UNCORRECTED TRANSCRIPT OF ORAL EVIDENCE To be published as HC 1817--ii

HOUSE OF COMMONS

ORAL EVIDENCE

TAKEN BEFORE THE

EUROPEAN SCRUTINY COMMITTEE

REINFORCING THE EUROZONE

WEDNESDAY 8 FEBRUARY 2012

PROFESSOR MICHAEL DOUGAN and MARTIN HOWE QC

ROGER BOOTLE, DOUGLAS MCWILLIAMS and WOLFGANG MÜNCHAU

Evidence heard in Public

Questions 61 - 124

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Oral Evidence

Taken before the European Scrutiny Committee

on Wednesday 8 February 2012

Members present:

Mr William Cash (Chair)

Mr James Clappison

Michael Connarty

Julie Elliott

Nia Griffith

Chris Heaton-Harris

Chris Kelly

Penny Mordaunt

Stephen Phillips

Jacob Rees-Mogg

Henry Smith

Examination of Witnesses

Witnesses: Professor Michael Dougan, Liverpool Law School, and Martin Howe QC gave evidence.

Q61 Chair: Thank you very much for coming, Professor Dougan and Martin Howe. The simplest thing is to get straight into the questions. Tomorrow the website will have the evidence that has already been taken and the written opinions that we have received from others so far. As far as you are concerned, what you are doing today will be up within 48 hours. I think that would be a fair comment.

The first question is in regard to the obligations on eurozone states. Mr Howe, to what extent does the agreement increase the obligations on eurozone states that are not already contained in existing or draft EU rules?

Martin Howe: The increase in obligations on eurozone states includes first of all an obligation on them as to how they vote in the context of the excessive deficit procedure. They are required by this treaty to act as a voting bloc or caucus. Second is the obligation to incorporate internal mechanisms to secure a balanced budget in their domestic law or domestic constitution. Those are the principal additional obligations imposed on eurozone states.

Chair: Professor Dougan, what is your view about that?

Professor Dougan: I would agree with Martin on that point. The voting requirement and the balanced budget rule would seem to go beyond what already exists or what we know to be imminent in terms of Commission proposals that are expressly envisaged by the terms of the new treaty. Beyond that, it is probably worth noting that some of the obligations set out in the new treaty are really more in the character of aspirations for future EU action, rather than direct obligations for the member states involved, in the sense that they envisage or exhort the Commission to carry out forms of secondary action under the EU treaties, which it really is the prerogative of the Commission to decide to carry out for itself. Although they may well express the aspiration that they would like the Commission to do so, it is really not an obligation as such. It is merely an invitation to the Commission to behave in that way.

Q62 Chair: Do you regard this legislative overlap as necessary, or might there be adverse consequences?

Martin Howe: This is the legislative overlap between this treaty and the TFEU?

Chair: And the non-EU treaty.

Martin Howe: Let us take the balanced budget requirement. The TFEU itself requires member states to maintain their deficits within a band of-in normal circumstances-3%. This treaty, as it were, is not inconsistent with that. It imposes a tighter obligation. It overlaps by imposing a tighter obligation, but it is not inconsistent.

Chair: Professor Dougan, what is your view on that?

Professor Dougan: I would probably divide it between whether it is politically necessary and whether it is legally necessary. Politically, most people agree that certain member states, particularly Germany, felt that they needed an agreement of this sort at the level of primary law. Preferably, the Germans would have wanted an EU amending treaty, but as an alternative, they are happy for a public international law treaty. Politically, I think they needed that in order to feel that they could sell resolution of the eurozone crisis to their own population, and also perhaps persuade the European Central Bank to take some of the measures that are necessary in the short term to prop up some of the struggling economies. That is the political reason why it may well be necessary. Legally, it is probably not so necessary.

Q63 Chair: What do you mean by that?

Professor Dougan: Legally, it takes the form it does because of the UK veto in December. It could have been a very different type of treaty. There would still have been political pressure to have it, but legally it takes the form that it does because of the UK veto.

Q64 Chair: You obviously know Professor Paul Craig very well. Yesterday, he was saying, in effect, that there were serious questions about the rule of law in relation to this entire operation. His evidence will speak for itself, but that is the thrust of it. I have another question on this: is there a danger that this overlap, which we are discussing, makes the rules for the eurozone more difficult to understand? There is also a question of complexity, which I think you dealt with in your evidence-actually, I think it was Professor Peers who dealt with the complexity question. What is your view about that? Do you think that there is a danger that this overlap makes the rules for the eurozone more difficult to understand?

Martin Howe: I think it does make them somewhat more difficult to understand, although they are rules that are primarily almost entirely directed to member states, rather than to the population at large. I am afraid I do not know what Professor Craig said to you yesterday at the evidence session, but I have read the paper he submitted. Personally, I share concerns about propriety in the rule of law, particularly in the context of the use of the Commission and, to a lesser extent, the use of the Court-the use of the institutions-for the private purposes of this subgroup of member states, without any formal mechanism of the Commission under the EU treaties. However, I look at it, if you like, from a practitioner’s perspective. I find that what my clients are interested in is not my opinion of what I think is the right decision a court should make; it is my opinion of what decision the court that is going to hear a case will make.

If you look in practical terms at the use made of the institutions, what would happen supposing, hypothetically, that the United Kingdom were to mount some sort of challenge or some other member state were to mount some sort of challenge? While there are strong theoretical arguments that the Commission should not allow itself to be used in this way, the European Court of Justice is a court that is-put it this way-highly attuned to the political context in which it operates.

Q65 Chair: Is that a euphemism or a joke?

Martin Howe: Take it whichever way. The Court reflects political developments and the political ethos of the European Union in which it operates. One would be asking that Court, as it were, to ban the Commission from performing an activity that the Commission itself wants to perform and which the majority of member states want it to perform, in the face of the objection of maybe the United Kingdom and possibly one or two others. Unless the legal arguments are crystal clear, the prospects of winning that might not be too good.

Q66 Chair: Professor Dougan, do you have anything to add to what Martin Howe said?

Professor Dougan: I think I could probably add quite a lot, if you would like me to. I had the advantage of reading Professor Craig’s written evidence, which was circulated on Monday, I think. I saw several points at which Professor Craig expressed the view that there were rule of law issues in relation to both the form and the content of the new intergovernmental treaty. I will say quite honestly that although I very much respect Professor Craig’s views and analysis, I certainly do not share them. I am not sure that I see the same types of issues. I can see issues, like Martin, but I do not see the same types of issues, particularly as regards the principle of whether member states, having failed to achieve a treaty amendment so as to pursue an objective that they want to achieve, can then pursue that objective outside the EU framework by means of ordinary international law. That is one issue that Professor Craig flagged up, and it is one that I would disagree with.

On the use of the EU institutions for a non-EU purpose, Dr Gordon and I indicated in our written evidence that there is relatively clear authority from the European Court of Justice that it is possible in principle for the EU institutions to be delegated non-EU functions by the member states. The real question is not the principle; it is the conditions under which that type of delegation can take place. There are lots of factors that could be used by analogy to try to figure out what those conditions might be, but on the point of principle I think it is possible. It is just a matter of trying to decide how and when that would be lawful.

Martin Howe: Those cases are ones in which all member states agreed to the Community institutions’ carrying out the additional tasks, in treaties to which the Community and all the member states were parties. There is a significant legal difference in an instance where not all member states have consented to the extension of the functions of the institutions beyond those under the treaty.

Q67 Chair: Lastly, before I bring in Michael Connarty, I just want to get this one question to Professor Dougan on the record. Would you like to comment on the danger that this overlap would make the rules for the eurozone more difficult to understand-the complexity question?

Professor Dougan: The rules on the single currency-on the eurozone-are difficult for any of us to understand at the best of times. I think this is an unhelpful degree of overlap, which makes the situation more complex.

Chair: That is what I needed to know.

Q68 Michael Connarty: Professor Dougan, you commented on Professor Craig’s written evidence. He and our other witness pointed out that they were dealing with a treaty that has since been amended again. We have the fifth version before us, from 27 January. Chapter 3, section 2, of the original draft stated, as Martin said, that there would be provisions of a binding force and permanent constitutional character. That has now been changed to "preferably constitutional, or otherwise guaranteed", which both our witnesses said made it very much like it is at the moment. Basically, there has never been any infringement because those guarantees are so vague. Your stress on that as a second major change, which changes constitutional laws, seems to be so much euro-fudge at the moment. It is not likely to have any binding character at all, so in its present form in the fifth amendment it is not such a great threat as you put forward.

Martin Howe: I agree it has been weakened since its original draft.

Michael Connarty: Seriously.

Martin Howe: Yes. The legal test is still that it has to be of binding character. Internally, it seems to me that to satisfy a requirement of the treaty it must-

Q69 Michael Connarty: It is not what it was. It is not what the Germans and French were seeking-namely, binding constitutional changes in all countries that signed up to this. It has been watered down considerably. Do you agree?

Professor Dougan: I agree. Perhaps when we were talking about what is novel about this new treaty as compared with what exists already, it is partly the idea of the balanced budget as a substantive obligation. If we set aside the issue of the form that that guarantee takes, whether it is constitutional, equivalent to constitutional or merely of a binding character, it is the fact that the substantive obligation goes further than what exists already under EU law-the idea of the lower limit of the structural deficit being 0.5%. That is what is novel and significant, rather than necessarily the form it has to take.

Q70 Michael Connarty: It was not one of the things mentioned by Martin at the beginning. He mentioned two things: voting as a bloc and changes to constitutional law, and "changes to constitutional law" is not as strong as we wished for when they set out the first draft.

Martin Howe: I did say constitutional or other internal law. I think I said that. It has to be a law, it seems to me.

Q71 Michael Connarty: It does not say that. It just says, "otherwise guaranteed." It does not say law.

Martin Howe: "Binding force and permanent character," it says.

Michael Connarty: Yes. It’s waffle. Euro-waffle.

Chair: Henry, would you be kind enough to follow this up with your question to Martin Howe on article 7?

Q72 Henry Smith: Article 7 incorporates the mechanism for reverse qualified majority voting. In your opinion, is it possible for a non-EU treaty to stipulate voting procedures in an EU institution?

