House of Lords - European Union

Select Committee on European Union Thirteenth Report

CHAPTER 2: EMU mechanisms and policy Considerations

14. The European Central Bank (ECB) stands at the centre of the European System of Central Banks (which comprises all the central banks of the EU member states) and at the centre of the Eurosystem (the set of central banks of countries participating in the euro area). It is charged with the responsibility for formulating monetary policy for the Euro area and for organising and coordinating its execution.

15. The principal instrument of monetary policy is the setting of the main refinancing rate; this is the rate that emerges as the result of the ECB indicating the minimum price at which it will accept bids for the purchase of eligible assets in "repos" (repurchase agreements). Money market operations to enforce the rate are, so far as possible, devolved upon the money market operations of the participant Member States' central banks. The ECB can engage in operations in the money markets to relieve as necessary any perceived lack of liquidity (or to reduce liquidity if conditions demand such action). The ECB is able to intervene in foreign exchange markets (and has done so), but generally matters concerning foreign exchange markets are reserved for decision by the Council of Ministers[9] (which has not so far exercised this role) and are subject to a condition that any such interventions should not be in conflict with the ECB's primary responsibility to maintain price stability. Witnesses generally commented positively on the ECB's handling of monetary policy, although some said that its communication with the market left a lot to be desired (Goodhart Q 13).

16. Professor Schwartz, Juan Castañeda, Professor Goodhart, Professor Walter and Roger Bootle also drew attention to the institutional difficulties that will emerge as more countries switch to the euro and expressed concerns that the decision-making committees will become more unwieldy[10] (pp 73, 77, QQ 39, 144). In our 2003 Report on the ECB[11], we discussed the rotation system for membership of the ECB Governing Council agreed that year; Professor Walter expressed concern about the complexity and lack of transparency of the institutional structure, which as the eurozone grows will also deprive the biggest economies in the eurozone of a permanent voting right (p 77). We concluded in 2003 that the rotation system was not an appropriate mechanism for appointing the body to set interest rates in the euro area; that it capped the number of voting and non-voting members of the Governing Council at a level which is too high; that it is not transparent; and that it is overly complicated and difficult to communicate. These issues were not generally raised by witnesses during this inquiry, nor was there significant pressure to introduce reforms during the Lisbon Treaty process. We conclude that only our concern about transparency still holds: the ECB Governing Council has gained public acceptance and market credibility.

The Eurogroup

17. The Eurogroup[12] gains formal recognition in the Lisbon Treaty, although the Protocol for the Group reflects current practice. In our recent report[13] on the impact of the Treaty of Lisbon, we concluded the change should not have a significant impact. Angela Eagle, Exchequer Secretary to the Treasury, explained that the Government expected its inclusion in the Treaty to narrow ECOFIN's "scope for mission creep" and described it as "informal recognition"[14]. Initial concerns[15] that the Eurogroup was becoming an exclusive "club" within ECOFIN were not raised by witnesses and there is no suggestion that Member States consider the system to be working badly. Suggestions have been made for increased European Parliament participation in the governance of the common currency and for a stronger role for the Eurogroup, as a democratically legitimate forum, in setting the inflation target for the ECB (Pervenche Berès MEP, Julian Callow and Professor Portes p 56, QQ 59, 160). However, these are not new proposals and neither found support during the Lisbon Treaty negotiations. We therefore conclude that there is currently no need or desire to reform the way the eurozone is governed.

The Inflation Target

18. The European Central Bank is enjoined in the Treaty establishing the European Community[16] to regard its primary statutory duty as being that of maintaining "price stability". The definition of price stability was left to the ECB itself and was subsequently defined by the Bank's Governing Council in October 1998 as a "year-on-year increase in the Harmonized Index of Consumer Prices (HICP) for the euro area of less than 2%", to be maintained over the "medium term". In May 2003 the objective was further refined to read "below but close to 2%."

19. Across the world inflation targeting has taken a wide variety of forms and no one model can be said to be correct. For example, it is common to find an inflation target formulated as a central target rate plus or minus an agreed band, and stated for a given period of time ahead. Political support for the target rate may be found in it being set by the government of the day, with the Central Bank having "instrument independence" to use its policy instruments to achieve the target set for it. The ECB, on the other hand, is accountable to the European Parliament only for the way it has carried out its mandate and has "the medium term" in which to realise it.

