Select Committee on European Union Minutes of Evidence

Examination of Witnesses (Questions 20-34)



Lord Marlesford

  20. I would like to go to a slightly more general point, really following up from something the Chairman said earlier on. I wonder whether you feel, as I am beginning to, that both the performance and the perception of the performance of the ECB results to some extent from a paradox of it being both more dependent and more independent than both the Bank of England and the Fed. More dependent in the sense that it does represent these national interests through the competition of the Council—and this of course has the inhibitory factors that we have discussed on the publication of minutes and that sort of thing—and more independent in the sense that it lacks a real economic management partner in the form of any sort of government. Its main overall partner, I suppose, is the Commission with the Stability Pact, which we have seen already has severe constraints in actually judging the economic situation at the time. This inevitably is going to make any assessment of the ECB a difficult one to make, unless there is some change in either the overt responsibilities given to it or perhaps some extension of the Commission's role in overall economic management.
  (Mr Weale) Could I say that in terms of the issue of setting monetary policy I do not see that there is a real problem. The fact that the European Central Bank chooses its own target, whereas in the United Kingdom it is set by Parliament, I must say I do not think that matters very much. After all, everyone can learn from experience. We have been arguing that the ECB should change their target slightly, or the way in which it is specified, but we have not been arguing that it should be thrown away completely and that the European Parliament should set something or would want to set something completely different. Indeed, if it did set a target of ten per cent plus or minus 5 per cent, I think I would feel I prefer the existing arrangements. I think where there is a weakness is in the coordination of monetary and fiscal policy. People have always known that this is a problem which can arise with European Central Banks. I think it is something of a relief that, at least so far, it does not seem to have arisen in the United Kingdom; but there does not seem to be (and certainly not an explicit mechanism) any implicit mechanism of the full European Central Bank to coordinate its interest rate changes with the fiscal plans of the national authorities. If they do it is kept well under wraps. They do not seem to be saying to the French, "If you do comply with the Stability and Growth Pact then it will be much easier for us to cut interest rates". That mechanism does not seem to be there. In those circumstances you can get into a situation, particularly if the Stability and Growth Pact is ignored, where the fiscal authorities are pulling in one direction and the monetary authority is pulling in a different direction, and the outcome is rather unpleasant.


  21. That is not quite right, is it? If you read the reports of the ECB they do take account and they do pay attention to public sector deficits in countries, and they are always advising countries to get the thing right.
  (Mr Weale) No, they pay attention to it, but I suspect the capacity to strike a bargain, given the structure of it, is different from the informal and unspoken way in which it is possible to sound out (and I do not know whether it happens) the Governor of the Bank of England as to his attitude to fiscal changes in this country. It may be that the French Government does, but it is harder to do that sort of thing, that is my point.
  (Mr Walton) Just to add to Martin's point, the ECB every month criticises governments for fiscal policy being too lax and for not making enough progress on structural policies; but that has not stopped it from cutting interest rates, particularly in the past few months. It is one thing to have this criticism, and it is another thing to know whether or not that actually changes the way they behave. At the end of the day, they have to take account of fiscal changes to the extent that they will have an impact on the real economy and ultimately on inflation. The way I would characterise the problem, and I like the characterisation Lord Marlesford makes, is that you have this collection of 12 countries which do have different economic structures and, through time, those structures will probably converge, as they will be forced to converge; but you do have situations where the economic environment in one country can be quite different from another, and that does create a few tensions potentially for policy and I think you can see that at the moment with Germany versus the rest. Germany is clearly weaker than the rest of Euroland. German inflation has actually fallen below 1 per cent on a core basis; whereas underlying inflation in the rest of Euroland is still running at around 2½-2¾ per cent, and that does create a dilemma. The ECB itself has said that if inflation in the euro zone drops below 1 per cent that would be a cause for concern. By implication, arguably, if inflation in Germany drops below 1 per cent then that also ought to be something of concern. I think that has created some tensions. I think that is why in the end the ECB has become a bit more tolerant of inflation above 2 per cent, because it has realised that to get inflation sustainably below 2 per cent in the whole euro area could quite possibly mean that in Germany you would forcing inflation down towards zero, which may be okay for a short period but is probably not something you would want to see as a permanent feature. I would say it is the different economic structures that still exist within these individual countries which, in some sense, create the perception of national interest, even though I do not think there is any particular evidence that ECB Board members themselves act in a particularly partisan way. As far as I can judge, they do look at the whole euro area but that in itself is not always that easy when you have got different performers in different parts of the region.
  (Mr Smith) I was just wondering if you were also getting at the issue of voting?