Martin Howe: It is not a question to which I can give you a certain answer, and I would rather not. There are other contexts where the answer would clearly be no. For example, to take an extreme case, members of the Commission owe duties as individuals under the treaties, and there is express provision in the treaty that they shall not take instructions from either their own or any other member state in how they perform their functions. The same rules apply explicitly to members of the Court of Justice, as one would expect.

Here, we are talking about voting by representatives of member states within the Council of Ministers, and in general the treaty does not explicitly say that you cannot bind the way you vote. One would not expect there to be a general prohibition on doing political deals as to how member states’ representatives will vote in the Council of Ministers.

On the other hand, what we have in article 7 of this treaty is, if you like, a formal and binding-in-international-law obligation on the members of the contracting states of this treaty as to how their representatives shall vote. Furthermore, the context in which they are voting could be argued to have quasi-judicial characteristics, because the Council of Ministers is judging the measures taken by a member state accused by the Commission of being in breach of its obligations under the excessive deficit procedure. The treaty itself explicitly requires the Council to consider representations made by the member state before reaching a decision, and it could therefore be argued that in considering those representations, the members of the Council are performing a role that certainly has quasi-judicial aspects. In that context, it is wrong that they should enter into a binding agreement that fetters the way they exercise their judgment.

Q73 Chair: And surely it is not just about the question of exercising a vote, as it were; it is about what they are dealing with, because this is about running the economy. It affects employment and the manner in which the economy functions, so from that point of view, it is not just a theoretical exercise. It is actually about practical questions that flow from whatever decisions are taken.

Martin Howe: Indeed, because what the Council will have to consider, if, for example, a member state is in breach of the excessive deficit criterion, is not merely a black and white economic question-is it in breach?-but how severe or acute the measures should be to get it back on track and balance what may be short-term damage to employment, and so forth, against other considerations.

Chair: Would you like to ask the same question of Professor Dougan, Henry?

Henry Smith: Yes, that would be useful.

Professor Dougan: I am grateful for the opportunity because I will disagree quite strongly with Martin.

The language of a quasi-judicial character being imposed upon what are the 27 Governments of the EU is quite strong, and I think it should be used only in cases where it is really justified. I do not doubt that there are cases where the Council acts in a way that we would consider it to be bound by rules of natural justice, and it should not fetter its discretion in advance; for example, when it comes to imposing financial sanctions on suspected terrorists. That function of the Council clearly infringes the rights of individuals and it is right that the Council should act in a quasi-judicial or administrative way. However, I think that outside that type of particular context, we should bear in mind that the Council is essentially a political institution. It is made up of representatives of the national Governments, its responsibilities are essentially political and its accountability is also essentially political. There might be a danger in trying to juridify or legalise the Council as an institution by trying to impose such quasi-judicial obligations on it in a way that is not necessarily appropriate.

I think therefore that there are three main characteristics of this article 7 procedure that we should bear in mind. First, the defendant member state-if you want to put it that way-still has the right to make its representations before any voting takes place, so it still has procedural rights, which the other member states have to respect. Secondly, although there is a commitment to vote presumptively in favour of a Commission proposal, it is not an absolute commitment. They can decide to change their minds, and if enough of them change their minds, none of them are bound to follow the Commission proposal. One might go further and say that they could simply breach this treaty because they are free in the Council to vote however they like, and if they want to breach their obligations under the treaty, there is no enforcement sanction that can be imposed upon them. They will incur a breach of international law, but there is nothing to stop them doing that if they so wish, and the sanctions are non-existent.

Finally, at least in certain cases you can go to the European Court of Justice if you feel that your procedural rights under this excessive deficit procedure have not been followed. Particularly at the later stages of the procedure, the Court can judicially review the acts of the Council, if it feels that the Council has behaved in a procedurally unfair way.

Q74 Mr Clappison: I am interested in what our eminent witnesses have said about this. Professor Dougan, you chose to highlight this in your evidence to us. You very academically set out the arguments for and against, but it is something that I think caught your eye as being an important development in these terms. Looking at it politically, as a political procedure it seems to place an awful lot of power in the hands of the Commission and a potential blocking minority. Looking at it politically, it is the case with the procedure-described as "reverse qualified majority voting"-that if the Commission comes to its view, it can be stopped only if there is a sufficient number of states in a blocking minority. It could be the case, could it not, that after the Commission has come to its view on what to do, a majority of states might be against the Commission and in favour of whatever the offending country says, but nevertheless, there is not a sufficient majority, because there is a blocking minority, and the Commission therefore has to do what the minority wants? I take that as being put in as a sign of toughness towards any potential offending countries. Is that right?

Professor Dougan: I think that it is true that the influence and the rule of the Commission are increased generally throughout most of the reforms taking place in relation to the eurozone crisis, including the Six Pack of legislation adopted last year. There are a couple of points to bear in mind in the light of what you said. First, recognise that reverse qualified majority voting is not unique to this new treaty. It is a feature-a central feature some would say-of the Six Pack of legislative measures. Its role precisely is to try to increase the automaticity of sanctions against member states that are incurring excessive deficits. It is not unique in that regard, even if it is still relatively unusual.

Q75 Mr Clappison: Am I right in saying that it is a relatively recent development?

Professor Dougan: Sure.

The second thing to bear in mind though is that, in a way, you could say that in the political realm this type of thing is relatively common in the way that the EU operates as a whole. Most of the Commission’s legislative proposals for example do not emanate from thin air; they come from a request by the European Council, the Council or through dialogue with the member states. They will very rarely appear from nowhere. Most of the time, when the Commission proposes to do X, we can identify the member states either largely or wholly in favour.

Q76 Mr Clappison: The concept of the qualified majority vote was brought in to prevent a single country from vetoing something unfairly to make progress on something like the single market, but it was designed to protect the rights of states. This is turning the thing on its head so the minority gets what it wants, not the majority. Put in legal terms, is it not a bit like an appeal coming to the Court of Appeal from a lower court, and one member of the Court of Appeal agreeing with the lower court and two being against, but the Court of Appeal having to do what the one member wants because he constitutes a blocking minority?

Chair: Henry, would you like to ask Professor Dougan a question?

Q77 Henry Smith: Yes, indeed. Could you outline your concern about the Commission’s role in proposing the principles underpinning the automatic correction mechanism in article 3(2)?

Professor Dougan: My concern as a matter of principle with the Commission’s having a role?

Henry Smith: The principles underpinning the automatic correction mechanism.

Professor Dougan: If we are talking specifically about the Commission’s role under article 3(2), it is interesting to note that compared with the earlier drafts of the treaty, which were very vague about the common principles that the Commission should take into account when it was going to elaborate its proposals, the final version is much more precise. It is interesting that the contracting parties have given the Commission quite a strong steer about the types of common principles that they want to see.

Beyond that, in terms of the more general concern that the Commission here is performing a role that is not laid out in the EU treaties and is additional to its functions under EU law, that would be a broader question about the conditions under which that is lawful. Martin and I alluded to those earlier. My concern is that we do not have any answers; we only have indications, ideas, analogies and equivalences. I can elaborate on those if you would like me to.

Q78 Henry Smith: Briefly, if I may ask you to do so.

Professor Dougan: There are a couple of things to bear in mind. Martin mentioned earlier that both of the cases-the Bangladesh case and the Lomé convention case, in which the Court recognised the principle that the member states could draw upon the EU institutions for non-EU purposes-involved all the member states participating and consenting, so as authorities they are not particularly useful. It is interesting that the advocate-general in both cases-Advocate-General Jacobs, as he then was-dealt more with the possibility that there could be situations where individual member states or even external organisations such as the UN might ask the Commission to carry out certain delegated functions on their behalf. The test that the advocate-general proposed in those cases is probably a very sensible one. The question is: is it incompatible with its obligations under the treaties? If, for example, the member states were asking the Commission to behave in a way that infringed its duty of impartiality or its duty of independence, we would all have a real problem. If they are not asking the Commission to behave in that way, however, it does not seem objectionable.

On the question of whether all the member states need to consent, there is probably an interesting analogy to be drawn with the enhanced co-operation provisions, because there we can have sub-groups of member states acting within the treaties and using the Parliament, the Council, the Commission and the Court even in the face of the opposition of certain member states, because enhanced co-operation can be authorised by a qualified majority vote. It is perfectly possible within the treaties to make use of the institutions for the interests of certain member states against the opposition of others. That is within the scope of the treaties, so obviously it is not a direct analogy, but it is an useful indication that, as a point of principle, it may be possible. The real question is whether that would make the Commission behave in a way that would be incompatible with its duty of impartiality. If it would, that is a real problem, but if it would not, it should not be.

Q79 Chair: Martin Howe, do you have a view on that?

Martin Howe: Certainly if a group of member states set up a treaty that required, or purported to require, the Commission to act in a way that was incompatible with its duties under the new treaty, it would clearly be unlawful for the Commission to act under that private treaty. I agree that if that condition is satisfied, the action by the Commission would certainly be unlawful under the treaties. The more difficult question, which genuinely has not been decided by the European Court, is whether that is a sufficient condition, and whether Advocate-General Jacobs was right to put that forward as a sufficient condition. I would also add that I am not sure that the existence of the enhanced co-operation procedure actually assists the argument that the Commission can act privately for a sub-group of member states. What one can draw from that is a contrary argument, which is that the treaty authorises the institutions to act under certain defined conditions on behalf of sub-groups of member states who wish to engage in enhanced co-operation. Hence, the argument would go that, in general, a sub-group of member states that wants to get together outside the authorised framework of enhanced co-operation cannot hijack-to use a pejorative word-the institutions for its private purposes.

Chair: I should like to move on to the legality of the role of the Commission under article 8. James, if you could tackle those questions. Against the background that a lot of this is legalese, if I can put it that way, but bearing in mind the impact it has on the people who have to bear the results and consequences of the decisions that are taken, sometimes one is left wondering how much of this they could possibly understand. James, would you start with those questions on article 8?

Q80 Mr Clappison: Perhaps I could start with Professor Dougan and ask him if he agrees that the Commission has de facto infringement powers under article 8, and what his view is of the legality of it.

