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Lord Radice: My Lords, the committee is carrying out an inquiry into the European Central Bank, so I hope that we may soon be able to help him on that as well.

Lord Barnett: My Lords, I am most grateful to my noble friend. I look forward to seeing the further report, which I am sure will be every bit as good as the present one.

The Financial Times, in an article on 13th May by someone called Paul de Grauwe, said that,

That is a very good comment about the way in which the European Central Bank operates.

As regards monetary policy, there has been a definition of a new inflation target. There was one in 1998, when it was to be at the most 2 per cent. Now the ECB tells us that inflation should not exceed 2 per cent in the medium term. There is obviously no point in denying that there is bound to be strong disagreement between 12 central bank governors on the European Central Bank. That is all the more reason why we need a strong UK voice on that bank.

At this point, I turn to an excellent report from our own committee—the Monetary Policy Committee report. It is my privilege and pleasure to congratulate the chairman of our committee, my noble friend Lord Peston, who has chaired all our deliberations so brilliantly, even if he sometimes refers to the wrong football team.

As an aside—and this is nothing to do with our report—we in the UK need to appreciate how low our inflation is on what is called "hiccup" terms. To help Hansard reporters, I should emphasise that I refer to HICP, which is sometimes called "hiccup". I checked on the findings of the Office for National Statistics on

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what the level of inflation would be if we adopted HICP, and discovered that it would be around 1.6 per cent over the 12 months to March 2003, as compared to 3 per cent on the RPIX, which is the figure that we normally use. That would have very substantial consequences for the UK economy generally.

I asked my noble friend Lord McIntosh about the matter a week or two ago, and he thought that it was all theoretical. However, as he must now be aware, the Chancellor indicated in his Budget speech that he is considering whether it might be sensible for us to switch to the HICP index, given that so many other countries are using that index—not only in Europe but elsewhere. I hope that my noble friend might be able to tell us in this debate how far the Chancellor has got in his study on switching the index. That would have enormously serious consequences for pensions and all kinds of other areas of our economy that are indexed. No doubt he will be able to tell us about that. The Chancellor said clearly in his Budget speech that he might consider the matter.

The Monetary Policy Committee of the Bank of England is much more transparent than that of the European Central Bank. Whatever one may think of the Bank of England's Monetary Policy Committee, no one can dispute its transparency and accountability, both in the excellent way in which it has responded to our reports and in the evidence for which we have asked it.

However, the Bank of England's committee can be compared to that of the European Central Bank. The Bank of England committee is obliged primarily to consider the inflation rate forecast that is given to it by the Chancellor of the Exchequer. In those famous three words, only "subject to that" should it consider other economic matters—namely, the Government's economic policies. Although we do not know precisely what the European Central Bank is doing, we are told that "as long as"—another three words—the other objectives do not interfere with price stability, it must consider those other matters. We do not know precisely what that bank is studying because it is not very transparent, but I hope that it may be in the not too distant future.

As paragraph 45 of our report makes clear,

    "the time is ripe for some serious research into the operation of monetary policy in the past five years".

There have been substantial changes in how that works. I hope that someone in the Treasury agrees with us, although the Government say that they have already published papers from the Treasury. In practice, as we say in the report, we need a more independent piece of research. We on the committee do not have the resources to do that, but perhaps the Treasury would provide us with the resources and we could do it ourselves. However, on the understanding that the Treasury may not give us that, could an independent piece of research be done by someone else? I note that the Government agree with much in our report, and I hope that they will come to agree with that as well.

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7.48 p.m.

Lord Northbrook: My Lords, I add my congratulations to the noble Lords, Lord Peston and Lord Radice, and their committees, for their interesting and stimulating reports. We are debating both reports together due, I understand, to the joint wishes of both chairmen, but two separate debates could well have been merited, as the reports cover very different issues.

In comparing the two reports, the success of the MPC since 1997 may be contrasted with the huge problems of the stability and growth pact. As a failure in the European Community's co-ordinated fiscal policy, it is matched by the ECB's lacklustre direction of monetary policy, which is causing major problems in countries such as Germany and Portugal. I look forward with great interest to the report of the noble Lord, Lord Radice, on the ECB. However, I should like to concentrate my remarks on the MPC report. Paragraph 14 states as the first conclusion:

    "Although the operation of the MPC has been satisfactory so far, we conclude that a re-examination of its remit to include broader concerns than inflation alone might benefit the United Kingdom economy".

That is a very sensible conclusion. While I am not an economist—I declare an interest as a City fund manager—I have to be aware of broad economic trends.

I should like the committee to include in its remit broader concerns such as the effect of global disinflation on the UK economy. I believe that the UK economy is experiencing disinflationary conditions, as indeed is the global economy, and that those may well turn to deflationary conditions. Part of the reason is that in many areas of the economy there is surplus capacity and consequently intense competition. Generally speaking, companies find it very difficult to pass on cost increases, having little or no pricing power. The problem may seem esoteric when inflation RPIX is running at 3.1 per cent. However, I believe that that is due to exceptional factors such as higher house and oil prices—both of which, as the MPC itself has stated, should weaken over the next year, as stated also in paragraph 49 of the report—together with higher council tax.

