SELECT COMMITTEE ON THE EU FINANCIAL AFFAIRS SUB-COMMITTEE

Completing ’s Economic and Monetary Union

Oral and written evidence

Contents Andrew Bailey and Sir Jon Cunliffe—Oral evidence (QQ186-194) ...... 1 Sebastian Barnes, Henning Christophersen, Janet Henry and Martin Sandbu—Oral evidence (QQ27- 44) ...... 16 BBA—Written evidence (EMU0008) ...... 40 Graham Bishop, Dr Dermot Hodson and Philippe Legrain—Oral evidence (QQ1-14) ...... 45 Jonathan Black and David Gauke MP—Oral evidence (QQ195-204) ...... 66 Baroness Bowles of Berkhamsted and Raoul Ruparel—Oral evidence (QQ15-26)...... 82 Bruegel—Written evidence (EMU0005) ...... 102 Henning Christophersen, Sebastian Barnes, Janet Henry and Martin Sandbu—Oral evidence (QQ27- 44) ...... 107 Professor Lorenzo Codogno and Reza Moghadam—Oral evidence (QQ56–67) ...... 108 Sir Jon Cunliffe and Andrew Bailey—Oral evidence (QQ186-194) ...... 124 Dr. Marek Dabrowski—Written evidence (EMU0010) ...... 125 Professor Paul De Grauwe and Alex White—Oral evidence (QQ179-185) ...... 133 MEP Anneliese Dodds—Written evidence (EMU0006)...... 144 Commissioner Valdis Dombrovskis—Oral evidence (QQ158-166) ...... 148 European Economics Financial Centre—Written evidence (EMU0009) ...... 161 Markus Ferber MEP and Kay Swinburne MEP—Oral evidence (QQ82-91) ...... 164 David Gauke MP and Jonathan Black—Oral evidence (QQ195-204) ...... 180 Sylvie Goulard MEP and Gunnar Hökmark MEP—Oral evidence (QQ92-100) ...... 181 Sylvie Goulard MEP—Supplementary written evidence (EMU0011) ...... 194 Megan Greene, Professor Erik Jones and John Peet—Oral evidence (QQ68-81) ...... 195 Roberto Gualtieri—Oral evidence (QQ101-107) ...... 214 Hans Hack, Guntram Wolff and Fabian Zuleeg—Oral evidence (QQ118-128)...... 226 Janet Henry, Sebastian Barnes, Henning Christophersen and Martin Sandbu—Oral evidence (QQ27- 44) ...... 242 Dr. Dermot Hodson—Written evidence (EMU0002) ...... 243 Dr Dermot Hodson, Graham Bishop and Philippe Legrain—Oral evidence (QQ1-14) ...... 249 Gunnar Hökmark MEP and Sylvie Goulard MEP—Oral evidence (QQ92-100) ...... 250

Andrew Bailey and Sir Jon Cunliffe—Oral evidence (QQ186-194)

Professor Otmar Issing—Oral evidence (QQ205-214) ...... 251 Professor Erik Jones, Megan Greene and John Peet—Oral evidence (QQ68-81) ...... 266 Philippe Legrain, Graham Bishop and Dr Dermot Hodson—Oral evidence (QQ1-14) ...... 267 Dr. Andrew Lilico—Written evidence (EMU0001) ...... 268 Dr Andrew Lilico, David Marsh and Professor Lucia Quaglia—Oral evidence (QQ167-178) ...... 270 David Marsh, Dr Andrew Lilico and Professor Lucia Quaglia—Oral evidence (QQ167-178) ...... 291 Reza Moghadam and Professor Lorenzo Codogno—Oral evidence (QQ56–67) ...... 292 Veronica Nilsson—Oral evidence (QQ129-140) ...... 293 Christian Odendahl—Oral evidence (QQ45-55) ...... 306 John Peet, Megan Greene and Professor Erik Jones—Oral evidence (QQ68-81) ...... 320 Professor Lucia Quaglia, Dr Andrew Lilico and David Marsh—Oral evidence (QQ167-178) ...... 321 Raoul Ruparel and Baroness Bowles of Berkhamsted—Oral evidence (QQ15-26) ...... 322 Professor John Ryan—Written evidence (EMU0007) ...... 323 Martin Sandbu, Sebastian Barnes, Henning Christophersen and Janet Henry—Oral evidence (QQ27- 44) ...... 325 Dr. Waltraud Schelkle—Written evidence (EMU0004) ...... 326 Kay Swinburne MEP and Markus Ferber MEP—Oral evidence (QQ82-91) ...... 330 Mike Vercnocke—Oral evidence (QQ141-157) ...... 331 Alex White and Professor Paul De Grauwe—Oral evidence (QQ179-185) ...... 347 Professor Michael Wickens—Written evidence (EMU0003) ...... 348 Thomas Wieser—Oral evidence (QQ108-117) ...... 353 Guntram Wolff, Hans Hack and Fabian Zuleeg—Oral evidence (QQ118-128)...... 365 Fabian Zuleeg, Hans Hack and Guntram Wolff—Oral evidence (QQ118-128) ...... 366

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Andrew Bailey and Sir Jon Cunliffe—Oral evidence (QQ186-194)

Evidence Session No.17 Heard in Public Questions 186 - 194

THURSDAY 11 FEBRUARY 2016

Members present

Baroness Falkner of Margravine (Chairman) Lord Butler of Brockwell Lord Haskins Lord Lawson of Blaby Lord McFall of Alcluith Lord Shutt of Greetland Lord Skidelsky ______

Examination of Witnesses Sir Jon Cunliffe, Deputy Governor for Financial Stability, , and Andrew Bailey, Chief Executive of the PRA and a Deputy Governor for Prudential Regulation, Bank of England

Q186 The Chairman: Good morning, Sir Jon Cunliffe and Mr Andrew Bailey, and thank you for agreeing to give evidence to us in our inquiry into Europe’s economic and monetary union. You have a list of interests that have been declared by Committee members. This is a formal evidence-taking session for the Committee, and a full transcript will be taken. This will be put on the public record in printed form and on the Parliamentary website. You will be sent a copy of the transcript, so you will be able to revise it in terms of any minor errors. This session is on the record; it is being webcast live, and will be subsequently accessible via the Parliamentary website.

I wonder if I can kick off by asking you, in broad terms, what your assessment is of the Five Presidents’ Report, the short-term actions envisaged in its later paper of 21 October, and the 24 November proposals on banking union. I wondered, to kick off, whether you would like to start, Sir Jon. Sir Jon Cunliffe: I am very happy to. Thank you for the opportunity to give evidence today. I find the Five Presidents’ Report reassuring, in that it is a very clear statement of recognition by the area of the things that need to be done. From a Bank of England perspective, the stability of the euro area matters very considerably to us. We put out a report that explains some of the impacts on our objectives of financial and monetary stability when

Andrew Bailey and Sir Jon Cunliffe—Oral evidence (QQ186-194) things go wrong in the euro area, so the recognition is very valuable. It is good that immediate action is being taken. It is quite an honest description of the political and other difficulties that the euro area will have in moving forward, and that pressure to move forward needs to be maintained. The short-term actions go a little bit further than I expected, to be honest. When you read the document, it suggests doing more within the existing framework, and the deposit guarantee proposal pushes further forward than a cynical observer might have thought, so there is something real there. Of course, that is a very difficult and sensitive issue. One last thing I would say about the report is that the area where one might have wanted to see more— although I understand why not—is a timetable. There is a timetable in there, there is an end date, but Europe has always worked by setting timetables and moving towards them, et cetera, and the timetable is, of necessity, quite broadly defined. That is one area that we would hope in future to see more on. The Chairman: Just on those points you have made in terms of the paper, as compared to the previous one—the Four Presidents’ Report—do you think they made a mistake in not going for debt mutualisation, as the four Presidents did? Sir Jon Cunliffe: I read the reference to the fiscal stabilisation mechanism, which “could be financed in various ways”, as a way of leaving open some of those possibilities. The stabilisation mechanism is not defined—it is going to be one of the most difficult things for the euro area and the states to agree—but it could be financed by debt, and there could be mutualisation underneath that. I did not think it closed any doors completely. The Chairman: Mr Bailey? Andrew Bailey: There is not much to add. As we make clear in the report that we published, and that Jon referred to, our overriding view is that further integration in terms of economic policy in the euro area is necessary to complete the currency union. The Chairman: Do you think that there are things that are missing from the paper that should have been there, apart from the timetable? The timetable says that they will produce a White Paper in 2017 and then hopefully come to an end point by 2025, but do you think there are things they should have said that are not there, in terms of policy? Sir Jon Cunliffe: From the Bank of England’s perspective, we believe further integration in the euro area is necessary to make it sustainable and stable. We have said that publicly, and we have explained why in the report we published in October. If we could have our preference, that would be the reality tomorrow. We acknowledge the difficulty of working these things out. Clearly, the further and the faster they can go towards that stability within the framework of the European Union the better, from our perspective. Yes, one would have liked to have seen a lot more things but, as a statement to drive them forward, I thought it was positive and, as an honest recognition of what needed to be done and the problems, I thought that was very positive as well.

Q187 Lord McFall of Alcluith: Mr Cunliffe, I have one question for you, and one for Mr Bailey. You mentioned about the further integration of financial union, which is in the interests of this country. I want to explore the extent to which further integration may affect the UK’s ability to influence macroprudential supervision, and whether the European supervisory risk board is successfully acting as a counterweight to the ECB’s inherent 2

Andrew Bailey and Sir Jon Cunliffe—Oral evidence (QQ186-194) incentive to act in the interests of the . I well remember that the then Governor, Mervyn King, was very proud of the fact that he was number two on the European supervisory risk board, and there was a crucial role played there by the Bank of England. In light of that, could you give me your comments about how the ESRB is functioning just now, and whether you were surprised that macroprudential concerns did not feature much in the Five Presidents’ Report? Sir Jon Cunliffe: No, I was not surprised that they did not feature much. The macroprudential architecture for the European Union was set quite well some years ago. It is an interesting example of how other areas of the banking union and the euro developing within the European Union might work. The ECB is there, but all the national supervisors and authorities are there as well. It is the only table that brings all the people concerned with financial stability in Europe together, and the UK plays a very large role, and the current Governor is Deputy Chairman of the ESRB. It is a place where we can look across the European Union, because we do have highly integrated financial sectors, and look at risk. It has worked. It has taken some time to get off the ground, like most new institutions, but it is actually working well. Lord McFall of Alcluith: What do you think are the most urgent issues it has to attend to? Sir Jon Cunliffe: It is looking now at real estate risks across the European Union, both in commercial property and housing. It has looked at insurance, and has produced a report. Lord McFall of Alcluith: It is work in progress. Sir Jon Cunliffe: It has produced a number of reports on risks across the European Union area, which we find useful, and it also has the ability to make recommendations to individual jurisdictions. The one point I would make, though, is as far as the banking union is concerned, they were given macroprudential top-up powers at the ECB level, so the national authorities have powers and the ECB has top-up powers within the banking union, and that is all very much settling down now. We will have to see how that works in practice, but, generally speaking, it has been quite a good model for the way the UK can work within the European Union framework alongside the ECB and the banking union. Lord McFall of Alcluith: Mr Bailey, congratulations on your new job, and good luck. I do not know which one I want to put the emphasis on. Andrew Bailey: That is very kind of you. Lord McFall of Alcluith: I am interested in your role there, particularly the interaction of the home regulator with the euro area, because the view has been given that all of the standards are made in Europe, and there is limited influence that the home regulator can have. Could you look at that? Also, you will be taking over at a time when there has been a plethora of scandals in the banking industry, but if we look at it, it could be reduced to one: namely, that the customer’s interests have been at the bottom of the pile. However, we now have a system of regulation that is more complex, and rather than a customer-focused approach, we could have a tick-box mentality applying to the rules. You know I have mentioned this issue before to you, but given the muddle that the Senior Managers Regime is in—in fact, I was talking to a senior banker last night who said that the old system’s regulations are up in March; the new system’s start in September, so there is an interregnum for six months—that is one big thing that is waiting for you. 3

Andrew Bailey and Sir Jon Cunliffe—Oral evidence (QQ186-194)

Andrew Bailey: That is quite wrong. Lord McFall of Alcluith: That came from a senior banker from a bank that is in the news this week. I can say that to you. Andrew Bailey: That does not narrow it down much. Lord McFall of Alcluith: That is a problem with the industry that you have: they are all in the news. But the issue of duty of care is very important, and I would suggest that if there were a simpler approach to this, with duty of care on the senior personnel, then it could aid the reduction in the plethora of complex regulation. What do you feel about that as you take up your new role? Andrew Bailey: That is a very interesting point. First of all, I am afraid that the banker you spoke to is quite wrong. The Senior Managers Regime is being introduced at the end of the first week of March, so I am afraid that if they think there is some sort of interregnum, they are wrong. The handover is quite clearly from one to the other, and there is not a gap. What you point to, of course, is the key feature of the Senior Managers Regime, which, to my mind, is the word “responsibility”. As you know from the investigations you have been responsible for in the past, it is a fact from the history of the crisis, the way the Approved Persons Regime operated, and the fact that action on approved persons in the current regime really hangs on the concept of culpability, rather than responsibility. There has been a tendency, therefore, to say, “I delegated that responsibility to somebody who made the loans, or did not make the provisions, even though I am the most senior person in the institution”. I have said it many times: you cannot delegate responsibility. The Senior Managers Regime is crucially important, both in prudential and conduct, and it is all about getting the incentives right. We have tried very hard, and we will have to go on trying very hard, to construct a regime that has the right incentives in it. Everything we are trying to do on remuneration has the same feature to it: it is about getting incentives right. If we can do that—I will give you an example in a moment—then I would like to think we would get more towards the promised land that you outlined, and, as you rightly say, we come away from the idea that you can do something that is more tick-box. The example that I was going to give you is the Fair and Effective Markets Review, because that has rightly raised the question, which is an old question in this country, about the balance between what the regulator does and what the industry is responsible for itself. In history, we have been backwards and forwards on this concept of self-regulation, but self-regulation is not, “Here you are; off you go” and it is all a bit of a free-for-all after that. The really important thing in the Fair and Effective Markets Review is to hook what we want to do in terms of industry standards and codes up to the Senior Managers Regime, and say, “There is real responsibility behind this. Off you go and put the codes into effect. You can do that in your firms—it is not for us to be in there at that level of detail; we frankly cannot do it—but there has to be a hook of responsibility to hold you to account.” The Chairman: Before I bring in Lord Lawson, I just had a small question for you, Sir Jon, to do with the European system of financial supervision. You placed a lot of importance in your opening remarks on deepening eurozone integration. Would the deepening of eurozone integration result in us losing this pivotal number two slot? Would it reduce our influence in

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Andrew Bailey and Sir Jon Cunliffe—Oral evidence (QQ186-194) financial supervision? As the deepening takes place, why would they want us sitting at number two? Sir Jon Cunliffe: I think not. As the deepening takes place, it may reduce the roles of the national authorities of the euro area, but the UK is the largest financial centre, arguably in the world and certainly, by far, within the European Union. We have a range of responsibilities, knowledge and influence within Europe, so the need to have the UK at that systemic risk table continues. In a way, what happens is that in the euro area, more goes up to the single supervisory mechanism, to the . The recognition of the UK’s role in financial stability within the European Union is reflected in the deputy chairmanship. I would not expect that to be affected. There will be issues about how future European regulation is built and conceived, which Lord McFall referred to. We set some of those issues out in our report, but I do not think the importance of the UK within the European Union on these issues will change. The Chairman: It is recognised, and it will prevail. Sir Jon Cunliffe: It is certainly recognised, yes.

Q188 Lord Lawson of Blaby: Since we have got on to the subject of prudential regulation, although there are other things we want to talk about, may I go off-piste, just for a little bit? Mr Bailey, I think about a year ago you made a very strong comment about Solvency II, which gave you cause for concern. Can you update us on the position of that, and can you also, apart from the specific recommendation, draw any general lessons from this difficulty? Andrew Bailey: Yes, I can. First, the update is that after many years, Solvency II came into effect on 1 January, so we are now in a world where it is in effect. There was a huge amount of work to get it over the line. We are now in the important phase of not only putting it into effect, but also, frankly, that huge amount of work to put it over the line—some of the issues with such a wide-ranging piece of legislation and the experience that we have already in implementing it—gives cause to say that some pieces of it need rethinking. Last week, as a response to the ’s call for evidence on European financial regulation, we published our own response, and in there are a number of points on Solvency II that we think need attention. The point I made a year or two years ago was that Solvency II is a good example of European legislation, warts and all, as it were. I do not know how many years it took. There were varying accounts of this, but it was at least 12 years from beginning to end, and there were several false dawns, where it looked like it was about to be agreed and it was not. The point I made was all about the costs of it. Cost to us is one thing; cost to the industry is a much bigger thing. There was a degree of leading up the path, to say, “It is going to be implemented. You have to be ready”. No, it is not, and there is probably little doubt that that put quite a lot of cost on to the whole process. It is important to bear in mind that when these pieces of legislation are done, there is not only the process of agreeing it, but also a very big implementation task that comes afterwards. You sometimes see that there is a huge amount of very important work in agreeing the legislation, and it gets thrown over the fence, and there is an assumption that it will be implemented very quickly. That is what lay behind it, because some of the false dawns undoubtedly added to the bill of doing it.

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Andrew Bailey and Sir Jon Cunliffe—Oral evidence (QQ186-194)

Lord Lawson of Blaby: But you did give the impression—I am sorry; it was about two years ago; time flies—that you felt many aspects of it were undesirable. Andrew Bailey: We have raised a number of quite important points in the call for evidence response that we put in. As Jon mentioned earlier, in the context of Europe, there is a very real issue about the lack of macroprudential tools in Solvency II. You can say that most of the macroprudential attention so far has been on banks rather than insurers, but we have case histories from the quite recent past where, in the context of large movements in financial markets that affect the value of assets held by insurers, industry-wide interventions were made in the UK—this happened just after 2000, where we had the dot-com equity market fall—to prevent what you might call systemic effects by the rules, to cause the dumping of assets into the market. In our reading, Solvency II does not yet have the sort of provisions you would like to take those actions, which not only were thought to be sensible at the time, but history shows they were sensible as well. That is one point. There are then several other points to do with the sensitivity of some of the provisions in Solvency II. The other point I would make, which I have made a few times—and this is really true of life insurance; it is not so true of general insurance—is that it remains, pretty much, a series of national product markets. That has a huge effect on the business models of the providers, the firms, and if you thought honestly that Solvency II was going to lead to an apples-and-apples comparison of the positions of firms, it does not, really. Some of that should be dealt with, and we have highlighted some points in our response. Some of it is about educating the market—analysts, rating agencies, and so on—to say that these are quite different national markets. The Chairman: Thank you. We are getting slightly sidetracked. Can I come back to Lord Haskins, and banking?

Q189 Lord Haskins: Just as a general point before I ask my question, this Five Presidents’ Report seemed to have a very ambitious heading—“Completing Europe’s Economic and Monetary Union”—when there are all sorts of obstacles that are not addressed in it, such as the need for treaty change and the need, fundamentally, for some progress towards fiscal and political union. To me, it seems a step that may be in the right direction, but is a long way away from completion. However, within that, we have been told that banking union and are possible without treaty change. We are also told that the UK could join banking union if it chose to do so. What would be the obstacles, as far as the UK is concerned, to a banking union, whether we are in it or not in it? What would be the problems? Sir Jon Cunliffe: I would separate the questions. A lot has been done without treaty change, and a lot has been done quite imaginatively during the crisis. The Five Presidents’ Report reflects that, but it also makes clear that some things that were done without treaty change should really be changed in future by putting them back into the treaty. My own view on this is when you are dealing with things like mutual funds to support different countries in times of crisis, or where you put the supervisor, et cetera, in the end you want that in heavy-duty constitutional law, depending on your system, which for the European Union and for the euro is the treaty. I would expect a number of the things that have been done without changing the treaty, in the longer term, to be put on a treaty basis, because there 6

Andrew Bailey and Sir Jon Cunliffe—Oral evidence (QQ186-194) really are quite big things about who has responsibility for supervising financial institutions, who contributes to funds, and how the money is used. That is reflected there. The obstacles to all of this are pretty large, and maybe it is a bit hubristic to talk about “completing” in that sense. Monetary union is interesting; I do not mean to be pejorative in my use of the word “interesting”, but it is a fairly novel and ambitious construction, so it may take 20 or 30 years before you might call it complete. Just to go back to the point I made at the beginning, though, if you or I had said in 2006 to the euro area, “You need a lot of action to complete this project”, they would have said, “No, this is done, and it works”. That recognition of what needs to be done is undervalued. You could say it took a very large crisis to get there, which is also true, but I sense that there really is a tectonic shift in the way it is thought about, which—as we live next door to it—is very important to us. Lord Lawson of Blaby: It did not need a major crisis, although that is what happened. It needed just a little knowledge of history. Sir Jon Cunliffe: I am not a historian, I am afraid. The Chairman: The interesting point that many of our witnesses have raised is whether this can move forward in the absence of another crisis, in terms of the end point that they want to get to. Sir Jon Cunliffe: It is an impossible question to answer, because one cannot read the future. Some European luminary did say that Europe is built by crises. My guess is that it is quite difficult to move forward at a time when you are coming out of a very bad financial and economic crisis. If I looked at the Five Presidents’ Report and this question of obstacles, it goes to the question of what you can do. The area that is least mapped out is the last one, about political union, and that is the area where you have to have the political support to make the changes in sovereignty, which are referred to explicitly in the report as changes in sovereignty. You have to have the political support of the electorates of the single currency member states to make those changes. Are you likely to get that support in crisis? Are you likely to get that support when you can convince people that this is the way forward for those that have chosen the single currency? I do not know the answer. Andrew Bailey: There is an obvious tension between risk-sharing and pooling of sovereignty of policy. That is, at the high level, the obvious tension. Lord Haskins: What about banking union, and the way it might impact on us if it happens? Sir Jon Cunliffe: The first point is that an awful lot of it has happened. There is now a single supervisor that supervises the large European banks. There is now a single resolution board that we would deal with as our partner, if we ever had to resolve a problem with a cross-border bank within the European Union; I hope we do not. There is an awful lot there already that just did not exist two years ago. In a number of different jobs, I have always supported banking union, because when you have a single central bank and you have a single currency, then your financial systems are linked together. They transfer risk, and we have just seen that happen in the crisis. It is a necessary move for a single currency, which perhaps could have been anticipated in advance—I do not know—but I am glad that it has at least been recognised. For us, it is the possibility of having a strong partner with similar concerns, the ECB, with whom we can build a relationship. The issue, which again is recognised in the Five Presidents’ Report and is now 7

Andrew Bailey and Sir Jon Cunliffe—Oral evidence (QQ186-194) generally recognised, is that some of the rules and the things you need to operate a single currency and a financial or banking union are different to, or go further than, what you might need to operate a single market. The issue for us is that that is recognised and properly reflected. Andrew Bailey: Just to be clear, we have had over a year now of experience of working with the ECB in this new role as the Single Supervisory Mechanism, and it has been a good experience. We obviously had one quite large event and problem in the euro area that they have had to deal with during that time—that is Greece—and I can say, from my own experience of having been involved in previous episodes of crisis, we welcomed it being put into place and we have welcomed it now it is in place. As Jon said, it gives us a natural counterpart, from the point of view of the supervisory process, and that is good. Lord Butler of Brockwell: If I may just continue Lord Haskins’s theme of testing your view of the Five Presidents’ Report, a good deal of the evidence we have had states that for one reason or another—some of which are political reasons—it is actually really rather unspecific. It may be there is a recognition that much needs to be done, but the Five Presidents’ Report does not carry us much further in what needs to be done. Sir Jon mentioned, in particular, the deposit guarantee proposal, which is one of the specific recommendations in the Five Presidents’ Report, and yet that has immediately run into opposition, particularly from Germany. It looks as if not much progress will be made on that. Would you like to comment on that, and then I will come on to one or two questions specifically about it? Sir Jon Cunliffe: The hardest issue here is that in order to move sovereignty up to the next level, and have risk transferring within the monetary union, you have to have collective discipline, and then you have to have collective support, or solidarity and discipline; these things go under different names. To me, that is the central bargain that has to be struck at the heart of the euro area going forward. How much collective discipline? How much do you give up national rights over budgets, et cetera? How much collective support? How much risk transfer? You are very right to say that that bargain has not been struck, and until it is struck, it is very difficult to move forward on anything that shares risk, because the moment you do, people say, “There is not enough collective discipline”, et cetera. There has been a very interesting article by the President of the Bundesbank and the President of the Banque de this week trying to take that forward, but in the end it ran into this. If the question is, “Can the larger pieces move forward without that bargain having been made, without a view about where the balance should be between collective discipline and collective support?” then the answer is “No”. It will continue to stop short until that question can be answered. My sense is that the question will not go away, and it is recognised in the euro area that it cannot go away, which is what leads me back to timetables and the fact that this report recognises it. Lord Butler of Brockwell: But in the absence of that, can there be progress? In particular, we look as if we are going to have two of the pillars in place, but not the third. Can we do without the third pillar if that proves so difficult to achieve? Sir Jon Cunliffe: It is better to have two than none, and I talked about resolution and supervision, which are the other two that exist. It was possible to do those, and there is an element of risk-sharing in those as well. I would not rule out progress on the deposit 8

Andrew Bailey and Sir Jon Cunliffe—Oral evidence (QQ186-194) guarantee scheme, but even the deposit guarantee scheme starts with reinsurance, with deposit guarantee schemes supporting each other—one supporting the other when the other is exhausted. It is a relatively small step, so it may be possible to make progress there. On the bigger issues of real risk-sharing that involve those questions of collective discipline and collective support, the political bargain has to be made first, and it has not been made yet. Andrew Bailey: It is probably worth tracing through for a moment our own experience of what the effect of that is. In many ways, if you look at big banks, the deposit insurance is there, but it is not the tool you use when the bank fails. That is why resolution is so important. It does come into play with smaller institutions, when you effectively want to use an insolvency tool, and you are not sure whether there is enough effective protection in the balance sheet. If you trace through the missing one, and ask what the effect of that would be, at the moment it is probably more likely that it would lead countries to wish to use public money to support small institutions, to avoid, if it comes to it, triggering the problem with the deposit protection scheme. If the problem with the bank then goes through into a problem with the state, that would need to bring in more than one small institution.

Q190 Lord Butler of Brockwell: We have had some evidence that the single resolution mechanism does not actually carry much conviction. Are you confident that without the deposit guarantee schemes, in the present state of banking union, the single resolution mechanism would be sufficient to deal with the failure of a major European bank? Sir Jon Cunliffe: Let me preface my answer with one point. In terms of sufficiency to deal with the failure of a major cross-border bank, the European Union and the UK are generally well advanced along that agenda, but we are not there yet, because although we now have the powers and the institutions to do that, building up the loss-absorbing resources that you could use in a resolution is going to happen over the next four years. We are all moving forward. I would say two things about the SRB. The SRB could work without a deposit guarantee scheme; you could resolve an institution without that, but, of course, you would be going to national schemes there, and the question then—which is why we have the joint one—is, when you go to national schemes, can the sovereign stand behind the scheme in the end? Even if it is only bridge-financing it, that will probably be for a very long period until the industry can repay that. That would perhaps be an issue, but resolution would be much better than it was before, even though we do not have that. The second question is one that is acknowledged in and in the SRB. The architecture is quite complicated, because responsibilities and authorities are divided in quite a complicated way within the euro area. If you look at the number of people that would have to come to the table to deal with a resolution on the Single Resolution Board, it is quite a few, and the wiring diagram, as I say, is quite complex. It could be made to work, and in a crisis, you find ways of making things work. The Single Resolution Board has only just been born, but they need to work through those issues as to how those different responsibilities and authorities would interact in a crisis. There is more work to be done on that side.

