Examination of Witnesses (Questions 89-99)
Mr Simon Tilford
10 JULY 2007
Q89 Chairman: Good morning and welcome
to our Committee. I apologise on behalf of our Chairman, Baroness
Cohen, who is away, and I am standing in for her on this occasion.
May I just remind you that this session is recorded and a transcript
will be available and will be sent to you. Is there anything particular
that you would like to say before we start?
Mr Tilford: No, I do not think so, that is fine.
Q90 Chairman: You have had a list of
the topics?
Mr Tilford: I have had a list of indicative
questions, yes.
Q91 Chairman: I thought in this session
we might start with a more general question. As we have seen in
your paper which you have circulated to us and we have had a chance
to look at, you seem to recognise some of the successes of the
eurozone but to be doubtful about its long-term sustainability,
and the question is do you really think it will crack, and if
so why or can it be saved and if so how?
Mr Tilford: I think the balance of probabilities
still is that it will not crack but many Member States have underestimated
the disciplines and the implications for policy of membership
and they have done that because there has not been sufficient
recognition of what membership of a currency union implies. We
have seen marked divergences in competitive positions within the
eurozone which at some point will have to be arrested and reversed.
On current trends I think there are some serious tensions that
cast some doubt over the sustainability of the current membership
but on balance I think it will not crack because obviously a currency
union can survive huge divergences as long as the costs of leaving
outweigh the costs of remaining in the currency union. However,
that does not mean that life is going to be comfortable for many
Member States that have lost competitiveness. I think that we
are going to see a number of economies experiencing very weak
growth and a really rather torrid time almost indefinitely without
taking steps to regain competitiveness, but I do not see it cracking
on the balance of probabilities, no.
Q92 Chairman: What do you think have
been the good points about it to date? Would we have been better
off if we had not had it?
Mr Tilford: The problem really is that many
of the issues that countries such as Italy, Spain and Portugal
have are problems that they would have had in any case. One of
the points we drew attention to in the piece we wrote is that
in some ways membership has insulated them or has provided them
with the space and the opportunity to go slow on necessary reforms,
so if you take Italy for example, back in 2000, Italy had a huge
primary budget surplus of about 5% of GDP. Instead of using suddenly
much lower debt servicing costs to consolidate its public finances
it basically eased up, particularly under Berlusconi, and much
of the work that the Italians did in the run-up to joining the
euro was reversed and undermined by that Government, and Italy
went from having a 5% primary budget surplus in 2000 to no primary
budget surplus at all in 2006. Had they still had their own currency
they would not have been able to do that because there would have
been a run on the lira and they would have faced much higher debt
servicing costs and hence there would have been problems, but
that is not necessarily an argument against the euro. I think
it has enormous potential. If it enables us to fulfil the potential
of the Single Market and to develop a truly integrated European
economy then great, but there is nothing inevitable about that.
For it to be able to do that there has to be a recognition of
what is needed to make a currency union work effectively. When
you are dealing with a currency union like the eurozone where
there is virtually nothing in the way of labour mobility between
the Member States—there are bits of labour mobility but
nothing really and, for example, there is more labour mobility
within the US than there is between individual states of the USA
let alone across the eurozone so there is no labour mobility and
there is very little in the way of fiscal transfers—so if
an economy, say a state in the US, gets into trouble, loses competitiveness,
its growth weakens, there are mechanisms to cushion the blow on
that state because there are transfers to wealthy more dynamic
states. In the eurozone we do not have that so we do not have
labour mobility, we do not have fiscal transfers and in the absence
of those two things it is of paramount importance that a number
of other criteria are met. You need the economies to be as integrated
as possible so trade flows, trade of goods and capital, which
can prevent differences in inflation becoming entrenched between
the Member States. You need a very high level of competition across
as much of those economies as possible to force economies into
being more innovative, boosting productivity. One of the key problems
we see in the eurozone is posed by weak productivity growth. If
productivity growth is weak, the burden of adjustment between
economies that have lost competitiveness vis-a"-vis more
successful ones has to fall on wages, and that can be hugely costly,
particularly if wages in the most competitive economy, ie Germany
at the moment, are not rising. Italy faces a big challenge at
the moment: how to regain competitiveness and how to undercut
the Germans when German unit wage costs are stagnant or falling,
and that is a big problem. For Italy to regain competitiveness
it needs to boost productivity but the policies needed to boost
productivity only take effect in the medium to long term. In the
short term they are going to have to make sure their unit wage
costs rise less rapidly than in Germany. That is a problem, so
you need competitive markets; you need the economies to be as
fully integrated as possible; you need flexible labour markets
so that real wages can fall relative to real wages in other Member
States and to make it easier for workers to move from under-performing
sectors to higher growth sectors or more productive sectors; and
you need fiscal discipline because particularly in the absence
of a mechanism for fiscal transfers, you need public finances
to be managed on a very sustainable basis so that if an economy
does lose competitiveness it has the opportunity to cushion the
blow just by loosening fiscal discipline to a certain extent so
as to cushion the blow and put policies in place that should enable
the economy to gain competitiveness. Ideally you also need some
convergence in per capita GDP so the economies respond to external
shocks in a roughly similar way.
