday 26 June 2012

Members present:

Richard Ottaway (Chair)

Bob Ainsworth

Mr John Baron

Sir Menzies Campbell

Ann Clwyd

Mike Gapes

Mark Hendrick

Andrew Rosindell

Mr Frank Roy

Sir John Stanley

Rory Stewart


Examination of Witness

Witness: Sir Howard Davies, Professor of Practice, Paris Institute of Political Studies, gave evidence.

Q1 Chair: Sir Howard, welcome. Thank you very much for coming along, it is very much appreciated.

Members of the public, we are now switching from our report on the Commonwealth to our first evidence session for the inquiry into the future of the UK Government’s European Union policy. The witness is Sir Howard Davies, who has huge experience in UK economic policy and the international financial sector.

Sir Howard, may I start proceedings with a fairly broad question? What do you think should happen, in so far as the Government’s relations with the EU are concerned, and what do you think will happen?

Sir Howard Davies: Gosh, I thought I was talking about the Commonwealth. I had better change tack!

I begin, Chair, by thanking you for the invitation to come and by getting any statements of conflict of interest out of the way. I am advertised as Professor of Sciences Po, which is exactly what I do, and I teach courses on financial regulation and central banking. I am also a non-executive director of the Prudential and of Morgan Stanley in New York, and I am an adviser to the Government of Singapore Investment Corporation and to the Chinese banking and securities regulators-but I do not speak for any of them, of course.

As far as what I think should happen, my view-coming at this from the perspective of someone who has been involved primarily in the financial sector in recent years-is, I hope, that we can remain a full member of the single market, because that is in our national interest. I fear that if we were not, we could see quite a lot of businesses choose to put themselves somewhere else. However, I do not think that if we are not in the euro we should take part in what is being called a banking union-we might come on to talk about what that means-because that banking union does arise from the tensions in the eurozone in particular, which, while they affect us, we are not centrally engaged in. I think it will be quite difficult to achieve continued full membership of the single financial market without any discrimination against us if we do not move towards the banking union. It will require considerable skill in negotiating that. That is what I hope will happen.

As to what I think will happen, well, I think that will happen, but it will be quite difficult, because it involves some complicated balancing acts, and it will require the Government to be prepared to facilitate moves by the rest of the eurozone that we might not wish to be engaged in. So it will require us to be constructive in helping them to solve their problems, in return for remaining as associated as we can be with the single market.

Q2 Chair: Thank you. You remember that all this arose out of the December 2011 summit and the exercise of the veto, because Britain was not offered the safeguards that it requested from the EU. What is the significance of these safeguards to Britain? Exactly how important are they to us? Is there any room for manoeuvre?

Sir Howard Davies: If I might question slightly your premise, Chair, I am not sure that all this did arise because of what happened at the December summit actually. This is a long-running problem of a flawed structure of the eurozone that is being worked out. When the eurozone was constructed, it was thought that a monetary union could be established, with a single currency and a single central bank, but with only a light-touch fiscal union in the form of the stability and growth pact. For a while, in benign economic and financial conditions, that appeared to be working. But, when stresses emerged-arising not originally from the eurozone-it became clear that there was a flaw at the heart of the single currency zone in that there was no ability to transfer resources from the centre to the periphery and peripheral governments and their banks, which are locked in a loveless embrace to try to support each other without the ability to draw on resources elsewhere. That is the underlying dynamic.

The December summit, which was an attempt to put together the outlines of a fiscal framework for the single currency, was one step along the way. At the moment, that does not look hugely significant. As for the safeguards we asked for, interestingly, people did not quite understand at the time in Europe where this was leading. Curiously, if you look back at those safeguards-I have read the letter the Chancellor wrote to you about it-actually we were then putting in requests that were appropriate more to the banking union now. I do not think that many of our partners saw the logic of asking for these protections in relation to the single financial market on the back of a treaty about fiscal union. Those safeguards are more relevant today when, this week as we understand it, they are talking about a banking union. Something along those lines would be quite useful. We perhaps have not started our negotiation on this at the right time or quite in the right way, but some of the substance of those safeguards is rather important.

Q3 Chair: Yes. The first one is unanimity and the transfer of powers relating to the prudential supervision of credit institutions and other financial institutions or financial market participants. Do you think that that was an unreasonable request?

Sir Howard Davies: We are not going to get that because there are various ways in which the eurozone can construct a single European prudential supervisor, which we can have nothing to do with, frankly. If they decide to go for the European Central Bank as the prudential supervisor, which is likely, you can extend article 127 of the Maastricht1 treaty quite easily to cover for it in prudential supervision. I am not aware that we could do much about that.