Professor Dougan: The principle that would inform my answer to virtually any question to do with article 8-but that question in particular-is that this is a voluntary jurisdiction that the member states in question offer to the ECJ. In a way, the legal test I referred to earlier, which was suggested by Advocate General Jacobs, would be equally applicable here. The question is not, "Does this supplement the treaties? Does it go further than the treaties?" It has to; otherwise it has no purpose. Its purpose is to supplement and go further than the existing treaties. The question is, "Does it infringe the existing treaties? Does it force an institution to do something that it is prohibited from doing under the treaties, or otherwise require them to act in breach of EU law?"

Setting aside that test, I think this is a voluntary agreement between member states and we should recognise that they should have a wide margin of discretion, subject to EU law and not breaching the treaties directly, to design the type of enforcement system they want to have imposed upon themselves. It is a voluntary thing. From that point of view, I don’t necessarily find it problematic that they want to offer the Commission a role in this enforcement system. If they had decided, as an earlier draft suggested, that the Commission should be capable of acting directly as a party to bring the proceedings before the Court, that might have been more problematic, because the relevant treaty provision, article 273, specifically says that it is the member states that should be parties.

Q81 Mr Clappison: I will come to that point in a moment. Taking it as given, as you correctly say, that there may not be active contradiction of treaties, what is your view on the point that it may be something new as far as the Commission is concerned, even though it does not necessarily contradict what happens elsewhere?

Professor Dougan: I think it is new in the sense that the Commission is being asked to produce a report and it would therefore fall within our previous discussion: can the member states ask the Commission, or delegate to the Commission, certain functions that are not already envisaged in the treaty? That is why I would use the same test. Is it incompatible with the treaties for the Commission to behave in this way? In other words, would it breach its duty of impartiality and independence? I think the answer must be, no, because the Commission is being asked to produce a report on all the relevant contracting parties about whether they have complied with an obligation that is clearly set out in this new treaty.

Q82 Mr Clappison: Do you think the role of the Commission in article 8 is provided for in existing treaties?

Professor Dougan: In article 8?

Q83 Mr Clappison: Yes, the role of the Commission in preparing the report on whether a state is in breach of its commitments on its budget and so forth.

Professor Dougan: It is analogous to what the Commission does on virtually a daily basis under EU law, which is constantly to monitor whether the member states are complying with their obligations under the EU treaties. Of course, this is not an obligation under the EU treaties; it is an obligation under this new treaty. So it is not an obligation that you could say the Commission has under EU law, but it is certainly analogous to the type of functions that the Commission carries out all the time under EU law.

Q84 Mr Clappison: Can I ask Martin Howe whether he has any views on that?

Martin Howe: I agree with that answer. The function envisaged for the Commission under article 8 of the treaty is not part of its functions under the EU treaty, but it is closely analogous to the types of function that it regularly performs. For example, when a directive is passed, the Commission will then monitor the national laws of each member state to check whether national law has been passed that will comply with its provisions. Obviously, it has been intentionally framed in such a way as to make it closely analogous to those procedures.

Q85 Mr Clappison: I do not have it at my fingertips, but I understand that article 126, paragraph 10, of the TFEU prohibits the Commission from bringing infringment proceedings in the context of excessive deficit rules at the moment.

Chair: This is the no bail-out provision.

Mr Clappison: Yes, that is what my briefing tells me. Do you think that article 8 is consistent with this? The Commission does not bring the infringement action itself to the European Court of Justice, but under article 8, if the Commission has produced a report, it is incumbent on one of the states to bring the infringement itself, acting as a sort of hit man for the Commission.

Martin Howe: There may be a bit of confusion here. I do not think that the task under article 8 is analogous to article 126 of the TFEU. That is the excessive deficit procedure. Paragraph 10 of article 126 excludes the jurisdiction of the European Court of Justice from application to the first part of the excessive deficit procedure, and it excludes its jurisdiction by reference to articles 258 and 259, so by reference to both Commission complaints and complaints by member states. That is a different point that perhaps requires separate discussion.

Q86 Mr Clappison: Looking at the generality of article 8, do you have any observations to make about the procedure of the Commission producing a report and then one of the states being obliged to take action as a result of it?

Martin Howe: They obviously realised that under this treaty, they could not authorise the Commission directly to take an action before the European Court under article 8, because there is simply no basis in the treaty to allow that, so they have to do something which at least arguably brings it into article 273 of the treaty. That door is open only to member states; hence, they have to frame it by way of saying that if the Commission says that one member state is in breach, they have to be able to co-opt another member state to initiate the action.

Q87 Mr Clappison: It looks, in a very basic way, like a bit of a device for getting around the problem of the Commission bringing a proceeding itself. Really, it is the Commission that is bringing a proceeding, because somebody else has been required to do that if the Commission produces its report.

Martin Howe: Indeed. It is a device to get around the lack of power for the Commission itself to bring the proceeding.

Professor Dougan: It is interesting to compare previous drafts with what we have ended up with. We can compare them in two respects. First of all, previous drafts envisaged that the enforcement proceedings in general under article 8 could be brought in respect of all the obligations contained in the treaty under title III. That would have raised problems with article 126, paragraph 10, because they would have been envisaging the possibility of infringement proceedings by the Commission, which are expressly excluded by the treaty, but the final version does not do that; it does limit it to the balanced budget rule. I agree entirely with Martin that it is a separate issue and that it is not problematic.

The other interesting thing is that the previous draft envisaged a direct enforcement role for the Commission. We can speculate that this is probably one point at which the UK’s position led to a tangible change in the text, because the UK insisted that the Commission’s role, if it had any at all, should be very limited. That is one area where the Commission’s role has been diluted compared with previous drafts.

In a broader sense, I come back to the idea that this is a voluntary agreement by the member states. If the member states devise a system with a margin of discretion to devise their own enforcement system, and they want to confer certain powers on the Commission in that and that is not incompatible with the treaties, it is not really objectionable. In a way, it has the same spirit as article 7. Both article 7 and article 8-the voting bloc rules and the article 8 role for the Commission-are seeking to give greater independent credibility to the obligations of the euro states; they are trying to make it less obviously a political bargaining chip between countries and give it greater credibility as an independent set of obligations that will be respected by Governments. They can both be seen in that light.

Q88 Chris Kelly: Given that the ECJ’s jurisdiction over this agreement derives from article 273 of the TFEU and that the UK is not a party to the agreement, what standing would the UK have to challenge it?

Martin Howe: I think the UK could in theory challenge the agreement. The thing about article 273 is that it is an article that explicitly provides that in some circumstances the services of the Court may be invoked by member states, on a private basis if you like. The question is how broad that power is and whether or not it covers this type of agreement. It would clearly cover a specific agreement relating to a specific dispute, as long as it is related to the subject matter of the EU treaties, but the real question is whether it is broad enough to cover a sort of standing arrangement that purports to confer a standing jurisdiction on the Court in future disputes.

I think there are strong theoretical arguments to say that article 273 is too narrow to do that but, realistically, I tend to think that if this were challenged in the Court of Justice, its past pattern of behaviour-in my written evidence, I used the word "avid"-to expand its jurisdiction rather points to the fact that it would come to a different result. In fact, on the first occasion when this process is invoked, the Court itself would need to consider, as a first step, whether or not a member state objected, the admissibility of the action; so the Court would, of its own motion, have to consider the compatibility of bringing the dispute in front of it under this treaty with article 273.

Professor Dougan: In a way, there are two separate issues, which I will deal with very briefly. The first issue is whether the UK would have standing to challenge this part of the new treaty as an article 273 agreement before the Court because it is believed to be unlawful. The answer is probably-clearly-yes: the UK has rights of standing before the ECJ. If the UK believes that other member states have acted in breach of their obligations under the EU treaties, it could bring an action under the existing treaties to challenge this part of the agreement, if it wished.

In a way, Martin’s answer related to one of the potential grounds for challenging this treaty, which is the idea that it is not a special agreement and is not envisaging a concrete dispute now between two member states, but is providing a system of dispute settlement and resolution for potential future disputes between member states.

Chair: I am sorry, someone has just popped out, so we are going to have to adjourn the proceedings for a few minutes. We will get him back in again, just hang on for a second. Perhaps it was a Michael Gove moment, I’m not sure.

We can now reconvene. Please continue, Professor Dougan.

Professor Dougan: Is it a special agreement? First, it is worth recalling the opinion of the Council Legal Service, which I think was circulated among the papers, certainly for us but for the Committee as well, I’m sure. It takes the view that the agreement has to be special in the sense of envisaging concrete disputes between the member states, but it also takes the view that if the set of disputes are in the future but they are defined with sufficient clarity and their scope and nature are identified in advance, the fact that the dispute is not already in existence now does not stop it being a special agreement for the purposes of the treaty. That is reinforced by past practice with member state international treaties that confer jurisdiction on the ECJ. The most famous example, I suppose, would be the convention on the recognition and enforcement of judgments in civil and commercial matters, which was an international treaty between the member states that gave jurisdiction to the ECJ. It gave rise to an enormous jurisprudence of hundreds and hundreds of cases, none of which existed, obviously, at the time of the treaty, but they were all envisaged by the treaty itself.

Chair: Perhaps we could now move on to the question of enhanced co-operation.

Q89 Michael Connarty: Thank you, Chairman. I have been holding fire for this one. Article 10 refers to the contracting parties and talks about enhanced co-operation being essential for the smooth functioning of the euro area. Does article 10 refer to enhanced co-operation within the eurozone or the eurozone plus, or by the eurozone or the eurozone plus? Which is it? What do you interpret that to mean?

Professor Dougan: I interpret that text to mean not very much, in fact. What they say in article 10 is that they are ready to make active use of two types of flexibility arrangements that are provided for under the treaties. There are the provisions which are specific to the eurozone states-that is article 136, which is the legal basis for a lot of the recent legislation on budgetary surveillance and excessive deficits. They then also refer very specifically to the enhanced co-operation system which is provided for under the treaties. What they are indicating is, I suppose, their political will to make greater use of that facility. Up till now, it has hardly ever been used-it has existed since the treaty of Amsterdam, but it has hardly ever been used. One of the questions that people like me have speculated a lot about is whether an event since Amsterdam would ever push the member states to break free of this real reluctance to make greater use of enhanced co-operation and see themselves as capable of forming ad hoc alliances to achieve certain policy objectives within the scope of EU law. Article 10 is a political indication that the contracting parties see themselves as politically able to do that. They have always been legally able to do it, but this is an indication of their political will to do it into the future.

