Select Committee on European Communities Twenty-Fourth Report


  99.    This Part of the report gives the opinion of the Committee on the main issues which arose during the enquiry. We start by describing what we see as the conventional wisdom on economic management today because it is this common approach which has shaped the Treaty's provisions on economic and monetary policy and has determined the role given to the ECB. We go on to deal with the main issues broadly in the order adopted in Part 3, the summary of the evidence received.


  100.    In the nation state as traditionally perceived, there was scope, subject to the impact of international market forces—which may be severe and, therefore, severely constraining of the scope for prudent action—for the government to operate its own monetary policy, its own fiscal policy and its own structural or supply-side policies. In the modern world, however, there is among central bankers, finance ministers and many, if not all, economists, even if not yet more widely among the general run of politicians and the public, a belief, derived from the experience of success and failure, that the best monetary policy is directed towards long-term price stability and is best left to the operation of a central bank acting independently of short-term political considerations. National fiscal policy is, in practice, constrained by the ability of international financial markets to punish countries pursuing profligate or otherwise unsustainable policies. In these prevailing modern conditions, to maximise the remaining abilities of the national economy to respond positively and flexibly to technological change and to economic shocks becomes a decisive determinant of economic performance. Our evidence brought home to us that a key question for the countries that initially adopt the euro and for the United Kingdom was whether the arrangements for the independence of the ECB, and for the operation of EMU, taken as a whole, were conducive to stability, growth and employment, or were broadly neutral in that respect or were such as to increase the risk of creating enduring and politically unacceptable economic strains. We think that to give our best estimate of the probabilities is more helpful to the House and to others than to sit on the fence on an issue of practical politics that, in the real world, cannot be ducked indefinitely. We conclude this Part of the report with our prognosis.

  101.    For the reasons sketched in the previous paragraph we accept that the single currency would not be credible unless monetary policy in the euro zone was set by an independent central bank. Many would think that the position is in essence no different for a large country outside the single currency. The United Kingdom is, according to this theory, more likely to develop a culture of stability, if it has an independent central bank with responsibility for monetary policy. The independence of the central bank and the primacy of the policy objective of price stability are foundation stones on which the practice of modern economic management rests.


  102.    The concepts of independence, transparency and accountability of the ECB are so inter-connected that it is helpful to consider them together. Credibility we see as the eventual outcome of a successfully operating central bank. While credibility cannot be fully inherited from the Bundesbank, the ECB is deliberately modelled on the structures of the successful German central bank. Structures can be conducive to success but circumstances and personalities will mould the early years of the new institution. It is the ECB's performance in these early years which will promote credibility or otherwise.

  103.    The ECB will have achieved its primary objective, set by the Treaty, if it maintains the domestic value of the currency. Zero inflation with low or negative growth would meet the primary objective of the ECB but would not, we believe, be consistent with the spirit of the Treaty. We see price stability as desirable because it is conducive to, or possibly even a pre-requisite for, long-term stable growth and employment. For citizens of the EU, as for us, success must go beyond price stability and, using some words from the Treaty[21], be associated with sustainable growth and a high level of employment. If inadequate growth or employment persisted over a long period we think that the economic system that delivered this result would be condemned. Although the ECB would be only one part of that system it would not escape blame. Indeed, it might well be cast, not altogether fairly, as principal scape-goat.

  104.    Judgment and decision-making by the ECB, independent of pressure from the political authorities, are required by what we have described as the conventional wisdom. This independence is safe-guarded by the Treaty. However, in the United Kingdom, where central bank subordination to the government was the national experience for fifty years, from 1947 until 1997, unease is often expressed about the political acceptability and wisdom of putting monetary policy at arms length from, or even out of reach of, government control. Despite this long, poor record of successive British governments in controlling inflation there remains a feeling in this country that central bankers, left to themselves, may be insufficiently sensitive to the impact of their policies on growth, employment and the real economy. There remains, therefore, a hankering for some ultimate political grip on monetary policy. This feeling is sometimes expressed, or perhaps, even disguised, by demands for more accountability of the monetary authority. Accountability is, of course, impossible without a substantial degree of transparency of decision-making processes and outcomes. So a favoured line of advance, for those who are uneasy with central bank independence, is to call first for transparency, which nourishes accountability, which, in turn, provides a democratic counter-weight to the politically uncomfortable exercise of independence in monetary policy. It is with this British history of experience and thinking in mind that we have had to assess the evidence heard on these issues.