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Andrew Bailey and Sir Jon Cunliffe—Oral evidence (QQ186-194)

Lord Butler of Brockwell: Perhaps I could ask Mr Bailey, as he faces the prospect of moving on from the PRA. Are you satisfied with the degree of co-operation between the PRA, the bank itself, and the single resolution mechanism? Andrew Bailey: The PRA are our primary point of interfacing with the single supervisory mechanism, because they are what I call the going-concern supervisor. In the Bank of England, Jon is responsible for resolution. I used to do resolutions, but I have very happily passed it on to Jon. It is the resolution part of the bank that has the primary relationship with the Single Resolution Mechanism; the supervisors have some relationship, but it is primarily a resolution-to-resolution issue. Sir Jon Cunliffe: Unfortunately, or fortunately, I have this responsibility, because there has to be a division between the supervisor and the resolution authority, because the objectives are different, so we sit across a Chinese wall. Andrew Bailey: We have not brought it with us today. Sir Jon Cunliffe: The SRB is just up and running. It took up its responsibilities on 1 January. We have an excellent relationship with this nascent organisation. We know some of the key staff well, particularly the chair, who was the head of the German supervisory authority beforehand, and we have worked very closely with them on the set-up and on the relationship. It is a good relationship, but it is a complicated thing. Lord Butler of Brockwell: And across the Chinese wall, you have confidence in each other, do you? Sir Jon Cunliffe: Absolutely.

Q191 The Chairman: Sir Jon, you have mentioned a particular country. Many of our witnesses said to us that the greatest obstruction, as you have implied, on EDIS was political. Do you think there is going to be movement on the part of the Germans, given that the Dutch presidency have said that they intend to make progress on this? Sir Jon Cunliffe: To be honest, Chairman, it is hard for me to give you an informed view that is better than the witnesses you have had. My instinct is, yes, there will be some progress. It will be slow; it will be fought through all of the skirmishing and trench warfare of European legislative negotiation, but there will be some move towards the reinsurance phase, probably. That would be my view, but this is conditioned generally by the political environment in the European Union, and other things are going on in Germany and elsewhere, in non-economic areas, that make European solutions not very popular. The Chairman: I am conscious of time, but I just have one quick one before we leave the topic of banking union; it is to you, Sir Jon. Many of our witnesses have commented on the absurdity, in a way, of the UK not coming into aspects of banking union, given how pivotal a player it is. Do you see the United Kingdom coming into banking union? Sir Jon Cunliffe: No. It is a political decision, and it could be taken. My view on why banking union is necessary and exists is because there is a shared currency and a shared lender of last resort. It still has not, to be blunt, solved the problem of where the ultimate fiscal backstop is. That is something that you will see in the Five Presidents’ Report, and that goes to these political issues. I do not think a banking union is necessary to operate the single market in financial services, and so I cannot see, when we retain responsibility for our 10

Andrew Bailey and Sir Jon Cunliffe—Oral evidence (QQ186-194) currency, central bank and lender of last resort, why it would be necessary or, in terms of accountability, desirable to make that step, because we then would be in a rather odd situation. Of course, that could change in the future, and we deal with the world we live in.

Q192 Lord Lawson of Blaby: One of the most important things that the Five Presidents’ Report says is that in order to “complete” the monetary union, there needs to be fiscal union. I take it you would agree with that? Sir Jon Cunliffe: Yes, although I do not agree that fiscal union necessarily means becoming a complete federal country, but there has to be a much higher level of fiscal integration that includes risk-sharing and collective support. Lord Lawson of Blaby: I am going to press this further. Fiscal union is very much akin to what the Germans like to call the transfer union, is it not? Sir Jon Cunliffe: It can be. It depends how far you go. Lord Lawson of Blaby: What do you mean by “fiscal union”? Sir Jon Cunliffe: By “fiscal union”, I mean that some of the sovereignty for taking fiscal decisions is moved up to the supra-national level, and, secondly, that those decisions that are taken at the supra-national level would include the fiscal choices that individual members of the monetary union make. The Chairman: Policy choices? Sir Jon Cunliffe: Policy choices, yes, which is why the political side of this is very important. But it would also include, as part of the fiscal choices, the transfer—to use that word—of the single currency between member states. When the Germans think of transfer union, I think they think that German taxpayers will be basically supporting southern European budgets with transfers. One would not necessarily have to go to that extreme, but there has to be a way of member states of the euro area supporting each other in times of stress. The mechanism that is sketched out—and it is very sketchy—in the Five Presidents’ Report is one in which you access this mechanism at times of stress and emergency. It is not a normal budget support mechanism, as you might find in federal transfers between states in the United States, or even between Länder in Germany. There are different degrees, but when I said that I did not think monetary union had to go to full fiscal federalism, that is what I meant. Lord Lawson of Blaby: But that has been the view of every reputable economist who has ever pronounced on this matter, so far as I am aware, from the MacDougall report—which you may recall—onwards. Sir Jon Cunliffe: I do recall it. Lord Lawson of Blaby: Donald MacDougall made it absolutely clear that there has to be a fiscal union, which is a kind of budgetary union, in which federal taxes, or European taxes—I do not want to pre-judge the political thing; the political implications are fairly clear—are of substantially greater size than we have at the present time. Do you disagree, and, if so, why do you disagree with the accumulated view of the economists? Sir Jon Cunliffe: No, I thought I had agreed with it, actually. The Five Presidents’ Report agrees with it as well, because it says that for a monetary union to function—I forget the 11

Andrew Bailey and Sir Jon Cunliffe—Oral evidence (QQ186-194) exact words—this rule-based fiscal system of the growth stability pact is insufficient, and we need to take some of these fiscal decisions to the supra-national level, which is exactly the MacDougall point. The point I was making is how far you go, and whether that means you only have a federal, euro-area tax—you have no local powers—and you have the sorts of transfer mechanisms that exist with the German Länder, or whether you have something that is only activated in times of crisis. There is a range of choices there. Lord Lawson of Blaby: Yes, but are you seriously saying that this second option, by which you just have an agreement to help each other out in times of crisis, is satisfactory? It is not what the five Presidents have in mind, and they are right; it is much more the model of the German Länder, which you have talked about. Sir Jon Cunliffe: You could have a fiscal stabilisation fund that would act as a fiscal stabiliser but that would not necessarily have to be acting all the time. Lord Lawson of Blaby: If there were this eurozone tax system for this purpose, how would it impact on this country? Sir Jon Cunliffe: It is part of the general question of how the UK functions in a European Union in which a group of countries have gone for a tighter integration. That is the reality at the moment. The fiscal integration that would lead to transfers and supra-national decisions on budgets will make that group tighter, and then the question becomes, “Can the boundary of the single market, and the things that we are involved in, be different and broader than the boundary of the single currency?” That is possible; it has been possible up until now. There is a recognition now that that issue needs to be addressed, and it is being addressed at the moment in the renegotiation that the Government is having. It is not axiomatic that the single currency and the single market have to share the same boundary, but it is necessary that if one group is going to integrate more tightly, we think about how the relationships are governed between those who are in that tighter integration and those who are not. That is a big task, but I do not think it is an insurmountable one. Andrew Bailey: Jon makes the absolutely right point that this is hugely subject to the boundary issue but, setting the boundary issue aside for a moment, is something within the euro area that led to faster decision-making and faster outcomes in times of crisis. You saw this with Greece. Of course, those incidents can have wider spill-over effects; that would be a positive thing. The Chairman: Thank you. In this particular area, you have touched on the tension between deepening integration for the eurozone and keeping the single market intact. I have a lot of sympathy with your interpretation, by which it does not necessarily lead to an EU/EMU treasury function. It may do, but it may well not.

Q193 Lord Shutt of Greetland: The subject of the European Deposit Insurance Scheme has been alluded to quite a bit, but we understand that an expert group is being asked to work it up, and that something is to be reported in March. Where do the current risks need to be reduced, and what are the implications for the UK and the wider single market of the group’s focus on reducing national discretion? Would they differ if these rules were applied specifically to the 19 eurozone members, or if they were applied to the 28? Sir Jon Cunliffe: The reason why there is, alongside the deposit guarantee proposal, a risk reduction agenda comes back to this point that if we are going to share risk, then we have to 12

Andrew Bailey and Sir Jon Cunliffe—Oral evidence (QQ186-194) reduce the risk, because otherwise we are all responsible for each other but we have no guarantee that the other person is actually reducing risk. The risk reduction agenda is a direct consequence of the proposal for a euro area deposit guarantee scheme, and it is looking at a number of areas. Some of those areas are relevant to all European Union members, and we would like to see progress in them, so there is pressure to implement the resolution directive, which, from our point of view, would be a good thing. We would like all European Union member states to implement that law. There is a requirement to implement the work that is going on in Basel now to complete Basel III, which Andrew might want to talk about. There are other things there that are relevant to those who are going to share the deposit guarantee scheme, but they are not necessarily relevant outside of that. We have to make sure that those in the euro area who need to have the deposit guarantee scheme get what they need, but it does not necessarily have to extend to those who are not in that scheme. The question of national discretion is very important there. It is quite difficult to run a banking union with 18 separate jurisdictions and national laws, and I have a lot of sympathy for those who have to do that, so they may need to agree to have less discretion, because they cannot operate in that way. That should not mean that countries within the single market that are not in the banking union should have those discretions removed. I think the Five Presidents’ Report actually says, “We will need more uniformity”, so there is a recognition that it has to be done. It is important that it is done properly as this negotiation goes forward. Andrew Bailey: Could I just give a practical example of how this affects us directly? Where a bank branches from a country in the euro area to the UK, as it can do under the passporting regimes in the single market, the deposit protection for the depositors in that branch in the UK comes from the home state, which is wherever it is branching from. It does not come from the UK. We have had cases in point where we have become quite nervous about this, because the solvency of a national deposit protection scheme depends upon the solvency of the sovereign of that country. They are inevitably inextricably linked. We have had incidents where the solvency of the banking system of the home country is a direct product of the solvency of the sovereign, and when both of those are called into question, you then get a situation where you say, “Do the depositors in the UK really understand where their deposit protection is coming from?” The worst thing is for the thing to go wrong, and then they say, “Well, I never knew it was coming from wherever. I thought the UK was providing it”. We have had to go through an exercise of some sort to say to branches, “You have to tell your depositors where it comes from”, but you can never rest easy that the depositors really have got it, frankly. Lord McFall of Alcluith: Is there still not a gap there? Sir Jon mentioned about the deposit guarantee scheme, and the host countries could undertake that, but we had our very own problem with Iceland. Andrew Bailey: Yes, we did. Lord McFall of Alcluith: I think we used the Terrorism Act at the time. Sir Jon Cunliffe: We did. Lord McFall of Alcluith: It was huge, and, to me, that cross-border problem is not solved yet. That is still a big issue for you.

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Andrew Bailey and Sir Jon Cunliffe—Oral evidence (QQ186-194)

Andrew Bailey: That is where this whole question about risk-sharing and the link between the sovereign and the bank sector comes in. In the case of Greece and Cyprus, where we had branches in this country, we were asking ourselves, “Do the depositors understand their position?” Lord McFall of Alcluith: But that cross-border aspect is not yet solved, Sir Jon. Sir Jon Cunliffe: It is necessary in the single market to depend on the actions taken by other authorities and other Governments. In the Iceland case, which I can remember well, the rules and the supervision of the Icelandic financial system were nowhere near capable of dealing with that system. When people say to me, “Why do we need common European rules for financial services?”, that is a good reason why we need much tougher and really high-quality regulation in the European Union. Lord McFall of Alcluith: It is important for us not to mislead here. There is still a lot to do in Europe to get a uniform system. That is really what I am interested in getting from you. Andrew Bailey: That is an example of where having the third pillar in place would help us, because it would take away a residual piece of the problem that can occur. Sir Jon Cunliffe: Just to make it clear, even if the euro area comes to full risk-sharing within EDIS, we would still be subject to those risks in relation to a non-banking union country. That has not changed. Andrew Bailey: Iceland is different. The Chairman: It seems to me that you are making a good argument for us to be in EDIS, if it comes about. Andrew Bailey: No, I was not. It is an argument for why, if you are a host regulator, you welcome that assurance from the home states that are in the banking union. Sir Jon Cunliffe: But then you will want to make sure that the home states are actually regulating properly with high-quality law, which is why we are in favour of, in the single market, having the highest-quality regulation that we can. Andrew Bailey: It is the argument for having all three pillars in place in the euro area.

Q194 The Chairman: Sir Jon, you will be aware, from the Five Presidents’ Report, of the concern within the eurozone countries that they do not have a single voice on the IMF. We have not quite been able to glean what the detriments of that are, but I wonder whether you would share with us your view on this unified representation, and particularly whether you believe it would have any impact on the United Kingdom’s place. Sir Jon Cunliffe: First of all, to be brutally frank, I do not think there is necessarily a concern among the eurozone countries that there is not a united voice, but there is a concern among the eurozone institutions that there is not a united voice. If you ask the question in the capitals of the major euro area member states, you might get a different answer than if you asked it in Brussels. The Chairman: Particularly the ones who are represented already. Sir Jon Cunliffe: Correct. It is a difficult set of issues, and most of this is not the bank’s responsibility. The difficulty is that the IMF is a nation-state member-led institution, and

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Andrew Bailey and Sir Jon Cunliffe—Oral evidence (QQ186-194) what I thought of the proposals was that that is a level of common representation that requires more integration. You do not have the integration there. To explain that, when you sit around the IMF table, you discuss all aspects of a nation’s economy. It is not just its monetary policy; it is its fiscal policy, and, as Lord Lawson was saying, that would need to move. It is its economic structure and those kinds of issues, and the IMF discussion is a broad discussion. The difficulty is that within the euro area, those responsibilities have been divided between the national and the euro area level, and the only single euro area institution that exists at the moment is the central bank. The Chairman: Which has observer status. Sir Jon Cunliffe: It has observer status, and there is heavy co-ordination. The fund look at the member states, but they look at the euro area as a whole, and they try to find a way that they can deal with the euro area institutions as a whole as well, but they are not a whole, because they are not a federal country, and you have to find a way to get all those people who have a responsibility at the table. My personal view is that you would do the single representation when you had moved sufficient of those responsibilities to the supra-national level to mean that the single representative could cover all those things. That is not a view that is generally agreed to in Brussels, though; I will just point that out. The Chairman: What are the implications for the UK, if and when? Sir Jon Cunliffe: I do not think there are big implications for the UK, and the proposal is to do this under a treaty article that applies specifically to the euro area. I do not think there is a question of “Would we join?” or whatever. The Chairman: And our place would be secure. Sir Jon Cunliffe: Our membership of the IMF? The Chairman: The IMF, yes. Sir Jon Cunliffe: There is a general debate going on about how many advanced economies have a chair at the IMF. “Shares and chairs”, as it is called, has been a huge discussion in the IMF for the last 35 years, along with how the emerging markets are represented. Our position may well change as a result of that, as our economic power in the world relative to China or wherever changes, but would we be part of a single representation, or would it impact directly on us? I do not think so. Andrew Bailey: It is important to remember that there is a fundamental link back to currencies here. If you go back to Bretton Woods, it was about currencies. That is mainly a national thing, as Jon rightly said, but that is the tension within the euro area. The Chairman: Thank you, Sir Jon Cunliffe and Mr Andrew Bailey. This concludes today’s public evidence session. Thank you very much indeed.

15

Sebastian Barnes, Henning Christophersen, Janet Henry and Martin Sandbu—Oral evidence (QQ27- 44)

Sebastian Barnes, Henning Christophersen, Janet Henry and Martin Sandbu— Oral evidence (QQ27-44)

Evidence Session No. 3 Heard in Public Questions 27 - 44

WEDNESDAY 9 DECEMBER 2015

Members present

Baroness Falkner of Margravine (Chairman) Lord Borwick Lord Butler of Brockwell Lord Davies of Stamford Lord Haskins Baroness Kingsmill Lord Lawson of Blaby Earl of Lindsay Lord McFall of Alcluith Lord Shutt of Greetland Lord Skidelsky ______

Examination of Witnesses

Martin Sandbu, the , Janet Henry, Global Chief Economist, HSBC, and Sebastian Barnes, Economic Counsellor to the Chief Economist, OECD

Q27 The Chairman: Welcome to the European Financial Affairs Sub-Committee’s inquiry into Europe’s economic and monetary union. You will have in front of you a list of Committee members’ interests. This is a formal evidence-taking session of the sub- committee. A full transcript will be taken. This will be put on the public record in printed form and will be on the parliamentary website. You will be sent a copy of the transcript, and you will be able to revise any minor errors. The session is on the record; it is being webcast live, and will be subsequently accessible via the parliamentary website. Mr Sandbu, Ms Henry and Mr Barnes, I will start the session with a general question, and Committee members will pick it up as they go along. Do not feel it incumbent upon all three of you to answer every question. You bring varying strengths and experiences to the table, but do feel free to come in when you wish to say something.

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Sebastian Barnes, Henning Christophersen, Janet Henry and Martin Sandbu—Oral evidence (QQ27- 44) I want to start by asking you for your assessment of the Five Presidents’ Report and the actions introduced in the short term as well as the longer term. In reflecting on that, I was hoping you would also think about the sustainability of the eurozone overall. I also ask whether, in the period referred to in the Five Presidents’ Report up to 2025, you see the eurozone still being in the form envisaged and as we know it today. I am going to start with Mr Sandbu. Would you like to take that up? Martin Sandbu: Thank you for inviting me. The premise behind both the work happening in the eurozone on further integration and all the debates surrounding it is that the eurozone, or any monetary union, is unsustainable in its current form without a deeper fiscal and political union. That is the premise behind the Five Presidents’ Report, the further integration process and the official agenda of the eurozone. I am in the minority of people who believe that that premise is false and that the eurozone’s economic stagnation has to do with unforced policy errors, partly awfully bad economic aggregate demand management and an unwillingness to countenance losses by creditors to sovereigns and banks, and that those were avoidable policy mistakes without which we would be in a much better place and would not need to talk about further integration of the eurozone. Given the intellectual premise that guides the deliberations in the eurozone, the Five Presidents’ Report is where we are. A very brief assessment from my perspective is that, first, this is a committee work and, as such, it has some inconsistencies and infelicities. Let me mention just a few examples. There is a push for convergence. We are told about convergence between and within EU eurozone countries. It is said on one page that this does not mean everyone has to do the same but that they should all converge in terms of incomes, but a couple of pages further on it says there needs to be a definition of best standard policies towards which member states should be held. There is talk of economic convergence within eurozone countries, which is linked to the idea of a social market economy, social Europe and so on. At the same time, there is a focus on competitiveness, which seems to be defined as reining in labour costs, i.e. lower wages, and it is hard to see how that is compatible with what they also call convergence within countries. Therefore, there are a number of inconsistencies and ill-defined and ill-thought- out concepts. Another point is that, to the extent there is sharp substance in this, I think everyone is better served by reading some of Mario Draghi’s speeches rather than the Five Presidents’ Report itself, because the main ideas really come from there. I would commend to you Draghi’s and Sintra speeches on the need for centralised power over structural policies in the eurozone, and his Jackson Hole speech from a while back on the need for a common fiscal stance in the eurozone, which he has not really talked much about since. Those are the two chief ideas in the Five Presidents’ Report. I think the need for a common fiscal stance for the eurozone is a very good idea. I think the need for convergence in structural policy, which, despite some of these inconsistencies, really means that countries should be held to similar policies, is a bad idea, in part because we do not know very well what sort of structural policies lead to growth, and because the policies that are right for an individual country will differ from those that are right for a different country. 17

Sebastian Barnes, Henning Christophersen, Janet Henry and Martin Sandbu—Oral evidence (QQ27- 44) Janet Henry: On the first point, I have a slightly different take on the source of the problem. It is much more basic and one that I think we are all very much aware of, namely that the euro was a political project to start with. It was never an optimal currency area and there were always going to be problems, and now we need to come up with a political solution. That is what is set out broadly in this report. My assessment of this report is that it is a continuation of the previous Presidents’ reports that we have had over the course of the past few years, which in many ways were insisted upon by Mr Draghi, to take up Mr Sandbu’s point. He was the one who originally asked for a road map towards future integration to give him the cover to deliver much more monetary stimulus and address some of the systemic risks to the eurozone. The report sets out what needs to happen. The bigger question is whether it is ever capable of being delivered, especially given that it will require treaty changes and in turn referenda in certain countries. I am sure we will come on to some of those issues. In terms of recent initiatives and the European Commission report, the initial step towards a common fiscal stance is critical to all this. It feeds through into the issue of the longer-term sustainability of the eurozone, which was the question you asked at the beginning, because it seems to me that everything is quite path-dependent. If, over the next decade, we were still to have a very strong global economy, there is some hope that the eurozone can export its way out of some of its current problems, but at the moment I still think that, without central fiscal co-ordination that takes a view of the whole eurozone, rather than allowing national Governments to run fiscal policies that are not necessarily consistent with the needs of the eurozone as a whole and can have negative spillovers, we will be at risk of exerting some longer-term deflationary pressures on the eurozone. We will go into this in a little more detail.

Q28 The Chairman: Mr Barnes, I know that you are speaking today in a personal capacity, but could you also comment on the OECD’s Going for Growth, which is supposed to explain what kind of structural policies are needed? Sebastian Barnes: I will turn to that last. In terms of my own comments—here we have three economists and three opinions—and coming back to the original question, the most likely scenario for the euro area is to continue essentially muddling through, which is what has been happening so far. That is really a path for steady decline, at least in relative if not absolute terms. Growth and inflation today are very weak. I expect growth to remain fairly weak in the medium term, based on the kinds of reports we see here. There is an obvious risk that a more catastrophic outcome could happen, but the central scenario based on this report is essentially to continue muddling through, because a lot of the fundamental problems of the euro area are not addressed in this report. For the short term, it is very weak, and for the long term there is lack of detail about how to get to its vision. Starting from where Martin Sandbu was, I agree with him that moving to a centralised fiscal system is neither desirable nor feasible now, but one area where it is essential for the good operation of the monetary union to have greater integration is on the financial side. A huge amount of progress has already been made, but in my view the one thing of substance in this report is deposit insurance, which we have seen is a very live topic. That is essential for two reasons. First, the euro area crisis was essentially not a fiscal one in origin but a financial one; it was due to the build-up of excessive financial imbalances and debt in countries in the 18

Sebastian Barnes, Henning Christophersen, Janet Henry and Martin Sandbu—Oral evidence (QQ27- 44) euro area. That in itself was linked to a lack of meaningful financial integration, so from a crisis management point of view this financial aspect deserves much more attention than it gets in this report. Secondly, the real problem in Europe today is lack of growth, partly because Europe has a very poorly performing financial system, not just in the cyclical sense because of the credit cycle but also in the structural sense. Bank finance is still far too dominant, and in many countries far too limited. That is why I think this report is inadequate. I will make two brief points, one on the fiscal side. The one substantive suggestion is the creation of a European fiscal board. I have some concerns about that, because the system is already very complicated, with many rules and many institutions. I do not see the value of adding one more, and I can expand on that later. Another point Martin Sandbu made was about the impact of structural reforms being uncertain. Going back into OECD mode, I recognise that they are uncertain, but we do know a lot about them. We also know—this is very important—that the benefits of structural reforms depend a lot on demand conditions. Too often, particularly in the European context, it has been the view that structural reforms will somehow miraculously generate growth. They will over the long term, but we need the right demand conditions as well.

Q29 Lord Borwick: On the Five Presidents’ Report, there are many plans for the future of the euro area. What are the implications of them actually achieving it, for the non-euro area? Janet Henry: I will start with a positive note on that. A prosperous eurozone is absolutely essential to the future prosperity of the UK economy. The truth is that 40% of our exports go to the eurozone. Therefore, if we can achieve a lot of the things in the Five Presidents’ Report and it can deliver a prosperous eurozone in the coming decades, that is something from which the UK can benefit in a very big sense. If the eurozone is going to go into a continued very weak growth environment and this is the best of the recovery, that will be a permanent drag on the outlook for UK external demand at a time when UK growth is very unbalanced. The size of the current account deficit is at record levels, and that will deliver some negative implications over the longer term. That is one of the implications. One of the other ones in the latest report of the European Commission is the need to speak with “a common voice”. One clarification they made was to say that this refers to the eurozone rather than the EU, so presumably this would not alter the UK’s role as a permanent member of the IMF board. It seems that we would still have that, and that goes along with sterling still being a . To pick up Sebastian’s comment regarding financial integration, this is something from which the UK economy, as an exporter of financial services and provider of financial services, would benefit as part of that integration process. But there are potential concerns—maybe that is a matter my colleagues can pick up—regarding the UK having a seat at the table and the ability to influence decision-making on eurozone laws that could impact the UK. Martin Sandbu: Fiscal policy has spillovers across borders between countries that trade with one another, regardless of their currency arrangements. There is a spillover from the eurozone fiscal stance, and monetary policy for that matter, to Britain and other non-euro countries. If that stance is better, that is probably a good thing, so, to the extent these 19

Sebastian Barnes, Henning Christophersen, Janet Henry and Martin Sandbu—Oral evidence (QQ27- 44) proposals will lead to getting the overall fiscal stance to a more optimal point, that would be a good thing. On the general move towards integration, to the extent it happens, the more policies you have in common and the more institutions you build to tie yourself together, inevitably the greater the community of interest that will grow around that, and that will alter the balance of power in the broader councils of Europe. It seems to me that that will inevitably lead to a loss of influence over European affairs across the board for non-euro countries. Lord Lawson of Blaby: I am not going to comment on a number of the things that have been said. I would just like some elucidation. All three of you have said that what the eurozone needs are a common fiscal stance and financial integration. Can you tell me precisely what is meant by a common fiscal stance and by financial integration? Sebastian Barnes: On financial integration, ultimately the eurozone should be going towards something that looks like what you have in one country: that is, common standards, common regulation, a common backstop and, more importantly, looking beyond regulation, a system that functions like it is one system. You would have some banks that would really be present in a meaningful way across the euro area. One of the big problems running up to the crisis was a lack of risk management. All the risks were concentrated in the same place. Irish banks basically lent to people in Ireland, so when the bubble burst in the housing market in Ireland all the risk was still in that country. If it had been diversified across the euro area, it would have made very little difference to anyone. That is what I mean by financial integration and financial development.

Q30 Lord Lawson of Blaby: I want to pursue this further. Financial integration means mergers of banks in different countries, so their lending is more spread out. I am not sure it would make a lot of difference. How do you promote that? Sebastian Barnes: At the moment, there are lots of barriers to doing that, particularly regulatory ones. The steps that have been taken in terms of moving to a single supervisor make a huge difference, but an awful lot of regulations still stand in the way. One idea some people have promoted is to have a separate 29th regime where banks could incorporate at European level, and then you really would start to create European banks, because all the corporate governance and consumer protection regulation is very national-specific. That is why there are not many bank with branches abroad. Typically, when a bank moves across a border it will buy another bank, so it inherits all of that kind of stuff, but that limits this process. The regulator does not look at concentration of risk in this way, so there is a kind of distortion. If you are a perfectly diversified bank, you are treated in the same way as one having all its assets in the greater Dublin area. That does not make a lot of sense. Lord Davies of Stamford: This one has been resolved by common supervision. Sebastian Barnes: I think it goes a long way to doing that. Deposit insurance is one of the big steps that would be needed. The Chairman: We are coming to that later in our discussion. Sebastian Barnes: I disagree a little on the importance of a common euro area fiscal stance. Lord Lawson of Blaby: What does it mean, anyway?