The deflationary problem is in my view a fundamental long-term issue. Its examination would help the committee to have a more global outlook and to consider, for example, whether the problems relating to Japanese deflation are relevant to the UK economy or whether German economic disinflation problems will replicate themselves here. I therefore ask the Minister to use his influence to persuade the Chancellor to broaden the formulation of the MPC's remit to something similar to that of the Federal Reserve Bank of the United States—where, as stated in footnote 4 on page 6 of the report, the remit in the Humphrey-Hawkins Act of 1958 setting up the Federal Reserve is to,

    "maintain long-run growth of the monetary and credit aggregates commensurate with the economy's long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates".

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Another important issue with regard to the MPC's remit, which does not seem to have been covered in the report, although it has been mentioned by the noble Lord, Lord Barnett, is the Chancellor's proposed change to the inflation measure from RPIX to the European HICP. This important change would remove in particular housing costs from the inflation figures. As I understand it—and luckily my figures agree with those of the noble Lord, Lord Barnett—that would cut the rate of inflation by 1.4 per cent per annum. However, if adopted, it could cut government payouts to index-linked bondholders and index-linked pensions. Will the Minister, to whom I have given prior notice of the question, both confirm that and say whether the MPC's inflation target will be adjusted as a consequence? Does the Minister agree that the change would also bring forward the timing of interest rate reductions since inflation would fall below the current target of 2.5 per cent? It is for that reason that I largely applaud its possible introduction.

The issue to which I now turn does not seem to be covered in the report but is still important—the accuracy of the MPC's forecasting record. For statistics on that I turn to the Bank of England's Inflation Report of May 2002. On page 53, table 3, we see that the MPC, between February 1998 and May 2001, overpredicted inflation one year ahead by 0.2 per cent and two years ahead by 0.5 per cent. With regard to annual GDP growth, it underpredicted this by 0.3 per cent one year ahead and 0.2 per cent two years ahead. As stated on the same page, the two-year ahead forecast error for inflation is smaller than that shown in the August 2001 Inflation Report, thus demonstrating that the MPC, by analysing its forecast errors, has improved its subsequent performance. The main conclusion of all this is that the MPC has done as good a job as could be expected in its forecasts.

The final area of the report on which I should like briefly to focus is the section on UK fiscal policy. The committee noted:

    "We are impressed by the unanimity with which witnesses supported the view that much of the deterioration of the fiscal position is cyclical and that fiscal intervention is therefore not necessary at present. We note that it is extremely difficult to know what is and what is not cyclical and we hope to return to this topic in a later report".

The shadow Chancellor said in evidence to the committee:

    "There was beginning to grow a suspicion that the length of the cycle would be determined by reference to the need to comply with the golden rule rather than the other way round".

It is that vagueness in fiscal policy that contrasts strongly with the disciplined approach of the MPC in monetary policy. I believe—this is my one political point—that that is where the Government's economic strategy is most at risk.

My final comment is to emphasise paragraph 3 of the report. It was a great pity that the Chancellor himself, even with good notice, was unable to appear before the committee to enlighten it on this matter. May I ask the Minister to try to persuade him to appear in the future?

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7.57 p.m.

Lord Oakeshott of Seagrove Bay: My Lords, from these Benches and following the noble Lord, Lord Barnett, I thank the noble Lord, Lord Peston, for his indefatigable chairmanship of the committee. I also thank our two indispensable Clerks and our specialist adviser.

    "The Government's macro-economic policy framework is based on the principles of transparency, responsibility and accountability . . . The Bank of England has operational independence to meet the Government's symmetrical inflation target".

I am quoting, of course, not from our objective evidence-based report but from page 3 of this year's Budget Red Book. So transparency, responsibility, accountability and independence are the buzzwords favoured by the Chancellor and the Treasury. Tonight I want to scrutinise one constitutional corner highlighted in our report where these admirable principles are conspicuous by their absence—in the appointment of members of the Monetary Policy Committee of the Bank of England. We on these Benches welcomed the Chancellor's Damascene conversion the weekend after polling day in 1997 to independence for the Bank in setting interest rates. However, he is still in my view a sinner who has only half repented. Independence for the Bank of England? "Yes!", says the Chancellor. But an independent or even an open appointments process to pick MPC members? "Perish the thought! Gordon Brown just appoints MPC members by the divine right of Chancellors as invented by the Bank of England Act 1998".

Our Select Committee and its predecessor, in each of the last three reports on the MPC, have rightly raised serious questions about the appointments process. As we put it this time round,

    "we favour a more open process, conducted in accordance with a Code of Practice analogous to the Code of Practice for Public Appointments published by the Office of the Commission for Public Appointments. We favour such an approach, partly as a matter of principle and partly as a way of enlarging and deepening the pool of people who might be considered for membership. The Chancellor has always rejected our view on the matter".

We also said:

    "Similar considerations apply to the appointment of staff of the Bank of England who become members of the MPC. It is difficult to discern any formal appointment procedures. As far as we can ascertain, posts are not advertised . . . We therefore recommend, as we have done consistently before, that members of the MPC should be recruited and appointed in a manner consistent with Nolan principles".

The independent interest rate setting policies worked well so far because the Chancellor has appointed high-quality independent economists to the MPC. However, a benevolent individual dictator does not justify dictatorship. We all agree that interest rates should be fixed by independent experts, not by a single politician. How, then, can it be right for Gordon Brown to pick all of those experts personally and in secret, decide whether to reappoint them to a second term, ignoring the Nolan principles and with no advertisement, no application process, no questions asked and no reasons given for his choices?