  105.    While we accept central bank independence, we are far from accepting or supporting a central bank isolated from or indifferent to the real economy. On the contrary, we see the need for the ECB to be closely informed about the real economy and sensitive to the, no doubt, various patterns of growth and decline which will occur across the euro zone. We welcome the arrangement for the governors of the national central banks, who should be well-stocked with information about the condition of their national economy and its constituent regions, to be members of the Governing Council which takes the key decisions about monetary policy.

  106.    However, we are sure that the position of the national central bank governors in the Governing Council will not be sufficient to replicate the desirable multiplicity of contacts, formal and informal, between central bankers, ministers, industrialists, financiers, employers and employees which occur in national contexts at present. We were, therefore, reassured to know that the Treasury see the Economic and Financial Committee (EFC)[22] as fulfilling at least some important part of the vital function of pulling together the different strands which together determine economic policy in the euro zone. The Treasury expect the membership of the EFC to include representatives of the national Finance Ministries sitting alongside the national central bank governors and the Commission.

  107.    Despite the existence of the EFC, we see a need for yet further widening of contacts and understanding between, on the one hand, the central bankers, finance ministers and officials in the EFC and, on the other hand, the individuals and businesses who run the real economy. We think it unnecessary to prescribe the format for these contacts provided the members of the ECB's Governing Council, and particularly the national central bank governors, on whom the prime responsibility for making these contacts will rest, accept that the ECB must be seen as open and as eager to listen as to explain.

  108.    We think the Bundesbank culture of mystique surrounding its decisions would be a dangerous one for the ECB to imitate. Over the years the Bundesbank has attained such credibility and public regard in Germany that it can afford not to submit to formal open examination by parliamentary process. This will not be so for the ECB: this new institution must earn its credibility by its results. This will take some time. In this unavoidable interim period the ECB should foster its political acceptability and its eventual credibility by whole-hearted commitment to listening and explaining—in a word, to transparency.

  109.    On one particular manifestation of transparency we see a case for less than the maximum possible openness. We are persuaded, largely by the arguments advanced by Dr Tietmeyer[23], that meetings of the Governing Council of the ECB should be followed promptly by publication of decisions taken and of the reasons for those decisions, but that publication should not go so far as to disclose the course of the argument, with its ebb and flow as minds are made up and changed. We think that disclosure to this extent would lead to the identification of individuals and countries with particular policy positions. This would, we believe, diminish the collective or collegiate nature of the Governing Council's decision-making process. It would also risk turning what should be decisions taken with the whole euro zone in mind into contests between national points of view with all the emotion, publicity and posturing that this would attract.


  110.    We attach great importance to the accountability of the ECB to the European Parliament. The European Parliament will provide the principal forum in which, in public, the ECB will have to justify itself to elected parliamentarians and, more importantly, to the public at large. We would expect hearings of the President of the ECB and members of the Executive Board to be televised and to become a prime means of communicating with the people of the euro zone countries.

  111.    The President of the ECB is formally required to appear before the European Parliament annually. Dr Duisenberg has told the European Parliament that he is willing to appear before them quarterly. We think it is important that the President and other members of the Executive Board should testify regularly and publicly before the appropriate Committees of the European Parliament. This process of accountability will also, no doubt, raise the public profile and perceived importance of the European Parliament. We welcome this. It may be difficult on logistical grounds for the President of the ECB to appear regularly before national parliaments in each of the Member States, although he or other members of the Executive Board might find it helpful to appear before national parliamentary committees from time to time. A national parliament, we think, should complement these procedures for accountability by looking to the national central bank governor for amplification and local application of the explanation given by the ECB President to the European Parliament. At national level we would expect the central bank governor to be vigorous in explaining these issues not only to his own parliament but also to those who run the enterprises which constitute the real economy and to the public.

  112.    We considered carefully whether the ECB's independence had been carried too far by the terms of the Treaty: "too far" in our view would be a situation in which the ECB could remain insensitive to the real economy. The independence of a national central bank operating in one country—Germany or the United Kingdom, for example—is governed by law which, ultimately, can be changed by the legislature. In this sense, the independence of the Bundesbank or of the Bank of England, to pursue our examples, is not absolute but conditional upon performance: continued poor performance would create a political climate in which the legislature could change the rules governing the relationship between the government and the national central bank. In Germany, the Bundesbank's success is measured by the strong popular political reluctance to tamper with an institution which is respected because it has delivered price stability.

