Select Committee on European Union Eighteenth Report


Converging or diverging?

80. A certain degree of economic convergence within the euro-zone was of course assured by the fact that all the participating Member States met—or were deemed to have met—the Maastricht convergence criteria. The Governor of the Bank of England said that in making their "terrific" efforts to meet the criteria many countries had "introduced a greater degree of discipline into their fiscal and monetary policies" (Q 262). Ms Bettina Schulz (Financial Correspondent of the Frankfurter Allgemeine Zeitung) considered that in Germany the SGP had forced the Government to reduce its deficit and its debt, and had accelerated structural reforms; even labour market reforms were starting (QQ 66-67). Of course, some Member States were already engaged in reform for other reasons[63].

81. We note that in general the economies of the euro-zone have been moving in the same direction. But, as we have noted earlier[64], within the overall picture there are variations between countries. This is not surprising, given the different starting points: in order for GDP per capita to converge, growth rates must diverge. Core euro-zone countries such as France and Germany have been growing less rapidly than some of the countries on the periphery, such as Ireland, Finland, and Spain[65]. And differences in inflation rates between participating Member States have widened a little[66].

82. Professor Minford interpreted these figures as showing an increase in cyclical divergence, because of the structural divergence between the "rather stagnant block [consisting of] the old big three economies at the centre, [which was] having a great deal of difficulty in adjusting its industrial structure" and the peripheral economies which were much more dynamic (Q 210). In theory a common currency should tend to harmonise inflation rates, because it would lead to goods being traded in a competitive international market. But that would not apply where it was particularly in the prices of non-traded goods that inflation was occurring[67] (Q 208). Asked whether in the longer term it would be possible to have a core within the euro-zone with low inflation and a periphery where inflation was three per cent higher, he thought in such a case there would be pressure for deflation (Q 226).

83. Mr David Ramsden (head of the EMU policy team in HM Treasury) pointed out that before the convergence criteria were met, the considerable harmonisation of inflation rates within what was now the euro-zone had been achieved by divergent interest rates—a tool now lost to participating Member States (Q 10). Our attention was drawn to the "Euroland Interest Rate Convergence Index" produced by Chantrey Vellacott DFK, designed to track the average interest rate basis points differential between the ECB rate and an estimate of the "appropriate" interest rate which national central banks would have set (calculated on the basis of an interest rates forecasting model based mainly on the output gap and the inflation rate). Table 3 below shows the figures for August 2000.

Table 3: Comparison of ECB interest rate with notional "appropriate" rate

Notional rate, being ECB rate adjusted for cost of living, August 2000
Difference from ECB rate, August 2000 (4.5%)

Source: Euro-Impact, September 2000, Volume 4, Number 8 (based on estimates by Chantrey Vellacott DFK).

84. According to these estimates, the participating Member State for which the August ECB interest rate was most appropriate was Italy, whereas of the countries included the rate diverged most for Spain. The published commentary suggested that these figures marginally understated the position, because the index covered only the larger euro-zone economies, and therefore did not include Finland, Ireland or Portugal, the countries showing the greatest divergence. A one-off calculation in mid-August had suggested that the ideal interest rate for Ireland would be 14 per cent[68].

85. There would be an increased threat of divergence if participating Member States were subject to shocks which affected them differently. For example, Professor Minford said that the Asian crisis in 1998 had been heavily focused on manufacturing industries, creating very large excess capacity in goods depending heavily on unskilled labour. It had therefore had a more serious effect in countries (like Italy and Germany) with a strong manufacturing sector than in those (like the Netherlands) which were more service-orientated (Q 209).

86. However, we received evidence from participating Member States that their membership had helped them to withstand shocks. The Belgian government considered that their membership of the single currency had smoothed the shock of the recent crisis caused by dioxin contamination of part of the food chain, when "had it not been for the euro, both the exchange rate and interest rates would probably have come under pressure and the consequences would have been felt far beyond the directly affected sectors" (p 115). The German Ambassador said that without EMU it was highly probable that the effects of the Russian financial crisis in August 1998 would have had repercussions in the money market, "and the normal course of events would have been that the German Mark would have gone up and other currencies of EU countries would have gone down". German trade unions had calculated that the effect on the labour market would have been the loss of about a quarter of a million jobs (Q 294).