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My Commons colleagues Norman Lamb and Matthew Taylor established that the MPC is officially an internal sub-committee of the Bank, but do the Government seriously intend to hide behind that technicality? To put the point another way, just because a car has not crashed in the first six years with one careful driver at the wheel, does not prove that the design is right or the brakes are safe in other conditions. How would noble Lords opposite have viewed an MPC packed with nominees such as, for example, the noble Lords, Lord Lamont or Lord Barber?

How can we make appointments to the MPC, which wields great power over our economy, more open and democratic? One way, which was suggested to us by the shadow Chancellor and, I am bound to say, tried so far with more noise than light so far by the Commons Select Committee, is post-appointment public confirmation hearings for newly appointed MPC members. That ex post, second-guessing system is rather the worst of both worlds. If the committee, or a Joint Committee of both Houses, has the formal power of veto over the Chancellor's choice, some outstanding candidates may be deterred by having to jump through the hoop twice and Opposition members of the committee may well be tempted to attack the Chancellor through the nominee. However, if the committee has no veto, the exercise is still basically a sham.

If we really want a transparent and robust way of picking MPC members, why not set up an independent monetary policy appointments committee to do the job? It should not need fresh legislation. The Chancellor could announce that he was inviting it to make a single nomination or renomination of a sitting member if a vacancy arose, which he would accept and appoint to the MPC using his powers under the Bank of England Act.

A membership of nine works well for the MPC, so why should it not for such an appointments committee as well? One could have a representative of the Treasury; the Governor or another representative of the Bank of England; the chairman or other representative of the Commons Treasury Select Committee and the Lords Economic Affairs Committee; a distinguished businessman such as Niall Fitzgerald; and a trade unionist such as John Monks, or people of similar standing from the Court of the Bank. That would make six people so far. The other three members of such a committee should be former MPC members who have done the job already and know exactly what mix of expertise and temperament are needed. Most of us agree that the quality of independent MPC members has been uniformly high so far, even though their turnover seems excessive, with a short term of office of only three years and only one independent member out of eight reappointed so far. The Governor made his views clear in his evidence to our committee two years ago. He said:

    "I think turnover is disruptive. In a sense to have an average outcome which is longer than the frequency of turnover we have had would be a positive thing. I do not know quite what one can do about it, frankly".

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Frankly, I do know what one can do about it—one can change the system, let members serve longer and stop Gordon Brown shuffling the MPC pack so often. I would far rather trust distinguished experts such as DeAnne Julius, John Vickers or Sushil Wadhwahi as part of a team nominating MPC members rather than a single Chancellor. Such a committee would shine out as a beacon of Bank of England independence. It would need to meet only once or twice a year and should have no problem in securing the most distinguished names to serve. It could even serve as a model of transparency and independence for future appointments to the European Central Bank.

The main Government argument that we have heard against a more open appointments process to the MPC is that it is "highly market sensitive". That is nonsense. The Chancellor told our predecessor committee that,

    "there would be difficulties if it became known that a particular individual was under consideration because that would have an influence on people's perceptions of what might happen to interest rates".

Here I declare my interest as an investment manager. That knowledge could look sensitive only to someone who does not know how markets work. How in practice would one change one's investments to reflect the chance that one person might be appointed to join a committee of nine people in several months' time, working to a very clear policy remit, when so much else would be moving markets far more in the mean time? Sir Edward George, in his evidence to the Select Committee, did not think that the appointments which had been made to the MPC were market sensitive. He must be right.

I end with a brief word of congratulation for the noble Lord, Lord Radice, on his committee's report. We first met 20 years ago when I travelled with my then boss, Roy Jenkins, up to County Durham to help him in his by-election campaign. I am delighted that we are together again in this House. Although we may now sit on opposite Benches, we still march together in the cause of European unity, which is well served by sober, sensible reports of this kind. That is in welcome contrast to the latest crescendos and hysteria in the anti-European press. I support both the analysis and conclusions of this practical and timely report.

8.5 p.m.

Lord Burns: My Lords, my remarks will be directed to the report of the Economic Affairs Committee on the MPC. I, too, express my thanks to the noble Lord, Lord Peston, for his chairmanship of the committee.

I include myself unambiguously in the group of people who regard both the design of the MPC and the execution of the remit that it has been given as a success. That is not to say that it cannot be improved upon but for me it continues to score high marks.

Enormous credit for the successful operation of the MPC is due to the Governor of the Bank of England, Sir Edward George, and I will be very sorry to see him retire from his post at the end of the month, even if Lady George does not share my concern. I saw at close

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hand over a number of years the skill and determination with which he discharged his responsibilities. He will be a difficult act to follow but I also wish his successor, Mervyn King, well in the role. He has done an excellent job in establishing the high level of analytical support for the decisions of the committee in his present role. I am sure that he will also carry out his job as chairman of the MPC extremely well.

A couple of years ago, it was common to say that the economic background had been benign, with the implicit warning that somehow or other we should not be too enthusiastic about the performance of the MPC because it had had a following wind. In one respect, that remains true; that is, an environment of low world inflation undoubtedly makes it easier for the MPC to follow a low inflation remit. But in other respects the MPC has had to cope with increasingly difficult challenges, and we should recognise that. These include the poor macro-performance of the euro zone and Japan, the threat of deflation, the stock market bubble and its impact on credit markets. We have seen huge volatility in the euro-dollar exchange rate and there was the shocking blow of 9/11 and the recent war.