Chairman: We will be going into some of these
topics in more detail. You mentioned Italy and—
Q93 Lord Steinberg: I was going to come
in before you move on. As more and more countries join the eurozone
they are generally the weaker rather than the stronger countries
that come in and that is obviously going to place a greater strain
on the rest of the eurozone whose economies, relative to theirs,
are quite strong. What do you see being done about helping and
assisting the weaker countries who are in the process of joining
the eurozone?
Mr Tilford: I do not think much is going to
be done to help. I think there is a lot of unease about further
expansion to include relatively weak Member States. I think the
problems that a number of countries have found themselves in like
Portugal (which stands out), Italy, and potentially Spain (and
Spain is held up currently as an example of a successful economy
but if you look at what has been driving growth there are some
real question marks over the sustainability of that boom because
Spain has lost even more competitiveness than Italy), there is
not the necessary solidarity within the eurozone for a mechanism
for fiscal transfers to be put in place. It is almost impossible
to imagine the more successful, richer Member States such as the
Netherlands and Germany agreeing to that. And I think there is
a real risk that if further Member States join before they are
ready then we could see them getting into similar difficulties
as some of the Mediterranean economies currently find themselves
in and we will see the stronger Member States benefiting disproportionately
from the eurozone, which I think is what we are seeing at the
moment. The Germans and the Dutch are clear winners from this.
Ironically they were expected to be among the losers but only
in the very short term will the winners I think be the Italians
and the Spanish because in the very short term they saw huge reductions
on their debt servicing costs, very low or even negative real
interest rates, but that is a very short-term benefit. The clear
message that we are seeing so far is that it is the Germans and
the Dutch that are emerging as the clear winners from this.
Q94 Lord Blackwell: Could I then come
on specifically to Italy. The general case as you have set it
out and as I understand it, is weaker economies like Italy going
into the euro have had effectively a free ride in the initial
period because they have been buffered by cottoning on to the
stronger economies and low interest rates and the confidence that
that has provided, but that is building up, nevertheless, the
need to make adjustments sooner or later to deal with competitiveness
divergence. The Italian economy nevertheless at the moment is
forecast to grow at a reasonable rate over the next couple of
years. What are the adjustments that you think are needed in the
Italian economy? You have talked about things that are needed
across the EU in terms of labour mobility and fiscal transfer,
et cetera, but if you take Italy, what do you think are the adjustments
that are needed in the Italian economy and what will drive them
against the political background in Italy to want to face up to
making those adjustments?