Lord Marlesford

  22. In a sense, yes.
  (Mr Smith) It seems to me at the moment it is quite likely you do not have a national versus European interest problem, because you have got the Executive with six votes and only need another three voting in the European interest as a whole, and basically the other three are quite likely to have been voting in the national interest and are likely to be aligned with European interests anyway. I do not think it is an issue now, but I think it might be an issue with expansion whether you do end up in a position where smaller countries could group together and outweigh the votes of the majority in terms of GDP. On the issue of coordination of monetary and fiscal policy, I think there is quite a difference in attitude in that the MPC basically takes into account what the government does in arriving at its forecasts and, therefore, its interest rates decision. Whereas the ECB tends to be rather more proactive in making comments about how it thinks fiscal policy ought to develop. I am not sure this has any real significance for the ECB but, given that it has to deal with a large number of governments rather than one, maybe it is the only way it feels it can make some sort of point about what is going on. The MPC does not have that problem. There is one government and you know what the situation is.


  23. Incidentally, on the point David Walton made about the German economy, it just so happens that we had the President of the Bundesbank here and he reminded us that the interest rates in Germany are real interest rates but lower than they have been for 50 years—quite an interesting point.
  (Mr Walton) I actually think he is wrong to say that. I guess it depends how you measure it, but certainly if you look at real short-term interest rates in Germany they have been lower on a number of occasions. Maybe if you look at the real long term situation it might have been what he was referring to.

Lord Hannay of Chiswick

  24. Could I ask the three of you a little about exchange rate policy or its absence. The European Central Bank statutes and the European Central Bank has been very determinedly of the view that it is not its job to conduct an exchange rate policy for the euro and it has not indeed done so. That is probably something which is, on the whole, welcome. The structure of the European Union as it is currently organised, and the lack of any institution that really conducts economic governance as a single unit, does that not mean, a combination of that and the complexity of the institution, that in fact the EMU would actually been incapable of conducting an exchange rate policy, even if somebody was unwise enough to think that it should have one; and that actually we are in a position now in which benign neglect of the exchange rate of the euro is almost imposed by the nature of the structure of the institutions?
  (Mr Weale) I think the answer to that depends to some extent upon what one means by an "exchange rate policy". If you told the European Central Bank that its job was to maintain an exchange rate of, say, one euro equals one dollar—in other words, to deliver a fixed exchange rate against the United States—then with appropriate reserves and a suitable interest rate policy I am sure it could do that. It and others might not like the consequences but that could happen. If you mean something more nebulous, then I suppose one really has to ask, "Why have it? What is it for?" If they were told or persuaded that the exchange rate should be the first pillar instead of money GDP or, as it is at the moment, the money stock, then I think they would be able to pursue interest rate-setting taking that in mind. I think the European Central Bank would, rightly, take the view that it would be an odd interpretation of their role to essentially pin themselves on to United States monetary policy; and that if there were to be a formal exchange rate policy, rather than the exchange rate simply being another indicator, the appropriate thing would be that that should be determined by bilateral negotiation between the European Union and the United States. I think the answer is that they would probably find it difficult to define and justify an explicit exchange rate policy as opposed to treating it as another indicator. That seems to me the circumstances one would expect to be in and circumstances that we should welcome.
  (Mr Walton) I do not see how you could have a formal exchange rate policy. At the end of the day, the ECB has got a mandate of price stability, and it only has one instrument to achieve that. That one instrument of interest rates, if it were directed, say, to stabilising the euro against the dollar—supposing the US were pursing a very inflationary policy—then you would presumably have inflation in the euro area. I do not think you could have some kind of formal mechanism. Clearly if you get into a position where a currency appears to have overshot substantially in either direction then you could have a temporary period in which central banks get together and intervene or try to talk the currency back to a more sensible level, that could always happen. I do not think you could ever go down the route of having a formal objective. In that sense it is very different, say, from the UK. The Chancellor one day could say, "The mandate for the Bank of England is no longer an inflation target of 2½ per cent, it is pursuit of a stable exchange rate versus the euro" That cannot happen in the euro zone area.