Faced with those challenges and shocks, I continue to take the view that the performance of the MPC has been impressive, although our economy is going through some strains and stresses. On balance, they are rather less than for many other economies.

Most of the issues raised in the committee's report have emerged in previous reports. The key issue remains whether it is right that the primary objective of monetary policy should be to seek an explicit and symmetrical inflation target. It is now more than 10 years since the regime of inflation targeting was introduced. Although there have been improvements on the way, including setting up the MPC, they are still recognisably the same arrangements today, and we now have more than 10 years of evidence, which is an unusually long period by the standards of most policy innovations.

The report raises the question whether this single-minded focus on inflation should remain the approach or whether the remit should be changed so that it includes broader concerns than inflation. I agree that this is a subject that needs to be kept under investigation. Few things are forever in economic policy. However, in my view the present targeting regime is working extremely well. I am far from persuaded of the need for a change, although I think that it is the right time to have another look at the issue.

The period since the introduction of the inflation target has seen the most impressive record of stability of output and inflation that most of us can recall. Output growth has been robust relative to other countries, and the inflation rate has been astonishingly close to its target. The experience of the past 10 years suggests that actions taken continually to meet the inflation rate will generally also be the actions needed to stabilise output at close to its trend growth rate. There is nothing by way of a conflict in those objectives.

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Fluctuations in the exchange rate are a problem for monetary policy and there is often a debate about how far interest rates should respond to a clear misalignment of exchange rates over and above the direct impact of the exchange rate on inflation. But the way in which it has been handled so far has worked reasonably well.

The noble Lord, Lord Northbrook, raised the general question of deflation. But the present symmetrical target means that the MPC would have to respond to any threat of deflation, so there is no need to take any other factors into account, other those already given. If the MPC has to take account of inflation falling below target every bit as seriously as it takes the threat of inflation going above target, it has built into it the safeguard against the type of threat of deflation that we have seen in some other countries. Therefore, I take the view that if the inflation target is not broke, I am not inclined to seek to fix it.

I can see that the approach could come under greater questioning if we had a shock that took the inflation rate significantly away from target. At some point we must face the fact that that is likely to happen. It is unlikely that we shall continue to have the same success in targeting the inflation rate as has been achieved in recent years. The history of the variances around the inflation rate suggests that there will be occasions when we shall see some figure errors.

At that stage there would be room for debate and a judgment on how quickly to bring inflation back to target. The MPC has been given discretion on how to do that, should the circumstance arise. In deciding the speed of response, it makes sense to have some regard to the wider economic environment. However, that is recognised in the Government's response and the drafting of the legislation. A more general objective for the MPC undoubtedly appeals to some members of the Economic Affairs Committee, but it is not something that I wish to support at this stage, although the matter needs to be kept under review.

As the noble Lord, Lord Oakeshott, has described, the Select Committee has again commented on a number of other issues—in particular, the question of appointments made to the MPC. I support the committee's conclusions, although given my experience and background, noble Lords will not be surprised if I say that I fully understand why the Chancellor wishes to maintain a substantial degree of control over the process. I have a certain amount of sympathy for him. After all, he has a high degree of interest in good appointments of members who will discharge their remit with skill. He has decided to delegate those powers, and not surprisingly he thinks that he should be given quite a lot of weight in the appointments to the MPC. I can understand why he does not want a lot of embarrassing speculation in the newspapers about how the process might work.

Nevertheless, given the sympathy that I have for his position, it puzzles me why the Chancellor wants to make a stand on this issue, given the emphasis elsewhere on transparency and openness. As the noble Lord, Lord Oakeshott, said, the arguments against

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impress no one. I could not possibly use the sort of language used by the noble Lord, Lord Oakeshott, about this, but I am wholly unpersuaded by the arguments on market sensitivity. I should be surprised to discover any significant market effect from the news that one member was stepping down, that there was a vacancy and that the Treasury were seeking a replacement in the period ahead. Indeed, I suggest that here there are the makings of a small research study using conventional techniques to see whether any past changes to the MPC have brought about any market movements at all and what their scale has been. We might then hear rather less about its defence for the present arrangements.

The issue of the length of term and whether to have re-appointment is a further issue, which we have previously discussed. It arises in particular when we have the opaque method of appointment. There seems to be widespread agreement outside the Treasury that members' terms should be longer and that there should be renewal only very rarely. So far we have seen a heavy turnover of members of the committee, and, so far, only one has been reappointed. But what are the criteria for reappointment? Why are some people reappointed and not others? Why do some have to be silenced as to whether or not they would have liked reappointment? What does it say about the independence of members? Again, it seems quite extraordinary that we should be seeing stubbornness on this issue in an environment that has otherwise worked well.

The report touches on the issue of fiscal policy. If we had been updating the report, this is one area where opinion may have moved on a little from February. I think that there is no doubt now about the deterioration of public finances. The main issue is how far this deterioration is a function of the cycle and how far it reflects a deterioration in the underlying budget balance. And, of course, there is the implied question of how far the fiscal situation will deteriorate further.