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Sebastian Barnes, Henning Christophersen, Janet Henry and Martin Sandbu—Oral evidence (QQ27- 44) Sebastian Barnes: I guess the idea is that, in the same way in which you think about a country’s fiscal stance, there should be a decision in the euro area about whether on average across the euro area it is expansionary or contractionary. Lord Lawson of Blaby: This is old-fashioned Keynesian policy, is it not? It is not what we do in this country. What the Government are concerned about—it is particularly difficult to know what the Labour Party believes at the present time—is to reduce the deficit. It is not manipulation in the old-fashioned Keynesian way, which never worked anyway. That is where you are, and that is the view of the authorities in the European Union. Sebastian Barnes: There is also a distinction between discretionary policy and the automatic stabilisers. Lord Lawson of Blaby: We are talking about discretionary policy. Sebastian Barnes: I think that distinction works very nicely in the textbook, but in reality it is very hard to distinguish between those two things. Lord Lawson of Blaby: No, it is not. I have done it. The Chairman: Let us hear from Mr Barnes. Sebastian Barnes: However one defines it, I do not think a common fiscal stance is really necessary. In normal times, monetary policy should provide area-wide macroeconomic management, and fiscal policy is, as I think Lord Lawson is advocating, essentially setting a medium-term path and allowing the automatic stabilisers to work around that. You do have exceptional times, of which this is one, and maybe you want to do something different, but I am not sure that needs to be hard-wired into the legislation. The real issue is about spillovers from one country to another. There are two types of spillover. There is the Greece-type spillover, where you run policy very poorly and that leads to a systemic crisis. There should be something in place—regulations, mechanisms and co-ordination—to stop that happening. On the wider spillovers between countries, it is very hard to manage it at a common level. If every country acted in its own interests in the same way you would not need this, but, moving beyond that, it is really an issue of macroeconomic imbalance, not fiscal policy per se. It is very challenging in practice to have any kind of co-ordination on this. Janet Henry: Maybe “common fiscal stance” is the wrong expression; it is much more about a co-ordinated fiscal stance, and the risk of negative spillover effects is one reason why a co- ordinated stance is needed. Even if we think about what the eurozone looked like before the crisis, to some degree there was a free rider problem, because everyone benefited from Germany’s very strong credit rating and the fact that just before the crisis it was in a much stronger fiscal position. Then we had the sovereign crisis; now we are in a QE world, and fiscal dynamics are not driving market implications to the same degree they did before the crisis. As for the need for a common fiscal stance, there is a set of European rules regarding deficits and debt burdens. Governments typically find it difficult to stick to them. At the same time, some Governments, such as Germany’s, have a national rule to run effectively a balanced budget. Germany running a balanced budget, rather than perhaps a looser fiscal policy in a way that might lower its current account surplus, which could be more beneficial to the rest

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Sebastian Barnes, Henning Christophersen, Janet Henry and Martin Sandbu—Oral evidence (QQ27- 44) of the eurozone, you could have a different policy mix within the eurozone. Therefore, a lot of what is needed is just co-ordination of fiscal policies across eurozone member states so that they think about growing the whole pie rather than having a deflationary influence on the rest of the Eurozone by the actions of one government. Martin Sandbu: I agree that we should speak of it as a co-ordinated and not common fiscal stance. I agree it is not necessary, but it would be economically beneficial because it would allow you to get an optimal, or closer to optimal, fiscalmonetary policy mix. That is why Draghi called for it in his Jackson Hole speech two years ago, because he perceived, as many other monetary policymakers did, that he was running out of monetary road and so monetary policy could not take the full burden of increasing aggregate demand in the recession in which the eurozone found itself at the time. On financial integration, I agree that the key is risk-sharing or risk dispersion. The comparison with the US is very often made. In the US, about 80% of regional or local GDP shocks are spread out before they hit local consumption; in other words, local consumption varies only by about 20% of the size of local GDP shocks. Most of that—some 60% or three- quarters—of the total smoothing happens through private financial channels, not through fiscal risk-sharing, which is why I believe it is a mistake to think that the eurozone needs large fiscal risk-sharing in order to survive. It could do what the US does, which is to have large private risk-sharing. It means that, regardless of the details of how, investors or private agents in one country are exposed to the GDP of another country. It is as simple as that. There are a lot of ways in which you could imagine that happening, and I do not think policymakers should necessarily have an opinion on which way is best. Surely, one crucial precondition for that is that investors do not fear that the currency will be redenominated, in which case you have absolutely no incentive to stay exposed to a country that might leave. Lord Butler of Brockwell: I want to follow up with Janet Henry and Martin Sandbu a question that Sebastian Barnes answered. You have talked about the importance of a co-ordinated fiscal stance and greater financial integration. On the basis of your assessment of the realistic prospects of those things, do you expect the economic and monetary union in 2025 to be muddling through in the way Mr Barnes suggested it would, or not? What do you expect will have happened to the eurozone by 2025, on the basis of your realistic assessment of how likely the necessary conditions for it will be achieved? Janet Henry: I broadly agree. Ten years from now, I would expect the eurozone still to be muddling through. We will probably go through renewed signs of strain, and often it is signs of strain that will take us to the next stage of integration. There might be some political difficulties along the way. It is not just the fear of catastrophe that can be used to take us forward; we will need to have a more positive narrative about the reasons why the eurozone works better together going forward. It will require much more work in a lot of circles. I think that at the moment, while they are coming together with the reports, there is still a sense in Europe that what is set out in this report will not be easy to achieve. Perhaps some may be hoping that they will not have to go the full distance on a lot of these because we will be able to muddle through without new signs of strain. Ultimately, I think we will still be muddling through.

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Sebastian Barnes, Henning Christophersen, Janet Henry and Martin Sandbu—Oral evidence (QQ27- 44) Lord Lawson of Blaby: I was interested in the parallel Mr Sandbu drew with the United States. It is very useful because that is an example of a large monetary union, if you like, but the fiscal thing that is important in the United States is that it is not a common fiscal stance. What is important is that federal taxation and expenditure are both key: in other words, there is a common fiscal policy in the sense of revenue and expenditure, and many people might think that needs to happen to make a success of European monetary union. You talk about a common fiscal stance in a neo-Keynesian way. I think Keynes would have rejected it altogether, but you do not mention what really matters: fiscal union, which is what the United States is, as well as monetary union. I am just surprised. The Chairman: Very briefly, Mr Sandbu, although you will be able to pick up some of that as we go on. Martin Sandbu: The large federal budget in the US has three economic functions. First, it ensures a fiscal common stance to the extent that is a share of the economy. Secondly, it does fiscal risk-sharing to some extent—that is to say, transfers from those having a good time to those going through a rough patch, but over time that is revenue neutral. The third function is fiscal redistribution from the rich to the poor, which can be a permanent redistribution. I think the economic arguments for the sustainability of the monetary union relate to the fiscal stance and fiscal risk-sharing. As to permanent fiscal redistribution from rich to poor, there may be an issue about political sustainability of monetary union. I do not think there is a good economic argument that redistribution from the rich to the poor is necessary. Of course, the US had a functioning monetary union for a good 150 years before it had much of a federal budget at all. As late as 1936, the federal budget was about 5% of GDP, and that was with the New Deal spending. It was really the war and the Great Society afterwards that created the federal budget we know today.

Q31 Lord Davies of Stamford: There has been quite a wide disparity in the economic experience over the past few years of eurozone countries. Some of them are doing very well. Obviously, Germany and the Baltic states are doing pretty well; Spain and Ireland, two of the countries, seem to be doing rather well. Others are doing much less well. What conclusion do you draw from this disparity in terms of the structural nature of the economies, or the fiscal policies being pursued, or the extent to which markets have been liberated and deregulated? In your view, what explains this very different performance? The Chairman: Mr Barnes, we have already covered a bit of the Irish situation. Do you want to pick up one or two of the key points? Sebastian Barnes: Frustratingly, in each case, there is a specific set of reasons, but I think there are some general points that you can draw out. One is the way that fiscal consolidation was managed. Countries that did it early and credibly in a neat way got a lot of benefits. For example, Ireland was relatively ahead of the curve. You can see that the market interest rate fell much faster than in some of the other countries that struggled to get there. Therefore, having sound fiscal institutions that can deliver is very important. The state of the financial sector has been critical and that is holding back a lot of countries, and that is partly to do with how rigorously the financial system has been cleaned up. Ireland did not get it right first time, but eventually it had a very comprehensive solution, which has been helpful.

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Sebastian Barnes, Henning Christophersen, Janet Henry and Martin Sandbu—Oral evidence (QQ27- 44) The final and perhaps most important thing is the inherent capacity of the economy to grow and particularly to export. Ireland’s export performance has been extraordinary, partly through good luck but partly because it managed to restore competitiveness very quickly. Wages were cut. It is basically an attractive economy to be located in. People are dynamic and well educated, and it is a good place to do business. In other countries, some reforms have been helpful. Spain’s export performance, despite many headwinds, has been very successful as well, which I think points to some sound economic fundamentals. Spain also carried out important labour market reforms, which, although against the backdrop of very high unemployment, came at the right moment in encouraging new hiring as soon as demand came back. External demand started driving it. Those are some of the common factors. The Chairman: Ms Henry, I ask you to respond only if you disagree with what has been said. Janet Henry: I draw a comparison with what it means for the rest of the eurozone. We have to bear in mind that Ireland had about the most flexible labour market in the eurozone before the crisis. It was because of that flexibility in the labour and product markets that it was able to undergo the internal devaluation that made it regain competitiveness quite quickly. I think that, when the crisis first hit, fiscal consolidation was perhaps less important; it was much more about being able to regain competitiveness. Ireland has a unique structure with a massive US dollar-based export business and a high exposure to the UK and US, which obviously had a strong recovery. In the case of Spain— Lord Davies of Stamford: Greece undertook very considerable internal devaluation. That did not produce the same results. Janet Henry: But Ireland had a massive export sector as a share of GDP, whereas in the case of Greece it was largely oil-related in terms of products and tourism. It was not able to benefit in terms of export markets, nor did it have flexible labour markets. The Chairman: You were going to talk about Spain. Janet Henry: You need to view Spain’s recovery in the context of the recession that preceded it. Looking at the eurozone today, the aggregate is still not back at pre-crisis levels. The level of GDP is still below pre-crisis levels. Spain’s level of GDP is still 5% below pre-crisis levels because it had such a deep recession. That is not to downplay the structural reform efforts put in place by the Spanish Government to liberalise the labour market, with wage indexation and so on, and to make the labour market more flexible, but it still has over 20% unemployment. This is where a fiscal role for the eurozone could come into play. I think there would be big objections to permanent fiscal transfers, but there could be an element of a fiscal stabilisation fund which rewards countries delivering reforms, because that was the way the peripheral programmes like Ireland’s and Portugal’s worked. When they were in the adjustment programme and given financial support, they delivered the structural reforms, whereas perhaps some of those countries with bigger structural problems have delivered a lot less on the structural reform front over the course of the past couple of years. The Chairman: You are talking about a kind of EU Marshall plan. Janet Henry: There are elements of similarity.

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Sebastian Barnes, Henning Christophersen, Janet Henry and Martin Sandbu—Oral evidence (QQ27- 44) The Chairman: I want to bring in Lord Haskins and then Lord Skidelsky on implementation of EU rules.

Q32 Lord Haskins: The eurozone had rules right from the beginning. The problem is that local politicians have chosen to ignore them or not apply them. At the beginning, in the setting up of the eurozone, there were some pretty credible criteria for countries joining it, which were immediately ignored in two or three cases at that time. On the stability pacts, some quite sensible disciplines were to be applied, which again were ignored even by the French and Germans. First, if those rules had been applied properly, would we be in a different position? Secondly, if those rules were inadequate, will the new rules be any better, and will they be implemented? The Chairman: Mr Sandbu, of course that is relevant to your book. Martin Sandbu: The stability and growth pact consisted of rules that were bad but toothless. After the crisis I think they have been made worse but given teeth. There would not have been much difference, even if the fiscal rules had been stuck to, because most of the crisis did not involve a fiscal crisis. There was the Greek case, but of course Ireland entered the crisis with a public debt to GDP ratio of about 25%; Spain was at 36%. They were well within any of the rules. I do not think it would have been much better. The problem now is that the rules are a little more binding but not necessarily better; they are probably worse, in that they do not allow for an appropriate overall co-ordinated fiscal stance where those that have to cut, cut, but those who do not can expand to keep overall aggregate demand adequate. Lord Davies of Stamford: I did not think it was the first time they had these structural and cyclical deficits. Martin Sandbu: Indeed, and that is one illustration of how there is quite a lot of interpretive room for manoeuvre inside the rules. We see that with the Commission communication back in January on how it would interpret the rules in light of structural reforms being undertaken, and so on. It is quite clear that, if you look at the letter of the rules, there are many ways to judge what count as the correct policies towards these medium-term objectives. Indeed, one could imagine a much more traditionally Keynesian interpretation that the goal of the rules is to make it sustainable in the medium run. You do that not by squeezing GDP but getting growth going, and that means increasing the deficits before cutting them harsher later. That is, logically speaking, quite consistent with the rules, but that all depends on the politics. That is why—to pick up Lord Butler’s question— policymakers will muddle through, but that is not necessarily a bad thing and, depending on the politics of whoever is in power five years from now, things might be practised in quite a different way. Sebastian Barnes: The way the question was posed was: would things be different without the rules? I think things would be worse without the rules. I think they increase the focus on sustainability, and in the current period, since the “Six-pack”, “Two-pack” and Fiscal Compact, governments are taking them more seriously, partly because they see they have more teeth. However, the rules are essentially a mess; they are very complicated and in parts poorly thought-through, and that raises a question about sustainability of the rules going forward. It is the experience of advanced economies that when they have a downturn 25

Sebastian Barnes, Henning Christophersen, Janet Henry and Martin Sandbu—Oral evidence (QQ27- 44) and the deficits blow out, and then governments tend to close the deficits. The problem is that they do not move towards surplus in the upswing. There has been an increasing debt trend in basically every developed country. If you want to reverse that, fiscal discipline has to apply in the good times. There is a risk that, because of the flaws in the rules, in good times they will be ignored again and ineffective. That is partly because there are political pressures to ignore them, but also because the economics of the rules are sometimes very hard to defend. To come back to the point raised by Lord Davies, although it is now based much more on the concept of structural balance, the measurement of it suffers from very severe problems. It suffered very severe problems before the crisis. The only two countries that have consistently met those kinds of requirements were Spain and Ireland, but we all know now that that was unsustainable, and essentially the Commission has not made any changes to the methodology that led to that. They use a measure of potential output that is incredibly cyclical. That will give misleading signals in bad times when it requires countries to consolidate. Therefore, if they get hit by a negative shock they should allow the automatic stabilisers to work, but the structural balance will go into massive deficit and then government have to take pro-cyclical corrective action. In good times, even though the situation is unsustainable and governments have lots of cyclical revenues, the structural balance measure will tend to tell you that things are fine, and many governments will settle for that. The Chairman: Should there be better rules to deal with the good times to direct Governments in the good times? Sebastian Barnes: I think one of the most positive developments is away from these headlines. One relates to having better statistics. It is not a very exciting issue, but it would be important in the case of Greece, for example. Much more substantially, the development of national independent fiscal councils—I sit on one—is a very positive development, because essentially you need a culture change. You need real ownership of the public finances to counter the short-termism that can emerge within the political system. In my experience at least, that seems to be a very promising way of getting a culture of thinking about the public finances in the medium term, which is what you need. They have to be careful that the rules do not interfere with setting good policy, and they can support it. Janet Henry: I completely agree with what Sebastian has said, but I would add a point regarding the sanctions procedure. This relates to enforcement. The eurozone has chosen to have a sanctions procedure but it has never imposed one, which means that the rules themselves lack credibility. It is not just the fiscal rules but the macroeconomic imbalance procedure and the asymmetric way in which it is applied, which is: deficits bad, surpluses good. Therefore, a current account deficit of 4% of GDP is considered to be a problem, but a current account surplus has to go beyond 6% of GDP before it is considered a problem. Germany running on an 8% of GDP surplus has not been heavily criticised, or been the subject of action to address it. I agree there needs to be rules. Things might have been worse without some of the rules, but they need to be sensible and credible.

Q33 Lord Skidelsky: Can I pick up the current macro-imbalances? One of our witnesses talked about a mercantilist German core and the deflationary impact of that. Of course, the use of the word “mercantilist” is interesting, because it was the chief aim of the mercantilists 26

Sebastian Barnes, Henning Christophersen, Janet Henry and Martin Sandbu—Oral evidence (QQ27- 44) to run a permanent export surplus, which David Hume, in a famous essay on the balance of trade, said was self-defeating, but that seems to be the German aim. Of course, in a fixed exchange rate system, the adjustment mechanism is somewhat different, but the question I want to ask you is: do you see any chance of Germany’s current account surplus disappearing over the medium term? Martin Sandbu: I would like to make two points in answer to that. One is that current account asymmetries, as I prefer to call them, can often be a very good thing. It makes perfect economic sense for an ageing and rich country to export capital to a younger and poorer country, which presumably has greater potential for growth. The large current account surpluses and deficits in the eurozone in the run-up to the crisis were not bad in themselves, but they were bad because the capital imported in the periphery was badly invested or, in the case of Greece and Portugal, not invested at all but consumed. In Ireland and Spain, it was invested in houses nobody wanted. It is not necessarily the magnitude that is a problem but how it is used. I think the eurozone would be wise to try to return to a situation of permanent capital exports and imports, although perhaps not as large as they were. In preparation for this meeting, I looked up the latest figure on the German current account surplus, or the trade surplus which largely accounts for it. The German statistical bureau has the January to September figures for this year. They show a surplus of about €186 billion. That puts them well on course to being a bit over 8% of GDP for 2015 as a whole. That is a very large surplus; it is the largest in the world in absolute terms. Out of that, how much is with which group of countries? Out of the €186 billion, €130 billion is with countries not just outside the eurozone but outside the EU. This is part of the story that Germany has succeeded in selling a lot to China, for example. That leaves €55 billion of the surplus with the rest of Europe or the EU. Out of that €55 billion, how much is with eurozone countries? The answer is €6 billion out of €186 billion. Therefore, to all intents and purposes, the current account surplus with the rest of the eurozone has disappeared. Those people who thought that that surplus was a particularly harmful problem for the rest of the currency union should presumably say that the elimination of it has been a very good thing and a boost to growth on the periphery. I do not hear them say that. As I have just explained, I am a bit more agnostic about what these balances should be, but, to the extent that there was a problem, it is no longer there. Lord Skidelsky: The fact that the imbalance with the eurozone has shrunk to €6 billion means that the capital exports increasingly go to the countries that are running balance of trade deficits with Germany. That means that you do not get the capital export mechanism in the eurozone that you were talking about earlier; in other words, deflation just goes on in a more roundabout way. Martin Sandbu: That is the problem. I think the elimination of the imbalance is as much a problem as the existence of it. I do not think countries like Greece and Spain should be in current account balance; it would be good for them to import capital and invest it properly to grow faster. The Chairman: I am going to turn to Lord Butler on financial integration, and in the few minutes left we will deal briefly with capital markets union. Would you speak to the question as briefly as possible? 27

Sebastian Barnes, Henning Christophersen, Janet Henry and Martin Sandbu—Oral evidence (QQ27- 44) Q34 Lord Butler of Brockwell: We touched on this a little earlier. What is your assessment of whether the three-stage approach in the Five Presidents’ Report, given that it is opposed by Germany, presents a realistic prospect of achieving financial integration? Martin Sandbu: I do not think so. Lord Butler of Brockwell: That is the sort of short answer we want. The Chairman: We are talking here specifically about deposit insurance. Lord Butler of Brockwell: That is one of the stages. Martin Sandbu: To add one longer sentence, capital markets union matters a whole lot. That is not really a key point in the Five Presidents’ Report; it is mentioned. That is where the action really is, more than deposit insurance. Lord Davies of Stamford: Is it going to happen? Martin Sandbu: We are going in that direction, but, in terms of degree, there is a very long way to go. As I am sure you know, the financial systems of Europe and the US are about the same size relative to GDP. In Europe, three-quarters is bank lending; in the US, one-quarter is bank lending and the rest is capital markets. It is a very long way to go. Lord Butler of Brockwell: Given Janet Henry’s position in HSBC, I would be particularly interested in her reply to this point. Janet Henry: I just make the point that I sit in global research at HSBC, behind very strictly enforced Chinese walls. I am not a decision-maker at HSBC. I think it is an incomplete banking union if it does not have an element of common deposit insurance, but German resistance is clear, without certain prerequisites being in place. It certainly sees it as something that would require treaty change, and we all know that anything to do with treaty change will take a very long time to come through. I think deposit insurance is quite critical at least to show there is something in place to deal with asymmetric shocks, or a shock within a country, in the eurozone. We cannot go back to the situation where one country with a massive financial or banking problem can shake the eurozone on the scale that we saw during the financial crisis. We probably will get some element of deposit insurance coming through, not to the full extent required. It will probably take 10 years before it is in place, and there will be some uncertainty in the interim, but I agree with Martin that it is the capital markets union that is more important. Sebastian Barnes: My response also spans Lord Skidelsky’s question as well. A key issue is that countries that run very large surpluses feel that they are in a much stronger position than those that run large deficits. Germany has done very little in terms of reform in recent years. Some of the reasons it has an excessive current account surplus are to do with the lack of reform and the structural features of its economy. While its economy has been performing very well it sees very little need to engage with these kinds of processes, although its financial system is not as great as one would expect it to be. Maybe in a different conjuncture, Germany will see the benefits of co-operating more clearly than it does today.

Q35 Earl of Lindsay: You have just said that capital markets union is of greater importance. Do you want to expand on exactly why that is? 28

Sebastian Barnes, Henning Christophersen, Janet Henry and Martin Sandbu—Oral evidence (QQ27- 44) Martin Sandbu: In my view, it is because the more equity-like your financing, the more you can expect that the investments will take proper account of the risks involved, and the easier it is to deal with them in a crisis where bad risks materialise. There is an interesting comparison to be made between Greece and , which had a much larger current account deficit than Greece but had a sharp but short crisis. Its current account deficit was financed through direct foreign investment—actually, not portfolio equity—but the point is the same. Debt is problematic; bank debt is even more problematic. It is very hard to deal with if something goes wrong. The key to capital markets union is that capital market debt is more like equity than bank debt, and capital market equity is equity and that is a better way both to direct investments and resolve failed investments. Janet Henry: I would agree with that, but a lot needs to be put in place before you can have a fully integrated capital markets union, especially as a lot of it is aimed at improving finance to SMEs. To go back to Martin’s point, only about 10% of US corporate finance is provided by the bank lending and nearly 90% of eurozone corporate finance is provided by the banking system. If you are going to have cross-border capital market issuance, you have to have common schemes for things like insolvency. You may even need common taxation of savings and investment instruments. It will take a long time to put this in place, but it is about spreading economic risk across the eurozone. It still poses questions regarding financial stability risk. There is still a role for financial sector supervisors and banking supervisors that would need to be put in place. We saw what happened even in the US where they have very large capital markets. It did not mean that there was no financial crisis; it was just not as concentrated perhaps in the banking system. Earl of Lindsay: Will it be achieved? Janet Henry: Will capital markets union be achieved? I think we will see progress on capital markets union. I am a bit more optimistic about the speed of progress on capital markets union. A lot of work has been done on this and there are very clear ideas of how it should happen and what needs to come into place. There is perhaps less political resistance to it than to some of the fiscal integration issues. The Chairman: On that optimistic note, thank you very much indeed, Mr Barnes, Ms Henry and Mr Sandbu. This concludes today's first public evidence session.

Examination of Witness

Henning Christophersen, Senior Partner, Kreab, and former Deputy Prime Minister of

Q36 The Chairman: Good morning, Mr Christophersen. Welcome to the European Union Financial Affairs Sub-Committee’s inquiry into Europe’s economic and monetary union. We are delighted to welcome you here. You are former Deputy Prime Minister and Finance Minister of Denmark. It is our pleasure to have you giving evidence to us. You have a list of interests that have been declared by Sub-Committee members. This is a formal evidence- taking session of the Sub-Committee. A full transcript will be taken. This will be put on the 29

Sebastian Barnes, Henning Christophersen, Janet Henry and Martin Sandbu—Oral evidence (QQ27- 44) public record in printed form and will be on the parliamentary website. You will be sent a copy of the transcript, and you will be able to revise it in terms of any minor errors. This session is on the record and is being webcast live, and it will be subsequently accessible via the United Kingdom parliamentary website. In starting this session, what is your assessment of the Five Presidents’ Report? Could you also give a general evaluation of the sustainability of the eurozone? We know that the Five Presidents’ Report envisages a series of stages leading up to 2025. Could I ask you whether you think the eurozone will survive in its current form? Henning Christophersen: First, I would like to thank you for the invitation to attend this meeting and be a witness. For me, it is a great privilege and pleasure, as I hope it is for you, but let us wait and see. I have read the report from the presidents: Mr Schulz, Mr Juncker, Mr Draghi and Mr Dijsselbloem. Some work still has to be done; it is only the very beginning of a long process. They foresee that what they have outlined as options should be finalised around 2025. They do not speak about changes of the treaty, but I could come back to that question at a later stage. I think they have divided their options into four parts. First, they want member states to improve convergence and the structures of their economies to bring them closer to one another, and improve employment and things like that. In the next step they speak about how to establish a genuine financial union with integrated finance for an integrated economy. The third part speaks about the need for better fiscal union. There are many different options in that chapter, because better fiscal union also means you will have to converge the fiscal legislation of the member states. One example is to create a common basis, not necessarily a common rate, for corporate tax, and that part has been a little actualised by all the discussions we have seen about how some member states have tried to circumvent the good idea of having genuine fiscal union by giving special treatment to certain companies, mainly from third countries. Finally, there is the whole question of democratic accountability, and that could lead to a long discussion. I am ready to go into that, because I do not think you can do all these things without changing the way the institutions are working. In the first instance, the Presidents are proposing an inter-institutional agreement, but I think that after 2025 we would have to see how this could be transformed into amendments to the . That itself is a difficult matter. Does it mean that the EMU is a separate part of the treaty, or is it open to everybody? We could come back to that. I still believe there are a lot of issues they should have addressed, but for political reasons they have not done it. There is the whole question of the budgetary consequences of their proposals. Should there be a separate budget for the eurozone? That is what some Governments have in mind. Who should take care of that? Today, the eurozone does not have a separate budget. Some smaller expenses are paid out of the general budget because the Commission is doing work as part of the troika, but it cannot go on like that. If you really want to have more substantial financial support for member states encountering difficulties, you need a separate budget, and what will be the institutional consequences of that? That is one more thing they have not addressed.

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Sebastian Barnes, Henning Christophersen, Janet Henry and Martin Sandbu—Oral evidence (QQ27- 44) Q37 The Chairman: We will pick up several of those very interesting things you have pointed out as we go through the session.

In light of the fact that the United Kingdom and Denmark are in a very particular situation given the eurozone, what are your views on the implications of the proposals in the Five Presidents’ Report for these two countries in particular? Henning Christophersen: There are three opt-out countries. Two of them, the UK and Denmark, have a protocol, and then we have a de facto opt-out country, . Sweden has decided to have a floating currency. If you have a floating currency rate vis-à-vis the euro, you cannot join the European exchange rate mechanism for two years, and, if you have not done that, you are not eligible for the EMU. Therefore, we have two legal and one illegal, if I may use that expression, opt-out countries. I am half-Swedish, so it is not a chauvinist remark. The Swedes have been very clever in the way they have been doing this. The Commission could have taken Sweden to the Court of Justice and said this was a violation of the treaty, but they have not done so for political reasons. So there are three opt-out countries, but ones with different consequences. My country has decided to have a fixed currency rate vis-à-vis the euro. I introduced that myself in 1982 when I was Minister of Finance. I think Lord Lawson will remember that. We decided to have a fixed rate vis-à-vis the ECU, as it was called at that time. Later on it became the German mark, and finally it became the euro. Therefore, the Danish currency can deviate from the central rate of the euro by only 0.3%. That is not very much, but they have been able to stick to that. They have a special arrangement with the ECB whereby the ECB is obliged to intervene in favour of the Danish currency if there are problems. There are no problems for the time being. On the contrary, there has been a huge inflow of foreign currency into the Danish central bank. At a certain moment in the summer our currency reserve was about 750 billion Danish crowns, which is €100 billion. That was because some people in the capital markets thought that, after Switzerland left the fixed rate vis-à-vis the euro, Denmark would do the same, but the Danish central bank, with full political support by all parties, decided to stick to the ECU system we established in 1982. So the fixed exchange rate for the Danish currency vis-à-vis the euro is the anchor of Danish macroeconomic policy. In Sweden you have another kind of opt-out. They are using the currency rate, but, at the same time, the inflation rate as the guiding principle for monetary policy, and the UK has a third way of handling these things. So it is very difficult to say that these three countries are on the same line. That is not the case. Denmark is in theory an opt-in country; Sweden is a stay-as-we-are country; and the UK is perhaps an opt-out country. I do not know. I will not make any remarks about the upcoming negotiations between the EU 27 and the UK, but you cannot really compare the three countries. In Denmark my compatriots are satisfied with the present regime, and they want a strengthening of the macro-economic programme for member states. They have no problems with the present situation. The Chairman: Coming to the politics of it, particularly given what happened in last week’s Danish referendum on justice and home affairs, are you able to say briefly whether you think that the Five Presidents’ Report in any way threatens Denmark’s interests?

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Sebastian Barnes, Henning Christophersen, Janet Henry and Martin Sandbu—Oral evidence (QQ27- 44) Henning Christophersen: It was not discussed at all. The Danish referendum was mainly the result of a discussion about the interpretation of the Danish constitution. What are the rules for the transfer of sovereignty to the European Union? The Chairman: That is a very active question in Denmark, is it not? Henning Christophersen: It has become so, but now you see that most of the political parties, also the No parties, are trying to find out how Denmark could still stay in Europol and use 21 of the legal Acts which are part of the home and justice chapter. The UK is using more than 130, so the UK is much more European than Denmark in this respect, but we will wait and see. The Danish Prime Minister will be in Brussels on Friday to discuss these matters with Mr Tusk and Mr Juncker. I will be there on Friday and will have a talk with these people to find out what will be the road for the Danish Government. It is a very difficult situation, but it is mainly a question about the interpretation of the Danish constitution.