Lord Lea of Crondall

  25. Could I just follow up the point about the exchange rate policy. In a sense there is a contraction, is there not, in that of course the reason why the "markets" watch this like a hawk is that it affects the markets. Certainly the ECB would be marked down if it did not worry about the markets and the markets start to take a view. In the City of London there is this implicit idea, "Why can't we all be more like the Anglo Saxons?" You could set it to music. Is it not a fact that the name of the game is somehow relating to the markets? I do not know which markets you are talking about—bond markets, foreign exchange markets—but this is the name of the game, is it not, to some extent in what you are looking for? The absence of an exchange rate does not mean that the ECB is not as worried as hell sometimes about the effect of what it does on the markets in terms of the euro/dollar relationship or the movement of the bond markets or the movements of any other market?
  (Mr Walton) I think at the end of the day the ECB is concerned about achieving its objective of price stability, however you define that. If you have big swings in asset prices that could compromise your ability as a central bank to achieve that target. Clearly you do not want to see big unjustified swings in asset prices. It is one thing to observe those swings and then to conduct policy but it is another to say that the markets are actually dictating what your policy is going to be. I genuinely think that all central banks at the end of the day do not have much control over asset markets; I do not think the markets have much control over asset prices; but they have to observe what is going on as best they can to reach a judgement as to what that means for their ultimate objectives and, if necessary, modify their policy in order to attain those objectives.
  (Mr Smith) I think theoretically you either have to have a very strong exchange rate policy if you are going to have one or you do not have one at all because anything in the middle normally leads to some sort of disaster. My comments about transparency I limit to the banks' interest rate policy. I think one area where I would exempt central banks from being open about what they are doing is in terms of currencies, for those reasons. It is an issue, to me, which you might have talked about five or ten years ago, but it is actually quite difficult to make it relevant given the way countries are set up at the moment.

Lord Armstrong of Ilminster

  26. I wondered if we could turn the discussion towards what you might call the "governance of the ECB" and particularly when the European Union is enlarged. It is clearly more difficult to structure the governance of the ECB than it would be of a national central bank. Do you think the arrangements that were created when it was set up were sound? Do you think that the changes now proposed are going to work; or do you think we should be looking for some more fundamental change in the way that the ECB is managed, and the way that the basic decision-making occurs?
  (Mr Walton) The key thing is, can you reach decisions as a committee? As Martin pointed out at the beginning, the ECB has managed to change interest rates as often as the UK; so it is not that they cannot reach decisions. To my mind, 18 people seems a little bit unwieldy. Indeed, that could go up to 21 under the new arrangements. I think if you were just an economist speaking you would probably prefer to halve that number rather than see the number increase. At the end of the day I think the issue of democratic accountability is an important one. The European Central Bank is there representing all of these nations. To say that you cannot have most national central banks being represented and actually voting that is a big decision to make. It seems to me in the end that the compromise the ECB itself has reached is probably a reasonable compromise in the circumstances. They have prevented a situation in which you would get 30-odd people having to vote each month. They have capped it at 21. That is probably a bit larger than ideally one would like but it does at least preserve some notion of democratic accountability and gets away from a situation where any individual country has got a guaranteed right to vote every month in perpetuity. I would say they have struck a reasonable balance.

  27. Would you like the ECB to have an MPC of its own?
  (Mr Walton) I am less keen on that, to be honest, from this point of view of accountability. I think national central bank governors are very well qualified to take decisions about interest rates. To delegate that to nine or so supposed experts, I am not sure that that is the route I would go down personally—relative to saying that these people who run these national central banks, who have been observing and participating in monetary policy for a very long time, are very well qualified to reach these judgments, it seems to me.