Q4 Mr Baron: Sir Howard, welcome. Can I suggest to you that what has complicated the issue this time round is that we have a recession that is a deleveraging recession rather than a destocking recession-it has been built on debt. Although I agree with you that the processes and safeguards were not put into place sufficiently well enough when the EU was born, we all know that you cannot have monetary union without fiscal union. What seems to be happening here is that the eurozone leaders are shuffling the debt around the system between bank and Government, but no amount of shuffling can conceal or erode its scale. What really needs to happen is for sweeping supply-side reforms to be introduced that would create a better growth environment. That is the best way in the longer term-the more sustainable way-of closing the gap between what governments earn and what they spend. Do you agree with that?

Sir Howard Davies: I agree with that. The problem is that we may not get to the long term if we do not do some of the other things as well. Whatever package emerges in the European Union, a programme of supply side reform, particularly in countries like Spain and Italy, is absolutely crucial.

On your first point about shuffling the debt, you are correct to point to that, but the difficulty is that, unless some kind of additional capacity is brought into countries like Spain and Italy, this pack of cards will ultimately collapse. That is why some form of mutually guaranteed borrowing is required. The Germans have baulked at the idea of eurobonds, so another sideways route into this is some kind of banking union, where you have mutual guarantees between the deposit guarantee schemes of banks in Europe to create the comfort to avoid bank runs in these countries, and some kind of resolution authority that allows central European institutions to lend directly to banks rather than via their government. That is the bit that people are attempting to put in place this week. It is a short-term crisis management response, but I completely agree that, in the longer term, it is the divergences in competitiveness that have created the major internal balance of payments crises, and those will require structural reform.

Q5 Mr Baron: Do you not agree, though, that an element of time has been bought with the £1 trillion of loans to the banks, but that what the markets urgently require is a very strong signal that the eurozone gets the message about the need for greater competitiveness? At the moment, as we see with Spanish bond yields and so on, the feeling is, certainly from the market’s point of view, that all these mini summits to save the euro-we must have had more than 20 of them now-are nothing more than sticking plasters, and that you need seriously to send out a signal that you are going to address the structural imbalances and the supply side need for reforms to kick-start a more growth-oriented response.

Sir Howard Davies: I think that will help the mood music, but I don’t honestly think that it is what the markets want. I think that what they want is some guarantee that if they keep their money in Spanish and Italian banks, they might get it back. Competitiveness reforms and supply side reforms in the long term are not going to give them that assurance. What they are looking for is a central European institution-probably the European stability mechanism-that puts capital into those banks directly and not via a sovereign which itself is fiscally challenged.

Q6 Mark Hendrick: The last time we sat at a table together, Sir Howard, was in 1998 when I was a Member of the European Parliament and its Economic and Monetary Affairs Committee. At the time, we talked about the convergence criteria, which led to the stability and growth pact, which you have just said was a fairly light-touch approach to creating some stability. Do you think that if the stability and growth pact had been enforced strictly, with penalties, and that if all the member states of the eurozone at the time had been far more disciplined, the financial crisis and the eurozone crisis could have been avoided?

Sir Howard Davies: I actually don’t think that. I think it would have been somewhat less extreme. On the different countries in the eurozone and how they have got into difficulty, you might argue that case in relation to Greece, because it clearly did run extravagant deficits and conceal them, but it is hard to argue that case in relation to, for example, Ireland or Spain, where the leverage-the debt-was really in the private sector and associated with a large property boom, which itself was fuelled by the fact that they then had much lower interest rates than before, as a result of joining the single currency. There, the fiscal stability and growth pact would have constrained government debt to some degree, but actually, government debt was not particularly the problem in Spain, and it certainly wasn’t the problem in Ireland, which had a surplus running up to the crisis.

I think it was not the only point, so the need to address the financial sector issues is just as important as the need to address the fiscal union. For example, the way in which Ireland and Spain should, in retrospect, have dealt with their problem was by increasing capital requirements on banks and restricting banks’ lending to risky property development, because they clearly had a property bubble to a massive degree. That can best be addressed by tightening up capital requirements in banks, rather than simply by interest rates. That is the macro-prudential mechanism that people now talk about in the jargon.

I think that we are going forward. You need to look at fiscal reforms, but you also need to look at financial sector reforms, to allow different countries to be able to respond to different financial circumstances where the single interest rate and single currency may affect them in very different ways.

Q7 Chair: What was your sense of the reaction, particularly in the financial sector, to the use of the veto? Were financial institutions pleased? Were they horrified?

Sir Howard Davies: I think they were quite nervous about the implications because they see a continued set of negotiations about the regulation of financial markets in Europe. On the whole, they think that the British Government and a few others of a liberal persuasion-I mean small "l", although, of course, also large "L" here-see the best guarantee of a pro-competition framework of regulation as one over which the British Government exercise a degree of influence. Also, the British Government understands financial markets because of the City of London. So they were nervous about whether the veto would result in a diminution of British influence in those decisions. At the moment, it is a little bit early to say whether it has or not, but that was the principal reaction.