Q38 Lord Lawson of Blaby: First, may I say how good it is to see you again, Mr Christophersen? We have known each other for a long time. I think it was more than 30 years ago that we sat alongside each other in the ECOFIN council meetings when you were the Danish Finance Minister, so it is good to see you again. There is a widespread belief, which I think is correct, that the European Union has a bureaucratic surplus and democratic deficit. I would like to focus on the democratic deficit, because this will become more acute if the integration path of the eurozone countries is pursued as the Five Presidents’ Report and many other people in the European Union would like to see. What do you feel needs to be done to create some kind of democratic accountability to overcome the problem of the democratic deficit? Henning Christophersen: Now I will say something you cannot find in the report. I think it will be necessary at a certain moment to make the Euro Council a genuine European institution, subject to the supervision of part of the where members come from the euro countries. You need to separate the work of the Commission and transfer the euro-related work to the secretariat at the Euro Council, because it is strange that for the time being euro bailout countries are under the supervision of a Commission that also represents non-euro member states. In my view, you need to split the work of the Commission and transfer the euro-related work to a secretariat of the Euro Council, which should be made a genuine institution subject to the supervision and control of that part of the European Parliament that is elected by the euro countries. Lord Lawson of Blaby: I am not quite clear. By “Euro Council” you do not mean the , but something that does not exist as an institution. Henning Christophersen: Yes, as long as they discuss euro-related issues. There are many other issues that have to be discussed by all 28 member states. The Chairman: Another of our witnesses has raised that option. The big question that arises there is that, if you are setting up different institutional structures for the eurozone, in terms of the eurozone budget should you have non-eurozone countries contributing to run those institutions? Henning Christophersen: No. I think the eurozone countries and the Euro Council, as an institution with its own secretariat under the supervision of the elected eurozone members of the European Parliament, should have its own budget. That is what Mrs Merkel and 32

Sebastian Barnes, Henning Christophersen, Janet Henry and Martin Sandbu—Oral evidence (QQ27- 44) President Hollande are speaking about. You need some substance, and you cannot continue with the present methodology where you spend part of the EU budget that is financed by everybody on euro countries. We have seen that. It is not much; it is about €20 billion in guarantees, but you have to separate these two things. Then there will be no problems with the opt-out countries. Lord Lawson of Blaby: But there might be another problem. I am not sure I fully understand what you are proposing, but it looks rather more like a duplication of bureaucracy than the introduction of democracy. Henning Christophersen: No. “Bureaucracy” is a strange word to use. You can have an efficient or an inefficient bureaucracy. Many years ago Reich Chancellor Otto von Bismarck was asked, “What do you think about the bureaucracy in the new countries you have taken on board?”. He said, “I will tell you one thing. If I am told tomorrow that the end of this world is very near, I will without any hesitation move to Mecklenburg because I know that everything of importance for Mecklenburg will happen with a delay of at least 100 years”. You can have inefficient bureaucracy, but I know the ECOFIN council very well and that part of the Commission is working. I have some good friends who are working in the troika system. We must no longer call it the troika system; the Greeks do not like it. Call it the inter- institutional system. The Commission is working in a strange way on this, because it is a combination of a Commission service, which is a service for all 28 member states in agreement with the IMF, where you have many other countries involved, working on the euro countries. My view is that that is not sustainable. You must have a separate bureaucracy, if you call it that, working efficiently on the euro countries, with the necessary machinery, financed by a separate budget for the eurozone. That budget must be approved by the European Parliament and the Euro Council, and they must have their mandate from national parliaments to do it. In my view, that is the most logical way out of the present mess. I do not know whether you should put “mess” into the record. Lord Lawson of Blaby: Oh, yes. It is a four-letter word, but it is acceptable.

Q39 Lord Shutt of Greetland: How do you think the current economic prospects and problems of individual countries impinge on the plans for further reform of economic governance set out in the report? In addition, we had a trio of people before us a few months ago and one thing they kept saying was that the euro would muddle through. Is it your view that the euro will muddle through in respect of all the euro states? Henning Christophersen: It will continue to exist. The rate of the euro vis-à-vis the dollar and other main reserve currencies has not really been affected by the euro crisis. It has to a certain extent been affected by the move by the ECB to loosen monetary policy, but it has not really had an impact on the rate of the euro. It is clear that there are big differences we have to overcome between the rate of unemployment in the euro countries and non-euro countries. In my country it is on its way down; we have reached 6% unemployment for all registered people. In some other countries it is much closer to 25%. Youth unemployment in Spain is 30% or 35%, and it is the same in Greece. You cannot continue with that big difference and lack of convergence. That has very much to do with the completely different systems of labour legislation. It is extremely difficult in France to dismiss people and for a company to reduce employment. We have seen the problems with ferry boats in the channel. One victim was the Danish shipping company DFDS. Finally, they were allowed to 33

Sebastian Barnes, Henning Christophersen, Janet Henry and Martin Sandbu—Oral evidence (QQ27- 44) buy it but it cost them a lot of money. There are other problems in France that have a big negative impact on the willingness of foreigners to invest in that country. It is different here in the UK and in Germany. In Denmark you can dismiss people from one day to another. You can give them a letter on Friday afternoon saying, “Don’t come here any more; goodbye. See you when we need you”. That has been accepted because we have a rather generous unemployment benefits system. Therefore, the state is financing a large part of the costs of the dismissal of people, but in other countries you do not have that system. You also have different tax levels and the age at which you can get your pension. In France, for some jobs—locomotive drivers—you have the right to draw a pension when you are 50; in Denmark you must be 67. I do not know what it is in the UK, but the report points out lack of convergence as an important area where we should start work, and then we can see how we can strengthen the financial and fiscal parts of the Union. The fiscal part is very, very difficult. I was a member of the convention and praesidium for the Lisbon treaty, together with John Kerr, Valéry Giscard d’Estaing, Giuliano Amato and others, in what finally became the Lisbon treaty, which was also ratified by this House. For fiscal co-ordination you need unanimity. Lord Davies of Stamford: On your point about the widely varying unemployment rates in the European Union, it seems to show that the labour market is not clearing. You have 25% unemployment in Spain and 5% unemployment in Germany and Denmark. If those figures are correct, why does 25% of the adult population in Spain not move to Denmark, Germany or here, where there are lots of job vacancies? They are moving from and , but perhaps not from Spain. Why is that? Henning Christophersen: I am chairman of a metro company. We are building metro systems, and for the time being we have projects to the value of €7 billion. That is going very well, but we have many Italian, Portuguese, Irish, British and French staff members. You have some linguistic problems in Europe that you do not have in the United States. That is one problem. We are spending millions of translating all kinds of manuals into 10 different languages: for example, Portuguese, English and Swedish. There are also other traditions in some countries. In Spain, for example, young people stay at home and live with their parents. They feel they have an obligation to support their parents. It is not so easy to move away as it is in other countries. To be frank, if you go to Denmark, Sweden or the UK, perhaps taxation is lower and social benefits are higher, so in some parts of Europe there is an ambition to move. We do not have so many Poles in Denmark, but we have always had Poles, or people of Polish origin. We have for the time being 50,000 Polish workers. They have no problems getting a job because they are doing a lot of things Danish workers do not like to touch. You have the same situation in Germany. You have a lot of people from the former Yugoslavian Federation in Germany who are ready to do the work that Germans do not want to touch, because they prefer to work for Mercedes Benz or Volkswagen—or at least they preferred to work for Volkswagen.

Q40 Lord Borwick: There is a notable gap between the implementation of EU rules and the writing of them. That seems to have been the history for a long time, starting off with the euro, for example, and the introduction of Greece into the eurozone. How can you get the Governments of the individual states to stick to the rules they have agreed at European level? 34

Sebastian Barnes, Henning Christophersen, Janet Henry and Martin Sandbu—Oral evidence (QQ27- 44) Henning Christophersen: Now I will tell you one thing about the creation of the euro. I was responsible for the implementation of that part of the until January 1995. There was a very big discussion—Lord Lawson will remember it—between the French and the Germans. The French were in favour of something the Germans are now in favour of but at that time rejected. The French talked about the need for “gouvernement économique”, or economic government. They said it was not sufficient to have a central bank and common currency; there should also be a common fiscal and macroeconomic policy. That was rejected by the Germans. A good friend, Theo Vaigel, told me, “Yes, but we in Germany do not want the French and others to water down our strict fiscal policy; that is up to us to decide, so that must be done by each member state itself”. The French said, “No, it’s very important to have it”. Personally, Delors and I were in favour of continuing that discussion because we felt they had a point. It was not because he was French but we felt they had a point. They had a point because some years later Theo Vaigel said, “We thought that only five, perhaps six countries would join the euro from the beginning: Benelux, France, Germany and perhaps Denmark and nobody else. Now we have discovered that there are 11 candidates for membership because the Italians, Spanish, Portuguese and Greeks have decided to join, together with the Finns. How can we be sure that they will also implement the convergence criteria when they have joined? We must have a stability pact”. Therefore, Theo Vaigel and the Germans came up with the idea—but it was a little too late—of a stability pact. That stability pact did not have a very rosy life when Monsieur Chirac and Mr Schröder together decided to suspend the 3% deficit. In my view, that was a major catastrophe because it led my friends in the Netherlands, Belgium, Luxembourg and Finland to say, “If the bigger ones can do it, we can also do it. Why should there be this difference between big and small countries?”. I think it was one of the errors of the construction of the euro that there was no genuine concept of the development of a real financial and fiscal policy. Lord Borwick: But will this change in the future? Will countries in future stick to the rules that are being produced now? Henning Christophersen: That is what they propose in the report. In 2025 the four pillars should be established: better convergence; better financial union; better fiscal union; and then better democratic accountability. They do not say it in the report, but the logic of it is that by 2025 at the latest it would be a good idea to make treaty changes that can live up to these promises. You should not underestimate the importance of changes in the treaty. All member states are following the treaty every day. We accept the ruling of the Court of Justice of the European Union. We normally follow the decisions taken by the Competition Commissioner, even if they go against the national interests of our country. So I think there is a good chance, but it must be possible for the Commission and Council to implement these things. That is where the role of the Euro Council comes in as an institution. Today we should not forget that the Euro Council is only an informal group of countries. It does not really have a role in the treaty. It is a group of countries working together, but it does not have the role of an institution. The Chairman: What you are saying is that, for economic governance to work as envisaged by the Five Presidents’ Report, the report is pointing implicitly, not explicitly, to separate eurozone institutions.

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Sebastian Barnes, Henning Christophersen, Janet Henry and Martin Sandbu—Oral evidence (QQ27- 44) Henning Christophersen: Yes. I think that the result will be a two-layer Union, but we should not forget one thing. With the exception of Sweden and the UK, all the other countries want to join the eurozone. We will see if the new Polish Government will stick to that position and Mr Kaczynski will accept the commitment made by Mr Tusk. The personalities are perhaps not on the best speaking terms, but let us forget about that. So far Mr Kaczynski and his party have not said they do not want to join the euro.

Q41 Lord Butler of Brockwell: May I ask you about financial integration? Do you think that the three-stage process in the Five Presidents’ Report towards banking union is a realistic proposal, particularly given the opposition of Germany? Henning Christophersen: The first two stages have been implemented. There is better supervision, and part of that supervision is done by the European Banking Authority located in the City of London. If my British friends had followed my advice when we discussed the Maastricht treaty, the UK could have got the ECB located in London, but there was no interest in that. I said to Lord Lamont, “It is an option. I think you should look at that. We could move the ECB to London. It would be better to have it there than in Frankfurt. In London they could do the interventions, and it would have a much bigger impact on the financial markets of the world to have the ECB here rather than in Frankfurt”. But it was not of interest at that stage. However, the EBA is here. Then we have the European resolution directive—the rules for how to dissolve a bank and get rid of all the problems. That has been approved, but because it is a directive it is not yet fully implemented by member states. It has been approved by the Council of Ministers and the European Parliament, but because European directives normally take two years to be transferred into national legislation it can take a year or 18 months before the resolution directive is enforced 100%. The outstanding question is the European deposit insurance scheme. The EDIS proposal was one of the proposals made by the Commission on 21 October. The Germans and Dutch are not so happy about it—I will explain why in two minutes—but that is now a proposal that will have to be discussed by the Ministers and the European Parliament. The reason the Germans and Dutch are not so happy about it is that they say it introduces common financing of banking crises, so the wealthier member states will have to finance the recapitalisation of less profitable banks in some member states. I will not mention names, but we all know what I am speaking about. Lord Butler of Brockwell: If it is eventually agreed, do you expect Denmark to take part in it? Henning Christophersen: I think we would be interested because, if you look at the banking landscape of Denmark, some of the banks are far too big for a country of our size. I have been a member of the supervisory board of Danske Bank for 30 years and I know a bit about it. It was unfortunate that we bought a bank in Ireland and another one in Belfast. We should not have done that. We bought Sampo Bank in Finland; we bought banks in Estonia and Latvia. We are the owner of Fokus Bank in Norway, and we are the owner of the third- largest bank in Sweden. Our total balance is much larger than could be absorbed if there were problems with that bank. During the banking crisis the Danish central bank had secretly to make clear that of course Danske Bank would have unlimited access to the borrowing capacity of the central bank outside Denmark. They could do that because our currency reserves were as big as they were, but, seen from a purely fiscal point of view, it is far too big to take that risk. We have another big bank called . Nordea is a Swedish, Finnish, 36

Sebastian Barnes, Henning Christophersen, Janet Henry and Martin Sandbu—Oral evidence (QQ27- 44) Danish and Norwegian conglomerate and is nearly as big as Danske Bank in Denmark. It is the biggest bank in Scandinavia. I know that if you speak to the Nordea people—I know the CEO and members of the board—they would also like the to participate in the banking union. Some people are even talking about the option that, if Sweden and Denmark do not want to participate, Nordea will move its headquarters to Helsinki.

Q42 The Chairman: Do you think the UK should take part in any element of banking union and, if so, why do you think this is important? Henning Christophersen: Is it right that sometimes you have had a banking problem: for example, Royal Bank of Scotland and Barclays? The Chairman: Indeed. Henning Christophersen: I mention two but there are others. Why should you not be interested in banking union? The Chairman: Which elements do you think we should go for? Henning Christophersen: Banking union will give better access to a deeper financial market. I remember when the crisis began. It began in the United States, and then Lehman Brothers went broke. The question we asked in our supervisory board—it was asked everywhere— was: “Who here in Europe is sitting on the toxic sub-prime loans? We must be careful to whom we lend money and extend credit lines”. Within 48 hours the internal banking market in Europe was on strike; it was nearly impossible to raise credits, because everybody said, “We must be cautious”. The Chairman: Contagion spread. Henning Christophersen: Yes. Q43 Earl of Lindsay: How important do you think capital markets union is to what the Five Presidents’ Report wants to achieve? Henning Christophersen: The presidents mention capital union, and now we also have a communication from the Commission. I think it was published on 30 September of this year. The main reason is that they see capital union giving access to a deeper and more integrated capital market, with more converging financial products. So it could make it easier for companies everywhere, including those outside the eurozone, to get access to credit lines. Small and medium-sized companies would get better access. The argument is that it would be a market with a deeper volume of available credits. I have not seen a counter-argument. If I was sitting in the City of London, I would be very much in favour of that. Earl of Lindsay: Do you see a deeper market being a more resilient landscape for economic and monetary union in terms of asymmetric shocks, for instance? Henning Christophersen: Yes, but it could also be a good thing for non-members. I do not really understand the problems of the UK in this respect. I understand other UK problems. I understand the problems about bureaucratic rules on how financial products should be designed, used and controlled: for example, the crazy idea to split banks into investment banks and normal banks. I do not think it is going to work because it is not too difficult to circumvent such a construction. I can see some problems, but they are not only UK problems. You would also find certain reservations in the Netherlands, and even in Germany 37

Sebastian Barnes, Henning Christophersen, Janet Henry and Martin Sandbu—Oral evidence (QQ27- 44) and Italy, about some parts of the planned legislation. But as for the banking union as such, I do not really see a counter-argument for non-euro countries. Even if you want to continue with your own currency I do not see the problem—but perhaps I am wrong. Earl of Lindsay: Are there any concerns or problems that you or we should have about capital markets union in terms of other consequences that might flow from it? Henning Christophersen: There is one thing already mentioned in the report: the lack of good co-operation between the European Union and international financial institutions. That is a real problem. Take the IMF. Who is representing the 28 member states in the IMF? It is not even each of them, because each of them belongs to a special group. For example, the Netherlands, Luxembourg and Austria are bound together with Ukraine in the IMF. Some other countries working in the IMF belong to the same elected group as Afghanistan, Iraq and places like that. One of the real problems for the EU perhaps and the involvement of IMF in bailout operations is the old-fashioned structure of the IMF. That is small but it could be a bigger problem for Europe, because at a certain moment in time some of the bigger economies outside Europe would say, “Enough is enough. The purpose of the IMF is not to help European countries that should be able to help themselves”.

Q44 Lord Davies of Stamford: I want to ask again about capital markets union. We have had quite a lot of evidence in this Sub-Committee that capital markets union is a very important prospect, if we can achieve it, from the point of view of both economic stabilisation, which involves risk-sharing by investors and, therefore, is an automatic stabilisation mechanism, and also improving firms’ balance sheets and enabling them to raise more equity, with close- to-equity instruments and so forth, not merely being dependent on bank debt. All those theoretically sound very attractive. As a former investment banker, I always look at markets from the point of view of potential investment demand. We have not explored this question at all from that point of view. The question is whether investors will have an appetite to buy Portuguese or Latvian bonds or potentially Romanian equities, if Romania joins the eurozone and so forth. It occurs to me that Denmark must have a lot of experience in this area. It is a small country and its investors, institutional or private, must always have had diversified portfolios going outside Denmark, because you cannot find all the risks you might want in a diversified portfolio within a small economy. Do you have any comments on developing investor demand for a more widely diversified range of portfolio instruments? Henning Christophersen: Equity has been a more popular and interesting option in Denmark than it has been. That is because large parts of state-owned industry have been privatised. You can take DONG, for example. It is a big oil and natural gas company. It was owned by the state until five years ago and now one of the big owners is Goldman Sachs. It is owned by other private companies, pension funds and investment funds, and the state is now preparing the further privatisation of DONG so it will sit back perhaps with 15% or something like that. You can take the Danish telecom company TDC. It was originally owned by municipalities and the state. Now they are no longer shareholders; everything has been privatised. You can take the airport of . That was originally a state-owned airport; now the main shareholders are the Canadian teachers’ pension fund, with an office in Amsterdam. You can take what we are doing in Greenland and many other activities that have been privatised. Therefore, the supply of equity in the Danish market is better than it 38

Sebastian Barnes, Henning Christophersen, Janet Henry and Martin Sandbu—Oral evidence (QQ27- 44) has been, but you are completely right. Many Danes are investing outside Denmark. We are investing so much that it makes a very good contribution to our account balance. We are getting about €20 billion a year in dividends from foreign investments. Lord Davies of Stamford: A lot of that is private portfolio equities, is it? Henning Christophersen: Yes. Lord Davies of Stamford: It is not just direct investment by Novo, AP Møller or United Breweries. Henning Christophersen: Yes, but you also have other investors. There are big shipping companies. For example, 8% of all the containers on the sea— Lord Davies of Stamford: Maersk. That is what I meant. A lot of this will be direct investment by major Danish multinationals like the ones I have just mentioned. It would be interesting to know how much of that is portfolio investment. Henning Christophersen: Many are investment funds. Danske Bank is taking care of my money; it puts it into a portfolio for me, and I have nothing to do. We have low-risk, middle- risk and high-risk options. I think the point about equity is a very valid one, because, if you compare the continental market with the Anglo-Saxon market, you will see that in the United Kingdom, the United States and Australia, much more capital comes from equities. The continental tradition has been to let the banking system finance investments, and I see that as another benefit of banking union. You will make it more usual for continental companies to finance their investments via equity. The Chairman: Thank you so much, Mr Christophersen. We have slightly overrun. We greatly appreciate your coming to see us. This now concludes our public evidence session.

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BBA—Written evidence (EMU0008)

BBA—Written evidence (EMU0008)

Introduction

The BBA welcomes the opportunity to respond to the Committee’s call for evidence on the completion of Europe’s Economic and Monetary Union (‘EMU’). The evidence provided below focuses on those aspects of the Committee’s inquiry which are of direct relevance to the members of the BBA. The BBA represents 200 banks from 50 countries with operations in 180 jurisdictions.

At the time of writing, it has not been possible to review and fully consider the European Commission’s proposal for a Regulation to establish a European Deposit Insurance Scheme1 which would become the third pillar of Banking Union. The BBA would, however, be willing to provide further evidence on this topic should this be of assistance.

Completing Banking Union

5. How should the Banking Union be completed? Is there merit in the European Deposit Insurance Scheme proposed by the Five Presidents?

The BBA has been supportive of the establishment of the Banking Union and the underlying objectives of addressing the specific risks which arise from EMU. The Five Presidents’ report represents an important opportunity to consider the progress which has been made and what more can be done to strengthen EMU and enhance the Banking Union.

Current status of Banking Union

It is, nevertheless, still early days in the work to implement Banking Union. Indeed, whilst the ECB has made great progress in its work to deliver the Single Supervisory Mechanism (the first Pillar of Banking Union) and has begun to embed a consistent approach to supervision by removing existing national discretions this is inevitably an iterative process that will take time. For example, whilst the ECB has now completed its first Supervisory Review and Evaluation Process (‘SREP’), this framework is expected to evolve over the coming years and it is likely that the ECB will seek the future harmonisation of individual capital and liquidity adequacy assessments (‘ICAAPs’ & ‘ILAAPs’). The second Pillar of Banking Union is also a work in progress, with the Single Resolution Board not due to become fully operational until 1st January 2016. Significant work remains to agree Resolution Plans and determine minimum requirements for loss absorbing capacity (‘MREL’)2.

1 http://ec.europa.eu/finance/general-policy/docs/banking-union/european-deposit-insurance-scheme/151124- proposal_en.pdf 2 MREL is a concept introduced by the Bank Recovery & Resolution Directive which mandates that each institution should be subject to a requirement to maintain a minimum amount of its own funds and other liabilities in a form which can be subject to bail-in should the institution fail. Resolution Authorities are required to begin setting MREL requirements for institutions 40

BBA—Written evidence (EMU0008)

Notwithstanding the evolution of the institutional framework, it is clear that there are still factors which indicate the existence of ongoing fragmentation detrimental to the objectives of EMU. The European Banking Federation (‘EBF’), of which the BBA is a member, has identified that tensions remain between national and Banking Union authorities regarding the treatment of deposits held by smaller banks under national supervision (regardless of the fact that the ECB has ultimate responsibility). Furthermore, all banks continue to be affected by national economic policies and national legislation which are outside the scope of the Banking Union initiative, for example accounting requirements and insolvency procedures.

The national basis of deposit insurance is certainly a factor in the diminished but continuing sovereign-bank nexus, given existing Deposit Guarantee Schemes (‘DGS’) are ultimately backstopped by governments. As a consequence of this, national authorities are reticent to permit the free movement of liquidity and deposit funds across Member States thereby providing an incentive for measures such as liquidity ring-fencing. This is contrary to the objective of the efficient allocation of capital which underpins the EMU and acts as a deterrent to further integration of the banking market. This is, as the question alludes, a Banking Union rather than a Single Market issue.

Deposit protection within the new regulatory framework

It should be recalled that the regulatory developments agreed in recent years have greatly enhanced the framework for dealing with a failing bank and altered the role of DGS within this. In particular, the implementation of the Bank Recovery and Resolution Directive (‘BRRD’) and its provisions for early supervisory intervention, pre-balance sheet insolvency resolution, open bank bail-in, minimum loss absorbing capacity and depositor preference significantly reduce the circumstances in which it can be expected that a bank would be liquidated, with DGS called upon to compensate eligible depositors. Indeed, under the new framework, it is likely that larger or cross-border banks would be resolved via the BRRD resolution regime (with a greatly reduced role for the DGS) and smaller, domestically focused banks subject to liquidation & DGS pay-out. This diminishing role for DGS must therefore be a central factor when designing any possible Banking Union framework for deposit insurance. It should also be noted that existing national DGS have very different mandates and funding positions and that this will persist following the implementation of the recast Deposit Guarantee Scheme Directive (‘DGSD’). In some jurisdictions they act as a risk or loss minimiser but in others are limited to a pay-box function only.

Proposals for a European Deposit Insurance Scheme

These are all factors that should be considered when assessing the Commission’s new proposal for a European Deposit Insurance Scheme (‘EDIS’), which follows the recommendation made in the Five Presidents’ report.

from 1st January 2016. MREL is conceptually similar to the TLAC requirement for GSIBs which has been agreed by the Financial Stability Board (discussed in response to question 6 below). 41

BBA—Written evidence (EMU0008)

In many ways, however, a decision on whether or not to proceed with the proposal cannot be taken until the recast DGSD has been implemented across Member States and the options for enhancing cooperation and coordination among Banking Union Member States in the short-term explored and understood. Should an EDIS be developed, then the BBA endorses the following design principles developed by the EBF:

 Banks should not be required to make contributions to two separate tiers of funds at national and Banking Union level. Instead, financing should be based on contributions collected from all participating national DGSs and not directly from banks.  An effective reinsurance scheme, such as the one proposed by the Five Presidents’ report, is preferable to a mutualisation system or a mutual guarantee, because it will not endanger deposits of savers.  All deposit takers (the beneficiaries of any EDIS) should contribute to the funding of their respective national schemes, irrespective of the size of the institution.  DGS financing should generally be based on fair and risk-based contributions calculated with respect to covered deposits.  In order to avoid moral hazard there should be a first tranche of losses borne by the national DGS before an EDIS intervention. In this way national DGSs will be able to deal with idiosyncratic failures of domestic banks, and recourse to the EDIS would be limited.  There should be a limit to the amount that the EDIS pays out.  EDIS should be clearly integrated in the Banking Union framework such that the scope of banks mirrors closely the scope of the single supervisory and resolution mechanisms.  EDIS should adhere to the “least-cost (to the DGS) principle” embedded in the DGSD when deciding on DGS or resolution actions.  A common backstop needs to be available to all Member States participating in the Banking Union and to their DGSs. 6. In what ways can the EU’s financial framework be strengthened to reduce the negative sovereign-bank feedback loop?

It is clear that significant progress has been made towards the reduction in the sovereign- bank feedback loop. This has been driven principally by the development of recovery & resolution frameworks such as the BRRD in Europe. It is noteworthy that ratings agencies have taken action to reduce ratings for banks to reflect lower expectations of extraordinary support in light of the implementation of the BRRD. Support assumptions have reduced most notably for non-operating holding companies, reflecting the expectation that senior unsecured creditors will be exposed to losses via bail-in in the event of any failure.

The implementation of the recently agreed principles developed by the Financial Stability Board (‘FSB’) for Total Loss Absorbing Capacity (‘TLAC’) will bring further confidence that the link between sovereigns and banks has been broken. These principles (and the broadly equivalent BRRD requirements for MREL) will ensure that each institution maintains liabilities which, in the event of failure, can be exposed to bail-in to absorb losses and

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BBA—Written evidence (EMU0008) provide recapitalisation resources. Implementation of MREL and TLAC in Europe must therefore be seen a priority.

The chart below, drawn from the impact assessment undertaken by the Basel Committee and FSB relating to TLAC, illustrates the expected changes to credit ratings that are due to resolution regimes and TLAC3:

Democratic accountability, legitimacy, institutional strengthening and implications for the UK

13. What areas of EMU governance are ripe for institutional strengthening? What are the consequences of introducing intergovernmental agreements (such as those establishing the ESM and the Single Resolution Fund) into the EU community framework? What are the implications for non-euro area Member States?

The Commission must act as of the Single Market and the Treaties. If inter- governmental agreements are used to progress future EMU strengthening, then they should include clear provisions establishing the principle of equal treatment between participating and non-participating Member States. Specifically, any future IGAs of this type should include clear non-discrimination provisions and be classified as ‘special agreements’ under the provisions of Article 273 of the Treaty on the Functioning of the EU bringing them within the jurisdiction of the Court of Justice and a robust mechanism for settling disagreements.

