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Lord Skidelsky: My Lords, does the noble Lord agree that if investors have confidence in an economy, it can sustain a substantial balance of payments deficit for a long time? Is not the United States an example of that? Why is he particularly worried about the fact that our payments are in deficit at the moment?

Lord Tomlinson: My Lords, I agree that a deficit can be sustained for some time. I said that we had managed a deficit for a long time. However, I am concerned about the direction of the deficit--the fact that it is widening substantially, particularly with the European Union. I am concerned about the trend.

My second cause for concern in this attempt to look forward was also addressed by the noble Lord, Lord Skidelsky, and by my noble friend Lord Haskel, who

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is no longer in his seat. It concerns the trend in productivity. The noble Lord, Lord Hodgson, referred to productivity problems, but in no sense can they be held to have started in 1997 or anywhere thereabout. We have had constant productivity problems over a long period. Even a superficial examination of the document entitled Productivity in the UK: Enterprise and the Productivity Challenge, recently produced by my right honourable friends Gordon Brown and Patricia Hewitt, begins to show us how serious some of our productivity problems are. Output has been boosted in recent times by higher employment, but further improvements in productivity are the imperative of the greater prosperity foreseen in the Queen's Speech. The Chancellor's accumulated surplus will disappear speedily with present spending plans without recourse either to the improvements in productivity that we need to match our major competitors or to the tax increases that the noble Lord, Lord Skidelsky, referred to in his interesting speech.

The statistics on productivity in Gordon Brown's recent paper show that output per worker is 40 per cent higher in the United States than in the United Kingdom and the gap is growing. It is also 10 per cent higher in Germany and nearly 30 per cent higher in France.

Other statistics are also relevant to productivity. In the United Kingdom, research and development spending has fallen from 1.5 per cent of GDP 20 years ago to barely 1.2 per cent of GDP today, whereas France, the United States and Japan are all on rising trends and invest substantially higher percentages of GDP than we do. Germany's trend is slightly downwards, but it, too, has had a consistently higher level of investment in research and development than the United Kingdom.

There are other manifestations of the result of higher productivity and higher investment to consider. On a pro rata basis by population, there are 30 per cent more patent applications in the United States, 40 per cent more in France and 200 per cent more in Germany.

The major reason for our relatively poor productivity is our relatively poor investment in physical capital. We have had a lot of debate and discussion about the benefits that might accrue from investment in human capital, but the poor performance of investment in physical capital is largely responsible for our poor productivity, despite the fact that we have highly developed capital markets in the United Kingdom and despite our great success in attracting inward capital investment from other countries. After those two facts, which should be to our benefit, have been taken into account, the United States now has 25 per cent more capital stock per hour worked, France has 40 per cent more and Germany has 60 per cent more. We have a substantial backlog to make up on fixed capital stock per worker.

There are other aspects of the problem relating to productivity. Every time in the past 40 years that we have reached full employment, the first thing that we have bemoaned is skill shortages in areas relevant to

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the needs of industry. We have got wrong almost every massive investment that we have made in trying to train our labour force. At times of full employment the first cry has been "skill shortages".

Therefore, we have serious problems which require the concern of government and which do not enable us to assume that economic prosperity will continue automatically. We have a problem both in relation to our trade situation and in relation to the productivity that will be necessary to enable us to maintain the type of investment in public services that are foreseen in the gracious Speech without resort to tax increases.

Finally, I want to say one or two things about the effect of the exchange rate on sterling and our international performance by returning inevitably to the question raised so clearly by my noble friend Lord Lea--that of our membership of the single currency.

First, in the short time available, I want to say clearly that I agree substantially with his arguments. I hope that the Government will begin to indicate their views on which, if any, of the five economic tests remain problematic to them. I hope that they will do so sooner rather than later.

In the meantime, I have expectations of the Government in which I hope not to find myself disappointed. If we are invited constantly to support the euro in principle, subject to the five-test assessment, or if we are told constantly that we are pragmatically pro-euro, I believe that we have a right to look to the Government to start spelling out clearly not merely to us but, through us, to the whole of the British people what they anticipate the benefits of the successful attainment of those tests to be. When we have completed those tests successfully, they anticipate a government view in favour of joining the euro. I look to the Government to start telling us what the benefits will be because they should be spelt out clearly now. They remain constant whether or not we attain success in those five rather subjective tests.

Not only do I understand but I share concerns that the incantation of those three words--"five economic tests"--is being used not as part of the debate on the euro but rather as a shroud to avoid debate. That cannot continue any longer. I believe that a number of Members on the government side of the House will be quite content to assist the Government in bringing forward that debate.

6.12 p.m.