  28. Do you think there is a case for the big countries having a vote all the time?
  (Mr Walton) No, because I think the big countries will get a greater representation on the Executive Board anyway. When you are looking at Euroland, you clearly need to take account of the fact that Germany is one third of Euroland and it will still be 30 per cent of the enlarged euro area. If you are looking at Euroland as a whole, Germany is clearly going to figure in the considerations of everybody. Whether that is the Bundesbank President or whether that is the Governor of the Central Bank of Ireland looking at Euroland, Germany is going to get adequately represented.

Lord Hannay of Chiswick

  29. I think what you are saying is what I would agree with, that you have to get away from each of the constitute states of the euro zone having a vote, partly because it becomes unwieldy with enlargement, but partly also because it is contrary to the whole ethos under which the ECB was set up; but you do not want to go too far away from it; but that in order to show you had gone away from it for everyone (and treating the small and large in a reasonably equitable way) you had to break this link between the large Member States always having a vote. Having said that, and broadly the analysis is one I would share, do you actually think that the structure of the ECB is well suited to deal with the ten new Member States which have very different economic tracks on which they are set—high growth rate, probably a bit higher inflation and so on, very big inputs of European money going into them for a number of years? Do you think that the European Central Bank will be able to cope adequately with that? What do you think their attitude will be towards attempts by the new Member States to join the euro zone very quickly?
  (Mr Weale) I think your last question was actually the answer I was going to give on your first question. Are or at what stage will the new members be fit and ready to join the euro area? When they are fit and ready to join the euro area, in other words they are happy with exchange rate stability, with inflation rates slightly faster than those in the existing part of the euro area (probably because countries that are catching up tend to have faster inflation), then I cannot see why it should be a problem for them in the euro area; and I cannot see why the ECB should have a problem coping with them. We hear a lot of this in another context. The issue will be whether and when they are ready to join and, provided that is assessed sensibly, there should not be a problem for the European Central Bank because they are there.
  (Mr Walton) One thing I should just add is, it is not out of the question that when some of these countries do join that in equilibrium they will tend to have slightly faster inflation. Referring to Balassa-Samuelson, countries with higher productivity growth tend to have on average higher inflation. At the moment these countries only represent about five per cent of Euroland GDP, so they are not going to have an enormous distortion on the overall aggregate inflation figure. As those countries get a bit bigger and if they have a bit higher inflation there will be a case at that point for thinking, "Is the inflation target that the ECB has appropriate, or should they reconsider whether or not they should nudge it up by half a per cent or so"? In other words, just to keep inflation at an acceptable level, say, in Germany you do not want inflation in Germany to be going down to negative territory, just because you have got inflation in the rest of Central Europe running at five or six per cent? That would be another plea I would make at the end of the day, that the ECB should not regard this review of monetary strategy as the only review it ever conducts into its monetary strategy. This is something which they have done after the first four or five years of EMU; this is something, arguably, they should do every five years or maybe every time another Member State actually joins the European area. There is certainly precedent for this. New Zealand I think is the best example. New Zealand was the country which was the first to have an inflation target, and it has these periodic reviews every time you get a new governor, or every time the governor is going to be re-appointed. That has meant that through time their inflation target has actually changed. It was zero to two per cent when it started in 1990, that reflected a desire to bring inflation down into a region that was low. Once they had achieved that they loosened that target a bit through time. It went from zero to three, and then last September it went from one to three per cent. These things should never be fixed in stone. There are always going to be advancements in economic thinking and there are always going to be changed circumstances. The ECB should never think that this is a one-off shot at trying to get the system right.