Martin Howe: Just to make it clear, article 136 is on provisions which are specific to the euro-the member states that have adopted the euro. It envisages measures, first, to strengthen the co-ordination and surveillance of their budgetary discipline; and secondly, a much broader one, to set out economic policy guidelines for them-i.e. just for the euro states-while ensuring that they are compatible with those adopted for the whole of the Union and are kept under surveillance. There is the existing basis in the treaty for having specific economic policy guidelines that apply only to the euro member states, and I think this is effectively a cross-reference back-a reminder to them that they can make use of those and a reminder to them that they can use, when appropriate, enhanced co-operation procedures-but it does not alter the conditions in the treaty under which those can be invoked.

Q90 Michael Connarty: Are you referring to enhanced co-operation by the 17 eurozone member states, or less than the 17 member states? The contracting parties to this treaty is everyone apart from the UK and the Czech Republic, so it could be 17, less than 17, or 25.

Professor Dougan: There is a minimum requirement in the treaties for how many member states participate in enhanced co-operation-I think it is currently nine. The "contracting parties" here clearly refers to the 25 states which have signed this treaty, but one of the fundamental principles of enhanced co-operation is that it is both voluntary-so if a contracting party decided it did not want to participate in an enhanced co-operation initiative, article 10 of the new treaty would not oblige it to-and, equally, open to all member states. If the UK or the Czech Republic were to decide that they wanted to participate in an enhanced co-operation initiative, they would be perfectly entitled to do so and there is nothing to stop it either in this treaty or the EU treaties themselves.

Martin Howe: I think the specific question you raised is whether the reference to the "contracting parties" in article 10 means all the contracting parties to this treaty including the non-euro states, or just the euro states. The combination of articles 10 and 14(5) effectively means that it will actually be only the euro states, because article 14(5) says: "This treaty shall apply to the contracting parties with a derogation"-that is, the non-euro states-"or with an exemption as defined in protocol 16", that is Denmark with its opt-out, "which have ratified it, as from the day when the decision abrogating that derogation or exemption takes effect, unless the contracting party concerned declares its intention to be bound at an earlier date by all or any part of the provisions in titles III and IV of this treaty." The answer, I think, is that unless one or more of the non-euro contracting states make a declaration that they are to be bound by article 10, that article will not apply to them.

Professor Dougan: I do not disagree with Martin on the technical substance, but given that article 10 is merely an expression of political will-"We are happy to see the use of enhanced co-operation in EU treaties"-I do not think a contracting state needs to have opted in to article 10 in order to participate in an enhanced co-operation. The EU treaties give it a right to participate in enhanced co-operations completely independently of article 10.

Q91 Michael Connarty: I have one remark on the way it has been drafted, having been through the whole Lisbon treaty in detail. The word "will" is used-that was the subject of a great debate in relation to the Lisbon treaty-in the new amendment. Article 10 says that the contracting parties "will" make recourse; it does not say "may". I will take you on to a different question, but I think that use of the word "will" in article 10 should be borne in mind.

Professor Dougan: In the final version? The version I have says that the contracting parties "stand ready to make active use of".

Michael Connarty: No, "will make recourse"-that is in the 27 January version.

Professor Dougan: But in the final version of 31 January, they had changed the wording.

Michael Connarty: We have the 27 January version.

Martin Howe: I have the 31 January version and it says "stand ready". One would probably need to look at the other language versions as well.

Q92 Michael Connarty: That is very useful-we have not been given the right one. I thought the one in the pack was the latest one. The question is still relevant, however. Article 10, even if the wording is "stand ready", encourages contracting states to use enhanced co-operation to ensure the smooth functioning of the euro area, and then it says, "whenever appropriate and necessary", whereas the requirement treaty of the European Union is that it be used as a "last resort"-that is in article 20(2). We can say that this is a significant inconsistency, which might change the way enhanced co-operation is used from that which was agreed in the original treaties. That leads to the second question: is there a danger that enhanced co-operation will become a default bloc position for the eurozone, if they cannot reach agreement in the Council?

Professor Dougan: I do not think I would read too much into the wording of article 10 in that regard. This new treaty says repeatedly that it is without prejudice to EU law, it is subject to EU law and, when secondary measures are required, they will be carried out under the procedures provided for under EU law, so I do not think there is anything in article 10 that can even purport to change the requirements for enhanced co-operation under the EU treaties. When the EU treaties say that enhanced co-operation is permissible only when it has been established in the Council that it is a last resort-because, for example, they could not meet the voting requirements necessary to pass an initiative in the Council-that will remain in place, and I do not think anything in this new treaty could even pretend to alter that obligation.

Chair: That may be the case, but I-

Q93 Michael Connarty: Let me pursue it to the end, Bill. Martin, do you agree with that?

Martin Howe: I think it is right that this cannot alter the requirements of the treaty on enhanced co-operation. I think one would say of the reference that the words "appropriate and necessary" may be a cross-reference to that, because it is not necessary to use enhanced co-operation unless and until the ordinary legislative means have failed; but I would say that it probably reflects a shift in the political willingness to use it. In other words, they may be more willing to say, "We have actually reached the last resort and we now want to go down this road."

Q94 Michael Connarty: Are you saying that maybe we are over-suspicious, and some of our previous witnesses were over-suspicious when they suggested that states might wish to use enhanced co-operation in policy areas which would in fact be essential to the functioning of the euro area, as far as they were concerned-areas such as employment, bank regulation or even taxation? You think this is not just a Trojan horse inside the single market, used to push the eurozone’s interest by dealing with these very things? You think this is just a mild collection that will be used only when you cannot find agreement?

Professor Dougan: Not necessarily. One of the very interesting possibilities raised by this expression of political will in article 10 is that, so far, enhanced co-operation, if it has proposed or in the very rare cases where it has actually been authorised, has been for an ad hoc measure-just a single measure on a single issue where they could not reach agreement in the Council. One of the possibilities which was opened up by the Lisbon treaty, but which has not yet been made use of, is that enhanced co-operation could be authorised for an entire sector of activity. They could actually decide in advance that this group of member states, for the future, will enact additional measures across employment, banking or the environment. This could be an indication of political will, that that possibility becomes much more real in the future than it has been in the past. There is still the obligation, under the treaties, that enhanced co-operation cannot undermine the internal market, it cannot create a barrier to trade or discrimination between member states and it cannot distort competition between member states, but nobody quite knows what those concepts might mean in the context where a group of countries are trying to press ahead with closer co-operation across a sector of activity, because that would be a very different thing from what we are used to already.

Martin Howe: I agree with that answer. It seems to me that you could argue that, over and above the specific provisions in the treaty relating to the euro area, there might be arguments for more closely co-ordinating matters such as bank regulation, for example, within a single currency zone than the rules that are necessary across the European Union as a whole. That is the sort of argument that might be put forward to justify taking such measures.

Q95 Chair: Professor Dougan, there is something I would like you to clarify. Do you think that the UK can block enhanced co-operation on a taxation measure which had to be agreed by unanimity?

Professor Dougan: I think it would depend on the nature of the taxation measure. If it was a measure where you could envisage that it would create a barrier to trade between member states, or a distortion of competition between member states, then either the enhanced co-operation authorisation should not be given or, if it was given, a non-participating state could challenge it before the European Court of Justice as being ultra vires the treaties. The real challenge for all of us now that enhanced co-operation could become a more regular phenomenon is to try to understand what these concepts mean in the context of enhanced co-operation. You could of course say that any regulation of anything creates additional regulatory costs for the undertakings in that territory, and that inevitably distorts competition because it artificially changes the way in which the competitive conditions operate between member states, so I do not think that we can take an extreme idea that any regulation which happens to increase costs for some companies will not be allowed. Equally, there will obviously be situations where if a group of member states were trying to exclude foreign competitors from their bit of the internal market that they regulated, that would clearly be unlawful. The difficulty is trying to find where that line is in between those two extremes.

Q96 Chair: But this is all part of the problem before this inquiry today, which is the impact that the complexity, the blurring of lines, the overlap and the question of the rule of law will have on the decision makers within the framework of voting arrangements and, at the same time, the impact that these decisions will have on ordinary citizens in the European Union when they are made. The question whether or not they are right or wrong, or whether they are even understood, seems to be a matter of some concern. You and other witnesses, from what I have seen so far, have all drawn attention to the complexity question. It is not just a theoretical argument, I hope you agree; it is really a matter of how on earth all this will actually work out in practice, given the crisis in the eurozone, which some would say is the result of the existing treaties.

Martin Howe: I agree with that point about complexity. It is really like a Russian doll. If you look at it at the global level, there are a number of principles under the WTO agreements which are binding on the European Union and the member states in terms of discrimination both in goods and services against imports. You then have European Union-level principles of the treaty involving the single market principles and non-discrimination; those bind the margin of discretion of member states. You can then envisage another Russian doll inside that: the sub-group of member states which act within the margin of discretion of member states under the EU treaties, but co-ordinate themselves more closely together in particular sectors. How a voter who dislikes one of these decisions can express that view at the ballot box in a way that can be understood, I do not know.

Q97 Chair: There is also, is there not, a problem relating to the manner in which the markets interpret all these different factors at work, which in itself is an economic question? We will be coming on to the economists in a moment, but the real question is: are we not faced with a blizzard of slightly contradictory inconsistencies-as you say in your evidence, Professor Dougan-and the possibility of inconsistencies arising between the terms of the draft treaty and the current and future state of Union law itself? This is part of the question that we will have to resolve.

Jacob, would you like to ask the next question?

Q98 Jacob Rees-Mogg: Thank you, Chairman. I am sorry that I had to pop off to the Procedure Committee halfway through.

Looking at article 16, what legal or political obligations do you think that article places on the UK? Given that it directly affects the UK, should we have given consent to it?