Q8 Chair: You have just pre-empted my next question. Do you think that we are in a stronger or weaker position? Do you think we have lost any influence as a result of the use of the veto?

Sir Howard Davies: We are probably not in a stronger position; actually, it would be hard to argue that we were because we asked for a set of assurances and played our cards and did not take any tricks. That does not seem a great way to start. As to whether it is likely to be a long-running disadvantage, I have to say that, from where I currently sit and the people I currently talk to, that fuss in the middle of the night in December has almost vanished-receded into the mists. There have been several summits and crises since and there will be several more, too, so I do not think that it is looming as large in the minds of other decision makers as perhaps it does here.

Q9 Mike Gapes: Nevertheless, the stability, co-ordination and governance treaty is due to come into effect on 1 January or earlier if 12 states ratify it. Within five years, the intention is that it should be incorporated as part of the European Union treaties. What is your view? Would that be a good or bad thing for the UK? How should we respond to it at that time?

Sir Howard Davies: I think more about what is going to happen between now and Friday than I do about what is going to happen in five years’ time. To answer your question, on its face I would say that it would not be a good thing because I do not think there is much chance of our being in the eurozone within five years and there would therefore have to be some other negotiation about how we were going to be affected by fiscal rules that were essentially constructed from a eurozone perspective and got folded into the treaty.

We would then need another negotiation about how they affected us and what kind of opt-out we would have. I have to say, Mr Gapes, that at the moment the position is not stable-neither the position within the eurozone nor the relationship between the UK and the eurozone. This is highly unstable and an awful lot of things will have to happen between now and when that five-year period arises.

Q10 Mike Gapes: Could this be the breaking point for the UK’s relationship with the rest of the European Union?

Sir Howard Davies: Yes, I think it could be. You might argue that the breaking point was when we decided not to go into the euro, whereas everybody else pretty much is still a "pre-in"-they still believe that, or are saying that, they will go in, although we could argue about the Swedes. That was a key decision, and I have always thought that we underestimated the integrationist dynamic created by the single currency. It is not just another technical thing such as another directive in the single market; it is a fundamental change that creates a mindset in the other countries that they will do what is necessary to defend the currency.

If that means doing things that they would otherwise not be very enthusiastic about-such as guaranteeing each other’s banks, etcetera-they will do it, because the alternative looks much worse. An integrationist, "ever closer union" dynamic has been in play within the eurozone, going much more rapidly than it is for us. The question is whether we can negotiate a stable relationship between the eurozone, with its tendency towards increasing integration, and the UK retaining the key elements of our relationship with the single financial market. That should be our negotiating objective, I think.

We are not in a particularly strong negotiating position, I would say, in trying to achieve that and therefore a constructive approach, recognising the problems of the eurozone, encouraging it to solve them and saying that we are prepared to do what we can and be as obliging as we can, short of writing a cheque, seems to me to be the tone that we should be adopting.

Q11 Mike Gapes: So, in essence, do you support the incorporation of this treaty into the EU treaties?

Sir Howard Davies: I am not sure in what position I would be supporting that, or not, because I am not a voter in a eurozone country. I think it is logical.

Q12 Mike Gapes: Could I put it a different way? Some of our witnesses have suggested that we should vehemently oppose this because it is not in Britain’s interest; others think it is necessary for the future stability of the European Union. What side do you come down on?

Sir Howard Davies: I think I would say that it is necessary for the future stability of the eurozone, probably. I cannot quite see that the eurozone can continue to exist on the basis of intergovernmental agreements. I think that will have to be anchored back into the treaty. As for whether it is good for the UK, that depends on what kind of deal we can negotiate for our relationship with the eurozone.

Q13 Sir John Stanley: Sir Howard, our Committee’s particular focus is, of course, the Foreign and Commonwealth Office. I wonder if you could tell us your view, given the European situation that we face today, of the imperatives, the policy priorities, as far as the Foreign Office is concerned in dealing with our present position vis-à-vis the EU.

Sir Howard Davies: Sir John, I left the Foreign Office 36 years ago, so I may be slightly out of touch on quite how the Foreign Office operates. I think that the approach needs to be to work with the grain of those people who believe that there is advantage in UK membership of the broader EU, even if the question of our euro membership is deferred sine die. I think that there are two important areas where that is true.

First, there is the single market. There are countries that recognise the UK’s importance in having pushed forward a broadly free-trade, pro-competition and pro-competitiveness agenda. We tend to be supportive of that and are good at structural reform. As Mr Baron was saying, that is going to be an important theme.

Secondly, there is foreign and defence policy, where, bluntly, if the UK is not involved, there isn’t much foreign and defence policy for the European Union. There are countries, including Germany, but also a lot of countries in the east, that regard it as really rather important that we are kept on board for all those aspects of policy in which our weight and strategic interests in the world are of great significance to the European Union.