We note that coordination would be enhanced and the risk of unintentional disagreements be reduced if the non-Euro Member States could also have observer status at meetings of the .

3 Summary of finding from the TLAC impact assessment studies: 9th November 2015 43

BBA—Written evidence (EMU0008)

14. How will the UK and other non-euro area Member States be affected by initiatives put forward by the European Commission and Five Presidents’ report? What effects will this have on the City of London?

The BBA believes that it is in the UK’s interest for the euro zone to be successful and therefore welcomes moves by the European authorities to consider the specific questions arising from EMU. That being said, a considerable portion of European banking activity takes place in London and institutions with global or regional bases in the UK operate across the EU, taking advantage of the ability to passport into other markets. It is of paramount importance that the Single Market continues to operate without restrictions on access or alternative rules based on location or membership of the euro area. Restrictions would damage the interests of consumers and banks in and outside the Banking Union area.

25 November 2015

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Graham Bishop, Dr Dermot Hodson and Philippe Legrain—Oral evidence (QQ1-14)

Graham Bishop, Dr Dermot Hodson and Philippe Legrain—Oral evidence (QQ1-14)

Evidence Session No. 1 Heard in Public Questions 1 - 14

WEDNESDAY 25 NOVEMBER 2015

Members present

Baroness Falkner of Margravine (Chairman) Lord Borwick Lord Davies of Stamford Lord Haskins Lord Lawson of Blaby Lord McFall of Alcluith Lord Shutt of Greetland Lord Skidelsky ______

Examination of Witness Philippe Legrain, Visiting Senior Fellow, European Institute, London School of Economics and former economic adviser to the President of the European Commission (2011–14), Dr Dermot Hodson, Reader in Political Economy, Birkbeck, University of London, and Graham Bishop, Independent Consultant and Professorial Research Fellow at London Metropolitan University’s Global Policy Institute.

Q1 The Chairman: Good morning and welcome to the Financial Affairs Sub-Committee’s first session of inquiry into the impact of the Five Presidents' Report and Europe’s economic and monetary union. You have a list of interests that have been declared by Committee members, I understand. This is a formal evidence-taking session of the Committee. It is being webcast live, and a full transcript will be taken and put on the public record and the parliamentary website. You will be sent a copy of the transcript and will be able to revise any minor errors.

Mr Bishop, Mr Hodson and Mr Legrain, we would be very grateful if you first say your names. I understand that you would like to make very brief opening remarks, and I will start with Mr Bishop. Graham Bishop: Thank you Lord Chairman. My name is Graham Bishop. I am honoured to be giving evidence on the Five Presidents' Report and on completing economic and monetary 45

Graham Bishop, Dr Dermot Hodson and Philippe Legrain—Oral evidence (QQ1-14) union. Unfortunately, I am very powerfully reminded of the British political class’s reaction to the Maastricht treaty in 1992. To paraphrase the celebrated quotation from Bretherton at Messina, “It won’t happen. If it does, it won’t be very big and it won’t matter”. Following the timetable of the Delors report, the three-stage process started in 1992. In 1994, the Heads of Government decided to begin the technical preparations, and that was almost ignored, and even ridiculed, here in the UK, because the EU was engulfed in an existential crisis at the time about exchange rates, including sterling. In 1995, I was honoured to be on the committee of experts from the European Commission to design the changeover to the euro. We flawlessly got 300 million people to change their notes and coins by 2002. A decade later, 340 million use the euro. We have now had a series of Presidents’ reports laying out a fairly detailed plan for the major deepening to economic and monetary union, with a two- stage process of achieving it by 2025 at the latest. Again, the British establishment, with the exception of this Committee of the House of Lords rather than the elected Members of the Houses of Parliament, seems to be ignoring this process because the EU is engulfed in another existential crisis, this time about migration. If the EU survives that crisis, it has probably launched itself on a path to genuine economic union, financial union, fiscal union and, finally, political union, which will provide the necessary democratic legitimacy. As I listen to the debate in the UK about this process, I rather fear that there is now a clear risk either of an actual Brexit soon or a de facto Brexit by 2025 at the latest. I look forward to your questions. Dr Dermot Hodson: I am Dermot Hodson, from Birkbeck College. I have submitted written evidence, so I promise to be very brief. In a nutshell, I see the Five Presidents' Report as vintage Juncker; it is a set of concerns that he has taken through his time as the Eurogroup president. It is very integrationist in its rhetoric but rather modest in its proposals; it talks about a lot of unions, but if you dig deep, a lot of the time it is very incremental in what it proposes. I would argue that it is woefully inadequate when it comes to legitimacy. The real weak link is the talk of political union, which amounts to very little other than a bit more co- operation between national parliaments. Even though it is modest, it stands limited chance of success. This is vintage Juncker in its ambition, but perhaps also in its difficulties in reading where the power lies in the European Union. I think of the European Union as an essentially intergovermentalist organisation, so much of it depends on what happens in France, Germany and, I am afraid less these days, the UK. Philippe Legrain: I am Philippe Legrain. From a Brussels perspective, the most significant thing about this report is that it is in the name of Jean-Claude Juncker, whereas the Four Presidents' Report was in the name of Van Rompuy, and that Martin Schultz has managed to get his name on to it. From an outside perspective, the most significant thing about it is that the European Council merely took note of it—in other words, it feels free to completely disregard it. So I take a rather different view from Graham’s; I think this report, like the Commission Blueprint and the Four Presidents' Report, is of little significance, and I do not think there is going to be much movement towards further integration in the eurozone any time soon.

Q2 The Chairman: Thank you very much. I would like to delve just a bit further into your overall impression of the report, particularly in respect of the timings and the step-by-step approach that is advocated. What you said about it from your different perspectives is very

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Graham Bishop, Dr Dermot Hodson and Philippe Legrain—Oral evidence (QQ1-14) interesting, but I would like your overview of timings and whether you believe that this is accomplishable. Graham Bishop: These are classic EU incremental steps. Going back to the Schuman plan of 1949, Europe is not all done at once; it is done by a series of concrete achievements. The Delors process, which I mentioned, was a three-stage process, and all this is just the same approach. I agree with Philippe that many of the parts are being done already—banking union, and now capital market union. It is done by incremental steps rather than a giant leap forward, and I think that is a much sounder way of doing it. Dr Dermot Hodson: I have a slightly different take. The firmest date is 2017, and the significance of that date is the UK referendum on whether to remain in the European Union. One of the main political objectives of this report was not to trigger major treaty reforms that could get caught up in the treaty negotiations or the UK search for a new settlement. In a sense, there is a bit of subterfuge about this report. It is not quite the same as the Delors report, which had a genuine and reasonably credible path towards monetary union. This is about not mentioning the “T” word. The Chairman: So you are saying that the end of stage one was deliberately chosen in order not to get in the way of the UK referendum, or that the integrationist aspects of it were meant to come into place after there was a decision on the UK referendum. Dr Dermot Hodson: Correct. The report treads very cautiously when talking about treaty change. It is very vague on that, which is understandable because the idea of UK renegotiations getting caught up in a big bang treaty negotiation on the European Union would be very difficult. It would trigger referendums in more than just the UK. The Chairman: As a little follow-on from that—I will come to you, Mr Legrain; I saw that you disagreed—I want to press you a little, Dr Hodson. If it is so irrelevant and trivial, or not realisable, where does that leave the future of the euro? Dr Dermot Hodson: I did not say that it was trivial. Some of it is not realisable. The report sketches out a broad path for completing monetary union. It is relatively specific on banking union, but the broader narrative on things such as economic and fiscal union is very, very light. That would clearly trigger some sort of treaty reform, which is precisely why it does not go into as much detail compared to the Four Presidents' Report, in which there was a lot on fiscal capacity. There are just a few references to a stabilisation mechanism in the Five Presidents' Report. Philippe Legrain: First, on timing, a key consideration is not the UK referendum; it is the French and German elections in 2017, and everything is on hold at least until then. Secondly, the limited ambition has more to do with the ending of the panic through the ECB’s OMT and now with QE, which took the pressure off, and given the huge changes that were made between 2010 and 2012, there is reform fatigue. Thirdly, there is a realisation that referendums would not be won were there to be treaty change in countries such as France or the Netherlands, where public opinion has become even more sceptical since the no vote a decade ago. The Chairman: What you say about the French and German elections does not quite add up, from my recollection, because the German election takes place towards the end of September 2017 and the formation of the Government might not be complete by 47

Graham Bishop, Dr Dermot Hodson and Philippe Legrain—Oral evidence (QQ1-14)

November, so I certainly cannot see the German election having an impact. The report says that stage one will take place between July 2015 and mid-2017, so stage one will be complete well before the German election. Do you accept that? Philippe Legrain: Stage one will not be complete. I am willing to bet any member of this Committee that there will not be a deposit insurance by June 2017. Secondly, even if stage one were complete, stage two would only be started at the time of the German election, so nothing of consequence would have happened by then. The Chairman: Lord Lawson, did you want to pick up on the UK point?

Q3 Lord Lawson of Blaby: Yes. We have had three very interesting answers to the question. I must say that I find Mr Bishop’s answer the most convincing of the three: his account of how the British Foreign Office and the British establishment generally have consistently underestimated the determination of the European leaders to move into fundamental change, of which the single currency was one and this is another, with full European fiscal union to complement monetary union and then a political union which must go with fiscal union. I find that very compelling. It seems to me that although Dr Hodson said that he disagreed with it, in fact he agreed with it, in the sense that it is going slowly in order to get over the UK referendum and perhaps, if you believe Mr Legrain, the elections in France and Germany, but then it moves on. So this was purely a tactical move. I have three questions, if I may. First, do you agree that the object as set out by Mr Bishop is the purpose of the exercise, even though it may take a long time? Secondly, if, as Mr Legrain has said, public opinion throughout the European Union has changed, should not the whole process be aborted? Thirdly, influential figures such as Mr Hollande and Wolfgang Schäuble have explicitly said that it will be necessary to have a eurozone parliament to provide democratic legitimacy for the development of the eurozone. Do you agree with that, and how will this mesh in with the existing European assembly? Graham Bishop: First, I am pleased that you agree with me about the path that I believe we are on. On whether there will be a sufficient revival in electoral support, one of the critical questions will be the growth path of the EU economy. If that revives and the benefits of the competitiveness which is the core of the economic policy thrust at the moment come through, over the sort of timescales that we are talking about—not next quarter but the next two, three, four or five years—and if it is seen that unemployment comes down as a result of European actions, that should have a very positive impact on public opinion. What is clear is that the intention is to move as far as possible without treaty change, and a lot can be done, a lot has been done and I am sure that a lot will be done in the future without it. The role of the European Parliament is, of course, critical. We have already moved to a co-decision basis between the Parliament and member states and Council on legislation. What the communication on completing the EMU is about is giving the European Parliament co- decision on economic policy, because it will have a say on et cetera. There is no doubt that the European Parliament will play a much more substantial role. That might require a reformatting of it in some way. The way in which it is laid out in the communication suggests that that is up to the Parliament. The people I speak to there within their rules of practice can already see how ECON can meet in a eurozone-only format. That can be done within the existing framework—not easily but it can be done. That is how I see

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Graham Bishop, Dr Dermot Hodson and Philippe Legrain—Oral evidence (QQ1-14) that developing, and it gives the European dimension of the political legitimacy for the whole process. Lord Lawson of Blaby: Sorry, I did not make myself clear. I was not talking about the existing European Parliament; I was talking about the fact that political union requires a parliament. The United Kingdom will not be, we presume, part of a political union, whatever happens in the referendum. How is this going to work out? Will there be a European Parliament as we know and love it, which the United Kingdom, so long as it is in the European Union, will be part of and, alongside, it a parliament for the eurozone members because of the political union? I cannot see how this can work. Graham Bishop: The outline of the proposal in the communication is not to have a second parliament, but to use the existing European Parliament reformatting itself—and the key committee is ECON, the Economic and Monetary Affairs Committee, because they are the people who make the initial analysis and decisions on the European Semester process or the economic governance et cetera. They will simply meet in a form for this purpose, which does not include non-euro members and therefore does not include the UK. The comments that I have received are that this is capable of being done within the existing rules of procedure, let alone treaty change. There is no question of a new parliament; it would be the existing one, with a reformatting and a more specific role for looking only at the eurozone. The Chairman: With a sort of grand committee, as has been proposed in constitutional terms here, to deal with English votes for English laws. Graham Bishop: Effectively, yes, but in particular for ECON, which is where the economic governance lies. Dr Dermot Hodson: has proposed something more ambitious, which is a eurozone parliament. Lord Lawson of Blaby: That is right. Dr Dermot Hodson: That is not contained in the Five Presidents’ Report and it is not unexpected, because this is all about the fifth president. The President of the European Parliament is not going to allow an idea like this to go into the Five Presidents’ Report. The discussion is perhaps a bit too deterministic. I see this as a report that puts some ideas out there. The key institution to look for is the European Council and how it reacts. The European Council is not bound by the ideas in this, so you could in principle see something like a eurozone parliament. Personally, I would find it a very curious idea. I do not see the European Parliament as having very significant powers in macroeconomic policy; I would not have thought that the European Semester is the most significant part of this governance framework. When you have one parliament that is already a second-order player in this area of policymaking, it strikes me as curious that we would want a second. Philippe Legrain: What is striking about this is that it falls well short of the federal union that Graham thinks is desirable and Lord Lawson presumably thinks is necessary. If you look at banking union, for example, we do not have a banking union; we have a banking union where many German banks are excluded. We have a single resolution mechanism which is unworkable and leaves a veto in the hands of national Governments. We have banks and sovereigns as intertwined as they were when the process was launched in June 2012. 49

Graham Bishop, Dr Dermot Hodson and Philippe Legrain—Oral evidence (QQ1-14)

Nowhere in here is it mentioned that we are going to remedy those flaws. There are no proposals in here for issuing common debt or for creating a genuine eurozone fiscal Treasury. It does not even set out the federal ambitions that are ascribed to it. More importantly, the European Council has merely taken note of it, which basically means, “Thank you very much. It is going to gather dust with some of the other reports”. Then politics intrudes, which is the debate in Brussels. People use big words and do not mean what they say. People will use the phrase “fiscal union”, which sounds to some people as though you are creating a common fiscal authority with tax-raising, spending and borrowing powers. Actually, Wolfgang Schäuble is saying that you need a super-Commissioner, a eurozone Finance Minister, who will simply be able to enforce the existing fiscal rules more stringently on national budgets. That is not a fiscal union of the sort an economist would recognise. What is striking to me is that it is a step back from what was being proposed in 2012, when, at least ostensibly, those bold proposals had the backing of eurozone leaders. Now they do not. In terms of public opinion and treaty change, my view is that you do not need greater centralisation in the eurozone to make it work better. Greater decentralisation would be a better idea, not least in the fiscal area. I think we have taken a wrong turn during the crisis in the measures taken since 2010. Lord Lawson of Blaby: Sorry, what does greater decentralisation in the fiscal area mean? Philippe Legrain: Greater decentralisation means restoring the no-bailout rule and making it credible, first, by creating a mechanism for restructuring sovereign debt and, secondly, by limiting banks’ holdings of sovereign debt so that the operation of that mechanism would be credible.

Q4 Lord Lawson of Blaby: In our experience, when there was a no-bailout rule and the financial markets thought it had no credibility, the financial markets were proved right. Do you think reinstating it could have any credibility? Philippe Legrain: As I said, two things were lacking in 2010. The first was a mechanism for restructuring sovereign debt, and post-Lehman there was, in my view, a misplaced belief that if you restructure sovereign debt the whole world would end. We restructured the Greek debt in 2012 and the world did not end. Secondly, there was the awesome political power of German and French banks, and even if policymakers had had that desire, politically it was not possible. Indeed, Angela Merkel initially favoured that option and then changed her mind. In order to make it credible you have to minimise banks’ holdings of sovereign debt. Lord Lawson asked whether it should be aborted. In my view, as it currently stands, the eurozone is not fit for purpose. It does not deliver economic growth and it constrains democracy in an unacceptable way. If you think the move towards a federal union is neither necessary nor feasible, short of breaking it up, the only other option is decentralisation. On how a eurozone parliament would work, I agree with what others have said. Such is the power of the European Parliament that it is inconceivable that you would create a separate structure and that a eurozone parliament, if such a parliament were to emerge, would basically start off as a committee made up of members of the European Parliament from 50

Graham Bishop, Dr Dermot Hodson and Philippe Legrain—Oral evidence (QQ1-14) eurozone countries. What is striking is that clearly decisions have been taken that involve large transfers of sovereignty, out of the hands of elected officials into those of technocrats. You need much greater democratic accountability. But it is not just a question of democratic accountability; it is a question of democratic choice. We have election after election in the eurozone in which voters reject the outgoing Government, and the first thing that happens is that voters are told that they have to stick to the old policies of the Government they have just rejected because EU rules say so, and I do not think that is desirable or sustainable. Lord Davies of Stamford: How can you possibly restrict banks’ holdings of sovereign debt? Banks need to have access to some so-called risk-free assets in the management of their liquidity, and if you did such a thing you would inhibit open-market operations between the central banks and local banks, the normal medium for which is of course sovereign debt— and usually short-term sovereign debt such as Treasury bills, in our case. There is no alternative for the EU public debt market. Some suggestion has been made, including by Mr Bishop, that a Treasury bill system should be developed, with bills issued by the European Union as such. Full faith and credit to the Union, but that proposal has not, as far as I know, got to the point where anybody is seriously planning to implement it. Philippe Legrain: First, you are right to say that banks generally hold short-term debt that can be used in the conducting of monetary policy, so this would primarily be about limiting their holdings of longer-term debt. Secondly, if you think that my proposals are unrealistic, similar ones have been made by Jens Weidmann, the president of the Bundesbank, so perhaps he is being unrealistic too. Lord Davies of Stamford: They have their own agenda, do they not? Philippe Legrain: He is a central banker and I think he knows how to conduct monetary policy. The Chairman: Lord McFall wants to come in on this question briefly. After that, I would like us to leave it and move on to the next question, because we will cover this a bit later. Lord McFall of Alcluith: You mentioned restructuring sovereign debt. Earlier in the week there was a proposal from Italy to establish a bad bank to cover its non-performing loans of about $330 billion. To do that, it would establish a private vehicle, with senior debt guaranteed by the state development agency. First, how much chance is there of that? Secondly, is that the type of thing you were talking about when you talked about decentralisation? Philippe Legrain: No, not really. That is a bad bank to deal with the non-performing loan side. Lord McFall of Alcluith: Yes, but how much chance does Italy have of getting that? Philippe Legrain: I am talking about the decentralisation of fiscal policy. I would also like there to be the decentralisation of economic policy. I think there is an incorrect view in this report that somehow we need to have a convergence of economic policy. As the United States shows, where different states have very different rules on all sorts of things, there are benefits to policy experimentation. That is perfectly compatible with sharing a currency. The important thing is risk-sharing, which can happen largely through capital markets and cross- border ownership. So the premise behind this is incorrect.

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Graham Bishop, Dr Dermot Hodson and Philippe Legrain—Oral evidence (QQ1-14)

The Chairman: We want to move on to the implications for the United Kingdom.

Q5 Lord Haskins: I get the impression from all of you that this is all a bit of a sham, that without treaty change the Commission is not going to get anywhere, and that the Commission will duck treaty change. There are two situations. I am talking about the non- euro areas. If treaty change has to be part of the process, that raises huge questions for the non-euro areas. If, on the other hand, the sham continues and the issues are ducked, does that make much difference to the non-euro areas? Graham Bishop: First, on the idea that there will be no treaty change, it is fairly clear that the Commission envisages something in the fullness of time, in particular to fold in the fiscal compact and that sort of thing. The question is when that time comes. In the present situation, we have developed a series of intergovernmental agreements, unfortunately in a sense. None the less, we have developed that for the ESM and suchlike, and if the euro area want to do things and they need to do something between themselves, they will go down that route, with the intention of folding it into an eventual treaty change and make it applicable to all, with opt-outs as appropriate. Lord Davies talked about euro bills. I have put forward a proposal, which is getting some traction I must say, particularly in the European Parliament, which would be run as an intergovernmental agreement to start with; if it happens in years to come, that can be changed. A lot can happen with intergovernmental agreements and within the existing treaty, and that will have major significance for the non- euro area players, because they need to deepen their economic and financial integration, which they are doing. I have to disagree with Philippe on banking union. I think it is really very significant; 85% of eurozone bank assets are now run by the ECB’s single supervisory mechanism. It is only 120 banks out of 6,000, but it is 85% of the assets. They are the big player. We now have capital market union coming in the next two years, of course—I am sure we will talk about that in a moment—but these are big plans that include a very major role for European-level supervision, rule-making and the enforcement of the rules. Dr Dermot Hodson: I am sympathetic to that idea of treaty reform. I do not think there is any appetite for a large-scale treaty reform because of the difficulty of ratifying it. That is the reality since Lisbon took effect after 10 long years of constitutional reform that were very difficult. The broader point is that it is in the UK’s interests to have a well-functioning monetary union; there is a lot that the UK could support in terms of the modest aspects of these proposals. Obviously, banking union is the key one, where the UK has to look closely at whether it finds itself facing some sort of eurozone court case. Looking aside from the technicalities of treaty reform, it is strongly in the UK’s interests to have governance reforms that would strengthen the euro. Philippe Legrain: I think Lord Haskins is right that it is very important better to define the relationship between euro members and non-euro members. I would think that is the most important aspect of the renegotiation that the Government are embarking on as we speak. In the immediate term, there is little prospect of eurozone members caucusing together, simply because they disagree on so much. In my view, we are not going to see much deeper integration, but areas where there already has been—for example, in the banking union— the model of a double-majority voting system is a good solution which satisfied the desire for the eurozone to integrate in banking matters and at the same time not having the Bank 52

Graham Bishop, Dr Dermot Hodson and Philippe Legrain—Oral evidence (QQ1-14) of England systematically outvoted and ignored. Does it make much difference? My initial reaction on being invited to give evidence to this Committee was to wonder why you are having this inquiry, because not much is going to happen. It is quite reassuring from the British perspective—I do not think that much is going to change; therefore, we are talking more about safeguarding against potential future changes than about imminent ones. Lord Skidelsky: Surely the implication behind Lord Haskins’s question is that the monetary union is unstable. Either it is reformed or it will break up. Presumably that possibility will come about when the next crisis comes. To be reformed, centralised institutions have to be set up. That, of course, raises very acutely the question of the UK’s relationship with the eurozone and the European Union, which has already been discussed. I do not think one can just say, “Nothing much is going to happen, so we don’t need to worry”, because what we need to worry about is the next crisis in the eurozone. No doubt if there is a lot of growth quickly, that could be postponed and it may wash away. But there is not going to be, is there? Growth prospects are not so brilliant. Dr Dermot Hodson: I would challenge the premise of the question, that centralised reform is the only type of reform that we could have. If you think about a fiscal union, a fiscal stabilisation function, that could have made things worse pre-crisis. The idea that transferring more money to Greece would make it take more sensible economic policies is an assumption that can be questioned. I agree that it needs reform, but this idea that it has to be centralised reform is the subject of debate in the literature. Philippe Legrain: I was not quite saying that. I was not saying that we would not be affected by a future crisis in the eurozone—clearly, we would be. I was saying that I do not think there is going to be deeper integration and therefore political implications from deeper integration within the eurozone. What is striking about this report is that it does not deal with any of the issues that might deal with the current crisis or prevent a future one. It does not tackle the issue of bank and debt restructuring; it does not tackle the issue of the monetary and fiscal straitjacket; it does not tackle the issue of a mercantilist German core and the deflationary impact of that. Actually, it is by the by, for both the current economic problems and preventing future ones. Graham Bishop: I agree with you that growth prospects are not very buoyant. The demographics of the EU over the next 20 or 30 years are very bad. The only source of growth will be competitiveness, which is why it is such a central part of the whole proposal. If that does not happen, when interest rates rise, as they surely must, for countries on average with nearly a 100% debt-to-GDP ratio, this will be a massive hit to public spending. Something has to be done to prepare for that inevitable crisis, and by far the best way is to grow your way out of it. Competitiveness is the only way, and that needs a good deal of pushing and shoving of many member states. Philippe Legrain: Competitiveness is completely irrelevant to this. Competitiveness as defined by this is basically a mercantilist policy of driving down your labour costs. The real priority, apart from dealing with the short-term demand problems, is boosting productivity growth. The idea that you grow out of this simply by holding down your wage costs in the short term is disastrous, particularly if you have large debts. From a dynamic perspective, it means you end up specialising in lower-end production rather than dynamically moving up

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Graham Bishop, Dr Dermot Hodson and Philippe Legrain—Oral evidence (QQ1-14) the value chain and producing better goods for higher wages. It is completely confused, and it illustrates why this report is irrelevant to the eurozone’s current challenges.

Q6 Lord Davies of Stamford: My question to the panel—and it is a genuine question; I do not understand the answer—is why it is not in our interests to be part of the banking union, as some other countries such as Denmark, which are not part of the euro, have decided to become. Will we go through agonies, wondering how our position will be protected against decisions taken within the decision-making structure? I think Mr Legrain mentioned the double-majority rule, but that breaks down once you have fewer than four members outside the system. The idea of preventing caucusing is ridiculous. You cannot prevent caucusing; it is part of human life. It is like saying that in a democratic parliament you are not allowed to talk to colleagues or even opponents occasionally and get together a common position on something—it is simply absurd. Life does not work like that. Surely the only point of staying outside banking union is because you want a different type or different methodology or different style of banking supervision. If you have that, either you have a more onerous or a less onerous system than prevails on the continent. If it is more onerous, you reduce the competitiveness of our own financial sector in this country; if it is less onerous, you undermine public confidence in the banking system or risk doing so. So you have to ask yourself what the benefit is. What you certainly do if you have this sort of dual system is create regulatory arbitrage and a great deal more regulatory compliance cost for all participants. A lot of the bigger banks will be operating on both sides and will have to have different supervision and compliance structures to cope with the different banking systems that they are part of. I do not understand why we are not part of this system. Can I be helped by the panel? The Chairman: A brief response to those questions. Graham Bishop: I can see very strong reasons why the UK should be part of banking union. I understand the politics of not wanting to be part of something that is a mark of a deepening eurozone. Lord Davies of Stamford: So it is just politics, not functional considerations. Graham Bishop: I think it is largely politics. The fact is that our banks in London do a huge amount of euro-denominated business—foreign exchange, derivatives et cetera. How do we cope with a crisis with one of them where we need euro liquidity? The Bank of England does not print euros. Only one bank does and it is in Frankfurt. So there is a risk for us if we are not part of this, and the ECB does not support us at some critical moment or exacts a price in some way or just dithers. Our banks are at greater risk. We are choosing to have a more rigorous regulatory framework, which put us at a disadvantage. Philippe Legrain: UK banks also do lots of business with the United States, but it does not mean that we enter into a banking union with the United States. The lender of last resort for UK banks is the Bank of England. If it needs foreign currency, that can be dealt with, as it was during the crisis, by swap lines between the Federal Reserve and the Bank of England or indeed between the ECB and the Bank of England. Lord Lawson of Blaby: There is also the IMF. The Chairman: Did you want to come in on this point particularly, Dr Hodson?

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Dr Dermot Hodson: On the economics of it, banking union comes very close to questions of fiscal sovereignty. That is the key reason why the UK is not involved. On the politics of it, or rather the governance of it, it is kind of too late. A lot of these decision-making structures are now located in the European Central Bank—there was a scenario in which they were not. What banking union would mean for the UK is ceding a measure of sovereignty to the European Central Bank. Lord Davies of Stamford: That is politics, then. Dr Dermot Hodson: It is economics and politics. The Chairman: Lord Lawson wanted to come in on a broader point.

