Select Committee on European Union Eighteenth Report



Economic and Monetary Union

20. The provisions governing Economic and Monetary Union (EMU) were added to the Treaty of Rome by the Maastricht Treaty. Article 4 EC refers to

Article 116 EC provides for the second stage of EMU to begin on 1 January 1994[5], and the subsequent Articles lay down the route to the third stage—at the starting date of which

    "the Council shall … adopt the conversion rates at which [the currencies of Member States without a derogation] shall be irrevocably fixed and at which irrevocably fixed rate the ECU shall be substituted for those currencies and … become a currency in its own right" (Article 123(6) EC).

The third stage took effect on 2 May 1998, with 11 Member States[6] being judged to meet the conditions for adopting a single currency. The European Central Bank formally took over monetary policy decision-making for those Member States participating in the euro-zone on 1 January 1999.

21. Article 105 EC specifies that the primary objective of monetary policy shall be price stability. In October 1998, the Governing Council of the ECB announced that its quantitative definition of "price stability" would be an annual increase of below 2 per cent in the Harmonised Index of Consumer Prices (HICP) for the euro-zone as a whole, and that it would aim to maintain stability in the medium term[7].

The Stability and Growth Pact

22. The Treaty of Maastricht obliged all EU Member States to endeavour to avoid excessive deficits (defined as deficits of more than three per cent), on pain of sanctions in the form of a non-interest bearing deposit or a fine "of an appropriate size"[8]. In 1997, the Stability and Growth Pact (SGP) was agreed by all EU Member States; it came into effect when the euro was launched on 1 January 1999[9]. Under the SGP, participating Member States are expected to maintain a deficit of less than 3 per cent of their GDP in all but "exceptional circumstances"[10]. In principle, the target should be determined so as to allow enough room for fiscal stabilisation to occur over the business cycle without the deficit exceeding the 3 per cent ceiling. If a country runs a deficit above 3 per cent, the Commission is required to prepare a report, on the basis of which the Council may declare that the deficit is excessive. A country held to have an excessive deficit is required to take steps to reduce it promptly, on pain of sanctions, which are more tightly defined than in the original Maastricht provision.

23. The prime responsibility for remaining within the ceiling rests with Member States, but the SGP also provides for regular monitoring of the budgets of participating Member States by the European Commission and Council, to provide early warning of prospective excessive deficits, and generally to promote co-ordination of fiscal policies. Each year, countries are required to submit Stability Programmes[11], setting out their plans for bringing their cyclically adjusted deficits towards a position close to balance or in surplus. The Council considers these, and may invite a Member State to adjust its Stability Programme. In addition, between these annual exercises, the Council and the Commission monitor the implementation of the Programmes. In the case of a "significant divergence" of actual deficits from their planned path, the Council is required to issue a Recommendation urging the Member State to take appropriate measures. If it does not, the imposition of sanctions may follow[12], according to a set of procedures to be followed by both sides on a fairly precise timetable[13].

24. The thresholds and ratios incorporated in the Stability and Growth Pact are based on the principle, expressed in the Broad Economic Policy Guidelines, that

    "Sound budgetary positions, in line with the SGP, will create the necessary scope for the full working of the automatic stabilisers without the risk of breaching the budget deficit threshold of 3 per cent of GDP. It will also have a favourable effect on interest rates and contribute to the crowding-in of private investment, to the further reduction in the government debt to GDP ratio and, by increasing the credibility of the budgetary framework of EMU, to a strengthening of investors' confidence" (p 3).

25. Our previous Report expressed concerns about the danger of "fiscal profligacy"[14]: the Stability and Growth Pact was designed to combat this. Its importance was confirmed in the declaration made in ECOFIN[15] on 1 May 1998, on the eve of the decision on the adoption of the single currency by the 11 participating Member States:

    "For the coming years, strong, sustained and non-inflationary growth will continue to be based in all Member States on economic convergence. Moreover, sound and sustainable public finances are prior conditions for growth and higher employment. The Stability and Growth Pact provides the means for securing this objective and for increasing the scope in national budgets to deal with future challenges" (p 1).