  113.    In the euro zone which will comprise many nations, for the ECB to be free from influence of national governments, the bank must derive its independent status from a supra-national source: the Treaty. We do not accept that this puts the ECB in a position where it is unaccountable and could become unacceptably insensitive to the real economy without any prospect of redress. We see the accountability of the ECB to the European Parliament as an adequate framework arrangement which will need to be given substance by the boldness of the European Parliament in calling the ECB publicly to account and by the readiness of the ECB to listen, to explain and, if necessary, to learn. Like all new institutional arrangements, the accountability of the ECB cannot, in advance, be guaranteed to work perfectly; but we think that the arrangements are sensible and capable of proving effective, if the qualities we have identified as necessary from the European Parliament and the ECB are displayed.

  114.    In the worst case scenario, where serious economic failure persisted and was attributable, or attributed, to the personnel or policies of the ECB, we believe that politicians would find that the Treaty was not, as feared by some, "effectively unamendable"[24]. The Treaty, like any other, could be amended if sufficient political will was present. It is unproductive to speculate in detail on what amendments might be thought necessary but we could imagine that a power for the Council, acting on the request of the European Parliament, to dismiss the President of the ECB might be a deterrent power the existence of which would prove persuasive and render its use unnecessary.


  115.    The Bundesbank operates without a public numerical definition of price stability. The Treaty is silent on how price stability is to be interpreted. We understand that the tacit consensus among central bankers is that a range for the approved measure of inflation of from zero to two per cent constitutes price stability. We think that the ECB should publish its definition of price stability in terms of an inflation range.

  116.    However, we see dangers in the ECB striving to keep prices within a narrow inflation range at all times: this could lead to unnecessary volatility in interest rates, employment and GDP. The ECB should set for itself, on the occasion of a deviation from its inflation range, a timescale within which the deviation should be corrected. More important than rigid adherence to an apparently straight and narrow path of monetary rectitude is that monetary policy should dampen or smooth fluctuation in both output and inflation. We see no contradiction between what we are advocating and the Treaty commitment to the ECB's primary objective of price stability. The crucial points, we think, are that the ECB's forward-looking policy objectives should be published and explained and the extent of their achievement should, equally, be regularly subject to open explanation and scrutiny.


  117.    We note that the ECB has said that it will set monetary targets, but we hope it will be flexible in their application in pursuit of low inflation. To rely solely on monetary aggregates of dubiously justified definition and of unknown behaviour across the whole euro zone in relation to inflation would be foolish. We do not expect this to happen. The central bankers from whom we heard evidence were of one mind: pragmatism and prudence must rule, using a combination of inflation targeting and monetary aggregate targeting on a trial and error basis when making interest rate decisions.


  118.    In the system being established in the euro zone it will be for the ECB to set monetary policy with the primary purpose of achieving price stability. We have already accepted[25] the inevitability of the ECB's independence. We see no scope for Euro-X to act in the field of monetary policy as a "counter-weight" to the ECB. The Treaty is designed to prevent this and any attempt to influence the ECB would be politically dangerous as subversive of the Treaty and, we believe, would lead to confusion and weakness in setting monetary policy. We see Euro-X as a forum in which, by discussion, the discipline of the stability pact could come to be reinforced by peer pressure. Ecofin is acknowledged to be the sole decision-making body at Council level on economic matters.


  119.    We think that there has certainly been a change of fashion and probably of hearts and minds, too, in the last decade or so in relation to the control of national budget deficits. The "culture of stability", particularly in relation to budget deficits, was embedded in the Treaty in the Maastricht convergence criteria. The success of so many Member States in achieving such a degree of convergence by early 1998 has been remarkable and unexpected. It remains true that debt ratios are too high in some countries: these Member States, notably Belgium and Italy, quite independently of EMU, will have to aim for primary budget surpluses over many years in order to bring their debt ratios to the reference level in the convergence criteria. Without progress in this debt reduction the ability of a Member State to use the 3 per cent of GDP flexibility in the stability pact to cushion the effects of cyclical variations will be reduced.