Q7 Lord Lawson of Blaby: I do not know whether it is a broader point; in some ways it is more specific, but I suppose it may be broader. It is certainly the case that London and the British banking system is not British or European but global, and in so far as we need a global back-up, that is provided by the IMF, which has stepped in in banking crises in the past, particularly in Latin America. Incidentally, I agreed with a great deal of what Mr Legrain said, but I was interested when he said that it is perfectly possible for there to be economic differences among the member countries of the European Union, and indeed of the eurozone, and he pointed to the example of the United States. Of course, the United States is a fully fledged fiscal and political union in which there are automatic transfers that oil the wheels and solve problems, so it was an interesting answer for that reason. Coming back to the United Kingdom, do you see tensions between the eurozone countries and the non-eurozone countries, particularly bearing in mind, as Lord Davies has rightly reminded us, that as more of the non-eurozone countries join the euro the double requirement disappears. Do you see, looking ahead in particular, the possibility of tensions? If you do, what are these tensions and how might they be resolved? The Chairman: I am going to go to Mr Legrain first this time. Philippe Legrain: First, on the issue of the United States, academic studies show that most risk-sharing takes place through capital markets and cross-state ownership and much less through fiscal policy. While you are right that if the political conditions existed a federal union in the eurozone would make sense, given that the political conditions do not exist for that, you need to look for second-best options, and second-best options include decentralisation, which I think is preferable to the current system. On the question of the tensions between eurozone and non-eurozone countries, of course they could exist, and the recognition of that is why we have the double majority. You are also right that over time, were the non-euro members to join, that would no longer operate. I do not think there is any prospect soon of Sweden, Romania, Bulgaria, or for that matter, joining the eurozone. It would be in Britain’s interests, assuming that it stays in the EU, to argue for continued enlargement so that there will always be a group of non- eurozone countries sufficient for that. In any case, I do not think that the future of the euro is necessarily assured. It might still break up. Indeed, unless it is reformed it probably will break up at some point. So while it is important to have these safeguards, the fear in Britain is that somehow there is an integrated eurozone whose preferences are aligned and that is ganging up on the non-

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Graham Bishop, Dr Dermot Hodson and Philippe Legrain—Oral evidence (QQ1-14) eurozone. There is a hypothetical risk that one needs to protect against, but I do not think it is imminent. Dr Dermot Hodson: I would say that we have already seen those tensions; they are exemplified by the referendum that we are having in this country. The Bloomberg speech that David Cameron gave in 2013 was premised on the fact that the eurozone was changing, that we did not know what it would look like in 2013, and that we would know what it would look like by 2017. We do not really know what it will look like. It creates uncertainty over the direction of , and there is a heightened risk to the UK’s relationship for that reason. That is why it is very difficult in the Brexit discussions to get a sense of exactly where the eurozone is headed. We were supposed to know by now, and we do not. Graham Bishop: Only the UK and Denmark have a formal opt-out from the euro. Over a period—and we are talking here about a decade—I would be quite surprised if the four or more “out” condition still operates, so I would expect our double majority to fall away at some stage. Would the others give it three or more, which is getting close to a veto? I find that unlikely. On the tensions that you talk about, as year after year we go through the European semester and the macroeconomic procedure for overall economic policy in the stability and growth pact for public finance, and if they succeed, which they are doing slowly, in driving up the level of competitiveness and productivity of some of these economies to the extent that they are running a current account surplus of some magnitude and we are running a monstrous deficit—5% of GDP, the biggest since 1948, which is hardly ever remarked on— this is evidence of a relative loss of competitiveness here. That will be the source of tension between us and them. They are solving their problem; we, at the moment, are not. This is very alarming today, not just in the future.

Q8 Lord McFall of Alcluith: The Five Presidents’ Report does not touch the ECB, which you can understand; they do not want to waste political capital formalising the role of it. However, questions arise from that regarding the future role of the governance framework, particularly given the outright monetary transaction programme, which, although not used yet, has still been criticised for assisting the finances of member states. Can you give us your view on that, particularly the implications for non-eurozone members? Dr Dermot Hodson: I think the most significant transfer to the European Central Bank is in the arena of banking union and the single supervisory mechanism. The governance arrangements are very curious; there is a body that is within the ECB but not totally of the ECB. So that is an area that we need to look at closely to see precisely how much control the governing council of the ECB has over its decisions and what role is left for national supervisors. National supervisors still seem to have a pretty significant role in the day-to-day operations of the single supervisory mechanism, so my answer to your question is that the European Central Bank plays an important role, but to a certain extent it has been fragmented in the role that it has been given because of these new governance structures. Lord McFall of Alcluith: Has the role of home regulators not been weakened as time has gone on anyway? Philippe Legrain: The problem with the ECB is that it is excessively independent, has no political master and meddles inappropriately in politics, and even questioning what it does is 56

Graham Bishop, Dr Dermot Hodson and Philippe Legrain—Oral evidence (QQ1-14) subject to a kind of taboo. The model that we have in Britain, where there is operational independence for the Bank of England to meet a target set by the Chancellor and where ultimately, even with that operational independence, you know that the Bank of England is basically an arm of government, is far healthier than an extremely independent central bank whose independence is in a treaty that can be changed only by unanimity; which towers over 19 member Governments; can refuse to intervene for a couple of years to prevent a panic; can write a letter to an elected Prime Minister saying, “We won’t buy your bonds unless you make these specific reforms”, and all sorts of things that are really completely outside the purview of monetary policy; which, as Dermot Hodson has just said, has now acquired all sorts of additional powers in the banking area that have distributional and potentially fiscal consequences; and which is largely unaccountable. The ECB just deigns to have a dialogue with the European Parliament. It does not provide sufficient information to the European Parliament for the European Parliament to hold it to account, and in any case ECB officials cannot be disciplined, or indeed sacked, for failing to do their duties or for overstepping them. It is clearly a completely inadequate state of affairs, and it is very telling that there is no mention of it whatever in this report or, indeed, in previous reports. Lord McFall of Alcluith: What are there dangers in it for the UK and particular for the home regulators? Graham Bishop Yes. The UK’s risk is that the ECB must be the regulator of anything that is in euros. We have already talked about that, and it lost the court case on whether it was pushing its boundary out too far. I do not think for a moment that it will stop at that, because it cannot. It is required to have oversight of the payments system. Anything which goes into that - securities, transactions et cetera—is something it needs to know about and can control. Its problem—here, I agree that democratic accountability is a difficulty—is that because of the nature of the banking system, it was obliged to provide to the Greek banks, for example, with liquidity on a colossal scale. Therefore, it is a player in any political decisions. It could say, “No, we won’t provide that liquidity”. The Greek banking system fails next day and, with it, the Greek economy. It is stuck, for better or worse, with being in a highly political situation. It is clearly uncomfortable with that. One question is how the rest of Europe will resolve that to bring back to democratically accountable politicians those sorts of decisions about providing liquidity to banks. The first thing is that banks are safer to begin with and do not hold too many assets of the member states’ Governments, breaking the “doom loop” between the bank and the sovereign. These are longer-term plans—we have talked about reducing the large exposures to the Governments. That has to happen. Then the ECB can be less directly involved. But at the moment, there is no alternative. If banks need support, there is only one place where the support comes from. Lord McFall of Alcluith: I will ask a quick question to Mr Legrain. There was mention of Italy and the bad bank. You mentioned subsequently that the Five Presidents’ Report does not tackle the issue of bad bank debt restructuring. Is that a fundamental issue that needs to be tackled if we are going to achieve growth in the eurozone? Philippe Legrain: Yes, I think so. There were two ideas behind creating a banking union. The first was breaking the link between banks and sovereigns; the second was the idea that national supervisors were captured by domestic banks and therefore you needed to hand it to an authority which was not. I do not think that it is clear that the ECB is independent of the banking interests that it supervises. I think that the asset-quality-review that it did last 57

Graham Bishop, Dr Dermot Hodson and Philippe Legrain—Oral evidence (QQ1-14) year was clearly inadequate, much more is needed to clean up Eurozone banks, which is essential for recovery there and therefore for the UK’s prospects of exporting.

Q9 Lord Shutt of Greetland: What is your understanding of what fiscal union is? How might it be achieved? Do you think it is useful? Dr Dermot Hodson: I see fiscal union as a term that does not have a stable meaning. Acknowledging that fact is the key to understanding how it is used and abused in the European discourse. For some people, it means some sort of fiscal stabilisation mechanism, so a centralised budget; for others, it means strong, central oversight of national fiscal rules. This report, to the extent that it talks about anything that looks like fiscal union, is talking about the possibility of some sort of stabilisation mechanism eventually, although it does not really go into detail on that. I see multiple types of fiscal union in the discourse and a degree of hesitancy about putting anything concrete on the table. Compare it to the four presidents’ report, which has pages and pages on a fiscal capacity, this being a euphemism for a centralised fiscal mechanism. Philippe Legrain: That is a fair characterisation: there is disagreement about what fiscal union means. I would go one step further and say that the idea that creating a eurozone Finance Minister who is basically a super budget enforcer for national budgets is not in my view a fiscal union. Lord Lawson of Blaby: A fiscal union, I would suggest, occurs when there is to a large extent a common system of taxation throughout the area and public expenditure decisions are taken to a large extent centrally. That does not mean that you do not have—as we are told we are going to have this afternoon—more talk of a northern powerhouse and separate things. But I think that a fiscal union does have a clear meaning. Philippe Legrain: Absolutely, it has a clear meaning, but the German use of the fiscal union, by, for example, Wolfgang Schäuble, when he talks about creating a super budget enforcer, is a misuse of the expression “fiscal union”. That is not the same as what you have just described, which is how I would also describe fiscal union. The Chairman: The sort of fiscal union that Lord Lawson is describing is not what is described in the Five Presidents’ Report or indeed in the context of this inquiry. Lord Shutt of Greetland: So it is not the same standard rates of income tax and corporation tax throughout Europe. That is not the case. Philippe Legrain: It would be having a federal level, like in the United States. There, you have a federal level of government and a state level of government. If one were to create a federal union in the eurozone, one would imagine that the national state level would be much larger relative to the federal level than it is in the United States. You would presumably still have some common resource, so some sort of tax at a European level. Then you would have varying taxes set at a national level. Lord Lawson of Blaby: In the United States, federal expenditure and federal taxation are much more important than local expenditure and local taxation. That is the nature of a political union, is it not? The Chairman: There is also the issue of debt mutualisation—Eurobonds and things.

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Philippe Legrain: Which has been completely dropped. In the two four presidents’ reports of 2012, there was aspiration to move towards Eurobonds, as indeed there was in the Commission’s Blueprint. This was completely dropped. The Chairman: Greece took it off, essentially. Graham Bishop: Two very quick points on taxation. The idea of a common income tax is for another century, but a consolidated corporate tax base is becoming a very real possibility. I am not saying the rate, but the tax base. That is something that we will have in a few years. On the common debt, I have proposed a scheme for a temporary Eurobill fund—I think the clerk will circulate my proposal on that. That has had quite a lot of interest. I was appointed to a European Commission expert group and the result of that was that my proposal is still seen as possible. That is being pushed by the European Parliament. I feel confident that the Parliament will come back and take this up. This would very easily fit into a European Treasury, and the way that it would operate would be a good discipline mechanism for the enforcement of public finance and macroeconomic policies. The Chairman: And we have received this paper, have we? Graham Bishop: Yes, you have.

Q10 Lord Borwick: Can we talk about within the eurozone and divergences between the economies? Will they try to achieve more convergence between the countries? Will that work? Dr Dermot Hodson: Well, they are going to try. They are going to try by setting up the competitiveness board, which will have a series of watchdogs at the national level that will sound the alarm. I think that will help to a certain extent. It will add another voice to the call for prudent economic policies. But I think that we are entering the zone of economic policy where economic policy does not necessarily have levers. You do not have a lever over competitiveness. It concerns things like wage-setting, which in many cases does not involve national Governments. So I think that the idea of multiple watchdogs will take pressure off the Commission, which often finds itself very isolated, but the idea that there is some sort of competitiveness lever is— Lord Lawson of Blaby: It is a good job creation scheme. Dr Dermot Hodson: Well, okay. Lord Borwick: Job creation for agencies. Philippe Legrain: Clearly, we have seen massive divergence since the crisis, with some countries doing badly and others doing catastrophically. There is an effort to promote greater convergence by the wrong means; that is, by driving everyone’s unit labour costs down to try to match the efforts that Germany has made. The result of that is that you will have a depression of wages and domestic demand in the eurozone and ever greater reliance on exporting and running large current account surpluses. I do not think that is a viable growth strategy. It will certainly have big implications for Britain—how much larger can the eurozone current account surplus get and how linked is that to our own growing current account deficit?

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Graham Bishop: On convergence with public finance, a lot has already been achieved. When you look at the number of countries in the corrective arm of the stability and growth pact process, you see that, in 2010, at the height of the difficulties, it was 15 and next year it should be four. So a great deal has been achieved. On the question of competitiveness and competitiveness committees and councils, I have no great belief that such bodies do very much. But the scorecard that the Commission keeps on a wide array of economic policies—it goes into education, healthcare et cetera, and everything which goes into the competitiveness of a country—that is what is done and looked at in the European Semester. We are now on the sixth round of that. Not enough has been done by the member states to deal with the identified problems. That is where the process is going to be toughened up. The “revamped”—as they put it in the literature—European Semester process has the capacity to bring much closer convergence; in particular, identifying the countries which have a problem; why they have a problem; and persuading them, and then finally forcing them, to do something about it. There is the threat in this of using the conditionality of all the structural funds and such like. If you are not in compliance with your macroeconomic imbalance procedure commitments, you will not get the money. That is a big threat coming, and it may yet be used. So this should bring the outliers more towards the centre. Dr Dermot Hodson: That is a threat that lacks credibility. The EU has never used fines. Graham Bishop: Not yet. Dr Dermot Hodson: Or the excessive deficit procedure. All those countries you talked about exited the excessive deficit procedure without getting anywhere close to fines. I do not think that the emphasis on pecuniary sanctions is where the real governance mechanisms lie. Philippe Legrain: I think that there is a tried and tested way of achieving convergence, which is to complete the single market in services. Following the failure to do so a decade ago, the Commission has gone for a different strategy, which is to try to micromanage national reforms. So we have a 10-year plan called Europe 2020 which is operationalised in all sorts of ways. From a British perspective and a eurozone perspective, it would be healthier to prioritise completing the single market rather than somehow deciding that the people in Brussels know best and ought to try to implement the same reforms everywhere. The Chairman: So the services directive, which has disappeared, would in your view have been the right way to go. Philippe Legrain: I think so. That is the way to achieve convergence. If you look at the European Union, you will see that massive convergence was achieved largely through trade and investment within the single market. There has been scarcely any progress since the failure a decade ago.

Q11 Lord Davies of Stamford: I agree with Monsieur Legrain on that point. One of my two great disappointments with this paper, and one of my great disappointments with the British Government’s strategy for a renegotiation, is that there is no mention of the services directive. We should have taken that up in the course of the renegotiation; I cannot think why the British Government did not do that. The other disappointment I have is on automatic stabilisation, which is a point made by Lord Lawson earlier. Monsieur Legrain said earlier that much stabilisation takes place through the workings of the capital markets, 60

Graham Bishop, Dr Dermot Hodson and Philippe Legrain—Oral evidence (QQ1-14) which of course is correct. That will improve in the European Union with capital markets union and with institutional and private savers holding a more diversified portfolio across the different member states. Nevertheless, one does need automatic stabilisation and one needs more of it. One has very little fiscal automatic stabilisation with the EU budget limited to something less than 2% of Union GDP. So it is very regrettable to me that no additional suggestions are made there. Of course, there is a role for direct investment as well as portfolio investment, with people taking advantage of lower factor costs in different parts of the Union and so forth. There was scope for using this opportunity to propose something more specific in the area of fiscal stabilisation. I have always been a great supporter of some sort of common unemployment reinsurance fund. You cannot have merger of unemployment funds, because that would involve subsidy by states with lower structural levels of unemployment of states with higher structural levels of unemployment, which would be an absurdity. You could have a reinsurance system under which, if the unemployment rate goes up by a certain acceleration factor, that country receives some insurance payment. Was it not a missed opportunity not to introduce some greater element of automatic stabilisation into the economy of the Union? Dr Dermot Hodson: I think that there is no political headwind for this. They talked about it in the Four Presidents’ Report; it got a very lukewarm reaction. It was one of the few elements of political restraint in this report that they did not recycle this idea. If that kind of stabilisation function is to emerge, the best place for it to start is not in a report authored by the President of the European Commission. A big integration step like this should not emerge from the European Commission if it wants to stand a chance of success. It has to emerge more organically from largely Franco-German co-operation. Lord Davies of Stamford: So we are back to a contradiction between economic functionality and political dysfunctionality. Dr Dermot Hodson: Well, I would call it political reality. Big political steps in European integration come via the member states, not via bright ideas from the Commission. Philippe Legrain: The problem is German opposition. Germany looks at any form of risk- sharing as a step towards a transfer union, because it cannot conceive itself as ever being a necessary recipient of any such mechanism. So when we were writing the Commission Blueprint, we were told very clearly that there could be no mention of a eurozone-wide unemployment insurance scheme because it was a red rag to Germany, so the Commission internalised that constraint and dropped it entirely. So I am not surprised that it does not feature here. Lord Davies of Stamford: A crude system of merger of unemployment insurance funds would not be possible. Philippe Legrain: Sorry, it was along the lines that you mentioned. Lord Davies of Stamford: If they used a bit more imagination, they might come up with something. At the end of the day, the Germans have to dig into their pockets or get out their chequebook when nasty things happen to the Union’s financing, so they might be persuaded by the experience of the crisis to take a slightly broader view in the future. Graham Bishop: The problem for unemployment insurance is that it is just such a sensitive and large number. The political sensitivity is huge. That is where you can see very large 61

Graham Bishop, Dr Dermot Hodson and Philippe Legrain—Oral evidence (QQ1-14) amounts of transfer payments coming. I can understand why the Germans in particular, as the assumed footers of the bill, would be very nervous about it. Philippe Legrain: That is the problem behind the whole premise of this: that somehow Germany foots the bill. If we had proper bank and debt restructuring, the losses would have been imposed on creditors rather than mutualised. By mutualising those losses, in effect Germany therefore demands greater control over everybody else as the price for that. That is a ratchet effect which is harmful economically and harmful politically. The Chairman: Thank you. Lord Skidelsky wanted to pick up countercyclical policies.

Q12 Lord Skidelsky: We have covered a lot of that already, but I have a specific question which goes back to something which Mr Bishop said and other witnesses may have said. The future of the eurozone depends on growth in the eurozone—at least that would postpone the operation of some of the structural problems. But, in fact, the GDP growth in the eurozone was 1.6% in 2011, -0.8% in 2012, -0.3% in 2013, 0.8% in 2014 and it is projected to be 1.5% this year. The output gap, as estimated by the OECD, was 2.7% in this year and unemployment was 10.9%. Those figures would be a lot worse if Germany was excluded. The IMF has also suggested that growth would be more vigorous if there was more countercyclical policy. Are you worried that the European Commission in its view of what should be done really focuses on debt reduction or, loosely, fiscal consolidation at the expense of any of these demand-increasing policies? Does that not jeopardise the future of the eurozone itself? It hopes to do everything through structural adjustment and ignore the problem of demand. Graham Bishop: I mentioned the problem of debt ratios. When I came into the financial world 40-odd years ago, the debt ratios of the EU states were 30% of GDP. Now they are 100%. The financial markets have now discovered the hard way that you can lose money on public debt, so the idea that countercyclical policy will finish up with a significant rise in public debt is quite alarming, because if you finish up with the financial system taking large losses, then through the leverage ratio, as it were, of the banking system, you knock through to bank credit to the economy being lost. Lord Skidelsky: What are you going to do about growth? Graham Bishop: That is where we are stuck with the demographics. The only way out of this box, in a sense, is greater productivity, and I call that competitiveness. If we do not get that, we have a problem, I agree. That is why it is so urgent that we make sure that we get the productivity growth that is then going to feed through into more growth et cetera. We are in a debt trap. Dr Dermot Hodson: I think that the stability and growth pact is a lot more flexible than it looks. For all the talk of the six-pack and the two-pack and the pecuniary approach of fines at an earlier stage, we have seen no fines. I think that the Commission, by not talking very much about the stability and growth pact, is trying to usher in a more flexible interpretation of it. There are not many mentions of the pact in the Five Presidents' Report, which in itself is significant. I think they are trying to encourage stabilisation through national budgets. What the pact fails to do is have any mechanism for encouraging some sort of fiscal stimulus package, and that is where it falls short on growth. How much faith you can place in a

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Graham Bishop, Dr Dermot Hodson and Philippe Legrain—Oral evidence (QQ1-14) stimulus package for long-term growth, I am not sure. You could perhaps generate more growth for a few quarters, but that is only going to be part of the solution. Lord Skidelsky: There has been almost no growth for four years. Dr Dermot Hodson: But if you look at the whole history of the project, growth has been regrettably low since the euro was created. Philippe Legrain: You are absolutely right to point to the terrible growth performance. In fact, the most pertinent statistic is that the eurozone is still smaller than it was in early 2008, whereas the UK is 6% bigger and the US is 11% bigger. The main problem is the deep reluctance to restructure banks and debts. Most of the debt is private debt. Only in some countries is the main problem public debt. That is what from the start greatly exacerbated the crisis, and it is why the terrible growth performance has endured. On top of that is the fiscal and monetary straitjacket, which you partly alluded to. Also important is the refusal to use the macroeconomic imbalances procedure to force Germany to tackle its vast and growing current account surplus. The Germans say that it is not a problem because it is no longer with the rest of the eurozone. Actually that means that it is exporting its capital elsewhere, draining demand from the eurozone and exporting deflation to the rest of the eurozone. That is a very big problem indeed, especially in the context of the other constraints that I just mentioned.

Q13 Lord Skidelsky: Mr Hodson, you saw some wriggle room somewhere, but broadly speaking there is nothing in the Five Presidents' Report or in the European Commission’s present thinking that offers much hope for a growth stimulus. Dr Dermot Hodson: You are right about the report, but if you look at the Commission’s record since Jean-Claude Juncker took over, he has promoted a more flexible interpretation of the pact, which I think is consistent with his track record on the pact during his time as Eurogroup president, so he is allowing more room for manoeuvre at the national level than some people suggested when these reforms took hold. How much fiscal stimulus we are really going to get from this is debatable. The Chairman: Before we go any further, can you stay on for a few minutes more? I am conscious that we have had the hour and 15 minutes that we had asked of you, but if you could stay for a few minutes I would like to go around the Committee and ask whether Committee members have any other questions that they would like to follow up with. Is that acceptable? Yes. Lord Davies, is there anything that you wanted to pick up on? Lord Davies of Stamford: No. It has been an excellent session, Madam Chairman. Thank you very much. Lord Lawson of Blaby: I agree with Lord Davies that it has been a good session, but may I ask one further question? What, in a nutshell, do you three think is the purpose of this whole exercise? I do not think that you want what the five presidents might say in answer to that question. I am talking about the Five Presidents' Report, particularly on stage two, because obviously the purpose of stage one is to transition to stage two. What is the purpose of stage two? Graham Bishop: I think I laid it out pretty clearly at the beginning, but I see these various unions—the economic, the monetary, the fiscal—and the political at the end, which is the

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Graham Bishop, Dr Dermot Hodson and Philippe Legrain—Oral evidence (QQ1-14) necessary democratic legitimation of the other economic elements. We have to get there, because if we do not—if they do not—the risk of crisis, from public finance or whatever, is far too great. There will be the risk of a break-up, which would have catastrophic effects. They are on a path, which I do not think they can escape from, of greater integration in all these areas that will produce the necessary result of much greater political union. One manifestation will be the European Parliament having a greater direct role as co-legislator on economic governance as well as purely on legislation, as we discussed at the beginning. Dr Dermot Hodson: I think it is partly about dealing with urgent business on banking union. Beyond that, it is about Jean-Claude Juncker and his idea of a legacy, putting forward integrationist ideas. For that reason, a lot of the bigger ideas stand a limited chance of success.

Q14 The Chairman: I was just going to wrap what you have said into following up what Dr Hodson said. I shall come to you in a minute, Mr Legrain; I think you will have an interest in what I am going to say. Dr Hodson, in terms of the banking union and wrapping up the urgent business that still needs to be undertaken, what is your assessment of the reinsurance approach being used in building a single deposit guarantee scheme? Dr Dermot Hodson: The Commission put its proposals on the table yesterday so I am still digesting them, as I am sure everyone else is. They struck me as very ambitious. They have as a goal a pooling of fiscal sovereignty. The reaction from Germany has been as expected: it is very wary of this. For this reason, it is another integrationist idea that is, perhaps, not well judged. Philippe Legrain: For the purpose of the report, there is a common realisation that the eurozone is not working properly and that its governance is inadequate. There is also a common—false, in my view—belief that further integration is necessary. Therefore, this report tries to suggest that momentum towards that destination exists when, in fact, none does. However, I would also place it in the context of my initial remark, when I said that this is about Brussels politics. The first report was from Van Rompuy, the President of the Council. This is Jean-Claude Juncker, in close co-operation with [others]. As you said4, this is about Jean-Claude Juncker saying, “This is my vision. I am putting this down in history so that I will be able to claim credit. If any of these things get done in future, I can say they came from me”. That is really at the heart of it. Anyone who has worked in Brussels knows that the biggest preoccupation of people there is where they stand in the inter-institutional pecking order. The Chairman: Do you have any comments on the DGS? Philippe Legrain: As I said, I do not think this deposit insurance scheme will happen. As Mr Hodson said, the German opposition has been furious. On carve-outs, for example, one could imagine the greatest opposition coming from the politically very powerful Sparkassen. Contrary to what Mr Bishop said, they are very significant. They have roughly €1 trillion in assets. Given its political power, one way around would be to carve it out, as it has been carved out of the banking union. But even with that political concession, I do not see this flying any time soon.

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Graham Bishop: If I may comment on the DGS, we are talking about a €45 billion fund in the fullness of time. It is tiny. Even the remaining bank deposits in Greece—tiny Greece—come to €140 billion. So if there is a systemic crisis anywhere, this will be completely insufficient. Philippe Legrain: Again, that is not true. If it is a liquidity problem, the central bank can provide liquidity to prevent any run. If it is a solvency issue, you can bail in the creditors, which is what is supposed to happen, and not call on public funds. Therefore, the absence or not of common fiscal funds is not that important. The real issue is the deep political reluctance to bail in bank creditors, despite what the BRRD and the SRM say. Lord McFall of Alcluith: It is a bit of dismal message this morning: we are not restructuring bank debt, debt mutualisation has been completely dropped and growth is problematic, as Lord Skidelsky said. Graham, you mentioned that the only solution is to increase productivity. The conundrum of the productivity increase in the UK, never mind Europe, is: how are we to achieve this productivity so that we get decent growth? That is the question. The Chairman: Perhaps not to be answered right away. Lord Skidelsky, did you have a concluding thought that you wanted to share? Lord Skidelsky: No. I was just going to say, on how you get productivity growth, that it is not by lowering wages. Graham Bishop: It is a complex problem but there is a very simple answer: a highly skilled, better educated, healthier workforce, et cetera. All those factors go into it. The Chairman: Thank you very much indeed. We greatly appreciate your staying so long and speaking to us with such candour and occasional disagreement. This concludes today’s public evidence. The Committee will now continue its meeting in private.

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Jonathan Black and David Gauke MP—Oral evidence (QQ195-204)

Jonathan Black and David Gauke MP—Oral evidence (QQ195-204)

Evidence Session No. 18 Heard in Public Questions 195 - 204

WEDNESDAY 24 FEBRUARY 2016

Members present

Baroness Falkner of Margravine (Chairman) Lord Borwick Lord Butler of Brockwell Earl of Caithness Lord Haskins Lord Lawson of Blaby Earl of Lindsay Lord McFall of Alcluith Lord Shutt of Greetland ______

Examination of Witnesses David Gauke MP, Financial Secretary to the Treasury, and Jonathan Black, Director, Europe, HM Treasury

Q195 The Chairman: Good morning, Financial Secretary to the Treasury Mr David Gauke and Jonathan Black, European affairs director at the Treasury. You have a list of interests that have been declared by Committee members. This is a formal evidence-taking session of the Committee and a full transcript will be taken. This will be put on public record in printed form and on the parliamentary website. You will be sent a copy of the transcript and will be able to correct minor errors. The session is on the record; it is being webcast live and will be accessible subsequently via the parliamentary website.

