Memorandum by HM Treasury
1. The Euro was created on 1 January 1999.
At this time the euro was introduced as a legal currency, the
exchange rates of the existing national currencies were irrevocably
fixed against the euro, and the ECB assumed control of the monetary
policy for the 11 founding members.[1]
In January 2002, Euro-denominated notes and coins replaced the
existing national currency denominations.
2. Greece adopted the Euro in 2001, Slovenia
in 2007 and Cyprus and Malta will join the Euro area in January
2008, which will take the number of participants to 15 countries.
3. The macro-economic framework of the Euro
area consists of an independent European Central Bank that implements
the single monetary policy of the Euro area; and an EU fiscal
framework, which applies to other European Union members as well
the Euro area countries. This has two arms: the Excessive Deficit
Procedure and multilateral surveillance. Within this framework,
national fiscal authorities of each member state have autonomy
over fiscal policy. The House of Lords has taken evidence on aspects
of the macro-economic framework of the Euro-area on several occasions,
most recently the Report of the Select Committee of the European
Union on the question "Is the European Central Bank Working"
(2002-03) and the inquiry of the same Committee into the "Stability
and Growth Pact and the European Central Bank" (2003-04).
MACRO-ECONOMIC
FRAMEWORK
4. Strong macroeconomic frameworks are essential
for achieving and sustaining high and stable levels of growth
and employment, and for maintaining long-term economic stability.
An effective framework is characterised by credibility, flexibility
and legitimacy.
— A credible framework is one
in which the policy makers' commitment to long-term sustainability
commands trust from the public, business and markets. This means
that agents will not expect policymakers to sacrifice their long-term
goals to short-term pressures;
— A robust framework will also
provide appropriate short-term flexibility to allow policy makers
to respond to shocks. This flexibility must however be delivered
while maintaining a credible commitment to long-term objectives;
and
— Legitimacy can be achieved through
building a consensus about the appropriate goals and about the
institutional arrangements through which they can be delivered.
ECONOMIC PERFORMANCE
OF THE
EURO AREA
5. Annual growth in the Euro Area averaged
2.1% between 1999 and 2006. Following a protracted period of slow
growth, a cyclical recovery emerged in the second half of 2005,
driven by the robust export performance and a gradual rise in
investment expenditure. This recovery became more broad-based
in 2006 with growth of 2.9% and the euro area's strength extended
into the first half of 2007. More recently, survey readings of
euro area and country-specific business and consumer confidence
have fallen following the disruption in financial markets, potentially
signaling a slower expansion in the quarters to come.
6. Nevertheless, reasonably solid growth
is forecast to continue during the rest of 2007, largely due to
the momentum implied by stronger than expected outturn data in
the first half of the year. Growth is expected to moderate to
around 2% in 2008, its trend growth rate.
MONETARY POLICY
IN THE
EURO AREA
7. Low and stable inflation is a key condition
for achieving the goal of high and stable levels of growth and
employment. Monetary policy in the euro area is conducted by the
Governing Council of the ECB with the primary objective of maintaining
price stability in the euro area as a whole. The ECB has defined
price stability as a year-on-year increase in the Harmonised Index
of Consumer Prices (HICP) for the euro area of below 2%. In the
pursuit of price stability, the ECB aims at maintaining inflation
rates below, but close to, 2% over the medium term.
8. Annual headline inflation rates in the
euro area have averaged 2% between January 1999, when the euro
was first introduced, and October 2007. Core inflation, which
excludes energy and unprocessed food, has averaged around 1.7%
over the same period. More recently, inflation has risen sharply
bringing the rate of inflation to 2.6%, significantly above the
inflation target. Inflation expectations have also increased markedly,
with recent European Commission's household surveys registering
a sharp rise compared to previous years.
FISCAL POLICY
IN THE
EURO AREA
9. The EU fiscal framework has two arms:
the Excessive Deficit Procedure (EDP) and multilateral surveillance.
The Treaty and Stability and Growth Pact set out an EDP. This
may be initiated under one or two scenarios: a government deficit
exceeds 3% of GDP; or government gross debt exceeds 60% of GDP,
unless the level of debt is "sufficiently diminishing and
approaching the reference value at a satisfactory pace" (Treaty
Article 104.2). The surveillance arm is designed to give an early
warning is risks exist of a member state having an excessive deficit.
10. The UK supports the principle of a strong
Stability and Growth Pact founded on sensible policy co-ordination.
However, initial experience with the operation of the SGP highlighted
a number of issues that undermined its effectiveness and credibility.