So I think we need to keep working on those other dossiers, which are positive for us and are where other people see our value, and do the best we can in the much more difficult areas where the construction of the eurozone demands integration that we do not want or, indeed, need.

Q14 Sir Menzies Campbell: To pick up on that last point, it is not the United Kingdom alone, but the United Kingdom together with France that gives credibility in the area of defence and security. Would you agree that that argues for close co-operation with the French on defence issues?

Sir Howard Davies: Yes, I agree. Perhaps I was eliding a point in my answer to Sir John in the sense that I think there are a lot of other countries in Europe that would not like European foreign and defence policy to be entirely driven by the French. A Franco-British approach, as the two countries with the ability and the willingness to project military power, is regarded by others as being likely to produce a better outcome. But, yes, as far as we can agree with the French, I think we should do so.

Q15 Sir Menzies Campbell: That desirability of Anglo-French co-operation on defence, which is particularly felt by the Balkan countries-Estonia, Lithuania and Latvia-because of their-

Sir Howard Davies: "Baltic," you mean.

Sir Menzies Campbell: "Baltic" is what I said.

Sir Howard Davies: You said "Balkan."

Sir Menzies Campbell: I beg your pardon.

Sir Howard Davies: These "Bal"s are difficult.

Q16 Sir Menzies Campbell: There is a world of difference because of their proximity to Russia and the occasions when political pressure at least is sometimes exerted against them.

Sir Howard Davies: Yes, you are taking me a bit out of my comfort zone, Sir Ming. I would have thought the Baltics attach very high importance to NATO and not just to the European Union, although they see their membership of the European Union as anchoring them more firmly in NATO than they otherwise would be.

Q17 Sir Menzies Campbell: Perhaps I could briefly take you back to your comfort zone. You set out very eloquently, if I may say so, what the United Kingdom’s objectives ought to be in relation to a more integrated eurozone. What do you think our chances are of achieving that agreement which you referred to? What would be the consequences if we did not achieve it?

Sir Howard Davies: I am a perennial optimist and I think that there are certainly people in the European Central Bank, the single market directorates of the Commission and in the three European regulators who do appreciate that the UK, with the presence of the financial markets in London and our understanding of these things, is a very important part of the debate. There have been areas where I know we have been making constructive suggestions about how the future regulation of the eurozone can be developed. As long as we adopt a constructive approach, there is a reasonable chance that we can stay closely engaged. If we get into a confrontational mode with the eurozone, where they perceive us as being obstructive of things that they absolutely know they have to do in their national interests, then there is a risk that, in the single market dimension, we find ourselves dealing with a eurozone bloc which has a guaranteed majority in approving directives, improving relations and approving the rule books below these directives which the three authorities are supposed to be producing. We would find ourselves in a position where we were not really being debated with-because they discussed it all beforehand and voted in favour-and some of those rules could effectively be discriminatory. We have already seen the ECB suggesting that any euro transactions with one leg in the eurozone must be cleared by an entity in the eurozone. The UK is taking it to court, but it is one swallow that is an uncomfortable sign of summer. We could find a lot more of that. If we did, the foreign-owned firms based in London for their pan-European activity might well decide to shift it. They might at least decide to shift the balance of their activity.

Most of the American banks, and indeed the Swiss and French banks, have the majority of their capital markets activity based in London and they operate from here. If they thought that their trading based out of their London offices was going to be discriminated against because it had to be routed through a euro subsidiary, etc, then at some point they might say: "We will have to reconsider where we put our people". There are firms already asking themselves about the viability of London. This question was asked when the euro was constructed in the first place and because of the single market dimension we were roughly able to reassure people that it did not matter; they could do a lot of euro business and be based in London. If we get into a position where we are in a confrontational mode and not influencing the future, then that balance of argument could shift. That would be unfortunate, in my view.

Q18 Andrew Rosindell: Sir Howard, it is fascinating to hear your reflections, especially when you spoke about the dynamic for integration being much greater than people had expected. Do you therefore agree with me that Lady Thatcher’s warnings were right 20 years ago?

Sir Howard Davies: I am trying to recall all the things that Lady Thatcher warned me about. Over a decade there were many of them. It seems to me that in this country we have never taken as seriously as we should the phrase "ever-closer Union" in the original Treaty of Rome. Most people in other European countries do regard that as a general direction. They do not always know what they mean by it, but they regard it as a sign that this is the way that Europe is going. When the single currency was introduced, I remember being involved in debates in the European Monetary Institute. At the time I was deputy governor of the Bank of England, and I used to have to go to those, where we were constructing the single currency. Some people did say, "Surely we are going to need more fiscal co-ordination." The answer typically given was, "Look, the way Europe proceeds is, we make a great leap forward in one area and then we do all the things that are necessary. We retrofit it with all the things that you really should have done in the first place." The single market was like that. It began as a kind of aspiration for free trade, and that was followed by 142 directives, which were not what people thought at the time.