  120.    We do see the stability pact as having some persuasive force beyond that of the politically extreme weapon of imposing substantial financial penalties. We think that a culture of stability is taking an increasingly firm hold among the economically and politically literate classes in the EU. In a reasonably benign economic climate, such as the continental Member States may well experience over the next two or three years if the upswing of the economic cycle develops, we can hope that damaging strains in the operation of the stability pact will be avoided although the mechanisms of warnings and remedial actions might need to be invoked. In a harsher climate, which will arrive some day for some regions or countries in the euro zone, we would hope that the culture of stability would be strengthened by strong pressure from other countries to conform to the requirements of the pact. As some of our witnesses pointed out, the smaller countries have most to fear from back-sliding by larger countries and can be expected, therefore, to be insistent that the pact be observed by them. Moreover, we think that the dissuasive or deterrent effect of the possibility of financial penalties may work positively by emboldening finance ministers to resist calls for unsustainable tax breaks.

  121.    We considered whether the mechanisms of the stability pact for monitoring, giving advice, warnings, private then public, would take so long to act that a profligate country could, for too long, practise unneighbourly behaviour without incurring penalties. We have also considered the possibility that the 3 per cent of GDP flexibility in the national deficit allowed under the pact is insufficient. Some flexibility with regard to the budget deficit over the cycle is essential and our evidence suggests that for countries without a high debt ratio the 3 per cent scope is likely to be sufficient. In those countries with a high debt ratio there may be more serious difficulties. We conclude that the stability pact, as currently formulated, generally strikes what appears, ex ante, to be a reasonable balance between constraining deficits and allowing essential flexibility of the national budgetary balance. This assessment, ex post, may need to be revised, but we have heard no constructive proposals for amending the terms of the stability pact in advance of experience of its operation.


  122.    It is generally accepted that the economic fortune of a nation depends on the monetary, fiscal and structural policies that it pursues. Monetary union requires that there will be a single interest rate across the euro zone, leaving each of the 11 nations within that zone to adopt its own fiscal and structural policies. Coordination between these three policy elements, while theoretically desirable, is unlikely to be fully achieved, especially between countries in a different economic climate. However, in practice, the lack of such coordination in the past does not appear to have had major adverse effects on national economic performance. While we expect that the ECB will succeed in controlling inflation we have not formed a clear conclusion as to whether or not having a "one size fits all" monetary policy may, on occasion, cause some difficulties to individual countries in the short term.

  123.    We have, however, been able to reach firmly one crucial conclusion in advance of the operation of the single currency and the ECB. It is that, given the commitments by Member States to price stability and to running national budgets close to balance or in surplus over the cycle, there will be need of unprecedented urgency to free-up their labour, product and financial markets. The flexibilities of these markets will determine the euro zone's response to technological change, external shocks and increased competition. Structural reform is widely recognised in the EU, and by observers outside, as not only essential but also overdue, irrespective of the advent of the single currency. As Mr Volcker said in his evidence to us, the single currency and the constraints on fiscal balances will act as a political spur to making the necessary structural changes. Structural reforms take time to be introduced and to become effective in democracies. In the possibly quite long interim period there will inevitably be strains put on some national fiscal policies.

  124.    In our view, although we did not seek evidence on this point particularly, the United Kingdom is more favourably placed than many other Member States to take advantage of the climate of intensified competition likely to follow the introduction of the single currency. Transparent pricing in euros will foster price competition across the euro zone. In other words, it can only help the single market. The United Kingdom, because this country has already put in place many of the market freedoms which promote competition, has already endured the strains of painful reforms and could be ready to derive advantage from more open cross-border competition.


  125.    Under the single currency regime, according to the European Council[26], "in general, exchange rates should be seen as the outcome of all other economic policies". The euro zone will conduct a high proportion of its trade within its own borders: it will become, in this respect, more similar to the economy of the United States where economic management is governed primarily by domestic or internal concerns and is not unduly, or at all, constrained by exchange rate considerations.

  126.    In general, the reduced importance of the external exchange rate is to be welcomed as providing a new degree of freedom for economic management. However, there must be some concern[27] that the trading blocs of the United States and the EU would find their currencies increasingly volatile in relation to each other and to the yen. This might engender more trade disputes between the blocs and a greater willingness to argue about the relative burdens of security to be borne by the United States and the EU. We accept that these concerns may be justified but we see solutions in terms of greater mutual understanding of the advantages of freer trade and the equitable sharing of security burdens. We do not see that these concerns can be addressed by operating directly on the euro/dollar exchange rate unless there is to be a new international system of managed exchange rates. This possibility is outside the scope of this enquiry.


