House of Lords - The future of economic governance in the EU

The future of economic governance in the EU - European Union Committee Contents

The future of economic governance in the EU

CHAPTER 1: Introduction

Economic and monetary union

1. The foundations of the euro area were laid in 1988 when the European Council[1] asked Jacques Delors, then President of the European Commission, to set up a committee to study economic and monetary union (EMU), to result in Member States of the EU sharing a single currency. The committee's report concluded that if a single currency were introduced it would require: a greater coordination of economic policies; rules on the size of national budget deficits; and, the creation of a new, independent, European Central Bank (ECB), which would be responsible for the EMU's monetary policy.[2]

2. The European Council decided to move forward on the basis of the Delors report. The Treaty on European Union, signed on 7 February 1992 at Maastricht, set out the process and timetable for the introduction of economic and monetary union by the end of the century. This was to take place in three stages, which were designed to achieve economic convergence amongst Member States (in terms of inflation, stability of exchange rates and in budgetary positions, as opposed to the standards of living). This would, in turn, bring their economic cycles broadly in line. By the third stage Member States could progress to full economic and monetary union, so long as they achieved specified "convergence" criteria (these were requirements for a certain level of price stability, sustainable government finances, and stable exchange and interest rates). All Member States in the EU (with the exception of the UK and Denmark both of which secured formal opt-outs) and those who have joined since pledged to adopt the euro once they meet these criteria.

3. The third stage started on 1 January 1999. The 11 Member States which had achieved the convergence criteria launched the euro (although initially just for non-physical transactions such as electronic transfers) under a single monetary policy run by the ECB. After a three-year transition period, euro notes and coins were introduced on 1 January 2002.

4. The opt-out from the third stage of EMU secured by the United Kingdom stated that, even if it met the convergence criteria, it did not have to join the euro. Nor did Denmark, following a 'no' vote in a referendum.

5. Within the EU there are now 17 Member States who are members of the euro area, with a single currency and monetary policy. The expectation remains that other Member States without an opt-out will join the euro when they meet the convergence criteria.

Background of the crisis

DEEPENING PROBLEMS AND PIECEMEAL RESPONSES

6. The euro area initially appeared to have avoided the worst of the financial crisis that flared after the collapse of Lehman Brothers in September 2008, and early signs of economic recovery in the second half of 2009 gave grounds for optimism that the European economy was on the mend. But after the revelation in autumn 2009 that Greek public finances were in a much worse state than had hitherto been admitted, the capacity of the Greek government to finance its borrowing deteriorated. In early 2010, a sovereign default in the euro area looked a possibility and, after some hesitation, a rescue package worth €110 billion was put together at the beginning of May 2010, allowing Greece to avoid borrowing on the open market for three years if it so chose.

7. The package was made up of funding from euro area governments and from the IMF (and hence, indirectly, from non-euro area countries, of which the UK is the largest in the EU). This was routinely described as a 'bail-out'. In fact, this description was inaccurate, as Professor Charles Goodhart, Professor of Economics at the London School of Economics, made clear: "at the end of the day the money is supposed to be paid back with interest. It has not been a bailout; it has been financing".[3]

8. In the days after the Greek rescue, there were fears of contagion[4] spreading to other vulnerable Member States. Ireland, Portugal and Spain were seen as most at risk, and the high level of Italian and Belgian debt were also causes for concern. In an increasingly febrile atmosphere there was speculation that UK public finances might also attract market attention.

9. To provide a bulwark against market speculation, the EU's leaders agreed in May 2010 to create two temporary funds to provide liquidity to affected economies, the European Financial Stabilisation Mechanism (EFSM) and the larger European Financial Stability Facility (EFSF). These mechanisms will remain in place until 2013. At the time this report was published only one country, Ireland, had received assistance from these funds. The EFSM and EFSF are described in more detail later in this report (chapter 5).

THE EVOLVING POLICY RESPONSES

10. The crisis of confidence in the euro area exposed a variety of shortcomings in EU economic governance[5] which we analyse in detail in chapter 2. As the magnitude of the challenges confronting the EU, and the euro area in particular, became clear in the wake of Greece's problems, Member States began to consider what kind of governance reforms and capabilities were required, not only to ease the current crisis but to avoid another one.