What is now happening is that the European Union is having to retrofit the single currency with all the bits that arguably should have been put in place in the first place, but which create a new dynamic. That is the way Europe works. In this country, unfortunately, we tend not to see it that way. We tend to see it as a series of discrete transactions, where we look at each of them one by one and ask, "Does this make sense or not?" In many places in Europe, people do not think in that way. I was at a conference in Poland the other day. I talked about the eurozone, and I asked one of the Polish economic advisers what his view about it now was. He said, "We still want to get on this boat, even if it is sinking."

Q19 Andrew Rosindell: Based on that, as we have got ourselves into such a muddle over membership of the EU, and as it has very little public support, isn’t it time, as Lord Owen has suggested, that we change our relationship with the EU to have a trade and co-operation grouping but without political union?

Sir Howard Davies: I am afraid that I am a sort of practical fellow, and I always like to ask myself, "What do I actually mean by that? What is it that I am going to end up with specifically?" My fear is that a dynamic that says, "Well, we’re off, unless we can do this, this and this", might just result in a long, sad farewell, where quite a lot of British economic interests fall by the wayside.

I am not very enthusiastic about these sorts of grand gestures. I certainly do not think that we are in a particularly strong position, because at the moment, the preoccupation in the eurozone-you can see this by the plethora of summits to which we are not invited-is in solving that problem. If we come along at that particular moment and say, "By the way, you’ve not got to solve just that problem, you’ve got to solve our problem, because we want a complete renegotiation", I think this is not going to be a good place to start.

I do not disagree with the idea that it looks as if we are, to some degree, diverging, but I fear that the notion that we have a good negotiating position at this point to renegotiate our relationship with the EU and end up in a place that is very happy for us is pretty risky.

Q20 Rory Stewart: What do you think the time frame will be for the moment at which we find the UK and Denmark being the only countries outside the eurozone? What is your best guess? Are we looking at five years, 10 years or 20 years?

Sir Howard Davies: My best guess would be a reasonably long time frame. The inclination will be-certainly, the Central Bank will take this view-that it will not be keen to admit any new members unless they meet absolutely, rigorously and strictly every possible criterion. Whereas we know that in the past, the rules were bent to admit Italy, Belgium and Greece, that will not happen again. People will perceive the risks of that as being very severe. That will mean that whatever new fiscal arrangements emerge, people will have to meet those and show that they can meet them over a long period. Their currency alignment will have to have been achieved for a long period and their banking systems will have to be hunky-dory. My feeling is that it will be quite a long time, so more in the 10-year or 20-year time frame than the five-year time frame.

Q21 Rory Stewart: Is Britain not facing almost a tragic choice that, increasingly, as more countries move into the eurozone, the European Union increasingly looks like the eurozone? Being in the EU but not in the eurozone will become an ever more uncomfortable situation for us, for a whole series of reasons. You have talked about banking reform, but simply in terms of people’s attitudes in the eurozone, will they not increasingly begin to behave as though the EU is the eurozone? What on earth do we do as a country to make contingency plans for that situation?

Sir Howard Davies: It is a reasonable hypothesis. I suppose the counter-view that one might advance is that, at the moment, there is quite a bit of variable geometry in the European Union. There is Schengen, which some people are in and some are not. Some are in the eurozone, and some are not. There are free-movement things, some of which we are in while other people are not, in relation to new members. There is defence co-operation, which is stronger in some areas. There is the notion of reinforced co-operation, which we are involved in, and some are not.

It is probably in our interests to try and argue that it is possible to construct a Europe of concentric circles, variable geometry or whatever, and that that is not just because we are terribly troublesome and would like an opt-out, but because it is a realistic way of running Europe for a decent period to come. A lot of people will not be able to get into these stricter criteria of the European Union.

If you say to me, "In 30 years’ time, can I see this being stable?", possibly I would agree with you, but for quite a period, there will be, as a practical matter, a Europe of variable geometry. Therefore, rather than taking a confrontational approach and saying, "We’re going to take our bat and ball home unless you agree this, this and this", we should be saying, "Look, we are faced with this complicated picture. The eurozone has not worked precisely as intended. One or two people may drop out"-my hunch is that the Greeks may well leave the eurozone at some point, or may be forced to. Therefore, it is not just "us and them" on this particular issue. We are going to be facing a variable geometry Europe, and we should all try to construct ways in which we can live as comfortably as we can in this house, even if we are no longer allowed in the dining room.

That would be a better way of looking at it, rather than seeing it as an opportunity to get some stuff back, which I do not think is going to be particularly good.