20. Figure 7 (page 24) suggests that inflation rates of the initial eurozone members have converged, albeit at a rate slightly above the 2% ceiling: the annualised rate of change in the HICP from 1998 to 2006 was 2.05% (Julian Callow, Barclays Capital Q 59). In evaluating its own performance the ECB highlights the fact that surveys of long-term inflation expectations in the euro area consistently point to 2%, even when realised inflation and short-term expectations have surpassed this figure. This suggests to us that the policies followed by the ECB (including its pronouncements and explanations) have in fact succeeded in anchoring expectations at an appropriate level—which is what is expected of a successful inflation targeting policy (Commissioner Alumina, Schwartz and Castañeda pp 52, 72). We agree with those witnesses who argue that the ECB has run a credible price-stabilising policy in the euro area and successfully anchored market price expectations.

21. The ECB's inflation target set-up is different in the formality of its expression and in its underlying political governance context from that to be found in some countries. The Lisbon Treaty does not adjust the ECB's remit to define monetary stability (by setting an inflation target) or its interest rate setting mechanism. Witnesses were generally in favour of a system, such as that in the UK, where the target inflation rate is established by elected representatives and the implementation of policy is left to the central bank (Callow, Portes QQ 59, 160). Concerns were raised, however, that it would prove hard if not impossible for politicians to agree unanimously on a target inflation rate. The Lisbon Treaty also confirms the ECB's independence in setting policy vis-à-vis other EU institutions or governments, ignoring suggestions made at the time of its drafting that MEPs, the Eurogroup or the Council should set policy to be then implemented by the ECB.

22. The formulation of the ECB's mandate encourages it to pursue other policy aims when these can be prosecuted "without prejudice" to the price stability objective[17]. The Committee received conflicting evidence regarding the possible negative impact of the ECB's policies on economic growth. Some witnesses called on the ECB to develop policies to contribute more widely to economic growth and employment (Berès, Bootle p 56, Q 130). Professors Goodhart, Portes and Walter, Julian Callow, Commissioner Almunia, Schwartz and Castañeda argue that—contrary to public belief—the ECB's policies have not been overly restrictive (QQ 13, 59, 160, pp 52, 72, 77). For, although the ECB's primary statutory duty is to preserve price stability, that objective has been set to be realized "over the medium term". This gives the ECB ample room for manoeuvre to phase any necessary interest rate increases over time in such a way that employment and growth are not prejudiced. In addition, Professor Walter noted that nominal interest rates have been lower, including in Germany, than in pre-euro times (p 77).

23. The Committee agree with the majority of the evidence: the ECB is performing its primary role of maintaining price stability effectively, and its behaviour since 1999 and the evidence of its monetary policy decisions show that it looks to factors other than price stability when setting interest rates.

Stability and Growth Pact

24. The Treaty establishing the European Community contained the criteria to be fulfilled for a country to be admitted to the group participating in monetary union—among them the ratios of public debt and budget deficit to GDP. Further rules laid out in the Treaty have been in place since the start of the monetary union to ensure sound fiscal policies, the primary responsibility for which remains at the national level. The Stability and Growth Pact (SGP) elaborated on the fiscal criteria to be observed by Member States[18]. In particular the SGP stipulated that member countries should avoid a current budget deficit of more than 3% of GDP and established mechanisms of surveillance (the "preventive arm") to provide early warning of such a contingency and of correction (the "corrective arm") in the event that a breach of the 3% reference value for the deficit ratio occurred. Both the need for a framework of added fiscal discipline (in addition to the actions of the national governments concerned) and the precise way in which such a framework should be applied have been subjects of controversy throughout the period of European monetary union.