Martin Howe: In my view, it imposes no legal obligations on the UK at all. What it imposes on, where it talks about necessary steps, is where the contracting parties are binding themselves together to seek to incorporate its provisions by amendment into the two EU treaties; but nothing in this weakens or removes the UK’s right to veto such a course being taken. That is the legal answer. At the political level, of course, it is sort of declaration of intent by the participants in this treaty that they are going to keep pushing at this door unless, or maybe they hope that at a point in the future, a Government in the UK come along who will allow them to open that door.

Q99 Chair: I take it you rather agreed with that in general, Professor Dougan.

Professor Dougan: With maybe one additional observation. I certainly agree that article 16, in a way, is a very good example of why so much of this treaty text is made up of a lot of nice ideas rather than very concrete things. It cannot change the requirement that unanimity among the member states and national ratification are required before anything in the EU treaties can be changed through the revision procedures.

For the UK, the interesting question is the interrelationship between a future article 16 initiative to try to incorporate this treaty into the EU treaties and the European Union Act. It is a question that Dr Gordon and I addressed at some length in our written evidence, so it is probably not necessary for me to say it now, but we think that there are interesting issues about the interrelationship between a future incorporation attempt for this new treaty and the way the UK would respond to it in terms of a referendum or parliamentary control. That is a much trickier question.

Q100 Chair: Could I bring this part of the inquiry to a conclusion by asking you what you think the United Kingdom achieved overall by exercising the veto? I ought to mention that I sense the Division bell is about to ring. In general, what do you think the UK achieved by exercising the veto?

Martin Howe: I think it makes it legally impossible for this treaty to amend or qualify the European Union treaties. This treaty has a subordinate status, because it will be entered into later than those anterior treaties to which all the members of this treaty are bound, so it cannot contradict or cut down them; whereas had it been incorporated or provisions similar to it had been incorporated-at least in theory-there would be a possibility that it could modify the application of other provisions of the treaty by implication.

Q101 Chair: Because it has been raised elsewhere, and just to get it on the record, you take a view that this not an EU treaty-we collectively agree about that, do we? This is not an EU treaty.

Martin Howe: In the context of the European Union Act?

Q102 Chair: No, all together. This is simply not an EU treaty, full stop. Is that agreed?

Martin Howe: Yes.

Q103 Chair: Professor Dougan, would you like to answer the question about what you think the UK achieved by a veto?

Professor Dougan: I will be slightly more critical than Martin. I am not convinced at all that the UK veto achieved anything positive for us. It is quite clear that the other member states have gone ahead and had pretty much the same fiscal compact that they were going to try to have as part of the EU treaties, and now they have pretty much the same deal and substance as a matter of international law. Conversely the governance of the single market and in particular the issues about regulation of the financial sector remain exactly the same as they were before the December European Council.

In terms of positive outcomes, I do not think there is really much to show for the veto. What worried me about the veto was that, first of all, it meant that the UK was not at the table in any real effective sense for the negotiations on this fiscal compact. It exercised an influence in a negative sense by saying, "We don’t want this. We don’t like it," as far as it could about the use of the institutions, but it wasn’t really a player in the negotiations. More worrying for us, but also for a lot of the member states, which look to the UK as being the natural leader of market integration, market liberalisation and of not having overtly protectionist policies or overly centralising policies, it puts them in a bit of a dilemma, because the UK has forfeited a little, I think, some of its natural leadership of that large group of member states, which would naturally look to the UK for those types of leads.

Q104 Chair: There is an expectation under article 16 that this treaty-to use the Deputy Prime Minister’s words-would be folded into the EU treaties. The legal adviser to the Council, in his evidence, which deals with the question of article 273, says that there are provisions for the folding in of the treaty within, at the most, five years. He then goes on to say quite baldly that when this happens-not if this happens-many of his arguments will seem then to have been realised. I am paraphrasing there. None the less, that seems to be quite an astonishing statement in terms of an opinion from somebody as eminent as the legal adviser to the Council. Do you not agree?

Professor Dougan: First, it is useful to clarify the position of article 16. There is no way that this treaty can be incorporated into EU law without the unanimous consent of all 27 member states. I read the legal opinion of the Council Legal Service as saying that the specific problems with the court’s jurisdiction over this treaty under article 273 of the TFEU would evaporate if and when-I know that he says it in less categorical terms-

Chair: He does not say if and when. He says when.

Professor Dougan: But I think that that is clearly the sense. He cannot suggest that this could happen without the unanimous consent of all 27 member states. By that time, we expect it to be 28.

Q105 Chair: This raises the real problem that we keep on coming up against, which is that there are these fuzzy lines, boundaries, uncertainties or questions of interpretation, and yet it is dealing with something that is critical to the whole future of the eurozone and the rest of the EU. It is the rule of law question in a broader sense. We will have to consider all that when we come to make a judgment. Thank you very much for coming. Did you want to say something else, Mr Howe?

Martin Howe: On that question of the legal advice from the Council, I just wanted to add that my own work that I brought to apply to this document was tortured.

Q106 Chair: Tortured?

Martin Howe: Tortured-to achieve the end result that political imperatives imposed. I did think that it was particularly remarkable, in that final paragraph, as to why the intention that was expressed by these particular states to incorporate the material into the EU treaties was at all relevant to the question of whether or not it complies with article 273 in the first place.

Chair: Thank you very much. We now have a Division, so we come to a natural break.

Examination of Witnesses

Witnesses: Wolfgang Münchau, President, Eurointelligence ASBL and Associate Editor of the Financial Times, Douglas McWilliams, Chief Executive, Centre for Economic and Business Research, and Roger Bootle, Capital Economics, gave evidence.

Q107 Chair: Thank you very much for coming. I will start the questioning. We have a number of questions and we have moved on to the economic front. Of course, feel free to comment on any of the legal questions that you feel need to be addressed, but we have had quite a lot of evidence from the lawyers, some of which you may have heard just now. Because there are three of you, we will ask the same questions, which you should answer as directly as possible. Then there will be some supplementaries. First, will the fiscal compact achieve its objective of helping to solve the immediate problems of the eurozone? I shall start with Roger Bootle and work down the line.

Roger Bootle: I don’t think it will contribute a great deal, no. I consider it to be essentially motherhood and apple pie. There are a number of different issues. One of course concerns the enforceability of the fiscal compact, and I see nothing in what I have read to make it credible. Of course, the stability and growth pact itself was broken by France and Germany, no less, who did not seem to be subject to massive sanctions-certainly not sanctions that could change what they were going to do. Someone described this as the stability and growth pact on steroids. I think that that is not an inaccurate description.

There is that problem but, more fundamentally, there is an issue about the nature of the problem that is facing the eurozone countries. The fiscal compact, of course, is drawn up on the presumption that it is a fiscal problem. In my view, the fiscal problem is one aspect of the various difficulties facing the eurozone, but it is not even the most important one. The most important is the lack of competitiveness in the periphery and the failure of the eurozone as a group to generate significant rates of economic growth.

Without solving those two problems, the objectives of the fiscal compact will be impossible to achieve. If there is going to be a very weak economic outlook in the eurozone, which looks to me to be very likely, and then countries of the eurozone in pursuit of their objectives lay down the fiscal compact-cut their fiscal deficits still more to meet their objectives-what will result is, quite simply, even weaker economic growth, with hardly any impact on the deficits.

Q108 Chair: That could not be clearer. Mr Münchau.

Wolfgang Münchau: I agree with Roger on the broad assessment. I am playing devil’s advocate, because I agree with Roger on the thing. Even Angela Merkel would not claim that the fiscal compact would solve the eurozone crisis. The idea behind it was that it would bring out a strong statement of intent of fiscal co-ordination in the future, and that this strong statement that "We are staying together; we are sticking together; we are working together" would impress the financial markets. The markets are momentarily impressed, but this is more to do with the European Central Bank’s liquidity policies than with the fiscal compact, which is generally not of particular relevance to market actors.

To answer your question, the fiscal compact itself cannot solve the crisis, simply because, even if it was good, it will not come into effect for many years, so it will not have that effect. The problem that we have in the eurozone-the fundamental problem in the political debate-is what you could call the fiscalisation of the crisis. Roger was mentioning this: everything is reduced to fiscal policy. We are having a crisis of imbalances. You can see this on charts. If you look at the current account deficits and if you look at the budget deficits of eurozone member states since the beginning of the euro, you see that budget deficits have not converged but, relative to the ’90s, they have converged, and that they are not as divergent as the current account deficits which have diverged incredibly. The difference between the two is, of course, the private sector.

The eurozone is first, second and third a private sector crisis. It is a fiscal crisis in Greece. Clearly, it is a private sector crisis in Spain, Portugal and Ireland. It is partly a fiscal crisis in Italy, but that’s not really new; it’s an old one. The difference is that, now, market interest rates have risen, which raises questions about Italy’s solvency. In this complex web, you have a banking system that is largely dysfunctional and undercapitalised, and heavily influenced by the Governments. It is a very complex situation that cannot be addressed by fiscal policy.

The pact-I am sure others have given evidence to this effect-will not create significantly new fiscal rules for the eurozone. The main fiscal rule is the 3% rule in the Maastricht Treaty. A much forgotten rule was in the Stability Pact. It says that countries should run a balanced budget over the cycle, or a surplus. Essentially, the new pact economically reinstates that rule. It makes it more specific: it says countries should have a structural deficit of no more than 0.5% of GDP over the cycle. The only addition it makes is that it establishes some mechanisms to ensure that you don’t reposition the cycle as you please. It is quite a sophisticated machinery. The Germans introduced that into their constitution a couple of years ago. The hope is that if everyone introduces the same rule, it will be better.

I don’t believe it’s a fiscal crisis, but even if you do believe it’s a fiscal crisis, I still don’t think the measure is going to work, because it has got the logic wrong. The Germans wanted a fiscal consolidation. That’s why they put it in the constitution. They are likely to get it because they wanted it in the first place. If, in other countries where there isn’t the same political consensus behind it, it is imposed by treaty from the outside, the chances of it really happening are significantly lower, especially as there are ways around it. Even in Germany, there are ways around it. The Parliament has always reserved rights to declare a state of emergency, so there is a degree of leeway for national Parliaments to circumvent the rule. It’s not a key that you throw away.