Mr Tilford: Two things are needed for Italy
to regain competitiveness. One is a sustained pick-up in the German
domestic economy, and I think this is neglected. Germany for a
number of years now, for seven or eight years, has been dependent
for a good part of its growth on rising net exports to other members
of the eurozone. That is not to say Germany is pursuing very good
labour policies, it is not, but I think much as membership has
lessened the necessity for the Italians to put their public finances
on a sustainable basis, I think it has also undermined pressure
on the Germans to address the underlying reasons for the weakness
of their domestic demand because they have been able to rely on
their exports. For Italy to regain competitiveness, I think first
and foremost you need the German domestic economy to strengthen
so for German growth to be carried as much by the domestic economy
as by exports, and indeed if you look at how Germany has gained
competitiveness in recent years, it did that by holding down wage
settlements essentially. Productivity growth was not that impressive,
it just held down wage settlements, but because wage settlements
were too high in Italy and Spain and a number of other economies
it managed to reduce its unit wage cost dramatically vis-a"-vis
the eurozone average. For Italy to be able to do that, firstly
it needs to address some of the domestic obstacles to stronger
productivity growth, so I think that requires them to look very
carefully at much of their service sector much of which is essentially
protected from competition and highly regulated, and that is a
major obstacle. If you look at its productivity in the service
sector right across Europe, but particularly in southern Italy,
that is holding back our economic performance as a whole vis-a"-vis
the US. If you look at the last ten years in particular we have
seen a huge pick-up in service sector productivity in the US which
has not been matched across Europe, with the exception of one
or two economies. They need to look very carefully at that. I
think Italy more broadly has a very unfavourable industrial structure
which is concentrated in low to medium-tech goods which are relatively
slow-growing and where it is actually difficult to boost productivity.
I think there is a weak use of ICT in Italy. If you look at levels
of investment in information technology in Italy they are much
lower than in comparable economies even in Europe, let alone compared
to the States. There are all kinds of things, ethnic skills generally,
higher education, levels of R&D—they need to look at
a whole range of issues. The problem with all of those things
is that they are all addressable, and of course they can do that,
but they need to move very quickly to prevent further loss of
competitiveness. My concern really with what we have seen in recent
years is that it is going to be very difficult for them to do
that without Germany picking up because it is one thing for Germany
to gain competitiveness vis-a"-vis other countries when they
are pursuing relatively irresponsible labour market policies and
when their wage settlements have been excessive, but for Italy
to regain competitiveness when German wage settlements are going
to remain where they are. They have picked up maybe but you are
probably not going to see increases in German unit wage costs
overall, so I think it is challenging for Italy, I am not saying
it is impossible, but I think there is a tendency to underestimate
the extent of the challenge some of these economies face.
Q95 Lord Blackwell: In your report you
put at 40% the probability that Italy would not successfully make
the changes necessary to make the euro work and a 40% probability
that it would leave the euro at some point.
Mr Tilford: I think that is too high. I think
what we are seeing in Germany is positive. I think there is a
much greater chance than appeared likely a year ago that the German
economy will start growing sustainably, ie that we will see a
real pick-up in domestic activity. I think it is still too soon
to be truly confident that that is going to happen because they
still remain quite dependent on the external sector and if there
was a big external shock then German economy world slow quite
rapidly, but it is much easier now than it was 12 months ago to
be positive about that outcome for Germany. That will make it
much, much easier for Italy. Also I think I underestimated the
costs that Italy would incur from leaving, so on balance there
is still a chance that it could happen but I think we overstated
the likelihood of it happening. That does not mean I am any less
positive about what we are seeing in Italy. I do not think the
new Italian Government has done that much really, and they have
only made some small changes so I am not really more optimistic
on that score, but I am more optimistic about Germany and more
pessimistic about Italy being able to cope with the costs of leaving.
Q96 Lord Trimble: I wanted to refer you
to the European Central Bank and just ask you what your views
are with regard to the policies that the ECB has been adopting
and the way in which it is managing the euro?
Mr Tilford: I think this is a second order issue.
If you look at the tensions within the eurozone, I think a lot
of criticism has been levelled at the ECB for pursuing an allegedly
excessively restrictive definition of inflation. I think it is
perhaps a little bit too restrictive because for example I think
it makes it harder for economies that have lost competitiveness
to regain it if the inflation does not stay at 2% because that
increases the risk of deflation or excessively low inflation with
the obvious impacts on output. Two or close to 2% is too low.