The Broad Economic Policy Guidelines

26. The Treaty[16] requires Member States to regard their economic policies as a matter of common concern, and to conduct them with a view to contributing to the achievement of the objectives of the Union and in the context of the Broad Economic Policy Guidelines (BEPGs). A new set of guidelines is agreed each year by the European Council[17], and forms the core of the economic policy co-ordination process in the EU—although, unlike the provisions of the Stability and Growth Pact, the Guidelines are not binding, and there are no sanctions for failure to observe them. They contain country-specific guidelines both for participating Member States and for those outside the single currency. But because all Member States "face broadly the same challenges and policy needs", the general recommendations are formulated so as to be applicable to all of them, whether or not they are participating in the single currency—although this year's BEPGs note that closer co-operation is developing among participating Member States[18].


27. Before the euro was launched, a number of expectations had been voiced; our witnesses recalled some of them in their evidence.

28. The main hope was for an increased rate of growth, greater incentives for fiscal responsibility, and stronger incentives for structural reforms (in labour, goods, and financial markets). Interest rates would be lower in the long term. It was hoped that increased transparency in international cost and price comparisons within the euro zone, reinforcing the completion of the Single Market, would lead to enhanced competition between producers. This would improve resource allocation (as well as leading to lower prices for consumers). The euro would thus become a stable, strong currency to rival the US dollar in world markets, being used to price international transactions, both as an international means of payment, and also as a reserve currency. Benefits were foreseen from the greater liquidity of large markets in euro-denominated financial instruments, from the removal of exchange rate risk within the euro-zone, and from savings on transaction costs. It was hoped that their greater competitiveness would strengthen the international position of participating Member States, and that the resulting increase in confidence would lead to higher investment.

29. But there were fears too. There was a concern that, without control over exchange rates and with a one-size-fits-all interest rate, national governments would find that the adjustment tools remaining to them were not strong enough, given the lack of labour mobility, and inflexibility in wages and prices. This could cause problems in reacting to shocks, and might lead to divergence rather than convergence within the euro-zone (whether between participating Member States or within individual Member States). Post-EMU fiscal fatigue might set in, resulting in breaches of the public borrowing limits set by the SGP, and consequential instability. Some feared increasing pressure for co-ordination or centralisation of fiscal policy in the euro zone, or for harmonisation of social security provisions, and others thought that the single currency might increase the pressure for closer political union.

30. Professor Patrick Minford (of Cardiff Business School) described the euro as "a political project" (Q 201). It was indeed apparent from the evidence which we received that the governments of some participating Member States had strong political motives for welcoming the single currency. The Belgian government, for example, reported a broad social consensus in Belgium "regarding the desirability of European economic and monetary integration and the macroeconomic discipline it requires" (p 114). The Italian government said that "in political terms" Italy had been determined not to be left behind in Economic and Monetary Union, which it welcomed as a step "towards an ever closer European integration" (p 116). The Spanish government referred to the "perception of belonging to an economic area—the euro-zone—with a growing weight in the international economic scene" (p 119). For the Dutch, "EMU marks the crown on the European internal market" (p 104).

31. HE Mr P Salolainen, the Ambassador of Finland (a former Deputy Prime Minister of Finland, who had been responsible for negotiating his country's entry) told us that the decision to join the European Union—and subsequently to join the single currency—had been for his country

Of course there would be economic advantages as well, and losing the currency would not be a great psychological blow: "our currency, the Finnish markka, has not had a glorious past", because after the war there had been a series of "lousy" economic policies and big devaluations (Q 127).

32. In the view of Mr Jim Power, Head of Economic Research at the Bank of Ireland[19]:

    "First and foremost EMU was a victory for politics over economics. It is a political project. The economic realities are not always logical. I think that is particularly the case for the Irish economy" (Q 199).