87. Because Ireland seemed be diverging the most, we examined the position there in some detail. Table 4 below shows a series of economic indicators for Ireland.

Table 4: Economic indicators for Ireland

Real GDP (% change)
Unemployment rate (%)
HICP (% change: annual rate)
CPI (% change: annual rate)
Trade balance (%of GDP)
Government net lending (% of GDP)
Government net lending (% of GDP, cyclically adjusted)
Government debt (% of GDP, at end of period)
Interest rate: 3 month interbank (%)
Interest rate: 10 year government bond yield (%)
Balance of Payments current account (% of GDP)

Sources:Eurostat database and Data for short-term economic analysis
Irish Government, Central Statistics Office, and Department of Finance
IMF, International Financial Statistics.
Note: Figures are annual averages, except where otherwise noted and for 2000.

We noted in particular that the exceptionally high growth rate was slowing down, but unemployment was continuing to fall (to 5.0 and 4.7 per cent for the first two quarters of 2000). Interest rates had fallen sharply. Inflation for the first two quarters of 2000 was 4.6 per cent and 5.1 per cent respectively, well above the average for the euro-zone (which was below 2 per cent until May 2000). Mr Power's prediction was that inflation would be as high as 5.7 per cent for 2000 as a whole, and that in 2001 it would fall only to 5 per cent (Q 197). The figures in Table 4 from the Irish government's own Consumer Price Index show that this would be the highest rate since at least 1992. The rise in house prices has been particularly striking.

88. The Irish Ambassador pointed out that Irish inflation was not likely to jeopardise the inflation rate in the euro-zone as a whole because it formed such a small component of the total (Q 241). Nevertheless, it might be damaging to the domestic economy: there were differences of view about this among our witnesses.

89. On the one hand, it was possible to view the present situation as positive, on the basis that whereas a increase in productivity relative to competitors would normally lead to a steady rise in the real exchange rate, within Monetary Union the same effect was achieved by means of a rise in relative earnings and prices; this could be seen as "part of the process by which Ireland becomes relatively richer"[69]. The Irish Ambassador did not consider that the present situation in Ireland represented a "boom" which might be followed by a "bust"[70]. Rather, the economy was catching up through a process of structural change and solid economic growth, brought about by "a focus on supply-side economics, getting our taxation right, getting our attractiveness for foreign investment right, and getting our educational system right". This should enable growth to continue, though the rate would slow down (Q 256d).

90. On the other hand, although Professor Fitz Gerald agreed that the rate of inflation in product prices need not cause concern[71], he thought that wage inflation did: the Irish labour market was over-tight (Q 234). The government said that while much of the current rise in prices could be attributed to external or one-off factors (such as oil prices, the relative movement of the euro and other major currencies, and increases in excise duties[72]), there was no doubt that it also reflected to some degree inflationary pressures, particularly in the services sector (p 75). For HM Treasury, Mr Ramsden told us that the Central Bank of Ireland had estimated "core" inflation at 4 per cent (compared with 1 per cent in the euro-zone as a whole), with the weakness of the euro against sterling accounting for ½ per cent[73], structural factors for 1 per cent, and cyclical effects for 1½ per cent. The remaining 1 per cent could be accounted for by inflation in the prices of non-traded goods (QQ 11-13)[74].