Q22 Rory Stewart: In terms of UK foreign policy, is it really responsible of us to press for closer fiscal union? Presumably, there are two possibilities: either it works really well, in which case Britain ends up with the potential risks and problems associated with a very coherent, powerful, unified economy and state structure on its borders. Alternatively, it does not work well-in other words, we push them into a situation in which, over the next five or 10 years, there are exactly the kind of tensions that Eurosceptics imagine are implicit in any kind of move towards more of a super-state. Neither of those is very good for Britain. Neither a super-strong unified eurozone, nor a weak, fragmented, unstable eurozone is in the UK’s national interests.

Sir Howard Davies: I think the worst possible outcome-it is always good to look at those-is that the eurozone collapses and we get blamed. That would be the worst outcome and it is not completely ridiculous. You can hear a lot of French rhetoric, as I frequently do, saying, "The crisis really came from London and New York. It is an Anglo-Saxon crisis, which we are having to deal with." If we were then perceived as having been obstructionist in terms of the eurozone doing what it needed to in order to try and strengthen, that would be a really bad outcome. So, when the Chancellor says-he wrote a good article in Le Figaro last week-"Look, we understand what you have to do. You need to do all these things", that is a good posture to take, because that is realistic, and it is what they have to do.

Coming back to your previous question in a sense, I agree with you that this could mean a coalescing in the eurozone, which is a bit uncomfortable for us. However, of a lot of relatively unattractive outcomes, that one is better than the collapse of the eurozone, which would be economically disastrous for us and might carry the additional risk that we were perceived somehow to be responsible for it. That would put us in a very poor position.

Q23 Mr Baron: May I, if you do not mind Sir Howard, pursue that line of questioning? I think that any reasonable assessment of the eurozone crisis would lead to the conclusion that it was because governments, particularly in the south, borrowed far too much, beyond their means and at artificially low interest rates, and went on a spending binge. Conspiratorial theories about New York and London would, I think, be given short shrift.

May I come back to your point about the general direction of the EU? You said, "ever-closer union". There is this feeling that there is, certainly within the eurozone, a wish to get ever closer. You have talked about the Polish attitude of wanting to jump on a boat even if it is sinking, and so on. But may I be devil’s advocate, and suggest to you that the number one priority should be economic growth within the eurozone, but that that has singularly failed? We see growth rates continuing to fall behind other areas of the global economy. The only country within the eurozone, to my knowledge, that has gained a market share in the past 10 to 15 years has been Germany, but that has been on the back of a strong manufacturing base and an artificially low currency-normally the two do not go hand in hand, in the normal economic world.

May I therefore suggest to you that if you look at the 80-plus currency unions that have fractured since the second world war, in the vast majority of them-I struggle to think of the exception-the countries involved have benefited from the break-up of that currency union? Even when you talk about bond default, if you take the Asian crisis in ’97, three years later GDP growth was higher than at the start of the crisis, when it came to bond default. Do you think we are right to be pushing down the road of closer fiscal union-saving the euro-when all the evidence is that it is curtailing growth and, in some countries, causing a democratic deficit?

Sir Howard Davies: There is a lot in that question. First, on the cause of the crisis, I think, as I have said, that it was not just government borrowing. In some countries it was private sector borrowing, so I do not completely accept that diagnosis. I have written a book about the causes of the crisis, which identifies 38 different causes, so perhaps we could spend two or three minutes on each of them-is that okay?

Mr Baron: To be fair, Sir Howard, I did not say government borrowing, I said country borrowing.

Sir Howard Davies: Okay, not just governments. In that case, I am with you.

As for whether it would be better just to call it quits, I guess that my conclusion on that would be that it would not. I would take a slightly different view about Greece. I have to say that I cannot see a way out for Greece, and that might be true for Cyprus-I don’t know. The indebtedness is too high, and I think that it will have to default and then, whether it would recover better within the eurozone or outside, is a moot point. I think it would probably be better that it recovered outside the eurozone. I follow your line of argument.

There are two worrying things: first is the sheer scale of recession that you might generate as a result of the grinding of gears change in the currency zone would produce. You might say that that is a transitional phase, but I think that it could be a very painful transition. Secondly-this is a political point, which again is beyond my normal area of expertise-I worry a lot about who the political inheritors of a collapse of the eurozone would be. In France, the key opponents of the euro are the National Front, and we have seen some exotic-let’s put it that way-political forces emerging in Greece, which are the ones that are opposed to it. We might find the political consequences of a break-up of the eurozone in some of these countries to be ones that we would not like the look of, and that is what frightens a lot of people in the eurozone.

Q24 Mr Baron: Do you not agree, though, that we are already seeing that? Take the Greek extremist parties. They are not necessarily against the euro; they are against the austerity packages involved. There is, I think, a valid concern that there is a democratic deficit out there, that the austerity packages, in many respects, are making matters worse because they are creating this spiral of cuts and further missing of targets when it comes to deficits and so forth. That is causing a real problem in the eurozone. What is desperately required is what economic history would suggest has happened. When countries leave such a union, yes there is short-term pain, but growth ultimately picks up much faster than would have otherwise been the case. Economic history is littered with those examples. I put it back to you that the austerity packages on their own are simply making matters worse. History suggests that what we should be doing is making strong contingency plans for the break-up. Yes, there will be short-term pain, but, as history shows us, once you have got through that pain, growth is much better and unemployment comes down.