Financial Secretary, perhaps I may say how good it is to see you again, particularly in this case early in the year. We hope to see you again later in the year. We appreciate that it is a very busy week for you, leading up to the Budget. Therefore, we welcome you even more, knowing how precious your time is. I understand that you would like to make an opening statement to the Committee. David Gauke MP: Thank you. First, perhaps I may thank you and the Committee for inviting me to give evidence today, and also introduce Jonathan Black, who as you say is the Treasury’s director in charge of EU policy. I am looking forward to this morning’s discussion

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Jonathan Black and David Gauke MP—Oral evidence (QQ195-204) and I welcome the Committee’s work on this important area of EU policy, which will certainly provide a very valuable contribution to the debate. I last spoke on this topic in July in a Westminster Hall debate initiated by John Redwood. Since then, we have had further details of a number of the proposals identified in the Five Presidents’ Report, but others remain subject to ongoing discussions. So in this regard the five Presidents process remains a work in progress. Of course, last week the Prime Minister secured an historic deal to reshape the UK’s membership of the European Union. That deal is not the focus of today’s discussion but it provides an important frame for it. The principles secured by the Prime Minister have an important bearing on how the implementation of the measures set out in the Five Presidents’ Report will affect the United Kingdom. It is also worth recalling the wider context. The fundamental economic challenges facing the euro area have been clear since its inception. Its members need to be able to prosper with a common monetary policy and to be able to manage the impact of economic shocks that may affect members differently. The political challenges are equally clear, as joining the euro requires a loss of national sovereignty over key aspects of economic policy. In light of these challenges, the UK decided not to join the euro and the Prime Minister has been clear that we will never join while he is in No. 10. The Chancellor has also long made clear his view that there is a remorseless logic that means that the euro area needs closer economic and fiscal integration. He has been equally clear that how this is achieved is a matter for the euro area countries. The debates in the euro area over further pooling of sovereignty and the appropriate degree of risk sharing are deeply political and are rightly matters for those Governments. It is in our interest that the euro area is a successful, strong currency area, so we do not want to stand in the way of the euro area resolving its difficulties. However, we will not let the integration of the euro area jeopardise the integrity of the single market or in any way disadvantage the UK. This is why I highlight the importance of the historic deal which the Prime Minister secured last week. We have secured agreement to a set of legally binding principles that ensure that the UK will not be discriminated against by EU rules because we have chosen to keep the pound. This is backed up by a new safeguard mechanism that means we can take our concerns to the European Council if these principles are not addressed. The EU has formally recognised that the UK will not take part in further integration. This means that the UK and its businesses trading in the single market cannot be discriminated against because the UK is outside the euro area. Responsibility for ensuring the financial stability of the UK will remain in the hands of the Bank of England and other UK authorities. UK taxpayers will never be required to pay for euro area . All discussions on matters that affect all EU members will involve all EU member states. This gives us the certainty that we need that the UK’s rights outside the euro will be respected as and when the euro area integrates further. I look forward to your questions. The Chairman: Thank you very much indeed. You appreciate, of course, as you raised the renegotiation, that there may well be different opinions across the Committee. David Gauke MP: I would expect that to be the case.

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The Chairman: Let me take you back to your interesting remarks about the Five Presidents’ Report. How do you see the long-term sustainability of the euro area working through, given the follow-up action plan of 21 October and so on, and given that you are expecting a White Paper in 2017? David Gauke MP: I would go back to what I said about the Chancellor’s comment about remorseless logic, if you like. Creating a monetary union creates a number of challenges for that area in terms of dealing with asymmetric economic shocks, for example, and how one addresses that. The Five Presidents’ Report provides a very useful contribution towards the debate as to how the members of the eurozone can work together to address the challenges of being in a monetary union. One of the arguments made, rightly, against the UK’s membership of the single currency was that it was necessary for further powers to flow and for there to be further integration among members of the single currency. Those member states that took the view that they wished to join the eurozone therefore need to respond to that. How they go about doing that in terms of the detail is largely a matter for them. They will need to determine that. There are clearly different views among different member states as to exactly how they respond to that challenge. The priority for the United Kingdom is to ensure that in that closer integration, members of the European Union who are outside the eurozone retain the rights that they should retain and retain access to the single market without discrimination. The precise nature and the speed of reform is something for eurozone countries. As I say, we do not want to stand in the way of that, but the Five Presidents’ Report is an important contribution to that debate. The Chairman: The Chancellor talked about headwinds in the global economy. We are all aware that the hard-won climb out of the great recession is not achieved, and particularly not for the euro area. The US economy, too, is looking less predictable than it was even a few months ago. How do you feel in principle about the United Kingdom sharing risks across the 28 versus saying very positive things about the eurozone needing to integrate but wanting to stand aside from it? In general terms, the Chancellor accepts—and I think most people would accept—that in a very integrated global economy we are affected by each other’s actions, so could you give us a general perspective on how you see risks being shared across all 28 as opposed to across the eurozone? David Gauke MP: I will give you one example. I do not think that it is reasonable for non- eurozone countries to have to be part of a bailout to preserve the euro. We made a very clear decision—one that I think history has certainly vindicated—that it would not be right for the United Kingdom to join the eurozone, and it does not seem right for United Kingdom taxpayers to be on the hook to bail out the eurozone. We made significant progress in the last Parliament in terms of protecting our position on that front. But last week’s deal provides further clarification and certainty as to the UK’s position in that respect. So I point to that as a clear example. This is a risk that should be shared not among the 28 but among the eurozone countries. The point that is clear, however, is that the United Kingdom retains access to the single market. The single market predates the euro currency. We are as entitled to participate in that single market as any other member state. Again, that was an important part of the Government’s objectives in the negotiations last week. 68

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The Chairman: So your attitude is really “pick and choose”. You were talking about bailing out, but actually now we are moving more towards bailing in. Anyway, we bailed out Ireland. So it is not as if on principle we never want to help other countries; we choose which ones we want to help and which ones we do not. David Gauke MP: The point I would make is that certain things flow from being in a monetary union. We are not in a monetary union and, therefore, those things do not flow for us in the way that they do for eurozone countries. The Chairman: But Ireland is. David Gauke MP: In Ireland there were particular circumstances. It is the only country with which we have a land border and one has to look at the Irish position on the basis of those particular circumstances: the geography, the strong economic tie and the circumstances of that tie. As a matter of principle, however, I do not think that it is right that UK taxpayers should be in a position of having to bail out other countries because they made a decision to be part of a single currency—we took a different decision. The Chairman: Thank you. We will come back to the risk issue in more detail a little later.

Q196 Lord Butler of Brockwell: Good morning, Financial Secretary. You have said that progress towards a European monetary union is largely a matter for the members of the eurozone, but the UK clearly has an interest in it. We have had evidence about the Five Presidents’ Report that it is rather a cautious document, partly because of the German and French elections, which will take place in the next year or so. What would you, as an observer—or with the UK as an observer—expect to be in the White Paper that will be produced next year? What are the most important things that you would expect to see included? David Gauke MP: First, I think that the Five Presidents’ Report is a useful contribution to this debate, but I accept that it is, by its nature, of quite a high level and that it is not the final blueprint, as such, for the future of the eurozone—I do not think that it particularly intends to be. In terms of what should be in the White Paper next year, I do not think that it is for the United Kingdom Government to be particularly prescriptive in this area. There are different approaches among eurozone member states that are understandable given the different circumstances that exist. It is important for us not to stand in the way and not to prevent the eurozone addressing the issues that it faces, because, for the reasons that Lady Falkner alludes to, it is in our interests for the eurozone to be a more robust and growth-driven economy than it has been of late. Our interests lie in, first, not getting in the way and, secondly, ensuring that the policies that are pursued do not put us at a disadvantage. That comes back to access to the single market. For example, I do not think that it is for me, or the Government, to be prescriptive as to precisely what should be in the 2017 White Paper. We should wish them well but not to try to dictate what they should say. Lord Butler of Brockwell: But the UK will be part of the informal consultations in the lead-up to that White Paper. What would be the mechanics of that? David Gauke MP: We have already made contributions to the informal consultation process that preceded the publication of the Five Presidents’ Report. The process is primarily aimed

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Jonathan Black and David Gauke MP—Oral evidence (QQ195-204) at strengthening economic governance in the euro area. That is for the eurozone countries but, as I say, we clearly have an interest, as a euro out country, in ensuring that the integrity of the single market is protected. Last week’s deal gives us the certainty that I think we need. When it comes to the precise mix of policies, to come back to your previous question, it is not for us to be dictating what is in there. One point I would make is that competitiveness remains a big challenge for the European Union as a whole and in particular for the eurozone. For example, one issue that the member states are considering is national competitiveness boards. This is still a high-level policy at the moment and there is a debate about whether that would make an effective contribution or not. If there is a view that it can contribute then it is certainly something that we would like to see. Lord Butler of Brockwell: Yes. You have said that the UK should not be prescriptive, but from the point of view of the UK’s own interests, are there any aspects that you would particularly like to see in the 2017 White Paper? Or indeed are there any that you would like not to see in the White Paper? David Gauke MP: Perhaps I will deal with your second question first as the easier one. We would not want to see—and would not expect to see, in the light of the recent negotiations—anything that we felt would undermine the single market. I come back to the agreement that was reached on Friday, which strengthens our position and provides greater clarity. It is, of course, something that we would need to be alive to but, as I say, I would not necessarily want to be prescriptive. I referred to the national competitiveness boards; if a case can be made that they are helpful—and I think that the intentions towards such boards are worthy—then we should support them, given that more clearly needs to be done to improve the European Union’s competitiveness.

Q197 Lord Shutt of Greetland: I wrote this down before you said it: we wish the euro well. I paraphrase what you said: we wish it well but we do not want too much to do with it. Is this not a dangerous position to be in? I see the European Union a little like an orange: we are part of the skin and the euro is the meat of the orange inside. I peeled an orange once and found that it was bad inside. Surely one needs to know what is going on inside. How can we be certain, by just wishing it well and not wanting to do much about it, that all is well and, indeed, that the resources are being used properly and that the people meeting together inside are not talking about things that perhaps ought to involve the UK? What if the border is not as clear as it might be or the resources are being used just for the insiders and not for the entirety? Are there not some dangers here? You say, “We wish it well but we don’t want to be too involved”, but is that not a dangerous, complacent position to be in? David Gauke MP: First, as far as the European Union is concerned, the UK plays a very active role in ensuring that it is as competitive as possible and, for example, that we pursue free trade agreements with other countries—and that we pursue that more rigorously and enthusiastically than has perhaps been the case before. The UK plays an important role within the European Union in advocating a more open, competitive—Atlanticist, if you like— policy than would otherwise be the case. That is not to say that we have no interest in the European Union being a successful economic area. The point I am making is that we are not part of the eurozone, so we need to ensure that we protect our position as a euro out and that we do not allow our access to the single market to be in any way compromised because we are a euro out. 70

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On your point about institutions, arrangements are already in place for the euro group. If the euro area wants to integrate further within the EU, for example by setting up euro area only institutions or a separate euro area budget within the EU, it will require treaty change. This of course would require the unanimous agreement of member states, which would give us the chance to address any concerns about the use of EU-wide resources for euro area purposes. You are right to raise the point and we have to remain vigilant. The Chairman: You mentioned the Atlanticist bent that there is. I found that quite an extraordinary comment to make in light of our interests. I would like you to give us an overview. It sounds as though you are saying that the euro area countries are merely another group—that as we trade with the US, so, too, do we trade with them. If you look at the figures, nearly half of our trade is with the EU and something in the order of 15% is with the US. So is the Atlanticist analogy that you use appropriate? Can we distance ourselves sufficiently from the EU when we have that kind of relationship? David Gauke MP: If I may say so, I feel that you may be overinterpreting what I am saying, so I am happy to provide some clarity. We bring, if you like, an Anglo-Saxon view of the world and how the economy should work. We advocate what in English rather than American would be described as liberal economics. We believe in free trade, we want to take down trade barriers and we believe that we should look outwards. As a country the UK has consistently not been “little European” but has believed that we are part of the European Union and that the European Union will prosper by trading more with other parts of the world. That is a role that the UK plays and will continue to play. Part of the Prime Minister’s negotiation for greater economic competitiveness was a recognition that mature western democracies such as the UK and indeed many of the other member states face challenges in terms of maintaining our prosperity, and that the way we should respond to that is not by closing in, having very high regulatory burdens that price European businesses out of world markets or putting up trade barriers to try to close out international competition. That is the position of the UK that Governments of different colours and compositions have argued over many years. That is the point I am making. It is nothing more than that. Lord Lawson of Blaby: May I come back to what you said earlier, Financial Secretary? I am always happy to see a Financial Secretary because I was a Financial Secretary to the Treasury once upon a time. The Chancellor of the Exchequer is clearly absolutely right to say that if you are going to have a reasonable monetary union, you have to have fiscal union, which means what the Germans—who do not like the idea—call a transfer union. That is always the rule. Indeed, the Five Presidents’ Report very logically says that there needs to be a European finance ministry. Whether it is going to happen by 2025 or not is another matter. The things that the European Union goes for, in my experience, tend not to happen by their due dates—but they do happen. So there would be a European finance ministry, which means a political union. Indeed, the Prime Minister explicitly said in his Statement to the House of Commons on Monday that this was about political union but that the United Kingdom would not be part of it. I suspect that if we remain in the European Union, it will be an increasingly uncomfortable and unsatisfactory position for us, which concerns me a great deal. But it is clear that that is the direction of travel. In the meantime, while we are travelling—I am not a lawyer; the lawyers will have to get their hands on it when there is a proper text and so on—although we say that we are outside the eurozone and will remain 71

Jonathan Black and David Gauke MP—Oral evidence (QQ195-204) outside it, with some protections against the inbuilt qualified majority that the eurozone countries have, the text also states that they reserve the right to do anything that in their opinion is necessary to preserve and strengthen the euro. Do you not see the possibility that there may be things there that are contrary to Britain’s interests? I am sure that they will not be deliberately aimed in a spirit of hostility to the United Kingdom, but their right to do whatever in their opinion is necessary to consolidate, strengthen and protect the euro, which overrides everything else, might well not be in our interests. David Gauke MP: I would look at the agreement as a whole. In there are a number of key protections for us. There is an explicit recognition that euro outs should not be discriminated against. There is also the ability for us to go to the European Council in the event that our view is that the agreement is not being abided by. It is legally binding. As I said, I would come back to the UK Government’s position, which is not to stand in the way of eurozone countries doing what is necessary given that they share a common currency, but also to ensure that we maintain access to that single market and that there is clear, legally binding protection for us that the ECJ has to take into account. We have the ability to go to the heads of state and government European Council in the event of any departure from that. It is not the role of the United Kingdom to stop those countries that are part of the eurozone doing what they need to do, but not in such a way that it overrides our right to be part of the single market. Lord Lawson of Blaby: It is not legally binding at the present time but may become legally binding at some time in the future. My point was not so much about whether it was legally binding in that sense but that there may be a conflict between what they believe is necessary to protect and strengthen the euro and what is in the interests of the United Kingdom. As I read the agreement, the former trumps the latter. David Gauke MP: My understanding—and, as you say, no doubt the lawyers will get their hands on this—is that our rights are protected, along with our access to the single market, notwithstanding the fact that we remain and will continue to remain outside the eurozone. Lord Butler of Brockwell: But that protection does not go as far as the Luxembourg compromise, does it? David Gauke MP: In terms of the projection, I will just come back on the point about it being legally binding. My understanding and the advice of Professor Sir Alan Dashwood is that an international legal document of this sort is legally binding and that the ECJ does have to take its contents into account. Lord Lawson of Blaby: “Take into account” and “legally binding” are two completely different things. The European Court of Justice would have to take it into account, as it would have to take a lot of other things into account, but that is different from it being legally binding. David Gauke MP: “Legally binding” is the phrase that Sir Alan Dashwood uses. Lord Lawson of Blaby: That is it exactly. The Chairman: I feel the need to curtail these semantics; they are not really to do with our inquiry. May I suggest to both the Financial Secretary, if he has time, and Lord Lawson, that they listen to the former Attorney-General Dominic Grieve’s comments this morning about

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“taking into account”. They come from a former law officer of the Government speaking very eloquently. Lord Lawson of Blaby: “Taking into account” is different from “legally binding”; that is the point.

Q198 Lord Shutt of Greetland: There is something else. We have not referred to taking into account the fact that—we are speaking in the UK, where they understand it all—there are other non-euro countries. Is there any comfort and fraternity in that and is the UK doing anything about getting comfort from other countries that are not members of the euro, in terms of our relationship with the eurozone? David Gauke MP: That is an important point. These are protections for the euro outs. We are not the only euro out. As it currently stands, nine of the 28 member states are outside the eurozone. The concerns that we raise do not simply represent our concerns; the other euro outs also have particular concerns. There are some issues, for example with regard to financial services, that are much more acute for the UK than perhaps for other member states, but we are not in a unique position being outside the eurozone.

Q199 Lord Borwick: Financial Secretary, what democratic accountability arrangements do you foresee for the euro area as it consolidates more in the future? If this is a sort of euro parliament for the euro ins, would it not be natural—without us being part of it, of course— for that group of euro ins to start blaming the euro outs for problems that may occur for them in the future?

You said that we are completely isolated from supporting any country that is affected within the euro area by euro problems. Will that withstand the euro parliament blaming us somehow indirectly for not taking enough refugees, or for not supporting it in some other way? Will it not become rather fudgy as to whether we are isolated from the euro in future when there are more democratic structures within the euro area? David Gauke MP: The first point I would make is that, in terms of the structures that might be created as a result of further integration among the eurozone countries, it is principally an issue for them. I come back to my answer to Lord Shutt a moment or so ago; if there is going to be use of any European institutions that would require treaty change and if there is such treaty change, we would have an important say in how that operates. In terms of the protections for us and the concern that we will be blamed, and what have you, I would make the point that it is important for us to have the robust protections that we need to ensure that some of the burdens of being a member of the eurozone currency are not imposed upon us and that we are not discriminated against as a consequence of our status. That is really what drove a lot of the negotiation last week: to ensure that we can protect ourselves in that position, so that we are not vulnerable to people turning around and saying that actually the UK does have to do this or the UK cannot have access to that. That is why we need to protect ourselves and why the Prime Minister was right to seek an agreement and to obtain the agreement that he did last week. Lord Borwick: But you do foresee the creation of some sort of euro parliament—with treaty change, as you so rightly say?

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David Gauke MP: My point is that it is a matter for the eurozone countries to determine whether they feel the need to make constitutional or accountability changes. But, if it is part of the European Union, it would require a treaty change, which would require the support of 28 member states, including the United Kingdom. The Chairman: Could I press you on something that we have been grappling with during this inquiry: why have most of our witnesses told us that they did not envisage a move towards a euro parliament or any such body? Has the Treasury given any thinking to what kind of voice it would have in a future eurozone treasury and how it would engage? I hear what you say about building in protections, but given the UK’s position as a predominant global financial centre, we may also need to engage in their consultations and discussions and so on. How do you foresee an institutional framework for doing that? Have you given it any thought? David Gauke MP: It is difficult to reach conclusions on this as it is very speculative at this point. We are a long way away from even having firm proposals along those lines. That is not where we are with the Five Presidents’ Report. I do not know if there is anything that Jonathan would want to add to that. Jonathan Black: Thank you, Minister. A few things come to mind. Clearly, if there is not a proposal, at least at the minute, for a new eurozone institution of the kind that you have talked about, a few things are relevant. The agreement last week was relevant; one of the principles in the text was about transparency, where issues that affect all member states should be discussed by all member states. That is an important principle and is one that also governs how the ECOFIN council of 28 Finance Ministers interacts with the Eurogroup council of 19 Finance Ministers. Quite a few of the things in the Five Presidents’ Report that are being developed now are involving working groups that, at the officials’ level, involve all 28 member states, even if the non-euro countries are not taking part in them. There is a parallel that we could look at for future institutions in some of the existing ones. For example, there are arrangements where the ECB and the Bank of England work together through the SRB—the Systemic Risk Board— on common issues to do with financial stability risk. So there are precedents for how this would work, but there are no proposals for a new institution at this point. On the extent to which some of the more modest proposals in stage 1 are being developed, it is being done in a way that involves discussion among all 28 member states.

Q200 Earl of Caithness: Good morning, Financial Secretary. Before I come on to banking union, I have two other questions for you. First, could you please write to us—there is no point going into it now—on the agreement? Under section B, on competitiveness, it is now legal for us to push the Commission into getting rid of surplus regulations. What is the Treasury’s list of surplus regulations that it wants to get rid of? Following up on Lord Lawson’s point, what happens if that clashes with the eurozone? How will you get around it?

My second question to which I would like an answer is: does the Treasury have any reservations about the proposed merger between the Frankfurt and London stock exchanges, which has been in the papers yesterday and today—particularly if Frankfurt is going to have a major share, given that we might stay in or we might come out? David Gauke MP: I am probably not in a position to give an answer on that, so it is probably best that I do not attempt to say anything more than that we will need to see the nature of 74

Jonathan Black and David Gauke MP—Oral evidence (QQ195-204) the details. It is the case that as a country we take the view that it is not for the Government as a rule—I make a general point rather than a specific one—to overly interfere in the ownership of businesses. We are an open economy. That is probably all I can say on that at this point. Earl of Caithness: Let us move on to banking union. We have heard evidence, from the Corporation of London among others, that in all probability some of the banks would have preferred to be in the banking union. What representations has the City made to you and what are you doing to alleviate their concerns and address their wishes? David Gauke MP: In terms of the approach to banking union and the City’s view on this, the approach that we have taken as a Government and in terms of the renegotiation deal was to ensure that UK firms and banks cannot be discriminated against because they are outside the eurozone. We have also ensured that the UK’s financial institutions are supervised by institutions such as the Bank of England that are experts in the operation of our leading international financial services sector. We believe that that is the best way of protecting the position of the UK taxpayer and our financial stability. The negotiation includes explicit recognition of the need to fully exploit the single market and to reinforce the global attractiveness of the European Union while also ensuring that the integrity of the single market can be protected during any further eurozone integration. So the objective here is to have the best of both worlds—to use the Prime Minister’s phrase—in terms of access to the European market for our UK-based banks while also ensuring that they are supervised by UK institutions that understand our sector and are not discriminated against. Earl of Caithness: I understand your position, but if it is against what the banks consider to be in their best interests, would you still hold that position? David Gauke MP: Well, we do think that the case for banking union makes sense in the context of countries sharing a common currency and sharing particular risks. In those circumstances, it contributes to financial stability within the eurozone, which is in our interests. But we are not going to be part of the eurozone. We protect our rights in terms of managing our fiscal, economic and financial stability risks. Therefore, we do not think that there is a case for us joining banking union. We think that our situation is different from that of the eurozone member states. Earl of Caithness: Can I turn to the original third leg of the stool on banking union? The common deposit insurance or reinsurance scheme was dropped. Is there a need for it now and how do you assess the three-stage proposals put forward by the Commission? David Gauke MP: In terms of deposit insurance, first of all, we understand the importance of measures to support eurozone stability and of action to promote the strength of the eurozone. We do see that a common deposit insurance scheme could be an important part of that. We also recognise that for it to operate effectively, those participating would need to consider measures to address risks and to develop a more consistent risk profile across member states in the eurozone. Given how interconnected our economies are, it is entirely in our interest to see the eurozone succeed. That is a key priority for us. But in terms of common deposit insurance, ultimately that is a matter for the eurozone member states to determine for themselves. We see how it could play a role. We do not have a fundamental

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Jonathan Black and David Gauke MP—Oral evidence (QQ195-204) objection to it. But this is for the eurozone countries to look at the details. The euro area does need to manage and reduce its systemic risk. We in turn need to ensure that that does not cut across the operation of the single market—but, as I say, primarily this is a matter for eurozone member states. Lord McFall of Alcluith: Minister, you mentioned interconnectedness. In the financial crisis of 2007 we were caught by that, particular with cross-border issues. Given that situation, is there not a case for us to will a deposit insurance scheme even though we are not in the euro because of the certain disadvantages to the UK if we are not in it? David Gauke MP: I think I probably come back to my previous answer. This is clearly an issue that eurozone member states need to look at. We can see that it could play an important role in policies to strengthen financial stability. But that is ultimately for eurozone member states. As far as the UK is concerned, we are outside banking union. We are in a different situation because we do not share a currency. As such, it remains our position that banking union would not be right for the United Kingdom. Common deposit insurance is part of that banking union process and is a matter for members of the banking union. Lord McFall of Alcluith: But banking and finance is global. Is there not a case for the UK to say that such a step would be welcome? David Gauke MP: It is global, but it also comes down to national taxpayers as well. The experience of 2007-08 and so on is that it is taxpayers and the tax collected by national institutions that stand behind financial institutions. If you are part of a common currency, that changes the nature of the relationship—but we are not part of that common currency and therefore it is right that we are outside it. The Chairman: I wonder whether I could press you on banking union and our approach to it. Several of our witnesses were at best confused about why the United Kingdom did not wish to be part of it. I hear you taking some comfort from the fact that several—I think you said nine—outs are on your side in several of the arguments. But of course, of the eurozone outs, 26 are in the fiscal compact and several of them are part of banking union as well. Given London’s role—I come back to this—as arguably the world’s financial centre, and given the size of our banking sector, would you be able to tell us briefly why you rule it out? David Gauke MP: I come back to the point that we do have a large financial sector and a great deal of expertise in terms of the regulatory capability of the Bank of England, for example. The Chairman: But we are allowed to have higher standards. We would not be forced to reduce our standards; we would be allowed to keep them. David Gauke MP: Indeed, but in terms of pursuing policies of financial stability and economic security, we can pursue the regulatory policies that we need outside banking union. We are not part of the common currency. I think that if we were part of the eurozone, it would be a different matter, but we are not. We have a financial services sector of a sufficient size that our regulatory institutions and our levels of expertise are such that we are perfectly capable of operating outside banking union and providing the level of regulatory expertise that we need.

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Jonathan Black and David Gauke MP—Oral evidence (QQ195-204)

Q201 The Chairman: Could I take you to developments in capital markets union, of which we are enthusiastic proponents? Could you tell us how you foresee supervisory functions being carried out as we deepen capital markets union? Again, our witnesses have told us that while they can see banking union supervision working fairly comfortably, in terms of capital markets there would be much greater difficulty, because in many of the participating member states there is simply not the expertise to rise up to the level of regulatory oversight that would be needed. How do you see that coming down the road? David Gauke MP: The first point is that the Government are very supportive of capital markets union. There are real opportunities for UK businesses and financial institutions in capital markets union. We are supportive of that. We are also of the view that this is principally a single market rather than a single currency project. So again I make the point about wanting to ensure that we protect our interests and that this is a matter for the 28 and not for the 19. In terms of the supervisory nature and so on, it is only fair to say that this is a long-term project and we are in the relatively early stages. The Commission is very clear about that. At the end of September last year the Commission published its action plan—you are familiar with it—which covers putting in building blocks for 2019 and onwards. It contains an indicative timetable. In terms of working out exactly how the supervisory relationships will work, we are still in the fairly early stages and it is difficult to comment too much. Perhaps Jonathan would like to add something. Jonathan Black: You commented yourself, Chair, that the action plan does not contain a proposal for a single supervisor. The action plan is very comprehensive in that respect. It is useful to distinguish between greater standardisation in terms of single market rules, whether that is common regulation or mutual recognition of regulation, and the question of how exactly those are implemented. But as I say, the proposal from the Commission, which is quite a full one and over a long time, does not include a proposal for a single supervisor. The Chairman: So in the longer term you are not planning in any sense for that eventuality. Can I take you back to banking again? We know that the December ECOFIN agreed an ad hoc working group. Do you support rule-making on sovereign exposures at the European and/or international level, and what role should the EBA play in that? Jonathan Black: As you say, this working group has been set up. It is quite a useful example of how some of these issues are being discussed by the 28, even though they are interests for the eurozone. This working group is looking at the question of how EU sovereign debt is treated in the prudential regime. The Committee will probably be aware that it is treated as riskless. Clearly the euro crisis raised some questions in that respect. This working group has been set up at official level in the EU to work through some of the questions in relation to institutions in the single market. It is still very early days but work is taking place in parallel with what I would describe as the primary work of the Basel committee, because these issues are not just European but global. The Basel committee will probably make some recommendations on that towards the end of this year, but there is some way to go. As I say, the issues stem from some of the questions in relation to what happened in certain parts of the euro area rather than, for example, in the UK. The Chairman: What are the headline issues in terms of risk?