My assessment is that it’s not necessary. It’s based on the wrong diagnosis of the crisis. It won’t solve the crisis. It might, for a short period, bring about some confidence among investors, but we have seen that investor sentiment is very fragile and volatile. It will not lead to greater fiscal discipline, either.

Q109 Chair: Thank you. Professor McWilliams.

Douglas McWilliams: First, I agree with everything said by both the previous speakers. Let me put this into a bit of context. The world is going through the biggest ever economic transformation. The last big one was the industrial revolution. The industrialisation of Asia and various other parts of the world is affecting 69% of the world’s population, as opposed to the industrial revolution, which affected only 8%. They are reaching roughly the stage that we did in 150 years, in 50 years. Because of the scale of that challenge, a lot of the other things that are having to be dealt with, things that might work in ordinary circumstances, don’t work in these circumstances.

The competitive problem within Europe is exacerbated by the fact that, first, the West in general is suffering a competitive problem against the East. Secondly, the impact of eastern industrialisation is differential within Europe. Germany, for example, produces things that the Chinese want to buy and that they don’t make themselves because they’re not yet at that level of industrial sophistication. Greece was never much in the exporting world anyway, unless you included things like exporting shipping services or souvlaki. The Portuguese had a thriving business selling textiles, which has been largely wiped out by Chinese competition. So the effects are differential.

You have three different problems. The West is uncompetitive against the East. On top of that is the differential competitiveness. Italy has lost 40% of its export market since it went into the euro, whereas Germany has gained 10% relative to its export markets. There is the problem that eastern industrialisation affects the European nations differentially. Not having the currency flexibility to cope with that enhances the scale of the difficulties that the different countries have, and basically has massively exacerbated the North versus South problem within Europe, essentially because southern Europe industrialised fairly late and so was very much in the industries that the Chinese got into first, whereas northern Europe industrialised a lot earlier and so still has some legacy advantages-in the case of countries such as Britain, brands and things like that; in the case of a country such as Germany, products that the Chinese still do not feel that they can make.

Q110 Chris Heaton-Harris: I was wondering, based on your remarks, whether what we have just gone through, the fiscal compact agreement and this treaty, is just no more than EU diplomatic bling-looks good, but actually has no value. Has this just been a waste of time?

Roger Bootle: Yes. To anyone trained in economics, with an eye to market fundamentals and market reactions, it is as though the people who put together this compact, and indeed EU treaties in general, simply live on another planet. They seem to think that economic progress is decided by committees in Brussels or Frankfurt. They seem to think that markets will be impressed by expressions of will. Neither of those two conditions, I’m afraid, is met in the world. The markets are very hard-nosed and, quite frankly, they see through this stuff and see it for what it is.

Wolfgang Münchau: It would have been different if this had been part of a process towards a fiscal union, which was debated ahead of the last summit-whether it should be a multi-stage process and you start off with a set of fiscal rules, and that leads to an eventual adoption of a single bond. But it was clear that that was rejected by Germany. It is not rejected in principle; it is rejected as unsuitable as a crisis resolution mechanism and unsuited to the current debate. Should the eurozone ever develop into a proper political union, it would still be possible, but they certainly do not want the combination of a eurobond and no sovereign power transfer, so that every country is allowed to issue its own eurobond. That was a situation that was to be avoided, so they focused only on the fiscal discipline side. The result was-especially now that this is a separate treaty and not a series of treaty amendments-that they struggled very hard to produce something that was very different from what they had.

Also, if you are thinking of what they had, I think the legal interpretation is probably not really telling you the story of what happened with the stability pact. The stability pact had provisions for sanctions. It was not that these sanctions were difficult. Even if you had reversed the majority rule back in 2003 when Germany and France usurped the process and broke the rules, and even if you had to reverse the QMV thresholds, they would still have been able to break the rules, so it is not so simple that raising the threshold would protect you against rule-breaking by very large countries. These are always rules for very small countries.

I have no doubt that if Germany and France decide that they need to expand their budget policies, because they have different Governments in power, which is not a completely unrealistic prospect, certainly in the next five or 10 years, we could see a very different fiscal policy emerging. At best this treaty has no economic implication. At worst it leads us into more pro-cyclicality in the sense that maybe these automatic things do work, contrary to what I expect, but maybe they really believe in this and now basically just have an automatic rule-based fiscal policy.

Ask yourselves about Spain. The Spanish private sector came out of this crisis with massive debts and an incredible housing bubble-much worse than anything you have seen in your country. Spanish house prices have adjusted, but not quite as much as they need to. Spanish debts have not adjusted. The Spanish private sector has to deleverage in a serious way. The Americans have done it, or they have gone through most of it. The Spanish have not even started. I do not see how the Spanish private sector can deleverage-reduce its debt-and the Spanish state also reduce the debt at the same time, without having an exchange rate and an interest rate that is a recipe for depression. So that is the worst outcome of this pact. Over the long term, it might give rise to a disastrous policy mix applied from the centre.

Douglas McWilliams: Can I give a slightly different answer? I do not think that I completely agree with either of the gentlemen on my right. If you read the treaty as written down, I would agree with them completely. It is not a treaty that makes any difference, but that does not fully take into account the way that such things are perceived. The first is that the treaty is seen as a step in the direction of fiscal co-operation. It is clearly a very small step, but it opens up the possibility of further co-operation, so it is seen as movement in a direction. The second, which is rather more important, is that it has acted as a fig leaf that has enabled the ECB to pump a lot of money into the banking system in Europe, which has actually rather transformed the state of the world economy on a temporary basis.

In the second half of last year, the United States suddenly got flush with funds on the basis of, first of all, QE, but, secondly, the unexpected thing was that, when US banks withdrew their money from Europe, they suddenly had a lot of extra money that they did not quite know what to do with. That created the most relaxed credit conditions in the United States since before 2007, and that has been a very important factor in the recovery of the US economy over the last few months.

At the same time, Europe has pumped in money. We have had, in effect, QE in Europe under the fig leaf of bailing out banks, which has been done against the background of this treaty, and it has temporarily stabilised the economic position and temporarily stabilised the position in the markets. All the confidence indicators are looking up, but for how long that can happen and what the limits are to the process are a bit unclear. In the short term, however, there has actually been a market reaction, and we all said, "Oh. The markets will react badly." They did not, and then we said, "It’s just before Christmas. When they wake up from their new year hangovers, they will react badly." Well, they have not. We just need to accept the fact that some of our initial analysis has been slightly disproved by the fact that the pumping in of money has operated in the opposite direction, and we have to be prepared to admit that we got it wrong.

Chair: That brings us quite neatly to the next question, which is related to the European Central Bank.

Q111 Henry Smith: Yes. It is argued that were the European Central Bank able to operate like a sovereign central bank, that would be a way of helping to resolve the eurozone crisis. Do you think that the fiscal compact will help the ECB act more like a national central bank or not? Do you have any comments on that?

Chair: Can we ask Mr Bootle first, and then work backwards to Professor McWilliams?

Roger Bootle: I think there are several barriers to the embracing of quantitative easing pure and simple, which is something that a sovereign bank can do and has done in the case of the United States and the United Kingdom. Some of them are ideological and political with regard to what will wash in Germany and what will not wash in Germany. Douglas McWilliams may well be right in suggesting that this pact has acted as a fig leaf, in which case it has had some sort of value, but it would be rather odd to attribute the effect to the fig leaf, rather than to the fundamental thing that it is somehow disguising, which is a change of policy by the ECB.

It is quite wrong to imagine that quantitative easing pure and simple, in what we have seen so far, has not been the straightforward version of quantitative easing. It has been really rather different. It has been the relief of a liquidity crisis faced by banks. It would be quite wrong to imagine that quantitative easing in and of itself can relieve the European problem. In the United States and the UK, there is obviously a debate going on, but it does not seem as though it is exactly the answer to a maiden’s prayer and for very good reasons. It did not appear to do an awful lot of good in Japan, and I do not believe that it would do an enormous amount of good in the eurozone. It could of course relieve pressure on the bond markets, but there would be an interesting question as to how the ECB would operate it. Would it buy different countries’ bonds in some rigid proportion according to GDP ratios or something, or would it buy those bonds that had recently fallen and that the market did not apparently want?

Underlying all this, there is a question of the risk facing the ECB if one of the member countries were to default and/or leave the eurozone, which is not something that applies to either the US Federal Reserve or the Bank of England. The notion that the ECB could and should, without limit, buy the bonds of a country in a very difficult fiscal position, such as Greece, is pretty extraordinary. In the process, if it were to go on in that way, it would potentially loosen the pressures on that particular country to tackle its fundamental fiscal problems, which is one of the reasons why so much opinion in Germany is against the notion of quantitative easing.

Q112 Henry Smith: Do you think that the fiscal compact would make things more flexible for the ECB?

Roger Bootle: I don’t think so-not in substance. I largely agree with what Douglas McWilliams said about it at least providing some sort of fig leaf, and in that there may be some value.

Wolfgang Münchau: Let me answer that question directly. Given that the narrative of the crisis in continental Europe, especially in Germany, the Netherlands and the northern countries, is that the crisis was caused by fiscal indiscipline and that the ECB is hamstrung because of opposition, especially by the German central bank, to quantitative easing and the extension of liquidity policies, the fig leaf, as Roger was saying, of a fiscal compact that seems to address the deep-rooted cause of fiscal indiscipline in Europe would calm down German public opinion and give the ECB an excuse to run those policies. In that sense, there is a chain, and one should be careful of justifying something based on a mistaken narrative, but in the short-run it had that effect.

The effect of the liquidity policies has been significant in the short-run, which was underestimated. The eurozone was about to have a credit crunch in the last quarter, and there was evidence of credit crunches in various parts of the eurozone. The banking system completely seized up and the Government bond market was on course for major shocks.

The massive injections of liquidity have addressed those three problems-they have not solved those problems, but they have addressed them-and buy more time. When I say that they buy time, they buy time to do what? To have a fiscal compact that is not solving the crisis? We are getting into a circular argument. If you believe, as we do but they don’t, that the crisis is rooted in internal imbalances that have built up and are now reflected in payment and system imbalances, which produce all sorts of bad incentives and instability that is likely to get worse over the next years, the fiscal compact and the ECB’s policies are obviously not going to help because an undercapitalised bank will be as undercapitalised in a year’s time as it is today. They will be in the same weak position and no one would want to lend to them when this programme expires, as it eventually will.