11. Following the events in Greece in 2009, the Commission worked on legislative proposals to strengthen economic governance, culminating in a package of six proposals for new measures unveiled at the end of September 2010. Four of these are intended to improve fiscal[6] discipline amongst Member States (see chapter 3), while the other two introduce measures to oversee and correct macroeconomic imbalances[7] (see chapter 4).

12. In parallel, at its March 2010 meeting, the European Council asked its new President, Herman van Rompuy, to chair a taskforce (made up predominantly of finance ministers of Member States) and put forward proposals for a better approach to budgetary discipline ('the van Rompuy taskforce'). The taskforce presented its final report in October 2010 and its proposals were endorsed by the European Council at its meeting on 28 and 29 October. With one exception[8] there are only minor differences between the Commission's proposals and the van Rompuy taskforce's recommendations.

13. In addition, the van Rompuy taskforce looked at creating an improved crisis resolution framework. Following its report, Member States agreed at the European Council meeting in October 2010 to establish a permanent crisis resolution mechanism called the European Stability Mechanism (ESM), to replace the ad hoc EFSM and EFSF. We consider the proposed mechanism itself in more detail in chapter 5.

The EU 27 vs the euro area

14. In this report we consider and make recommendations on the proposals outlined above. Some of these will apply to all EU Member States, while others will only affect Member States of the euro area. The proposals which only apply to euro area Member States are those dealing with financial sanctions; all Member States are required to follow the same rules and submit to the same surveillance of their economic policies, but only euro area Member States can be punished for not doing so. In contrast, the proposals for a permanent crisis resolution mechanism indicate that it will be funded by, and apply solely to, euro area countries.

15. Mr José Leandro, Adviser on Monetary and Economic Affairs of the Cabinet of the President of the European Council, explained why the proposals for increased economic coordination applied to the whole EU, as opposed to just the euro area; "our economies are intertwined and interlinked ... decisions in one country may affect others". Irresponsible economic policies in one Member State may therefore have a damaging effect on other countries in the EU. Mr Leandro argued that this "spillover effect" needs to be "better taken into account through reinforced coordination".[9] For those countries sharing a single currency this interdependence is even more pronounced, and hence sanctions are available to compel countries to behave in ways that do not injure their neighbours.

16. Other witnesses gave additional reasons why cooperation should take place among all EU Member States. Dr Uri Dadush, Director of Carnegie's International Economics Program, argued that economic coordination from countries with independent monetary and exchange rate policy could help those countries inside the euro area, increasing "the probability that shocks emanating in the Eurozone do not spillover onto other EU members".[10] Mr Benoît de la Chapelle Bizot, Finance Ministry Adviser of the Permanent Representation of France to the EU, meanwhile, argued that economic coordination was required to ensure the effective working of the single market.[11]

17. Mr Declan Costello, Acting Director for Structural Reforms and Competitiveness in the Directorate General for Economic and Financial Affairs at the European Commission, informed us that the impetus for ensuring that many of the proposals about economic coordination applied to all EU countries and not exclusively to the euro area did not come from the Commission, but in fact was called for by those Member States of the EU hoping to join the euro one day. He explained that "they do not want a gulf to emerge between the surveillance elements and for there to be a wider gap between what we do for euro area countries and non-euro area countries",[12] since this would then make it harder to enter the euro area at a later date. The Minister echoed this statement: "My personal observation is that there are those Member States outside the Eurozone that are committed to joining it as part of their accession treaty ... they have a particular interest in how the rules of the club develop".[13]

The UK's interest in economic governance

18. The UK has an opt-out from Euro membership—it does not therefore need to move towards economic convergence in the same way as most other Member States who are prospectively joining the Euro. We heard, however, several reasons why the UK should be interested in what has frequently been described as the "euro crisis", when we are not, and are unlikely to be in the near future, members of the euro.