The Irish Ambassador, HE Mr Edward Barrington, accepted that there had been political reasons for the decision to join, saying that when time came for the decision on the single currency, Ireland had already

    "seen the advantages which could accrue to a small country from being involved in the decision making process on economic policies. We were going to be subject to, and influenced by, the decisions of the EU whether we were in or out. Far better to be inside affecting those decisions and shaping those decisions in our interests … When it came to the euro, it seemed to us that this experience of 20 years' participation in Europe could be brought similarly into monetary policy … Those were the political reasons" (Q 232).

But the government could not have recommended joining to the Irish people solely on that basis, nor would the public have endorsed the euro—or continued to support it—on the basis of the political advantage alone (Q 256j): "the economic argument was also persuasive" (Q 232). The Irish government told us that a study in 1996 by the Economic and Social Research Institute[20] had concluded that "membership of EMU would, on balance, be economically advantageous [to Ireland], even were the UK not to participate in EMU"[21]. By 1998, the risks attached to entry were judged to have decreased, and those of delaying entry to have increased (p 74). Professor Fitz Gerald of the Economic and Social Research Institute added that the main benefit which that study foresaw was lower interest rates in the long term, whereas over the previous 15 years Irish interest rates had been on average two percentage points higher than those in other Member States, resulting in lower investment and growth (Q 234).

33. We noted the balance between—and the complementary nature of—the hopes and fears of Member States, and examined the extent to which they had so far been realised.

5   The first stage having begun on 1 January 1990. Back

6   Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain; they have been joined this year by Greece.  Back

7   For a commentary on the ECB's objectives, see paragraphs 113 - 115. Back

8   See Article 104 EC and Protocol 20 to the EC Treaty (Protocol on the Excessive Deficit Procedure), introduced by the Maastricht Treaty. Under what is now Article 116 EC, this requirement still remains binding on non-participating Member States (to which the SGP does not apply). Back

9   Its provisions are set out in Council Regulations 1466/97 [1997] OJ L209/1 (on the strengthening of the surveillance and co-ordination of budgetary policies) and 1467/97 [1997] OJ L209/6 (on speeding up and clarifying the implementation of the excessive deficit procedure) and in a European Council Resolution of 17 June 1997 on the Stability and Growth Pact. Back

10   "Exceptional circumstances" normally include a fall in real GDP of 2 per cent or more within the year. A fall in real GDP of less than 0.75 per cent is not considered exceptional. Back

11   The first set of Stability Programmes was submitted at the end of 1998 and the beginning of 1999, and the Council's Opinions were delivered early in 1999. Revised Stability Programmes were submitted by Member States at the end of 1999 and early 2000, and the Council delivered its Opinions on them in early 2000. Back

12   For HM Treasury, Mr Robert Woods pointed out that there was a certain amount of flexibility in deciding whether sanctions should be applied, a decision which would be taken by the Council (Q 15). Back

13   That timetable implies that a country would be able to run excessive deficits for roughly two years-one year before the size of the deficit came to light, and a second to allow time to respond to it-without attracting sanctions under the SGP. Thereafter, in the first year in which sanctions are imposed, a country is required to make a non-interest bearing deposit of 0.2 per cent of GDP plus one-tenth of the excess of the deficit over 3 per cent, up to a maximum deposit of 0.5 per cent of GDP. In each subsequent year until the excessive deficit decision is abrogated, further deposits of one-tenth of the excess of the deficit over 3 per cent are required. Deposits are to be converted to fines after two years if the excessive deficit persists. Back

14   Op cit, paragraph 131. Back

15   The Council of the European Union, meeting on economic and financial affairs. Back

16   Articles 98-99 EC. Back

17   The current BEPGs were agreed at the June 2000 Feira European Council (9223/00). Back

18   See paragraph 119. Back

19   At the time when he gave evidence to us. Back

20   Terry Baker, John Fitz Gerald and Patrick Honahan (eds), Economic implications for Ireland of EMU, Economic and Social Research Institute (ESRI), Policy Research Series Paper no 28, July 1996. Back

21   The net benefit was estimated at additional 0.4 per cent of GDP on average annual basis over medium term, having allowed for possible shocks due to UK non-participation. There would also be other unquantifiable effects, like becoming increasingly attractive as a destination for foreign direct investment. Back

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