Q113 Chair: Professor McWilliams, would you like to make a brief comment?

Douglas McWilliams: Yes. I largely agree with what my two colleagues have just said. I think we have bought some time, but probably not very much time, for two different reasons. First, it is addressing one aspect of a multi-faceted crisis and the other aspects are not being touched. Secondly, the ECB is pretty close to the limits. I do not see any plausible way in which they could differentially buy the distressed bonds of the Governments in trouble, and if they did, I would argue that, during the present rather tense negotiations, they would probably do more damage than good anyway, because they would relieve a lot of the pressure for trying to sort out the problems internally. So the net effect would probably be fairly minor.

We could easily see this policy, which has had temporary success, coming to an end within the next few weeks if the Greeks fail to reach an agreement, because I suspect that would probably mean: first, default; secondly, that they could not easily stay within the single currency in the circumstances; and, thirdly, a domino effect on other countries if Greece finds itself unable to pay its debts and to sustain its currency. So I would expect to see quite a rapid crisis emerging if that happens, and I do not see that as at all impossible. I think there is quite a decent chance that that might happen.

Chair: Jacob, would you like to ask the next question? I think you had something that you wanted to say before you started.

Q114 Jacob Rees-Mogg: Oh, yes, thank you for reminding me of that. I have an interest to declare, in that Mr Bootle’s company Capital Economics provides an excellent service to my company Somerset Capital Management. With that interest and a brief advert on the record, I will move on to the questions of the reality of the limits that have been set and the judgment of a structural deficit. Can Governments and commentators judge a structural deficit effectively or are they essentially just guessing?

Roger Bootle: They are guessing, but hopefully they are guessing in an educated way. You only have to look back a few years in this country to see how easy it is to get a completely erroneous picture of the structural position, because to judge what is structural and what is not structural you have to take a view on the fundamental: both the cyclical position of the economy at that time and its prospective growth rate. Those things, of course, are not set in stone. You cannot establish them through incontrovertible scientific method. They have to be an act of judgment and, because they have to be an act of judgment, there is then a question not only about how you technically make that judgment, but on how you ensure that the judgment that is made is somehow or other insulated from political pressures, because we know from what happened in this country that there were definite political reasons why the technical judgments were made in the way that they were.

Q115 Jacob Rees-Mogg: But the treaty is aiming to enforce sanctions as a matter of rules on something that is essentially a matter of judgment. How do you square that circle?

Roger Bootle: I don’t. It is going to be extremely difficult. It is one of the reasons why I think that it is difficult to believe that the sanctions will be imposed. There could be quite legitimate reasons for questioning whether the deficit in question was structural or not. In those circumstances, perhaps under a condition where there had been a political change in one of the countries and there were serious domestic political difficulties, I find the notion that one of these countries will end up paying a large fine incredible.

Q116 Chair: Do either of the other gentlemen want to comment on that?

Wolfgang Münchau: Yes, I will just explain the mechanism of how they want to make the structural deficit stick. The Germans have started this and they use an account. Say it is year one of a cycle. It is all judgment. Year one you have to judge, "Am I up or down in the cycle?" I have 0.5%, so I say, "Okay, I am down in the cycle, so I am going to go down 1.5% on my deficit, so I am 1.1% below your structural average." That is booked in a separate account, which tells you that you have drawn down. It is like an overdraft. As you go along through the years, that account should balance, if your judgment is correct. If your judgment is incorrect, i.e. if you always think that you are at the bottom of the cycle in every year of the cycle, that account is obviously permanently in deficit-overdrawn-and it is clear for the public to see that your judgments have been wrong. The idea is to produce a transparent corrective that tells you whether the model on which you base your judgment is realistic or whether you are permanently fiddling the figures to make the cycle fit your policies, rather than your policies fit the cycle.

I have no idea how applying sanctions on procedures like that would work. They have never had sanctions. These are politicians who depend on each other for votes for which they require unanimity. You are not going to sanction somebody whom you need for something else. That is so unrealistic. That is why the Germans wanted to get this process completely out of the political process and have judges deciding on sanctions. Then again, you raise some other fundamental issues through that. Should the judiciary decide on an issue of fiscal policy, which is so fundamentally a matter of parliamentary privilege and not legislative privilege? You are getting into a real issue. I would be very surprised if sanctions were ever applied to a country larger than, say, Cyprus.

Douglas McWilliams: You might like to ask your colleagues from the Home Affairs Committee about the efficacy of fines on people who do not have the ability to pay. I suspect that you will probably get some very relevant information that will give you very much the same impression as we have given as economists.

Can I put a separate point about structural versus cyclical? The whole concept relates to a world of rough equilibrium, where things happen in a fairly incremental way and we know roughly what is going on. If something goes down, we know it is going to go up and so on. It is a sort of inverse law of economic gravity, where what goes down must come up. That is fine in ordinary circumstances. What we are going through at the moment could mean a period of disequilibrium for 25, even 50 years-that kind of scale. We are going through something that is very, very different.

In those circumstances, I do not believe that it is actually possible to try to understand what is cyclical and what is structural. I do not think that that distinction is possible. All you have to do is try to predict where you are going to be in five or 10 years’ time and so on, and make judgments on that basis. I therefore think that what previously might have been assumed to be a cyclical deficit actually becomes, in effect, a structural deficit.

In practical terms, that distinction no longer seems to be as relevant for an advanced western economy in these present circumstances, when we are going through something that is quite extraordinary. That is why I do not think this type of analysis is very helpful. I believe it is the reason for the Treasury’s failure at economic forecasting; I believe it is the reason for the OBR’s failure at economic forecasting. This attempt to try to make this false distinction between cyclical and structural that implies some kind of mean reversal-I just do not think that it washes in this modern world. Getting back to the mean would mean such a huge devaluation and would create so much inflation that, in practical terms, it is not going to happen, so they will not go back there.

Q117 Chair: If the fundamental problem for the eurozone is that it contains both surplus economies that are growing or that have prospects of doing so and deficit economies that are stalling or that are getting worse, how does the fiscal compact help in that respect-at all?

Douglas McWilliams: It doesn’t help, except to the extent that ultimately deficit countries will not find that someone else will be prepared to pay their debts. The normal rules of everyday life mean that you cannot keep for ever borrowing. You have to stop borrowing at some point; people stop lending to you at some point. The deficit countries that expect people will continue to finance their debts are just overoptimistic. The real world will come in on them in one way or the other, and it will be incredibly painful when it happens.

Q118 Chair: To cut to the chase as it were-I would like all three of you to answer this question in turn-do you, in fact, think that the eurozone is unsustainable in its present form?

Roger Bootle: Yes. There is a question about what form of break-up there will be, but I personally think that it is more likely there will be a break-up than that the current membership will be sustained. When you ask whether it is unsustainable, there is some way in which it could be sustained: a progress to full fiscal union. That would have to be essentially underwritten by a full political union. I would judge that to be pretty unlikely in current circumstances. Without that, I do not see how the current set-up can survive.

Q119 Chair: You know, for example-it is clear from statements already made-that the United Kingdom would not concede the possibility of a political union of the kind envisaged in what you have said. So that would be a unanimity issue for a start in any treaty change. Political union of that kind is off the agenda. Mr Münchau, on that basis what would you say about the sustainability of the eurozone in its present form?

Wolfgang Münchau: In its present form, the sustainability conditions are not given. A eurozone would have been sustainable among countries with very similar characteristics to Germany, like the Netherlands, Austria and Finland. Even with imperfections in the banking systems, it could have been made to work. Those countries have a history of very long exchange rate stabilities with Germany, and their labour markets function in a very similar form. There is already evidence that although France and Germany have stuck together for a very long time, they are diverging now, with France running increasing current account deficits inside the eurozone and against Germany in particular. The central axis is cracking. I am worried about Spain, whether Spain could maintain its membership. So, no, under present circumstances it is not possible. To make it sustainable you need a degree of centralised policy making that would address, in the first instance, the financial sector. That may already be sufficient, but it is certainly necessary.

One of the reasons we have fiscal crises in countries like Spain is because the Spanish Government is ultimately responsible for the liabilities of its banking sector. The banking sector is not a European sector or a eurozone-based sector, but a national sector. You may not need a political union, a single state or anything of that nature. It may be sufficient to Europeanise the banking sector of the eurozone states-it is not necessary for the non-eurozone states-to have a common deposit insurance system, a common supervisory system and, in particular, a common bank resolution system whereby a central authority could close down banks, merge banks, impose regulation. That may help stabilise the system. But without that it cannot be done.

I also believe that a eurobond of some kind is necessary in the long run. It will not solve the crisis. I agree with Angela Merkel on that but it is necessary in the long run because we have seen what Charles Goodhart calls these sub-sovereign bond markets. We see countries being able to issue bonds but there is no central bank that backs them, no lender of last resort respective to their own sphere. That is ultimately not sustainable in the long run. The eurobond is necessary too, but in the first instance I would say that the Europeanisation of the banking sector is absolutely necessary. A eurobond is possibly necessary, and common labour market rules to facilitate adjustment to make sure that labour markets respond in a very similar way may be necessary. If you are asking me whether this is realistic, I do not think that it is realistic now. I don’t know how future generations would answer the question: do we give up the euro or do this? But it is certainly a choice for people to make.

Q120 Chair: Do any of you have any further comments on that question?

Douglas McWilliams: I genuinely do not think that the euro can survive in its current form. How long it takes to break up is one of the things that is uncertain. Economists are much better at giving you a prediction than giving you a time, I’m afraid. I have gone on record as saying that I give it only a one in 100 chance of surviving the next 10 years.

Q121 Chair: Are there any of those you come across-you obviously meet a lot of economists from different quarters-who would simply disregard what you are saying and say that you are just wrong?

Douglas McWilliams: None to whose views I would give much credence.

Q122 Chair: That could be regarded as special pleading. On the other hand-

Chris Heaton-Harris: Talk about the others.

Douglas McWilliams: There are plenty. There are a lot of academics for a start and various other people who don’t run businesses that actually survive in the real world. Academics have all sorts of points of view. Some of them are sensible and some of them are not. So you have that kind of group.