Sir Howard Davies: These are imponderables really. I can understand your point, except that if you default and leave the eurozone, the austerity package that you have now will be nothing compared with the austerity package that you will have to have then in order to re-enter international capital markets. Secondly, you need to look country by country at what the problem really is. In Ireland, it is not fundamentally a problem of competitiveness. It has quite a significant trade surplus. It had a property bubble and a bust banking system, which is a completely different diagnosis from the diagnosis in Greece, which has a fundamental competitiveness problem. I am not sure whether Spain has a fundamental competitiveness problem. It was engaging in some sort of catch-up. Spain has quite a sizeable export sector. Again, there is a property bubble, and massive deleveraging is going on. You need to look country by country at what the problem is and what the best outcome would be. As I say, I am not totally opposing your way of thinking about this. Indeed, I think, if I looked at Greece, I would get to your position. I would say, "Actually, that is probably the better outcome for them." I do not think that I would get to that position if I looked at Ireland or Spain.

Q25 Mr Baron: Can I move us on briefly to regulation. We come back to the supply side story again. In my constituency, I have a disproportionate number of SMEs. Their main gripe is not bank lending but the weight of regulation that they are hit with, which can disproportionately affect small businesses. Some 90% of regulation emanates from Brussels. I am interested to know whether you feel that the business case for membership of the EU is still valid, particularly when it comes to small businesses. We look at other areas of the world that are growing at much faster rates that are not burdened by so much regulation, yet it feels as though Brussels and the eurozone still do not have the key message that in the longer term, if you want to bring down unemployment, you have to allow your businesses to breathe and thrive. They are finding it increasingly difficult to do that under this weight of regulation that emanates from Brussels.

Sir Howard Davies: I think that I look at the world slightly differently. We are part of it. Political choices have been made by governments in this country and in the rest of Europe to produce this. I also look around at other countries such as Australia and Canada and I do not find a highly deregulated economy. I think that they are regulated as heavily as we are. Then you have to say, "What would you do if you left?" Then your question would be, "Do you wish to stay with complete access to the rest of the European market?" If you do, you have to meet most of the standards-environmental, quality control and everything-anyway, which is what the Norwegians and the Swiss have to do. It is not clear to me either that it is Brussels doing it-it is us-or that it is much more regulated than other parts of the world. If we look at Australia, there is no way we are more regulated than Australia. You could not find a more regulated country. Whether we would escape anyway seems to me to be a moot point.

Q26 Mr Baron: But do you not accept that roughly 90% of regulation-a very high proportion anyway-emanates from Brussels? Do you have a tendency then to-I will not say gold plate because it is a bit of a cliché-enact those regulations? The gripe from small businesses is regulation.

Sir Howard Davies: I am sure that it is right that 90% emerges from Brussels, but that is because we-I mean we collectively and I include our Government-have agreed to expand Community competences in a whole number of areas. There is much less UK regulation than there was because we have agreed Community competences in a lot of areas. That in itself does not seem to be a significant point.

Q27 Mr Baron: I have a final question. Do you think that there is a case for Britain to look closely at a free trade agreement, or a relationship similar to that of Switzerland or other countries that have access to markets-okay, they may have less say in how those markets are formulated, but they have access to them-but do not have to sign up to this general, ever-closer political union that can also have an impact on economic regulation? I ask that question because those countries seem to thrive.

Sir Howard Davies: I would, on the whole, say that that would be a risky thing to do, and I think that it’s a different position when you have never been in than when you are in, because your economic structure has developed in a different way. If you look at the Swiss, for example, the big parts of the Swiss banks-I am sorry to use the financial sector as an example, but that is what I know about-are based in London for their access to the EU, as a matter of fact.

So I think that we would run some risks in attempting to disengage to that degree. And also I would attach quite high importance to things like co-operation on foreign policy and defence policy, which I think are good things from the UK point of view, but admittedly that is a matter of taste. And yet if you then say that, in order to off-set the economic disadvantages, we would want an agreement that allows us complete access, then you go back to the regulation that you started with, because they will not allow you to have that access if you do not follow regulation that is equal.

So, personally I do not think that there is an easy kind of Swiss option. I would also point out to you that actually Switzerland is not a deregulated country in any way and in the financial area there is something called the Swiss finish, which is actually over and above our capital requirements; the Swiss have higher capital requirements than we have.