Lord Layard: My Lords, there is probably only one proposition on which every Member of the House agrees--that the main economic issue for this Parliament is whether to join the euro. I very much agree with what has been said by a number of noble Lords: there must be a public debate on the matter. There is already half a public debate. The "no" campaign produces documents every day and the number of misconceptions increases every day. I want to spend a few minutes helping to do what the noble Lord, Lord Tomlinson, suggested was needed--that is, to make some of the key points on the other side.

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Quite simply, the matter concerns productivity. That has been talked about a great deal today. However, in a country such as ours probably the main issue which determines the level of productivity is its relations with the rest of the world. One grows rich by being part of a large market. If one takes any part of the United States, one sees that it is rich because it is part of the large US market.

We have also seen the impact on the prosperity of European countries of the formation of the European common market. We stayed out of it for a long time and that was the great period when our productivity growth fell way behind that of the rest of Europe. After we joined, we managed to keep up with the rest of Europe. Unfortunately, we have not been growing any faster than it, but at least for the past 20 years we have not been growing more slowly.

However, Europeans have recognised that they do not have a truly single market because they have not had a truly single currency. Exchange rate uncertainty has been a major deterrent to any real deep trade integration. That is why the nations have now joined together to adopt a common money, much as, if we can cast our minds back in a broad-minded sort of way to the period before the First World War, the whole world had a common money. It is not such an awful thing to have.

During that time, we saw one of the great periods of trade integration and its impact on the spread of prosperity between nations. Now that a single currency is coming to Europe, we are already seeing the restructuring of the European economy in response to that with production concentrated increasingly in least-cost locations to the great benefit of European consumers.

Some people say that if we had stayed out we would be maintaining the status quo. I believe that that is the first fallacy of which we should dispose. The old status quo in which we lived until the past few years was one in which production in every single European currency destined for a market in any other European country involved exchange rate risk. However, for continental producers who are producing for the continental market, that risk has now gone.

Therefore, if we keep our independent currency, we shall become more at risk than we were in the past when compared with our competitors. I do not need to quote the experience of BMW, Vauxhall, Corus and so on to underline the importance of that. It will become even more important as the years go by. Therefore, I believe that we should start by recognising that the decision to stay out is not the default position; it is as active a decision as if we decided to enter.

However, then critics say--this came out in the past week--that the European market is certainly not our only one, and they point out that it is growing more slowly, in some sense to be defined, than others. The "no" campaign recently published a paper by Roger Bootle putting forward those arguments. I believe that there are three widely-held fallacies.

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The first says that the importance to Britain of Europe has become exaggerated by "our side" because the argument has focused on the share of trade in goods and services that goes to Europe. Instead, it is argued that one should add in the flow of income from investments, which of course is much more related to the United States. However, that is wrong. We are interested in the problem of the set-up costs of penetrating a market. Those involve a much longer time horizon and lock in the fortunes of companies and workers to the vagaries of an exchange rate if it is floating, whereas most investments can be more rapidly reallocated between currencies.

The second argument put forward a great deal at present is that Europe is growing more slowly than the rest of the world. However, the funny thing is that people do not look at history. Of course, for a long time Europe has been growing more slowly than the overall world economy, yet the share of our trade with Europe has increased steadily over the past 30 years. That is because trade integration is so important when compared with anything else. I believe that one can say with almost complete certainty that we should not be looking only at the present share of trade with Europe. If we joined the euro-zone, our share of trade with Europe would increase because integration would be so rewarding in terms of gains in profits and productivity.

Finally, people love to point out that more of our goods exports are invoiced in dollars than in euros. Of course, the largest number are invoiced in sterling. But the currency in which one is invoiced is not the point. What matters is the relation between one's costs--in pounds in our case--in one's own currency and the prices of one's competitors when expressed in the same currency. If the invoicing is in a third currency, the prices can be adjusted to obtain whatever price one deems to be optimal in the market in which one is selling.

Exchange rate stability in Europe is the prize we would win; the cost of course is loss of control over our interest rates. If one is in principle in favour of joining, one has already judged that the gain from exchange rate stability outweighs the cost of losing control over one's interest rates. One could not have made one's decision in principle without having looked at that key central trade-off.

As the Government have presented the matter to us, the next issue is to decide when to join. The Government must of course make a careful assessment of the tests. One is bound to say that the basic convergence of economic cycles and thus of interest rates looks to be well within sight. The remaining problem is with the exchange rate. We could consider joining only at an appropriate rate, which would be substantially lower than that which currently prevails. However, the exchange rate is not an exogenous, external element that the Government are powerless to affect; they can influence it and ultimately it will have to be agreed with our European partners. If that involves a change in the exchange rate, there will be

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problems with demand management--a lower exchange rate would mean a higher level of demand for British production.

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