At the same time I do not think we would be materially less concerned
now about what we are seeing in the eurozone had they been pursuing
a 2.5% target rather than a close to 2% one. I think generally
they are right to constantly allude to the need for certain types
of reforms and to argue that fiscal discipline is an absolute
necessity. I think where there has been a problem is a failure
to differentiate sufficiently between current spending and investment
spending but that is not an ECB thing; the Stability and Growth
Pact needs to look at that. They have reformed to an extent but
I think one of the worrying things we have seen across Europe
in recent years is the decline in net public spending, particularly
on infrastructure, and that has happened in many countries because
they have been trying to control public spending and because the
Stability and Growth Pact has not made a distinction between current
spending and investment spending.
Q97 Lord Trimble: We went to visit the
ECB a couple of weeks ago and in meetings with them we put the
familiar arguments about their target being too inflexible and
how if they had a more flexible approach such as we had here this
might make things easier, and I was struck that each time we raised
this issue the ECB response was, "Well, these countries have
to reform, they are going to have to do it anyway, and us being
a bit more flexible is not really going to help them in the long
run, they just have to do it." That approach might have some
economic merit from a banker's point of view but it is leaving
out the political dimension that some of these countries are going
to have huge difficulties making the political decisions that
are necessary. I am curious as to how all that is going to work
out in the long run.
Mr Tilford: That is the core challenge. In the
case of some countries it is going to be very difficult because
they have got to do this at a time when public support for market-orientated
reforms is on the wane. People are very, very anxious about the
impact of globalisation and more open markets generally are having
on their living standards and on their security and it is very
hard for governments. The argument they have to win is without
doing this we are not going to be able to compensate the losers
from globalisation, without we can boost growth in productivity
we are going to be very poorly placed to maintain universal public
services and to compensate the groups in society that are going
to lose from this process. Clearly that is a big argument to make,
particularly in economies where there is a visceral suspicion
of more open markets and of the merits of globalisation, and so
I think it is a tough one, and hence that is why we struck a rather
downbeat tone in the piece we wrote because we see that some countries
do face big challenges.
Q98 Chairman: You argue the fact that
the Single Market is not yet complete and that is one of the points
that is threatening the sustainability of the single currency.
Can you tell us any steps that might be taken to complete the
Single Market?
Mr Tilford: I think a huge missed opportunity
was the Services Directive. I think this is one of the few downsides
of enlargement. Had we not had enlargement then I think the original
Services Directive would have stood a much greater chance of being
agreed but because of the fear of "dumping" from some
of the new Member States, that was watered down to the point where
the returns, I think, will be relatively modest. Clearly services
are never going to be as tradable as goods but the fact that services
account for only 20% of intra EU trade and they have remained
that proportion for a number of years now, and have actually fallen
slightly, is a problem. Information technology has made more and
more services tradable and we should be seeing the proportion
of intra-EU trade accounted for by services rising; we are not.
I think one of the reasons why our productivity performance is
so poor compared to the US is that large parts of the service
sectors of our economies do not have the necessary scale and incentives
therefore to invest and to innovate in the way they do in the
US and that is why productivity is low. One thing we really need
to do is accelerate the integration of service sectors. I think
the Commission with some of its sectoral inquiries is doing a
lot of good work in that area. Completing the Single Market is
hard. You cannot just continue to regulate and regulate and regulate
because obviously we find ourselves in a very different position
as compared to the late 1980s. Lots of the growth industries now
are high tech, they are service based, and you cannot standardise
across all of these sectors. You have to find new ways of making
sure that markets are competitive and open without legislating
across every last little bit of activity because obviously those
regulations quickly go out of date. I think we have to concentrate
on removing the principal obstacles to greater integration within
the EU. It is interesting that intra US exports are 70% higher
as a proportion of US GDP than they are within the eurozone. We
are still not that integrated. There is this perception that the
Single Market is complete and that we are now integrated. We are
really not and we are nowhere near as integrated as I would argue
we need to be.
Q99 Chairman: That is something that
is growing all the time, is it not?
Mr Tilford: Much less than you think. It is
interesting that intra eurozone trade has barely grown more rapidly
than, say, UK trade with the USA since 1999. There has been a
slight deepening but it is nothing like what people expected.
To accelerate that deepening I think we are going to really need
action on services.
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