91. To the extent that there was a real problem in Ireland, it was suggested that it was due not to a lack of tools to deal with inflation, but to the reluctance of the Irish government to use them. Professor Fitz Gerald said that the government should be using fiscal policy to take money out of the economy rather than pumping it in (Q 234). The government itself considered that it would be necessary to address the infrastructure constraints (such as transport and housing) which threatened to constrain the rate of growth in future. The policy challenge was to maintain economic stability, using income and fiscal policy to achieve an appropriate balance between demand and supply (p 75). It claimed that the PPF[75] would play an important role. Mr Power was more doubtful, suggesting that the agreement had already effectively broken down: wages were now rising as a consequence of full employment. In theory immigration could resolve the labour shortage, but it would be impossible to provide the necessary facilities (such as housing and health care) for the extra 200,000 people estimated to be needed. It would be preferable to increase female participation in the labour force, so in his view the government should be devoting resources to child care rather than cutting taxes (Q 189).

92. There were various views as to whether the difference in inflation rates would continue—and indeed could continue within a single currency zone. HM Treasury believed that the difference would be sustainable even in the long run without eroding competitiveness so long as Ireland's rate of productivity continued to grow (p 21). The German Ambassador pointed out that before re-unification in 1989 there had been great diversity within the Federal Republic, with Lower Saxony and parts of Bavaria 30 per cent behind the rest; he deduced that it was not "an iron rule" that the rate of inflation needed to be the same across an entire monetary area. He noted that within the United States there had been significant differences in inflation rates between regions[76] (Q 296). Professor Fitz Gerald saw this as an adjustment period, arising from the initial differentials in prices within the euro-zone[77]. In any case, he considered that for the Irish economy the consequences of getting things wrong were much less severe within monetary union than outside (Q 234). However, Professor Minford considered that the divergences within the euro-zone were leading to a loss of confidence in the euro, driving it down (Q 223).

93. The Governor of the Bank of England said that the performance in different countries was certainly not uniform in terms of inflation and in terms of growth—but nor would one expect it to be. He thought that it was difficult to generalise from the Irish example; Ireland's trade was still so strongly dependent on the United Kingdom that the weakness of the euro against sterling was causing a greater inflationary impulse there than elsewhere in the euro-zone. This added to the effects of being in a different cyclical and structural position (Q 266).

63   In Finland, for example, the government pointed out that "the consolidation efforts in public finances … were not motivated primarily by the prospect of euro participation", but it added that "participation has perhaps helped policy makers, social partners as well as the society as a whole to debate and assess the strategies for economic success" (pp 42-43). Back

64   See paragraphs 36 - 39 above. Back

65   See Appendix 3, Table 1.2.  Back

66   See Appendix 3, Table 5.2.  Back

67   The so-called Balassa-Samuelson effect, on which HM Treasury provided us with a note (at pp 20-21). Named after the two economists who developed it in 1964, the theory explains that countries which are experiencing relatively rapid economic growth in the tradable sector will tend to have high inflation in the prices of non-traded goods, but not in the prices of traded goods (because of relatively high productivity). This will result in their overall level of inflation being high without causing them to lose competitiveness. This phenomenon appears to be operating at present in Spain and Portugal as well as in Ireland.  Back

68   Euro-Impact, September 2000, Volume 4, Number 8. Back

69   Liberal Democrats, Britain's adoption of the euro, Report of the Expert Commission established by the Rt Hon Charles Kennedy MP, September 2000, p 34.  Back

70   As, he said, tended to be suggested in Britain in commentary on the Irish economy. Back

71   It would be sorted out by competition within the euro-zone ("you never hear the Governor of the Fed worrying about the inflation rate in Wyoming"). Back

72   The combination of rising prices due to the rise in sterling against the euro and the December 1999 increase in indirect taxes has been estimated to account for some 1.5 percentage points of the inflation: estimate by Jim O'Leary, chief economist at Davy stockbrokers, Dublin, quoted in Liberal Democrats, op cit p 35. Back

73   Because the United Kingdom is a major trading partner. Back

74   See paragraph 82. Back

75   See paragraph 69. Back

76   Which according to the Irish Ambassador had been as high as 7 per cent (Q 235). Back

77   For example, using data adjusted for purchasing power parity, prices in Spain were 14 per cent lower than those in Ireland; and prices in France were 6 per cent higher and those in the United Kingdom 29 per cent higher (Q 235). Back

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