  127.    We return now to the question we raised at the beginning of this Part of the Report. We have been impressed by the political will demonstrated by the 11 in achieving the present degree of inflation convergence and deficit reduction. In the light of this political will we ask whether arrangements for the ECB are generally conducive to stability, growth and employment.

  128.    The ECB has been well-prepared. Its forerunner, the EMI, has been actively engaged in bringing matters to the point where decisions can be quickly taken once the ECB is formally in existence. It is our impression that the EMI has worked thoroughly and impressively at its task. The ECB itself will be well-armoured in statutory independence. Its Executive Board and Governing Council will contain the brightest and best of the breed of central bankers. We are confident that the ECB will be able to determine a sensibly pragmatic strategy for achieving price stability defined in an acceptable way. Within the limits of its role, as envisaged by the Treaty, we are optimistic that the ECB can and will do a good job of achieving price stability across the euro zone.

  129.    Turning to the management of fiscal balances and the operation of the stability pact, it is to be hoped that a powerful combination of intellectual conviction and perceived self-interest over the medium term will lead to a workable combination of national fiscal policies across the euro zone. We do not expect the ultimate financial penalties available under the stability pact to be imposed because we expect governments to steer a more prudent course. There is some risk that a major recession, if it occurred, would be associated in people's minds with the actions of the ECB or with the constraints of the stability pact. We cannot deny that then there would be a danger—which we do not attempt to quantify—of political extremism causing pressure for a Member State to withdraw from EMU. However, we see this as a prospect which would only come about following prolonged economic mismanagement probably resulting from a failure of political will to make necessary domestic structural reforms.

  130.    Some of our witnesses considered whether short-term strains in particular countries or regions could or should be alleviated by some EC counter-cyclical fund. We have to say that, at present, we see no political prospect of this being agreed, even at a modest or token level although we think that this should be given further consideration. The perceived burdens of enlargement of the EU to the east and the strains of reform of the Common Agricultural Policy and the regional aid funds are, we think, sufficient to block any movement in this direction for some years to come. However, we recognise that politicians are often more creative than the treaties or rules that were agreed by their predecessors in earlier and different circumstances. Rules, including those governing the financial perspective of the EC, can be amended in response to compelling needs. We would not rule out at some time, after enlargement of the EU and after EMU has bedded down, further consideration being given to a modest enlargement of the EC Budget with some provision for short-term counter-cyclical compensation payments.

  131.    The two principal potential economic dangers to the success of the single currency that we see are fiscal profligacy—excessive and unjustified budget deficits—and failure to make structural reforms. The first danger, we think, is much reduced by the prevailing and strengthening culture of stability. Sustained efforts to reduce national debt ratios will certainly be required by some countries. The greater potential danger, we think, comes from the possibility of national failure to make essential structural reforms. We think that Ecofin and Euro-X and the Commission, at EU level, need to wage and sustain a vigorous campaign for these reforms, perhaps as part of the process of multi-lateral surveillance. The responsibility for implementation of structural reform rests with national governments who, in due course, will have to convince their electorates that these reforms are required, with or without the single currency, and will lead to greater economic health and prosperity.

  132.    There is also a political danger that the pursuit of national interests may hamper the smooth functioning of the ECB and the single currency. The manner of the appointment of the first President of the ECB is a prime example.

  133.    The single currency will come about for 11 countries and now seems certain to proceed on time. This is an immense and—from the perspective of only one year ago—a surprising achievement. It is the result of a sustained investment of political will by the leaders of the countries involved. The preparation process has called for, and received, considerable effort and has already affected the lives of ordinary citizens. Once adopted, the single currency is not absolutely irreversible, although it is intended to be so. However, the political and economic costs of failure would be such that we assume an overwhelming political will to make it acceptable and successful. The European Central Bank is an essential element in the operation of the single currency. While the risks are considerable we do not expect it to be allowed to fail.


  134.    The Committee considers that the operation of the European Central Bank raises important questions to which the attention of the House should be drawn, and makes this Report to the House for debate.

21   Article 2. Back

22   The EFC is set up by the provisions of Article 109c(2). These are summarised in paragraph 24 of this Report. Back

23   See Q 281. Back

24   See paragraph 32 above (Q 403). Back

25   See paragraph 105 above. Back

26   See paragraph 22 above. Back

27   Concern was expressed by Mr Volcker: see paragraph 94 above. Back

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