FIGURE 1

Annual Government Current Account Surplus/Deficit (as % of GDP)[19]

25. Figure 1 shows a reduction in government deficits in the late 1990s followed by a rise in the first part of this decade. This might suggest that Member States demonstrated the necessary discipline and appetite for reform ahead of the establishment of the single currency (Goodhart, Berès Q 9, pp 58-59). The drive for reform slowed down after 1999 and some eurozone members may have missed the opportunity to take advantage of the positive economic environment of the early part of this decade to implement structural reforms to reduce public debt and implement fiscal discipline. Such moves would have afforded the opportunity to set the eurozone economies on a stronger footing in the medium term.

26. Enforcement of the SGP has relied on peer pressure rather than use of the formal sanctions available to the Commission (Callow, Berès Q 64, p 56): however, while small and medium sized Member States were asked to conform when they were in breach of the Pact, others defied the rules. The breach, in 2003, of the Pact's rules by France and Germany, two of the biggest economies in the eurozone, and the Pact's subsequent reform in March 2005 had no noticeable impact upon financial markets[20]. We received no evidence of lingering frustration in the small and medium sized countries.

27. This may have been because the rules put in place by the original SGP seem to have been in some cases too restrictive: many of our witnesses viewed the system that was originally instituted as being very tight (Goodhart, Tilford, Bootle QQ 30, 96, 133). Its formulation did not sufficiently allow for the normal accommodation of cyclical effects and the discipline it potentially imposed was unrealistically harsh. The post-2005 SGP allows for the sustainability of public finances to be taken into account (Schwartz and Castañeda p 71) when considering whether to implement steps in the excessive deficit procedure. While some witnesses suggested that the reform of the SGP weakened the rules of the Pact and others promoted the need for fiscal discipline, the consensus view was that the changes introduced in 2005 enhanced the economic rationale and the flexibility of the budgetary rules over the economic cycle to take better account of (longer) periods of weak growth (Commissioner Almunia, HM Treasury, Leon Podkaminer, Schwartz and Castañeda pp 51, 63, 69, 71).

28. Pervenche Berès MEP, chair of the European Parliament Economic and Monetary Affairs Committee argued that there is a need for co-ordination before Member State governments publish their budgets (p 56). So far, in practice, the co-ordination has taken the form of peer pressure on the basis of actual returns. Co-ordination of Member State budgets as they are prepared is theoretically desirable from the perspective of monetary union but politically unrealistic. We accordingly oppose calls for supra-national co-ordination of fiscal policies.

29. The revision of the SGP has coincided with data which show that the deficit of the eurozone's general government sector for 2007 is likely to have been below 1% of GDP (it was 1.6% of GDP in 2006—see figure 1). Italy, Germany, Greece and Portugal have brought their rates down from above 3% to below the 3% mark (Callow Q 64). These figures have in part been the result of a benign period of global economic expansion and the Commission noted that greater attention must be given to the implementation of structural policies that enhance growth potential and long-term sustainability of public finances (p 51).

30. We welcome the revision of the Stability and Growth Pact but agree with the Commission that greater attention must be given to the implementation of structural policies that enhance growth potential and long-term sustainability of public finances.

Fiscal integration

31. Increases in the mobility of capital have made it increasingly difficult for any government to maintain a stable currency. Methods for so doing include a dollar peg or membership of a monetary union: the latter—depending on its structure—offers the advantage of shared control of monetary policy.

32. The traditional theoretical approach describes the cession of monetary policy to the Union's central bank as one of the costs of joining a monetary union[21]. Monetary policy is no longer available to deal with the economic shocks—both exogenous and self-inflicted—that hit the member country. If those shocks have the same impact across the Union as a whole then there is no cost, since the Union central bank's policy will be appropriate. If the shocks have diverse impacts[22] in different states within the monetary union, then the extent of the cost incurred in joining the monetary union will depend, among other things, on how effective monetary policy would have been in dealing with them had the country stayed out of the union. Counterbalances include the availability of alternative policies (e.g. fiscal policy) and the easing of credit constraints that may accompany the formation of a larger capital market and the abolition of exchange rate risk.

33. In the eurozone's case the loss of control over monetary policy was one of the main issues of debate when discussing membership of the currency union. Italy's inability to use monetary policy to deal with the loss of competitiveness in recent years is an example of the effect that loss of monetary sovereignty can have. It remains to be seen to what extent the inability of Member States to determine their own monetary policies may prove divisive in the short term during a period of unfavourable economic conditions.