I have two concerns. The first is that the underlying growth of the economy is less than the Government assume and that there is rather less spare capacity than judged. That means in turn that the growth rate in the next year or two might be less than suggested. Secondly, a larger part of the boom in taxes in the late 1990s was cyclical and the underlying level of tax collection is less than projected.

Taken together, the prospects for growth could be weaker; and for the budget balance much worse than hoped on a sustainable basis. In turn, that could pose challenges for monetary policy.

Finally, I want to touch on one subject that our committee did not dare mention: the implication for the remit of the MPC of the Government's policy towards the euro. Clearly, we cannot say much about this today as we do not yet know the results of the Treasury's tests, although we do not have very long to wait to see them. It is not difficult to see that if the Government embarked on a clear strategy to join the euro at some point in the future and wanted to direct policies towards being in a position to join, it could

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have some implications for the remit. At its simplest that might mean a change in the measure of inflation to be targeted to the harmonised index, as described earlier by the noble Lord, Lord Barnett, and at which the Chancellor hinted in his Budget speech.

The issue at its most complex could mean giving some weight in monetary policy decisions to the need for greater alignment between the UK economy and the European economy to put us into a position to join. Maybe this could also be the subject for another day, or it could be taken as part of the proposed investigation in the design of our remit.

8.17 p.m.

Lord Sheldon: My Lords, I want to speak mainly on the report of the committee on the stability and growth pact. There are serious matters that have been mentioned in the report of the Select Committee on Economic Affairs on monetary policy. In paragraph 41 it states that,

    "there are substantial imbalances in the economy at present".

These are important and serious matters. They are,

    "the imbalance between consumer spending and investment; rising house prices, and the attendant rise in mortgage equity withdrawal; and the trade balance and current account deficit".

It goes on to state:

    "In relation to these imbalances in the economy we consider that some intervention in the future may be necessary".

The committee was right to flag up that issue; it is most important.

So far as the stability and growth pact is concerned, I must offer my good wishes to my noble friend Lord Radice, who very ably chaired the committee which produced a valuable report. The concept of the stability and growth pact was obviously necessary. The problem is that the present circumstances are not the ones envisaged when the pact was originally introduced. The pact is inflexible and changes need to be made. The most immediate and urgent problem is that the pact presumed a world where inflation was the dragon. It did not consider that whereas inflation can be a most serious problem—we understand that—it may not be the greatest economic problem at all times and in all circumstances.

The question we must ask is: what are the basic rules and how can they be improved? The stability and growth pact cannot be seen in isolation. It is one part of an increasingly complex process of co-ordinating policies. Since complete integration is unacceptable we have to devise means of making the stability and growth pact more workable.

Member states are free to structure the expenditure and revenue side of their budgets according to their own national preferences. We know that. But, subject to that, member states have agreed a framework in the pact for the co-ordination of fiscal policy—as mentioned by my noble friend when introducing the debate—with a view to maintaining sound public finances. We welcome that and we want to see how it develops. In particular the pact imposes tight limits on government deficits.

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Once the deficit of a member state goes above 3 per cent of the gross domestic product the Council must judge that the country has an excessive deficit unless the breach is due to exceptional circumstances, is temporary and the deficit remains close to the reference value. The regulation spells out what is meant by exceptional and temporary. That shows when the 3 per cent limit may be exceeded. The Commission has to apply tighter rules than the Council for qualifying the deficit over the reference value as exceptional. As a rule a deficit is automatically considered exceptional by the Commission if output falls by at least 2 per cent of GDP in the year in question. In addition, the Council may consider a deficit to be exceptional if output falls by between 0.75 per cent and 2 per cent.

The committee heard four main reasons why the stability and growth pact is needed. First, the over-arching reason is that the performance and management of national economies in the European Union are a matter of common interest for the Community. Secondly, an important macroeconomic manifestation of the common interest is that the effect of public borrowing by one economy in the euro-zone may spill over onto other members of the euro-zone and there may be what is known as the "free rider problem". Thirdly, in extreme circumstances a heavily indebted member of the euro-zone might default on its debt, imposing costs on all the euro-zone members. Fourthly, low public debt would better enable member states to prepare for the increasing public pension obligations to ageing populations. That is a most serious matter to which I shall return.

There have been other important developments around the pact. For example, in the Amsterdam resolution the member states committed themselves to the medium-term target of achieving budgets that are close to balance or in surplus. Yet neither the resolution nor any of the other legal instruments of the pact specify the date by which member states must achieve that target of a balanced budget. It has been pointed out that one benefit of the stability and growth pact was that it prepared national budgets for the threatening time-bomb of an ageing population. So far as the time-bomb is concerned, there is the politically very difficult solution of dealing with it by raising the pensionable age, or more practically, having a range of retirement ages.

That is one of the most important economic consequences of an ageing population that is going to pursue the economic arguments over a long period ahead. We only have to see what is happening now in France to see the major problems that apply in many countries. Even in Britain we are not exceptional. We have our problems which are fortunately far less than those of many other countries.

I should mention the need to keep down the level of debt in the European Union in order to anticipate the burden on public finances and the consequences for public services of an ageing population. For the European Central Bank, that was the basic long-term justification of the stability and growth pact. The bank held that sticking to the pact might over time, maybe decades—because it takes take a very long view—create

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the room in budgets to cope with the costs of the ageing of the population which are expected to rise over a 30-year period by something in the neighbourhood of between 5 per cent and 6 per cent of GDP. Those are vast sums of money. So the question is: what realistic penalties can we impose on a country that is not meeting its obligations? Are fines really realistic? If a country were, in effect, found guilty and therefore fined, we have only to think of the political effects that that would produce. It is foolish to establish penalties that will never be used, and I cannot see those penalties being used. So we must consider the matter differently.