Can I just go back to the issue of fiscal union? There is a lot of rather loose talk about fiscal union. Actually people looked very much at the details. When I went into economics I was effectively apprenticed to man called Sir Donald MacDougall who had been the Government’s chief economic adviser under both the Labour Government and the Conservative Government before he stepped up to become the CBI’s chief economic adviser. I was fortunate enough to be his successor as the CBI’s chief economic adviser. He wrote the MacDougall report on European fiscal integration. It is a very complicated report but very worthwhile reading.

Chair: It was quite a long time ago. I think I remember reading it.

Douglas McWilliams: It was written in April 1977. I have a copy of it here. It is available on the internet. What he says there is that you really cannot have any serious fiscal integration without a minimum EU spending of about 10% of GDP, and probably you are thinking more about 20% to 25% of GDP EU competence if you want to have a fiscal union. He goes into a lot of detail about what is done in other federal unions, and so on, and comes to that conclusion. That gives an indication of the scale of the fiscal transfers that might be likely. I did a quick exercise last night just to look at the scale of the fiscal transfers within the UK, and it is quite interesting. London is a region that provides fiscal transfers, and £1 in £5 earned in London is used to subsidise other regions in the UK. In Northern Ireland, nearly £1 in £3 is received as a subsidy. In Wales, £1 in £4 is received as a subsidy, and in the north-east, about £1 in £5. That is the scale of the fiscal transfers that you tend to get in a fiscally integrated market. The idea that you could get political support for fiscal transfers between nation states on that scale-you are politicians and you will understand the prospects much better than I do, but they do not look to me to be very great.

Q123 Chair: Roger Bootle, what’s your assessment?

Roger Bootle: You asked if other people take a different view. I honestly think there are plenty, and plenty who would pass all the usual tests of respectability and competence. In particular, I do not think we should underestimate the divergence of views between London, if I may put it that way, and the continent. I speak a lot on the continent, in Frankfurt, Brussels, Paris and other centres, and I never cease to be amazed at the difference in the attitudes of people, many extremely well-qualified, to this question.

The alternative view to the ones that have been expressed pretty much by all three of us together would be along the lines that somehow or other, the euro will muddle through, through a combination of some of the things we have talked about; that is to say, eventually the ECB does QE, some form of eurobond is agreed, and there are bail-outs here and strengthening the banks there. There are two fundamental ideas underlying all that. First, politically and for the future of Europe, it is just unthinkable to give up the euro and secondly, some people believe that the direct economic costs of giving up the euro are enormous. There is the disaster view; the idea that if we lose the euro, we get some mega-disaster.

The balance of views has undoubtedly been changing. About two or three years ago, when I expressed the views that I still hold-I have not changed one jot-I was lucky to escape with my life in Paris. I was grateful that they had done away with the guillotine. There was no embrace whatsoever of the power of the economic thinking that all three of us have been talking about today-none whatsoever. I think there is still a very big divide between the way that people on the continent think about things and the way they are thought about in London.

Wolfgang Münchau: That is absolutely correct.

Chair: Chris, would you like to ask the last question?

Q124 Chris Heaton-Harris: I will put it in two parts, if I may. The question I have been asked to ask is one I think you have partially answered, certainly in articles that Mr Münchau has written: if there were a breakdown, either disorderly or orderly, of the eurozone, what consequences would you see for the UK, the EU, and the wider world economy? I would like to ask a question attached to that: is the fact that we are stringing out the slow death of the Greek economy for so long actually the factor that is killing-or chilling-the markets that we have now? Would it not be better if Greece were just allowed to go at this point so that there is a definite bottom to the crisis and we could recover from it?

Roger Bootle: Obviously there is room for lots of different views on what the consequences would be, but the main point I want to make is that I think we are living through one of these periodic major misjudgments by the political and economic establishment about the significant economic issue of the day; that is to say the widespread, accepted view is that if the euro breaks up, it is a mega-disaster. I think that is fundamentally wrong. The euro is part of the problem, not the solution.

I find it very odd that, in particular in America, when people in the policy establishment think about the global situation, so many of them-I think correctly-identify the imbalances between East and West as being a significant problem; that is to say China, with an undervalued currency and a tendency to underspend, accumulating significant current account surpluses. They identify that as being a big problem and say it would be better for the world as a whole if China let her currency rise and expanded domestic demand. I agree. What they do not seem to perceive so often is that we in Europe have exactly the same problem, between Germany and the northern core on the one hand-I agree with Wolfgang, so many other countries are similar to Germany and are compatible with it-and the rest of the eurozone on the other.

Before the euro existed, many of the tendencies that we have talked about were already there-that is to say, the tendency towards competitiveness improvements in Germany and a very strong presence in manufacturing and exporting or, by contrast, the lax control of both costs and financial balances in southern Europe. These have not suddenly emerged overnight, when the euro was formed; they were there all along. What was different was that the market had a way of adjusting to them, and that way was to send the Deutschmark higher and the Spanish peseta and the Italian lira lower, which then enabled these two very different groups of countries to co-exist in a state of reasonable prosperity. Of course with the German export surplus being continually attenuated by the rising currency, there would then be pressure on Germany to do something about the state of domestic demand.

So my fundamental answer to your question is completely at odds with the consensus. What would be the consequence of the break-up of the euro? I can answer with a single word: prosperity.

Wolfgang Münchau: I am not quite as optimistic as that. It would also depend on how the euro breaks up. There are different scenarios: you could start with a peripheral break-up, with just Greece leaving; you could have a slightly contagious break-up, with Greece, Portugal and maybe Spain leaving; you can have a much more contagious or third category, with Italy and perhaps France leaving as well; and then a category where the whole thing ends and everyone stops. I think it would be difficult to maintain the single market in such an environment, because countries will protect themselves or have an incentive to do so-they would obviously still be legally bound by it, but their political processes might enable them to withdraw from it or to leave the EU. So there is a risk that certain market integration processes might take a step back, and there is a risk-or an opportunity, as you might see it-of the EU breaking up too.

Then there is a cost if you split up a currency. Take the example of Germany, which has built up a surplus of about half a trillion euros in its target 2 payments balance, which is a kind of shadow of its current account surplus. That surplus is a claim that it has against the ECB. If that thing were to implode, half a trillion of German claims would not be met-that is about 20% of German GDP-so that is like a debt. We have to consider this carefully, because it is not as if we would all be going happily back to our currencies and trading with one another and prospering thereafter. There are break-up costs that one has to assess very carefully, and my sense is that those are not trivial.

On Greece, we are in year five of a recession. A new package is being negotiated right now-I am not sure whether an agreement has been reached, because I have not seen any news for the past hour or so. If it is agreed, it will prolong and deepen the recession, so we are looking at year six and year seven of that recession; there is no bottom-building. Government spending and the private sector are in freefall; there is no bottom-building. The strategy in place is based on forecasts that were made for normal times, but they do not incorporate the toxic interaction of austerity and growth, which is fairly extreme-not just a problem in Greece, I understand. However, Greece is not going to get out of this. This is a very long depression, much worse than the great depression that we had, which ended after a few years. This could well take 10 years.

So a kind of violent end is very likely. The question is whether Greece is going to default in the eurozone or outside it. We have to consider the structure of the Greek labour market, and its trade unions. If Greece were to leave the eurozone it would have a comparative advantage-it would increase competitiveness-but Greece does not have that many export industries to benefit from that. There are some manufacturing companies and there is tourism, of course, which would benefit from it. But in Greece the labour unions would negotiate that advantage away very quickly. You would want to reform your labour market before that happens, because it would probably take two years for them to have eradicated that competitive gain. If you gain a 50% comparative competitive advantage, you will have a 50% wage increase within two years, and that will then eradicate all the benefits.

The question is, I cannot see Greece wanting to leave the euro. The question is whether Greece might have no choice but to leave the euro, because its banking system would not get access to ECB funds if all Greek bonds were in default. That is the question. It simply needs to have its own currency in order to have a banking system-that is the answer. If the eurozone would help it in some way, it could stay inside, and it would be better for it to stay inside. The best thing would be, obviously, for it to reform and leave and devalue and benefit from the devaluation, but I cannot see it benefiting from the devaluation as more advanced economies would.

Douglas McWilliams: I think the outlook for Greece is that it leaves, fails to reform initially, then devalues again, and then the second time around probably gets round to reform. That is a long drawn out process. If it can get through it in 10 years, I would say that is a pretty optimistic outlook. It seems to me more like 20 to 25 years of depression that they are in for.

We are dealing with the consequences of one the world’s greatest ever economic misjudgments. It makes Churchill’s return to the gold standard look really quite clever by comparison. This is a serious, grade one miscalculation. Whatever happens is going to be immensely painful. It seems to me that there are two possible outcomes. One is an early break-up, which will certainly be very painful when it happens. How long it will be painful for, I do not know. For example, I could easily imagine a loss of 50% of GDP for the first week afterwards-something as big as that-for the eurozone itself, but I would have expected that markets would come into operation and that follow-up arrangements would be made to try and mitigate the damage.

The alternative, I suspect, is a period of prolonged austerity and then it breaks up. So in a sense I do not think you actually gain that much by delaying. All you get is a longer period of delay, and possibly avoiding making some of the reforms that you need to make. Keeping the eurozone together compared with breaking it up seems to me to be a slightly false choice, because I think it will break up one way or another, eventually. So you will probably get two lots of costs. At least if you take the pain early, you have the prospect of trying to reform and trying to organise things for the future.

Chair: Well, gentlemen, unless there are any further questions from the Committee I will say thank you for your evidence and we will have it out, hopefully, in 48 hours. Then we shall be seeing the Minister. At this juncture, as some people may know, we were hoping and requesting William Hague to come. Unfortunately, at this stage we have not yet been able to get him to come, which is a matter of concern to the Committee, but we will continue to have Mr Lidington. We feel that on a matter of this importance, the Secretary of State himself should come to give evidence to this Committee. We just want to get that on the record, as he was requested to let us know by 5 o’clock and we have not heard that he is coming. So that is the position as it stands.

Thank you very much indeed for your evidence and we will be reporting in due course. Thank you.

Prepared 10th February 2012