These included implementation that tended to focus on short-term
deficits rather than debt levels and longer-term fiscal challenges,
and too little attention being paid to cyclical factors.
11. In March 2004, the Treasury published
a discussion paper on the SGP,[2]
setting out the rationale for a strong and effective Pact to ensure
long-term sustainability, promote fiscal co-ordination and provide
the flexibility to respond to shocks. The Government supports
a prudent interpretation of the SGP, which takes account of the
economic cycle, the sustainability of public finances with low
levels of debt, and recognises the importance of public investment.
12. The SGP was reformed in March 2005.
The reformed Pact places a greater focus on reducing and maintaining
low debt, providing more flexibility for low debt countries to
invest in public services. Enlargement has brought countries into
the EU with relatively low debt and high investment needs. The
reforms also place a greater focus on the avoidance of pro-cyclical
policies.
13. The Government works closely with Member
States and EU institutions, as the success of the reforms will
depend on how they are implemented. It is also essential to recognize
the importance of national frameworks and national ownership of
fiscal policy.
EUROPEAN ECONOMIC
REFORM
14. Experience has shown that effective
frameworks for macroeconomic policy can make a significant contribution
to prosperity and economic stability. However, the most significant
challenges for the EU and its member states remain structural.
It is clear that, three years away from the original 2010 deadline
set in 2000, the Lisbon vision to make the EU "the most competitive
and dynamic knowledge based economy in the world" will not
be realised. The EU and its Member States still need to implement
significant economic reforms to improve the flexibility of product,
capital and labour markets, and to encourage greater investment
in skills and innovation.
15. These reforms will strengthen the single
market, which has been one of Europe's defining achievements and
has delivered jobs, growth and greater choice and prosperity for
Europe's citizens and businesses. By removing cross-border barriers
to the free movement of goods, services, capital and people, and
strengthening competition, the single market had by 2006 created
an additional 2.8 million jobs across the European Union and boosted
its GDP by €225 billion. Europe is now the largest market
in the world and accounts for 20% of world trade. But there is
more to be done to ensure the single market continues to deliver
benefits in the face of new challenges. For Europe to benefit
from the opportunities of globalisation and rapid technological
change, it needs to adopt a new, modern and more flexible approach.
This also reflects the fact that, increasingly, global markets
are the destination for European products as well as the source
of many goods and services consumed in Europe.
16. Structural reforms are also vital in
supporting a well-functioning currency union. Transactions between
different currency areas include the costs of currency exchange,
and are subject to the risks associated with movements in the
exchange rate. These increase the costs and reduce the volume
of trade between currency areas, relative to that in a single
currency area. However, these potential benefits are contingent
on having well-functioning labour, product and capital markets
that enable economies to maintain high levels of growth and employment
within the constraints entailed by a currency union. Wiithin a
monetary union individual countries are unable to use monetary
policy to adjust to country-specific shocks. Adjusting to shocks
and accommodating economic change without putting at risk high
and stable levels of growth and employment demands greater market
flexibility than outside a currency union.
THE EURO
AND UK FINANCIAL
SERVICES
17. Since the introduction of the euro,
the UK has attracted a significant level of wholesale financial
services business and the City has strengthened its position as
the world's leading international financial centre. The City has
become a major centre for euro foreign exchange, reflecting its
dominance of international foreign exchange markets, of which
it is estimated to account for 32%.[3]
In other markets, including international bonds (70% of global
secondary market), foreign equities trading (42% of global trade),
over-the-counter derivatives (43% of a global market that has
grown by over 700% in the last decade) and international banking
(20% share of all cross-border lending), the City has maintained
or strengthened its dominant position.
18. When the euro was introduced, some commentators
feared that both the financial services industry and British business
as a whole would lose out from the Government's decision not to
join the single currency. But based on a careful assessment based
on the five economic tests, the Government judged both then and
again in 2003 that it would not be in the UK national interest
to join. That decision remains under review on an annual basis.
Earlier this year the then Economic Secretary said in a speech
to the British Chamber of Commerce[4]
that so far that 2003 assessment had stood the test of time. Fears
that flows of foreign direct investment to the UK would suffer,
or the City would be set back, had not proved correct.
November 2007
1 Austria, Belgium, Finland, France, Germany, Ireland,
Italy, Luxembourg. Netherlands, Portugal, Spain. Back
2
HM Treasury, The Stability and Growth Pact: A Discussion Paper,
March 2004. Back
3
http://www.ifsl.org.uk/uploads/RP_IFM_2007_05.pdf Back
4
http://www.hm-treasury.gov.uk/newsroom_and_speeches/speeches/econsecspeeches/speech_est_160407.cfm Back
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