Much of the reasoning about the stability and growth pact was based on the over-arching importance of dealing with inflation. That situation has now changed and, as I said, deflation is appearing as a threat—perhaps not for very long. It is nevertheless a threat that must be dealt with. We should not be prepared to accept the decline of the standard of living of peoples all over Europe as the result of getting that judgment wrong. That is one further reason why a more flexible arrangement for the stability and growth pact is now required. My noble friend Lord Radice, who dealt with the matter, is fully aware of the problems that must be faced in the years to come.

8.26 p.m.

Lord St John of Bletso: My Lords, in my short contribution to the debate, I shall focus my remarks on the report of Sub-Committee A on the stability and growth pact. I join in thanking the noble Lord, Lord Radice, for his able chairmanship of our sub-committee. I should declare an interest as a consultant to Merrill Lynch because my personal interests were not declared in the report.

I fear that I differ somewhat in my views on the stability and growth pact from our chairman. Although I am broadly in favour of our joining the single currency when the time is right, I believe that the stability and growth pact is deeply flawed. In fact, I am tempted to call it the stagnation and instability pact. The economic reality is that when growth slows, deficits invariably rise and having to tighten fiscal policy often proves totally counter-productive. In my opinion, excessive deficits should be measured after adjusting for the economic cycle, to allow for the full use of automatic stabilisers in upswings and in recessions. As currently formulated, the pact is far too rigid—a common theme of our report.

Several commentators believe that the pact has been dead for some time and cannot be revived. Although the committee called for reform of the stability pact, my personal opinion is that the pact should be torn up and completely new fiscal rules drawn up. The noble Lord, Lord Barnett, mentioned an article in the Financial Times in May; I refer to the lead article on 7th May headed:

    "Patching the pact—The EU should start afresh for stability and growth".

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The central theme of the article was that for every member country, the overriding principle for budgetary control should be to maintain a sustainable debt position.

It is well known that the pact is a political agreement, depending on the willingness of countries to co-operate with the Commission and the Council. Unfortunately, the pact has had a long history of being disregarded for political reasons. It is ironic that France and Germany, who refused to support the military campaign in Iraq, have been allowed to blame their massive budget deficits this year on the war, even though they did not take part. I noted the recent concession by Pedro Solbes, the EU Commissioner for Economic and Monetary Affairs, that the war on Iraq would be deemed an exceptional situation, allowing for short-term breaches of the deficit limits.

Against a backdrop of the severe economic downturn in most of Europe and the recent sharp rise in the euro, the credibility of the pact was severely damaged by the recent announcements by Germany and France that they were abandoning their efforts to balance their budgets by 2006. It appears highly probable that Italy will soon join Germany, France and Portugal in a growing group of countries in breach of the pact's 3 per cent budget deficit limit.

For the pact to have any chance of regaining any credibility, there needs to be far more flexibility. In that regard, I support the main recommendation of our report that the target of being close to balance or in surplus should be measured in terms of the cyclically adjusted budget balance. Members that have low levels of underlying debt should be allowed a small deviation from this target. Each member country's level of borrowing should depend on their initial level of debt. In other words, the lower their debt the less concern there should be about their maintaining budget balance in the medium term.

The noble Lord, Lord Sheldon, spoke on the ageing population in Europe. I understand that 23 per cent of the population in Europe is above the age of 60. With the increasing percentage of ageing population across Europe, future liabilities of governments, particularly from pension promises, need to be included in any assessment of budgetary solvency.

I tend to agree with the proposal of Professor Artis and Christopher Allsopp, in their recent edition of the Oxford Review of Economic Policy, that euro-zone governments should set their own tax spending rules with Brussels simply policing the framework. They call for a looser but still constraining form of fiscal agreement among the member countries.

Even though Eurostat, the statistical office of the European communities, is in charge of providing the actual statistical data to be used for the implementation of the excessive deficit procedure on behalf of the Commission, I have several concerns as to the quality and the accuracy of several governments' accounts.

Some national statistical institutes have scarce resources to compile the government's accounts and are not immune from political pressures. Countries must convince outsiders that their accounts give a true

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and fair view of their obligations. There is a suspicion that some countries manipulate their figures with off-sheet financing.

Given that monetary policy is effectively blocked for dealing with a country's specific shocks, this points to an increasing burden on national fiscal policy to offset and remedy such shocks. For example, Germany is faced now with the problems in its banking system and cannot react with its easing of monetary policy. As we know, this is entirely the remit of the European Central Bank.

Under the stability and growth pact, it currently has to do the converse and tighten fiscal policy, which is effectively strangling any chance of rekindling economic growth in that country. Surely the solution is to allow more of the burden of the adjustment to fall on fiscal policy in Germany, which needs to be more flexible.

It is apparent that if the United Kingdom were now to be in the single currency with the current stability and growth pact, it is highly improbable that our government would have been able to embark on their aggressive programme of raising public expenditure and improving public services.