34. EMU is a monetary union without fiscal union, and the theoretical effect that this might have on the sustainability of the eurozone and the ability of its Member States to co-ordinate their policies in order to achieve stronger economic growth was widely discussed before the currency was introduced[23]. Pervenche Berès MEP advocated further co-ordination (p 56) and the Treaty of Lisbon offered the opportunity to introduce integration based on the experiences of the first years of the zone's operation. The fact that no further integration was suggested for inclusion in the Treaty of Lisbon suggests that eurozone members see no pressing need for any fiscal integration.

35. External shocks have not, to date, had the feared effect on the monetary union. The increase in oil prices from 2001-2008 constitutes a severe external shock with sharply differential effects on eurozone member states (some of whom (e.g. Italy) have no indigenous energy source, whereas others (e.g. France) have major domestic nuclear power programmes). Yet the stability of the common currency seems to be unaffected by the price increases. The steep fall of the dollar, and now sterling, against the euro affects Germany as a major exporter, more than most eurozone countries, but it too has not posed any problem for the cohesion of the eurozone.

36. Those witnesses who continued to speculate about the fragmentation of the euro area in their written evidence admitted on questioning that their scenarios were highly unlikely to occur (Wickens, Tilford QQ 76-77, 91). The common currency has solidified its position among decision makers, financial markets and consumers as a major international currency. The political and economic cost of leaving the EMU makes the possibility of a country submitting to popular pressure to withdraw unlikely even in the instance of a severe economic crisis (Simon Tilford, Centre for European Reform Q 95).

Financial Stability

37. As is the case in other North Atlantic economies, the ECB is required to balance the need to maintain low inflation expectations with the desire to support the financial system. But the European Central Bank (ECB) has no formal role in respect of supervision of financial institutions; this is assigned to the national central banks and the relevant national supervisory/regulatory agencies. The ECB coordinates these entities through the Banking Supervisory Committee and has instigated the publication of a semi-annual Financial Stability Review.

38. During the current periods of reduced liquidity in the financial markets the ECB has made very substantial interventions in the markets, over and above the regular monthly longer-term refinancing operations, to relieve possible liquidity shortages. In November 2007 the Bank announced that these operations would be renewed as they expired, and in December 2007 actions were taken to ensure that sufficient liquidity remained available over the year-end holiday period. The ECB has also acted with other central banks as part of the coordinated action to ensure sufficient liquidity remained in the financial system.

39. The difficulties in the financial markets commenced after we had taken evidence for this report and are unresolved. We have not therefore felt able to comment definitively on this aspect of the ECB's operations. However, the role of "lender of last resort" within the eurozone remains the responsibility of the national central banks, co-ordinated by the ECB[24]. We will return to this subject once conditions return to normal.

9 Article 111 TEU, which will become Article 219, Treaty on the Functioning of the European Union if the Lisbon Treaty is ratified. Back

10 The most significant of these is the Governing Council-the committee setting monetary policy, which involves the Governors of the national Central Banks and the Executive Committee of the ECB. The governors are required to act as independent experts rather than in their own national interest, and national governments are bound by the treaties not to seek to influence the decision-making bodies of the ECB. Back

11 European Union Committee, 42nd Report (2002-03): Is The European Central Bank Working? (HL 170) Back

12 Meetings of Finance Ministers from Member States participating in Monetary Union, normally held on the eve of Economic and Financial Council (ECOFIN) meetings. These meetings are not an official formation of the Council of Ministers and the Group has no formal role. Back

13 European Union Committee, 10th Report (2007-08) The Treaty of Lisbon: an impact assessment (HL 62). Back

14 Ibid. at Q A22-A24. Back

15 For example, some witnesses to the Committee's 2000 report on the single currency expressed concerns that the Group might try to take influence from ECOFIN. European Union Committee 18th Report (1999-2000) How is the euro working? (HL 124) Back

16 Article 105(1); this will become Article 127 Treaty on the Functioning of the European Union if the Lisbon Treaty is ratified. The Article gives this duty to the European System of Central Banks, whose decision making is centralised through the decision-making bodies of the ECB. Back