19. Our witnesses were unanimous in stating that the health of the euro area directly impacted upon the UK. Dr Thomas Mayer, Chief Economist at Deutsche Bank, told us that the current liquidity crisis "is first and foremost a Eurozone problem ... but the external, spillover effects of the Eurozone problem turn it into an EU and a global problem".[14] For example, the UK's financial sector has substantial investments in euro area countries—a crisis in these Member States could therefore pose a significant threat to financial institutions in the UK.[15] Dr Waltraud Schelkle, Senior Lecturer of Political Economy at the London School of Economics, therefore urged to the UK to recognise that it had "an enlightened self-interest" in ensuring the existence of a stable euro.[16] The UK, through its involvement in the single market, is heavily interconnected with other European economies. In 2009, nearly sixty percent of the UK's trade was with the EU. UK businesses will feel the strain if euro area economies stagnate or shrink.[17] Mr Fabian Zuleeg, Chief Economist at the European Policy Centre, put it succinctly: "interdependence does not stop with different currencies".[18]

20. In addition to these arguments for self-interest, we would emphasise another: solidarity. Professor Jean-Victor Louis, Honorary Professor at the Brussels Free University, reminded us that "the European Union is founded and grounded on solidarity"[19] and we believe that the UK should consider, and support where possible, the interests of other Member States in the Union.

21. The Government have stated that they "want to see, and have a strong interest in ... a much stronger and resilient Eurozone".[20] They conclude that the UK can play a role in supporting the euro area while at the same time protecting its own interests. At the same time, the Minister states that "there is a fine dividing line between providing support, ideas and advice, and getting stuck in to the detail of the rules when we are not part of the club".[21] Ms Katinka Barysch, Deputy Director of the Centre for European Reform, expressed this view in stronger terms when she told us, "[the UK] cannot expect to play a leading role in the debates about Eurozone governance, in as much as it is not prepared to be bound by whatever rules come out of that debate".[22]

22. The UK has a strong interest in seeing the euro area stable and prosperous. It is therefore directly affected by developments in the euro area. The Government have a vested interest in ensuring that proposals to increase stability in the euro area through increased economic coordination are effective. We will therefore consider and make recommendations on both those proposals that will apply to the UK and those that will not. In the latter case, we make these recommendations to inform the debate currently taking place whilst recognising that we are only observers not participants.

The inquiry

23. In this report, we consider the various proposals put forward by the Commission and the van Rompuy taskforce. As they are substantially the same in most areas (see paragraph 12 above) we have based our remarks on the Commission proposals. The exception is Chapter 5 on a permanent crisis resolution mechanism; the Commission has not brought forward proposals in this area so we have based our comments on the texts agreed by the European Council at its December 2010 meeting.

24. The membership of Sub-Committee A which undertook this inquiry is set out in Appendix 1. We are grateful to those who submitted written and oral evidence, who are listed in Appendix 2; all the evidence is printed with this report. The evidence taken as part of this inquiry was taken from October to December 2010. There is a glossary in Appendix 4. We also thank the Sub-Committee's specialist adviser Professor Iain Begg, Professorial Research Fellow at the European Institute, at the London School of Economics. We make this report for debate.

1 A council of all the heads of state or government of the European Union. Back

2 Monetary policy is the regulation of the money supply and interest rates by a central bank, such as the ECB. Back

4 Contagion is a scenario where the financial troubles of one economy spread to other economies. Back

5 There is some confusion about the meaning of the term 'economic governance' and the related, but distinct, term 'economic government'. The latter has long been espoused especially by French contributors to the debate on economic and monetary union and would imply the creation of EU (or euro area) institutions for economic policy as a counterpart to the centralised monetary policies of the European Central Bank. Economic governance is a looser term that captures the different arrangements for running the EMU, and for coordinating economic policies within the wider EU. Back

6 Fiscal policy relates to government taxation and spending decisions. Back

7 Such imbalances can be of different sorts, although their common characteristic is to affect the overall trajectory of an economy in terms of aggregate output (GDP), employment, competitiveness or the inflation rate. Back

8 The van Rompuy taskforce report includes the statement that financial sanctions "will be first applied to euro area Member States only. As soon as possible, and at the latest in the context of the next multi-annual financial framework, the enforcement measures will be extended to all Member States". A footnote excludes the UK because of the details of its opt-out from EMU. The Commission proposals, by contrast, do not foresee any extension of financial sanctions to non-members of the euro area. See paragraphs 111-114 for further discussion of this issue. Back

9 Q 227 Back

10 EGE 18 Back

11 Q 294 Back

12 Q 374 Back

13 Q 510 Back