Q28 Mark Hendrick: Coming back to some of the things that you said earlier, Sir Howard, you mentioned this idea of an even closer union and you said that we must not underestimate the degree to which European countries want to integrate and stay together. But then you conceded that you saw a possibility that Greece may come out of the eurozone, given what is happening at the moment. Do you foresee the possibility at all-you have mentioned looking country by country-of a core of countries providing a very, very strong eurozone area and perhaps other countries that, after the Greeks go, may be driven out, because of the size of their debts and the problems they face, effectively making a two-tier Europe and one that has a fairly strict group of countries inside the eurozone and others that incrementally have fallen off along the way?

Sir Howard Davies: This is partly a tactical issue and partly a strategic issue. I think the tactical issue is that if the Greeks cannot make it, because they cannot meet the austerity programmes or whatever and they go towards the exit, what would have to happen to prevent real mayhem in financial markets would be that the rest of Europe would have to wrap their arms around the rest. What I do not think you could possibly do is say, "Well, goodbye to Greece today, now let’s see what happens", because if you did that you would have a highly disorderly break-up, which would be catastrophic.

So, to my mind-this is just my way of thinking about it-Greece stays in or not, and if Greece goes that has to be the moment when effectively there is some mutually guaranteed borrowing and the rest are protected, with a firewall erected around the rest, because otherwise it would be too disorderly.

As for the impact of Greece going on future membership, I think that it will cause people to think twice, but I think that most of them still want to join. However, what Greece going will do, as I said earlier briefly, is to cause the European Commission and the Central Bank to erect the barriers to new entrants somewhat higher than they have been in the past, so that you will absolutely have to meet the criteria and have met them for some time before you get in.

As to whether it is helpful to think of that as two-tier, personally I prefer to think of it as variable geometry. You will have some countries that are in things and some countries that are not, and some countries that are on a flight path to join and some countries that are further down that flight path. Therefore, rather than saying, "All countries are equal, but some are more equal than others", we would say that there is an evolution here, which is taking different forms at different speeds in different places. Looking forward as far as I can reasonably see-about 10 or 20 years, which will be long enough for me-that is the way I see Europe. I don’t think everybody will be in the eurozone.

Q29 Mark Hendrick: Do you see it as an impossibility that Britain could acquire the status that Mr Baron talked about, of almost being like a member of the EEA or EFTA?

Sir Howard Davies: I think it is not impossible. If we approach this as "Take it or leave it; we want a renegotiation-otherwise we’re going to take our bat and ball home," I think we could find people saying, "Well, okay, do so, and let’s renegotiate," but I do not personally think that would be the best way of approaching what is a very difficult situation-and not, by any means, of our making, most of it. I don’t think that would be a good way of doing it. I think we will get a better outcome for the UK if we adopt a more co-operative and collaborative approach to this.

Q30 Chair: Sir Howard, thank you very much. That exhausts our questions. Have we asked you the right questions? Is there any point you would like to make, that perhaps we have not touched on?

Sir Howard Davies: If I could just be slightly specific on the financial thing, because that’s what is happening now. I think, if I may say so, that your inquiry is quite timely, because the first example of what we’ve been talking about, of coalescing in the eurozone, leaving us on the outside, is going to be the idea of a banking union. I think what will be proposed will be a linking together of the deposit guarantee scheme, with some kind of mutual guarantees between them.

There will be a new, pan-European supervisor, in the real sense of a supervisor that actually does the supervision from day to day, not just the European Banking Authority, which writes some rule books. There will be a resolution authority as well, probably the European stability mechanism; i.e. something that can provide capital to a failing bank on a pan-European basis, with a pan-European guarantee. I think something like that will now emerge. I think the supervisor will probably be the European Central Bank, because I think it is easier to do that than to do the European Banking Authority, which, after all, is based in London-so that would be slightly odd-but, also, is really a large committee; or that was its origin.

Therefore, we will have to decide how we deal with that. I think what we should then do is to ask for some things which are related to the Prime Minister’s red lines in December but are somewhat different, and express them in a more constructive way. We should try to ensure that the European Banking Authority remains the entity that writes the rules in the single market area for banking, which we are a full member of, and that what goes on in the eurozone is tucked underneath that, so that we don’t find ourselves in purely an ante-room of the single financial market. That negotiation is going on more or less as we speak, and I think that is how we should approach that particular problem. It will be an interesting example, if we can negotiate it, of how we might approach some of the other difficult issues that will come down the track.

Q31 Chair: So are you saying that it is important that we are a part of the banking union?

Sir Howard Davies: No. I don’t think we can be part of the banking union in the sense of the eurozone, because that involves mutual guarantees and the European Central Bank, which we are not a full member of; but I think what we should ensure is that we retain market access for banks based here, even if we are not in the banking union.

Chair: That may be easier said than done.

Thank you very much indeed, Sir Howard. Your evidence is much appreciated.

[1] Witness correction: Lisbon treaty intended

Prepared 10th June 2013