A central theme in our questioning of witnesses was that of enforcement of the pact. It was generally agreed that fines would not be a satisfactory penalty but that the threat of such fines should remain. There is no doubt—and the noble Lord, Lord Radice, has mentioned this—that peer pressure, not from the House of Lords, but from other member states, is the most effective enforcement mechanism available in the pact.

There is no doubt that the inadequacies of the stability and growth pact, as well as the lack of transparency of the European Central Bank, present a real barrier to the UK joining the single currency right now. We will hear more about this from the Chancellor when he makes his speech next week.

Although I support the co-ordination of national fiscal policies throughout the European Union, so as to maintain sound public finances, market discipline alone cannot be guaranteed to ensure the sustainability of public finances. The maintenance of a sustainable position of debt and effective measures of enforcement are critical. For the European Union to formulate a new set of budgetary rules, a new treaty and new attitudes would be needed. Without both of those, as the lead article in the Financial Times of 7th March said,

    "The Euro Zone is doomed to annual damaging fiscal squabbles just as debilitating as those of the past couple of years".

Finally, I again thank the noble Lord, Lord Radice, for his able stewardship of the sub-committee and of the report. I should mention our specialist adviser, Professor John Driffill, and our extremely able Clerk, Dr Richard McLean. It was gratifying to see that, at long last, our report made some headway in the broadsheets. It is always a concern that many of the great reports produced by your Lordships get such scant public exposure.

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8.36 p.m.

Lord Lea of Crondall: My Lords, I welcome the innovative decision to put the two reports together. Incidentally, given the whole question of finding time for European Union debates in the Chamber, it is an innovation that, if successful—I think that it has been—could be extended, so that we could cover three or four cognate topics in one debate. That would have the additional advantage that we would not be addressing our own committee all the time. We should consider that. As several noble Lords, beginning with my noble friend Lord Radice, pointed out, this is the lull before the storm. As of Monday, we will have a vast number of documents—some 800 pages—to consider. I do not whether the Minister can comment, but I would like to know how we will debate that lot. We should give some thought to that.

Everything that can be said about the growth and stability pact has been said, but, as was once pointed out, not everyone has said it. I shall not repeat it all. In one sense, it is water under the bridge because the decisions have been made, for the moment. They were made in the European Council in March. Generally, we welcome what it did, but it has less scope for going further, if I can put it that way.

The matter must be left on the table for the reasons touched on by the noble Lord, Lord St John of Bletso. There is also the question of enlargement. I mention it not just because of the mantra that there will be more countries, but, if those countries are to start really to converge, there will be some odd statistical consequences in money terms. They will move from having less than 30 per cent of the current EU average GDP per head and could go in a few years to 60 per cent. That is not an unreasonable figure for countries beginning at a level below 30 per cent, which is, incidentally, far lower than that of the previous entrants—Greece, Spain and Portugal. Some of the growth rate numbers, deficit numbers and inflation rate numbers should be examined. That is also a good reason for having a growth and stability pact.

Some argued that we would open the floodgates and end up paying for Italian pensions or the problems in Germany. The euro has got off the ground precisely because it is clear that there is no question of paying for Italian pensions, as they say in the vernacular, even if it were the case that the markets, without the growth and stability pact, would have been able to say that people could borrow against a single European interest rate and the market would notice the national position against which they were borrowing. There is some truth in that. The fact is that in getting the euro off the ground we have been well served by some of the developments since the Maastricht Treaty, but life now has to move on.

The British position is rather two-edged in some respects. It is that in the euro-zone there are various deficiencies of economic policy and that the pact is not really sufficient to deal with them. Those countries have to pull up their socks before the euro-zone is allowed to join Britain in a wider European scheme. I hear my noble friend say "Fog in Channel"; that quip

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was the other way round too. They may be allowed to join Britain in the new euro-zone once they have pulled their socks up. This is part of the logic of many people in considering the debate.

I was intrigued that Robin Marris wrote in today's Financial Times:

    "Arguments against UK entry into the euro-zone based on the Stability and Growth Pact are redundant. The pact reflects thinking of none other than Gordon Brown when in his early days in office he used to denounce Keynesianism. Yet the Treasury now complains in effect that the pact is not Keynesian enough."

The fact is that the four big European economies are now very similar. It may surprise some people to know that the latest GDP numbers at purchasing power parity are as follows: EU 100; Italy 105; Germany 104; UK 102; France 100. At a pub quiz night not many people would get that right. There is not a lot to choose between them.

The fact is that the Maastricht Treaty has worked remarkably well on the whole, but circumstances have been changing. We know that the main problem in one respect is the decision of Chancellor Kohl, though we understand the political reasons why he did it, to have the East German Lander come in at parity with West Germany. There is a huge burden, still, in trying to get the East German economy off the ground in a normal social market economy.

There was the paradox at that time, whose legacy we are still living with, that it was the Germans who were particularly adamant that we should not allow any free riders—hence the original conception of the stability and growth pact and the broadly 2 per cent inflation framework of the European Central Bank. All of this would require a big treaty change to fundamentally change the architecture. We are talking about adjustments to the interpretation of the pact. That is the exercise that we are involved in. Let us be clear that it is not another exercise, although after the Convention there will be another exercise.

Therefore, we reach the very clear conclusion, summarised in paragraph 163, that the "free-rider" problem was one of the overarching reasons for the pact. It would have been difficult to get the euro off the ground without that having been dealt with at that time.