Lord Lea of Crondall

  30. In the catch-up process, like Portugal and Greece in the past and now, hopefully, Hungary and Poland will catch up, the interest rate is the same for everybody. Let us assume in three or four years' time they are part of EMU, they still have to catch-up more from that point on. They will still have higher GDP growth rates which means, within the trend track, they will have higher money supply growth rates. This is not incompatible with your interpretation of a twin track governing the ECB?
  (Mr Walton) No, my point is slightly different. Clearly, any country can have a different growth rate. Germany happens to have a trend growth rate of around 1½ per cent a year versus the rest of Euroland, which is about a percentage point or so higher. Just bringing in Poland or Hungary, which has a trend growth rate which is even higher, that does not change the inflation situation particularly. What does change though is that you happen to have very high productivity growth in many of these Central European countries, particularly in the traded goods sector, and what that means is you can have a situation where wage inflation in the manufacturing sector in some of these succession countries can be quite high but fully paid for out of productivity, so those industries are able to compete.

  31. You mean real wages?
  (Mr Walton) Exactly, yes.

  32. You said "wage inflation".
  (Mr Walton) Yes, and that translates into higher real wages. Then the important point about this is that you will tend to see those same sorts of wage increases pass through to the more sheltered bits of the economy which do not have to compete with other European countries. What you will end up with is higher inflation on average in those countries, even though in the traded sectors inflation will have been much the same as in other European countries. The net effect of that will mean that Euroland inflation on average will tend to be a bit higher.

  33. How can you have different inflation rates when the rate at which the euro is inflating is somehow measured by the European Consumer Price Index? My point simply was, in your twin track, am I not right, one of the points of the twin track is inflation and the other one is money supply growth?
  (Mr Weale) Could I try and summarise David's point. Because the economies of Poland, Hungary and the Czech Republic are catching up they have inflation of, say, 5 or 6 per cent. If the ECB wants to keep inflation at, say, 2 per cent for the wide euro area that means in the existing euro area, depending on the arithmetic, they might have to be put up to 1½ per cent. In some of the extreme cases that could take it below a level that it felt desirable. Whereas if it raises the target for the euro area as a whole by half a percentage point then inflation in the more prosperous areas will not be depressed below levels that the European Central Bank feels comfortable with.

Lord Marlesford

  34. Do you feel it is likely or desirable for the Commission perhaps through ECOFIN, inside and outside countries, to have a greater role vis-a-vis the ECB? I am not sure what role, but perhaps in guiding them?
  (Mr Weale) Yes, going back to the point I made earlier in terms of coordinating monetary and fiscal policy (they have their own problem with the national governments in those respects) so that we do have the sort of situation we are in at the moment where national governments are saying, "We don't care. We're doing this because monetary policy is what it is", some sort of coordination is desirable. Britain, rather to my surprise, has managed without any formal arrangements, at least so far; but given the more disparate nature of the euro area, the fact that it has 12 national governments at the moment, I think that would be a job ECOFIN should be trying to do.
  (Mr Smith) I find it quite difficult given that the ECB's mandate is effectively just a single thing to control inflation. I find bringing anything else into that pretty difficult. While the ECB can change its own numerical inflation target, getting anything else changed probably requires treaty change. I agree with David that the ECB, hopefully going forward, will continue to adapt to circumstances, but I do think there are limits as to exactly how it can adapt.

  Lord Marlesford: They do. The fact is they actually take into account things beyond their mandate, partly fulfilling their mandate but basically how they operate de facto. The Bank of England has views on employment and growth rates, and I wonder whether we are moving to a situation where maybe you like changing the mandate for the ECB and there needs to be some greater conduit for responsiveness of the real world which has, after all, been a criticism of the ECB in terms of its interest rate policy?

  Lord Hannay of Chiswick: Surely that argument if it is pursued, which it may very well be, can only lead to the euro group, the euro zone countries conducting the dialogue with the ECB and not ECOFIN; because this is the way in which greater formality will be given to the meetings of the euro group because of the need, you say, for economic governance input into the overall dialogue, which is a worrying one for this country if we stay outside of that?

  Chairman: I am not going to allow at this late stage a debate between two members of the Committee, although it is a very interesting one! If there are no further points, may I thank you for the exceptionally intelligent way in which you have answered our questions, and say how useful you have been to us. It has been a very, very good beginning to our inquiry. Thank you very much.

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