I hope that we have now done enough to counter some of the very widespread nonsense about us paying for the Italian pensions, and so on—nonsense that has been generated by people who ought to know better. However, the British Government are to be congratulated on flagging-up the whole question of the economic effects of ageing. They produced the report entitled, Long-Term Public Finance, which points out that one way of securing the long-term sustainability of public finances is to pursue the comprehensive strategy to meet the challenges of ageing populations.

On the broader debate between the European growth and stability pact and the European Central Bank, which, as my noble friend pointed out, is the next project for Sub-Committee A, there is scope for

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looking more at the linkages between the role of what one might call the "fiscal policy side" and the monetary policy side. Is it not the case that we now have a reversal of traditional views on such matters and that it is the role of monetary policy to stimulate growth by cutting rates? Indeed, it is generally said: cut rates, stimulate growth. But fiscal policy, as in the growth and stability pact, can never do anything to stimulate growth; one can only, as it were, remove restrictions in that sense. A new consensus, as emerged in that respect, should perhaps be questioned.

Before I conclude, I should like to touch upon a matter raised initially by the noble Lord, Lord Barnett, and then picked up later by the noble Lord, Lord Northbrook. I refer to the Monetary Policy Committee. I, too, noticed the reference in paragraph 43 of the report to the question of the retail prices index. Tonight's debate was warmed up by reference to the potential move to the European harmonised index of consumer prices referred to by the Chancellor of the Exchequer in his Budget Speech. My reason for wanting to add a little to this debate is as follows. For several years I was a representative of the TUC on the Retail Prices Index Advisory Committee—not a very high-profile body, but an important one in its own way.

For many years, that committee made recommendations on any change in the RPI. Without fail, I do not know of an example where the government of the day—of either party—did not pick up the recommendations of the Retail Prices Index Advisory Committee, which was a committee of stakeholders that included statistical experts; namely, the Bank of England, the Treasury, and so on. Incidentally, that is why we now have the RPI alongside the RPIX in order to retain the mortgage interest in the RPI. Unlike some countries, we have never had any lack of confidence in the RPI. The TUC is currently worried about whether the RPI in some countries on the Continent is correct, but we have never faced that situation in Britain.

Ever since the First World War, when the cost of living committee was established to deal with the basic wage, there has always been confidence in our index. However, we are now told that there is to be a new index—namely, the European harmonised index—something which I believe to be inevitable. Side by side with that, the Chancellor has talked about regional indices that would be linked to pay bargaining.

Will my noble friend take on board very seriously, much more seriously than the rather brief—I was about to say "perfunctory"—replies that have been given to questions that I have raised on the matter hitherto, the danger of a collapse in confidence in the price index if changes are made without the fullest possible involvement of the stakeholders, as has, until recently, been axiomatic? I urge the Government to recognise the serious need to take that on board when addressing this important change that I believe is probably coming our way.

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8.50 p.m.

Lord Peston: My Lords, I thank my noble friend Lord Barnett for taking from me the burden of introducing the Economic Affairs Committee report on the MPC and related matters. Like him, I am unused to debating three reports on the same day and I felt that introducing one was as much as I could cope with.

I follow the noble Lord, Lord Burns, in taking the opportunity to mark the retirement of Sir Edward George as Governor of the Bank of England. The MPC ipso facto has been a success and has set a world standard for the conduct of monetary policy. But that was not obviously the case a priori. Many of us, not least me, had doubts. Its success has been due in a large part to Sir Edward. He has assured himself a place in history for that reason if no other.

Again following the noble Lord, Lord Burns, I take the opportunity to welcome the new governor Mervyn King. The noble Lord, Lord Burns, did not point out that for the first time in history a world class economist is heading a central bank. That means that the Economic Affairs Committee is looking forward to interrogating him and the current MPC in the not too distant future.

I wish to comment on three topics on the Economic Affairs Committee report. The first is the need, as my noble friend Lord Barnett emphasised, to undertake a systematic study of how monetary policy has been conducted over the past five years—the George era, so to speak. If it is not undertaken by an independent academic body it is possible that your Lordships' committee might undertake the task subject to the resources being available, as my noble friend said. It has been put to me that we should carry out the job jointly with the Commons Treasury Committee, but sadly co-operation between the two Houses always seems more likely in theory than it ever turns out in practice.

Secondly, we reiterate—as did the noble Lord, Lord Oakeshott—our view that the method of appointment to the MPC is wrong and that a more formal Nolan-based approach is the right way. The Treasury's reasons for rejecting this—I put it far more mildly than the noble Lord, Lord Oakeshott—are simply unconvincing. Naturally I shall take seriously his suggestion about an appointments committee made up of the great and the good, but I have to tell him that all my instincts are against it. A committee that had me as a member, as he knows, simply would not work.

The Economic Affairs Committee had in mind that the Chancellor would continue to make the appointment, but using Nolan methods. I regard it as ridiculous to suggest that a committee of this kind would have its membership appointed by an outside body, to which the noble Lord, Lord Burns, seemed to allude.

Thirdly, I am surprised that no one else has raised the important reference at paragraph 41 of the EAC report to the imbalances in the economy. That is a large part of what we were on about. While agreeing

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that they are in part cyclical we have to note that they are not entirely self-adjusting. Yet—this is what puzzles me as an economist—they do not appear to be leading to any kind of crisis.

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