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Jonathan Black and David Gauke MP—Oral evidence (QQ195-204)

Jonathan Black: As I said, sovereign debt is treated as being riskless in the prudential regime. Therefore, you do not have to make capital provision for it. But, as we discovered in some of the euro countries, that judgment on risk probably needs to be looked at. That is what the purpose of this is. It goes without saying that it is a very complicated issue and not a straightforward one. The right place for this to be looked at in the first instance is the Basel committee, because this question is not just for European banking institutions but for whichever part of the world they happen to be in. Lord Lawson of Blaby: May I come in on the question of so-called capital markets union? It seems that this is all a bit of a muddle. One of the problems with the European Union now is that anything it addresses has to have the word “union” tacked on the end. The issue, as I understand it—and I agree with it—is that on balance the financial system is healthier. There is relatively greater reliance on capital market finance and relatively less reliance on bank finance. That is very sensible. This country has, compared with the rest of Europe, a much greater reliance on capital market finance and a relatively lower reliance, apart from small businesses that do not have easy access to the capital markets, on bank finance. So we have achieved that, about which I am glad, without any capital markets union. So why do you not just talk about the desirability of countries becoming more like the United Kingdom or the United States rather than capital markets union, which seems to me to be a complete muddle? Do you not think that there are two issues here? David Gauke MP: I think I would say to you that I wonder whether the substance of the policies behind capital markets union is more attractive to you than the name. I take your point, but I think that the extent to which we can make progress in ensuring that across the European Union there is greater access to capital markets is something that would be of benefit to all the European Union. Lord Lawson of Blaby: It might be desirable if people worked harder, but we do not talk about a working harder union. I do not see the point of this. David Gauke MP: In terms of the details of capital markets union, it goes beyond mere aspiration. It is seeking to find ways in which capital markets can work more efficiently across the European Union. That seems to me to be something that is to be welcomed. The Chairman: You wisely stayed away from Lord Lawson’s point that they should all be like us. Might I suggest that in 2008, when our too-big-to-fail banks were spectacularly crashing, there may have been many other countries in the EU that were quite relieved that they were not us. Lord Lawson of Blaby: Ours were not the only banks that crashed, Chair. Lord McFall of Alcluith: It was a global financial crisis. The Chairman: I have allowed us to stray outside our remit.

Q202 Lord Haskins: I will go back to the Five Presidents’ Report. I support the Prime Minister’s position on Europe. Therefore, it is important for those of us who believe that we should stay in Europe that the eurozone works properly. If Lord Lawson has his way, this will all be of academic interest because we will have gone somewhere else and it will be somebody else’s problem. But assuming that it is our problem, and coming back to the Five Presidents’ Report, it has a very ambitious heading: “Completing economic and monetary

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Jonathan Black and David Gauke MP—Oral evidence (QQ195-204) union”. It does not begin to deal with completing economic and monetary union. It deals with a few superficial issues. We have mentioned banking union. There are some good things about that. We mentioned capital markets union. There are some good things there. But in taking evidence for our report, we found a lot of cynicism—not always openly stated—and little understanding of or agreement about what fiscal union means. Certainly there was little appetite for fiscal union or treaty change. All of that is in this report. The conclusion came that this was a holding report, a muddle-through report—and, by the way, at the end of it throw in the Semesters, which were a good idea, in my view. The question is: is any of this going to take us any further? David Gauke MP: I do think that it is a useful contribution to the debate. I do not think that anyone is pretending that the Five Presidents’ Report is a complete blueprint for the future of the eurozone, but it is a useful contribution. There is clearly a debate within the eurozone, and to some extent outside it, as to how the eurozone moves forward. I come back to the Chancellor’s comment about the remorseless logic of closer integration as a consequence of sharing a common currency and addressing the challenges of convergence and economic shocks. One thing that we have learned, if we did not already recognise it, is that when you have a common currency it is important that that area is able to respond to economic shocks. The eurozone has not been in a comfortable position to do that. It is in a less fragile position than it was and now there is an opportunity for eurozone countries to try to develop their ideas. The Five Presidents’ Report is part of that process, but is that the be all and end all? It clearly is not. Lord Haskins: I agree with the Chancellor’s point but, for that to work, you need political will among the nation states. At the moment, the eurozone crisis has gone into second place because of the migration crisis—but lots of witnesses have said to us, for example, that Greece could come back to haunt us and become a big problem. Would there be the political commitment in Greece to do what is needed to keep it in the eurozone or is it conceivable that Greece would have to leave the eurozone? David Gauke MP: When it comes down to it, the Greek Government and the Greek people have not shown an appetite for wanting to leave the eurozone. We have to respect that. It is for the eurozone member states to determine an effective and robust way to work together in a sustainable manner so that the eurozone is able to withstand economic shocks. As I said earlier, we do not wish to stand in the way of that. It is in our interests for the eurozone to work. We are where we are in terms of its member states and we wish to play a positive role. We do not wish in any way to impede the eurozone from making the decisions that it needs to make but, ultimately, it is for those eurozone countries, and indeed their peoples, to determine the right way forward. The Chairman: In your view, is the European Semester useful, in real, tangible terms? David Gauke MP: We recognise that more can be done to improve the effectiveness of the Semester. The spirit of partnership that characterises it is something that we support. Sharing national practices and experiences is helpful and coming forward with recommendations for improvements is good as far as it goes, but it could go further. It is really important that there continues to be a tight focus on jobs and growth and we think that it is right to emphasise that. I think that there is a case for moving the Semester to a

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Jonathan Black and David Gauke MP—Oral evidence (QQ195-204) multiannual process. It would allow member states to introduce the structural reforms recommended in the country-specific reports and for these to become embedded. There is also more to be done to improve the transparency of the Semester. The Commission could make greater use of pre-existing, relevant, objective, external and globally recognised indicators, in the context of the current EU-level processes and tools, including by refining the indicators already in use. That would allow more meaningful comparison of the impact of member states’ economic reforms and could assist in developing good practice. It has a role but it could be improved. The Chairman: Are all these reforms on your agenda, should we get to the other side of the referendum and take on the presidency in 2017? David Gauke MP: I am not sure whether it is for me today to determine what would be our presidency objectives. All I am doing today is sharing with you ways in which I think that the Semester could be improved. We would obviously have to view that as and when we get there. Perhaps Jonathan has something to add. Jonathan Black: That is right; the Minister has gone through areas in which we would further streamline the Semester. When it comes to the presidency, we will need to make a decision on whether it is something that we would prioritise over other things. Q203 Lord Lawson of Blaby: Let me ask you a very easy question. What do you and the Chancellor of the Exchequer understand by the term “fiscal union”? David Gauke MP: Lord Lawson, you describe that as an easy question, but I think different people—or different countries—take different views on that. Lord Lawson of Blaby: I was asking about you and the Chancellor. David Gauke MP: I think that it is about closer co-operation between member states to ensure that the fiscal risks of having a common currency are more closely shared. Within that, there are different ways one can do that. Some would argue that this is about the stability and growth pact and about ensuring that there are rules in place among members of fiscal union as to how they behave. Others would argue that it is more about fiscal transfers between richer parts of a fiscal union towards poorer parts. The precise nature of a fiscal union can vary and I do not think that there is consensus on what precisely a fiscal union should look like. That is one of the big challenges that the eurozone continues to face. Lord Lawson of Blaby: But there are, of course, plenty of fiscal unions in the world. You just need to look around. The United States, for example, is a fiscal union. Of course, population movements are also important, which are slightly more contentious within Europe than they are within the United States. But, leaving that aside, the fact that there is a significant federal tax base—although individual states have their own taxes, there is substantial federal tax—is agreed by most economists that I know to be an essential part of a fiscal union. It makes the monetary union of the United States workable. Is there any reason to believe that the laws of economics are different on the continent of Europe? David Gauke MP: No, but the point I would make is that the concept of fiscal union is a fairly broad one. As you say, there are many fiscal unions around the world. The United States provides one very important model, but there are different views within the eurozone as to the precise nature of what that fiscal union might be. Within the eurozone it is, I think, still

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Jonathan Black and David Gauke MP—Oral evidence (QQ195-204) referred to in a broad sense, and that covers a wide variety of high-level policy proposals. I do not think that there is consensus on that. Lord Lawson of Blaby: So when the Chancellor of the Exchequer, who is a very clever man, says that there would have to be a European, or eurozone, fiscal union, he does not really know what he means? David Gauke MP: No—I agree with the first part of your question about the cleverness of the Chancellor of the Exchequer, but not the second part. The nature of fiscal union—or, if you like, the phrase “fiscal union”—covers a multitude of models. To take the two purest, or clearest, positions, one is the view of fiscal union as about rules and restricting what member states within a fiscal union can do and ensuring that the deficits are of a certain size and so on, and the other view is that it is about the transfer of resources. Then there is a spectrum in between. The point I was making, and that I think the Chancellor would make, is that the objective is to ensure that there are fiscal policies that prevent instability within the eurozone. As we discussed, having created a common currency, it is clear that alongside that there needs to be fiscal policies, in one form or another, that complement, support and buttress that currency union. It is not something that you and I would ever want the United Kingdom to be part of—but, given that there are member states that have entered into a common currency zone, they need to consider, and are considering, how they address the fiscal challenges.

Q204 Lord Butler of Brockwell: Do you think that the proposed European fiscal board is going to make much difference to that? Could you also comment on the macroeconomic imbalances procedure and whether, again, you think it has an important influence on fiscal co-ordination? David Gauke MP: It is difficult to say how much of a difference the board would make without seeing more detail of precisely how the board would undertake its duties. So that is a definitive “don’t know” at this stage. It is too early to say whether it would make much difference. It may do, but it does not have the ability to compel member states to change their fiscal policies; it has an advisory role. We would need to see a more precise proposal. The macroeconomic imbalances procedure is still a relatively new process. We support it as a means of strengthening the understanding of macroeconomic risks, particularly in the euro area. But in terms of its effectiveness, it is fairly early days. Lord Haskins: The US fiscal union evolved over rather a long period of time. It did not come overnight. David Gauke MP: Indeed. I feel that this is one of those occasions where debate may be about to break out among Committee members. I do not want to impede that. The Chairman: Financial Secretary, you have been very kind and have given generously of your time. Unless the Committee has any further questions, I think that we can conclude today’s public session. The Committee will continue its work in private. Thank you again, Mr David Gauke and Mr Jonathan Black, for coming to give evidence.

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Baroness Bowles of Berkhamsted and Raoul Ruparel—Oral evidence (QQ15-26)

Baroness Bowles of Berkhamsted and Raoul Ruparel—Oral evidence (QQ15- 26)

Evidence Session No. 2 Heard in Public Questions 15 - 26

WEDNESDAY, 2 DECEMBER 2015

Members present

Baroness Falkner of Margravine (Chairman) Lord Borwick Lord Butler of Brockwell Lord Davies of Stamford Lord Haskins Baroness Kingsmill Lord Lawson of Blaby Earl of Lindsay Lord McFall of Alcluith Lord Shutt of Greetland Lord Skidelsky ______

Examination of Witnesses Baroness Bowles of Berkhamsted, former MEP and Chair of the Economic and Monetary Affairs Committee, and Raoul Ruparel, Co-Director, Open Europe

Q15 The Chairman: Good morning, Baroness Bowles of Berkhamsted and Mr Raoul Ruparel. Welcome to this evidence session of the Financial Affairs Sub-Committee in our inquiry on Europe’s economic and monetary union.

You have a list of interests that have been declared by Committee members. This is a formal evidence-taking session of the Committee and a full transcript will be taken. This will be put on the public record in printed form and on the parliamentary website. You will be sent a copy of the transcript and you will be able to revise it for any minor errors. The session is on the record; it is being webcast live and will be subsequently accessible via the parliamentary website. Would you like to make any brief opening remarks? Baroness Bowles of Berkhamsted: No. If we get into the business I am fine with that. The Chairman: Okay. We can go straight into the session itself then. You have both submitted quite interesting pieces of evidence coming from different perspectives, but in your assessment what do you make of the Five Presidents’ Report and the actions 82

Baroness Bowles of Berkhamsted and Raoul Ruparel—Oral evidence (QQ15-26) introduced in the short term by the European Commission, particularly in its 21 October paper? Beyond that, do you think the report does enough to strengthen the euro in its long-term sustainability and do you believe that there are significant omissions that need to be corrected? I would also like you, in your responses, to touch on what you think should be in the White Paper in 2017. Lady Bowles, would you like to start? Baroness Bowles of Berkhamsted: We will get into more details later, but broadly the situation that they have got to in the EU with EMU is that there has been an awful lot of activity following the various crises in a way that parallels what has been done on the financial services side. So they need to take a breather and, if you like, regularise some of the things that have been cooked up off treaty and to get those on treaty. The phrase that is used, “deepening by doing” gives the game away in the sense that, “We have made a lot of rules, we have tightened some rules, but we have not managed to get them fully functioning and fully going”. From that point of view, I can understand why it may be less ambitious than some people would expect. Of course, it then goes on to the subsequent phases, which will probably arouse more controversy. I suppose from the perspective of the UK that the things in it that concern me most are whether even in the short term—looking at these competitiveness authorities—they are going to create something that is going to set policy in a way that we might be excluded from, although in the more recent 21 October paper that came out from the Commission it did say it expected or hoped that the euro outs would have a similar structure. That is well worth looking at from the UK side, because, as far as I can see, we do not have a similar structure. We have the things done in various different places. If you send somebody along to a meeting who has only part of it in their remit, I know the European way is to ignore the things that you try to speak about that are the remit of another authority, even if they said, “Hey, you go and speak for us”. That is something we can adjust to. With regard to the things that are left out, some of them are not left out but are just hinted at, such as, “Are we going to have some form of euro treasury or not, and how are we going to get the democracy done?”. They should have been a little more upfront about what they were doing in banking regulation. Ever since I clapped eyes on zero-risk rates for sovereign debt, it has been something that I have been going on about. People thought I was a freak at first, but now it is accepted that it is not a very good idea, and it is even accepted internationally that it is not a very good idea. But the need to not have it resides in the eurozone because it is a partial monetary union. So you do not have the exposure to the markets if there is always this notion that you are going to get bailed out, that you can print your own currency—which, of course, you cannot in the eurozone—and that all sovereigns are equal when they are not, or if you say they are then you are basically saying you are always going to bail out. They are still trying to have their cake and eat it there, and to hide behind saying “We are waiting for international movement” is wrong. There should certainly be some kind of large exposures regime or something. They have to bite the bullet on that because, otherwise, it is really rather a fantasy. Looking forward to the White Paper, they need to sort out the issue of what form this treasury will take. Are they going to have some kind of euro bills, and how are these, if you like, pooled reinsurance schemes going to work? What level of financing is going into them? They already have quite a lot of backstops, but ultimately there is only a limited amount of money. Those are my initial thoughts. 83

Baroness Bowles of Berkhamsted and Raoul Ruparel—Oral evidence (QQ15-26)

The Chairman: Thank you. Mr Ruparel? Raoul Ruparel: Thank you for having me here. I would agree that much of the first stage of the Five Presidents’ Report is focused on reorganisation, efficiency and trying to improve what is already in place in the eurozone. For that reason, though, the key point is that there are no additional powers, no new institutions and no new rules of enforceability brought in stage 1, so for the most part it is about trying to improve what they have. For that reason, I do not think the first stage will make much of a difference to the eurozone. It might help on the margin, but the bigger question is what comes down the line. Looking at some of the specific aspects in the first stage, this becomes quite clear. The competitiveness boards, which Baroness Bowles mentioned, are a sensible idea and they can provide some useful input, but, again, they are independent authorities outside the Commission. Many of these types of authorities already exist in a number of countries. We have the council of wise men in Germany, for example, that produces similar sorts of recommendations. Again, it will be a recommending body; it will not have any additional power to really make any changes. It could contribute to the debate but I do not think it would necessarily make a substantial change. Similarly, with regard to the European Semester improvements, making it more focused, and making it more specific and not an all-encompassing policy programme, is welcome and could help allow a bit more freedom nationally to set some of these policy objectives. That will help in terms of the democratic deficit we see in the eurozone, but ultimately the European Semester has been found wanting in terms of enforcing any real changes. If you look at many of the reforms and changes that have taken place in the eurozone over the past few years, they have been very heavily located in the bailout countries—Greece to an extent, Portugal, Ireland and Spain, the countries where there was this direct link between cash and reform. That has proven to be an enforceable link. There have been reforms, and many of those countries have improved their business climate and brought down their labour costs, but other countries who were not in bailouts—I am thinking specifically of France and Italy—have not made substantial improvements in these areas and have fallen behind the curve. I do not think the European Semester will make much difference. It needs to be improved, but it clearly needs more power and more enforceability. That also needs to be democratically anchored, of course, but at the moment the changes in stage 1 do not really make much difference. Again, just briefly, the fiscal board suffers from a similar problem. The concept of trying to create a eurozone-wide fiscal approach is a valid one, given that you have that on monetary policy already. But, again, if this has no power and it is selected on certain preferences, or if it is or is not weighted according to member states—we do not know how it will be set up— it is clear to me that it is not likely to make a huge difference. Again, it can contribute to the debate but I do not think it will substantially change what is happening. The banking union is an area we will probably talk more about and I will not go into huge amounts of detail, but it is clear there is a very big focus on this idea of a deposit guarantee scheme. That is a necessary part of improving and completing the banking union, but it is probably not sufficient. There are lots of other things that need to happen. So far, it is clear to me that the sovereign-bank loop has not been broken in the eurozone; there is a very clear nexus in those countries and banking systems remain very locally and nationally

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Baroness Bowles of Berkhamsted and Raoul Ruparel—Oral evidence (QQ15-26) focused. To break the banking loop, there needs to be far more done in terms of improving the bail-in rules, having a clearer structural mechanism for sovereign debt and tackling this sovereign debt issue that Baroness Bowles mentioned. Finally, on what the White Paper should look at, again this is an existential question, to an extent, for the eurozone, but for me it is about giving these eurozone countries more economic tools. When you join the eurozone currently, you give up a huge number of economic policy tools: you no longer have the ability to print or devalue your own currency; you no longer have the ability to set your own specific interest rates and monetary policy; you are increasingly seeing your fiscal policy being closed in and tightened by a number of rules; and we may even start to see more harmonisation on tax and legal frameworks. You are giving up a huge amount of policy control and not getting a huge amount in return at the moment, so that has to be the focus for this White Paper. How do we give these countries the tools to respond to any future economic shocks? This could come in a number of forms. It could be through this fiscal integration—a eurozone treasury of some form. There are alternatives. It could come through this idea of a deeper financial integration and deeper capital markets, trying to mimic what happens in the US. Again, we might talk about that in more detail. Fundamentally, it also has to take account of this trade-off. What has worked in the eurozone so far to enforce reforms, I believe, is this cash in exchange for reform. How does that structure become formalised—if it is desirable to formalise it? How do we have this democratically anchored, in particular the transfer between sovereignty and solidarity? How do countries that are giving up sovereignty get solidarity in exchange, how is that justified to their populations and how will that be democratically anchored for the long term? These are the issues that the White Paper has to touch on—more than touch on. It has to clearly spell out how this framework will work. It should also be inclusive of non-eurozone countries because, clearly, these sorts of changes are huge institutional and structural changes for how the EU works and how the treaties are formulated. To not have any mention of non-eurozone countries would be a dereliction of duty, really. Whether it is in the same White Paper or if there is an accompanying White Paper looking at how these sorts of plans change the structure of the EU as a whole, it is important to have that discussion formalised. The Chairman: Can I just press you both a little bit on what you have just said? Lady Bowles, you have commented on the national competitiveness authorities. Do you believe that the UK has an equivalent one, or should it have one because they are being set up for the eurozone? There was a lot you said there. I just want to unpack a little bit about the fiscal board proposals and the Semester reforms, which hinted at a strong emphasis on a collective euro area fiscal stand. Do you think this is going far enough? It does not sound to me like you think it is going far enough. How should it be done? Should it be done through diktat or bargaining? You talked about the compact between giving up sovereignty and so on. Could you just elaborate on that momentarily?

Q16 Baroness Bowles of Berkhamsted: My problem is that I am rather better at European institutions than UK ones, but as envisaged—it depends what scope they have—it says that they are going to look at it for the purposes of setting wages and things like that. Things like

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Baroness Bowles of Berkhamsted and Raoul Ruparel—Oral evidence (QQ15-26) that are probably done more within the Bank of England and so forth. We have some things that might be in the Competition and Markets Authority and some things that might be in the Office for Budget Responsibility, although that has another parallel that everybody has to set up in Europe anyway—we were ahead of the game there in the UK. It is something that should be checked out—that they can go along and be in the room if they want to contribute. The Chairman: And produce— Baroness Bowles of Berkhamsted: It does not mean to say that the conclusions are necessarily always going to be the same, because, as Raoul has mentioned, they have more problems and more inflexibilities within the eurozone. It is also the fact that, by and large, on the single market issues and competitive issues, they have been the laggards. The countries that have reformed have, for the main part, had to become more liberalised. That is still a process. So, in a sense, on a lot of these issues they are trying to get to where we are. The danger is that if they settle on something, through knocking on into legislation and the way they think, that is subsequently going to close down on being more liberal. Raoul Ruparel: On the fiscal board, it is a very interim measure and I do not think it goes particularly far. The idea is to try to create pressure on countries. It is basically targeted at Germany, to try to get Germany to reduce its current account surplus and to provide more investment spending for the eurozone—this idea that we need a fiscal stance for the entire eurozone. We already have this macroeconomic imbalance procedure, which should address that issue, particularly on the current account side. The Commission has consistently resisted going very far and penalising Germany for its current account surplus. So, again, will creating another organisation that has no new power and no new method of enforcement really change anything? Not for me. With regard to the next step and more of a fiscal element to it, and this sovereignty solidarity transfer, it is very hard to know how this should be done, but, ultimately, fiscal policies remain national. They are nationally anchored in terms of democracy and it is a key part of what national parliaments do. Whatever fiscal element is at the eurozone level will be partial and limited. To me, it would be tied into specific circumstances. I am thinking here of this unemployment fund-type response; if you have a certain problem, the fund can pay out to aid you, or if you meet certain competitiveness criteria you get money in return or additional funds to help boost that. It is going to be partial and those decisions will have to have feed-in from national parliaments and national Governments or have some more democratic approach at European level, again possibly through groups of national Ministers or through the European Parliament. Again, it is very up in the air, but it is ultimately going to be piecemeal for the most part.

Q17 Baroness Kingsmill: I wondered if you had any ideas about institutions that might be appropriate for this or should it not be institutionalised? Is it something that is simply done at government committee-type/treasury sort of level? Baroness Bowles of Berkhamsted: From a UK perspective? Baroness Kingsmill: From a UK perspective, yes. Baroness Bowles of Berkhamsted: I do not know, in the sense that probably people get a little uncomfortable in some respects if they say we should always be adjusting to fit what 86

Baroness Bowles of Berkhamsted and Raoul Ruparel—Oral evidence (QQ15-26) the eurozone does, but I made a similar suggestion when they were setting up the European supervisory authorities that we had everything in one place, which is not the case, because we seem to have created more things and chopped things up more. When you are speaking in these various different forums it does help if, as far as power is appropriate, you have the power to be speaking about those things. They are always looking for a reason to discount when they do not agree with you. So if you are talking about something, because you are the Competition and Markets Authority and it is something that resides with the Bank of England, they will discount it because they will say, “You do not really do that, do you?”, and then go their own way. It is just human nature of negotiation as to how it works; you garner all the weapons that you can to your side. I just do not believe that one should go in without a full array of armaments. The Chairman: Mr Ruparel, did you have any points you wanted to make on institutional matters? Raoul Ruparel: Just on these competitiveness authorities. To me, the motivating factor behind them is to create a greater level of national ownership of these types of reforms. The problem is not at the high level of these types of policy discussions; the ownership of these reforms is a problem at the grass-roots level, and that is why we have seen the rise of many populist parties in a number of countries in the eurozone in particular. I am not sure that creating these boards will tackle that ownership problem. Again, they can contribute to the discussion. From the UK perspective though, I do not see any harm in us taking part or us having one of these boards, but I am not entirely sure it is necessary. We already have a very vibrant economic debate in this country. We have a much more developed think-tank and NGO sector than the rest of Europe, and it might be duplication. Lord Skidelsky: I would like to take up something that Mr Ruparel said. You suggested that the approach to fiscal union was very piecemeal and, basically, the new proposal did not add very much to what was already there; there were no new powers being envisaged. But it has also been represented to us that a fiscal union is really unnecessary; that if governments actually adopted proper fiscal rules and their credit markets correctly rated their credits, there would not be any need for a fiscal union; and that we know what good fiscal rules are. In fact, I quote from a paper we received from Professor Michael Wickens: “The successful implementation of these fiscal procedures would remove the threat of government insolvency, bailouts and inter-country fiscal transfers, the need for a banking union and ever closer political union. This is because the countries would be successfully managing” their own affairs. What is your comment on that? Do you think this whole thing is misguided? The Chairman: We already have that question on the paper, Lord Skidelsky, under question 4. I wonder whether you might give your responses to Lord Skidelsky when we come to question 4, on the fiscal stance. Lord Butler of Brockwell: I wanted, quickly, to follow up the reference to formalising. Is this code for treaty change? If so, how imminent do you see the prospect of treaty change and on what areas of this agenda? Baroness Bowles of Berkhamsted: A lot of what was done, in setting up rescue funds and the bailout funds for countries, has been done off treaty and it is intergovernmental. That is a great thorn in the side of the Parliament because they, of course, get cut out of that. Nevertheless, they do have a voice and have a point. One of the problems of going off treaty 87

Baroness Bowles of Berkhamsted and Raoul Ruparel—Oral evidence (QQ15-26) and on to intergovernmental treaties is that it is dubious as to whether you have the full protections of the treaties. In particular, the two big issues for the UK have always been the single market and state aid, because there is a hole in the original treaties and if you have joint state aid it is not covered. I have put it in all the individual pieces of legislation so that it is to everybody’s interests. But, of course, the whole issue of treaty change is difficult when you have major elections potentially coming up in France and Germany. That is why the notion of treaty changes and things is really in phase 2. It is get down, knuckle under, do all the things that you have promised you are going to do, and meanwhile create these bodies that are more independent experts to try and apply pressure. It is trying to apply pressure a lot of the time on Germany to say, “Come on, you cannot enjoy all of these imbalances in your favour and not give a bit”. That is the game.

Q18 Lord Borwick: Can I, first, declare two interests in that my wife, before she became an MP, used to work part-time for Open Europe, and I am a trustee of a discretionary trust that has supported Open Europe’s research in the past. Can I ask about the direct or indirect impacts on the UK and other non-euro area member states of these actions that are identified in the Five Presidents’ Report and identified by the European Commission? What do you think they will be? Baroness Bowles of Berkhamsted: The areas that I am looking at are preservation of the single market and, to some extent, the development of macroprudential controls and what body that might be, which lurks in the background of a lot of things. Also, going forward on to the whole capital market union, will there be a single supervisor side of things? Because of the legislation that was done on banking union—if you like, the second round of that when we did the single resolution authority and the single resolution mechanism, which was the way of enacting the bank recovery and resolution directive within the eurozone—that was done on the basis of a single market to level up the disadvantage suffered by the eurozone in the sense that they did not have the same single source of funding and so forth as euro outs did. It was a little bit of a perverse justification and it was done in quite a hurry. I do not think that we had fully elaborated the special circumstances, because it now seems to be interpreted as meaning that anything to do with banking union can be done under a single market basis. I think that that is wrong. On the other hand, we could not stop it because there is enhanced co-operation as a possibility, but if you trigger the enhanced co-operation then the Commission has this extra duty to make sure it is not harming the single market and so forth. The way it was done slightly bypassed making sure that that failsafe, “check that it is okay for the single market” duty was put firmly on to the Commission. They will say it was there and that was the spirit within which it was negotiated and, again, individual measures were put in. Among the think tanks in Brussels it is now said that the banking union is a single market issue, and that is not right. Again, I feel that there are parts of the Five Presidents’ Report where they are trying to say that the single market is more important to the eurozone, and that is not true. It is just they have been worse at it, so they are using their laggardness as an excuse to try and grasp the single market. That is something that I am quite concerned about. Just vocalising it and being prepared to repeatedly vocalise it is something that has to be done. Although we have given the ECB a duty of care for the single market, they will say that what they are given under the treaty will override what we have given them in secondary

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Baroness Bowles of Berkhamsted and Raoul Ruparel—Oral evidence (QQ15-26) legislation. These are all sorts of things that ought to be sorted out in our negotiations over the referendum and/or, if they are not then, will ultimately be sorted out when there is a treaty change, but there has to be somebody there who is playing tough on these games. Raoul Ruparel: I would very much agree about that risk in terms of the legal precedent that has been set and everything being hung now on this banking union under the single market. This is quite a worrying turn of events. We have seen it just the last couple of weeks with the deposit guarantee scheme, which involves quite a significant amount of mutualisation and a focus on the eurozone. That is being justified under the single market article, which is entirely wrong. Even Germany has come out quite strongly saying that. This also has another risk in that it could hollow out EU institutions and make them more eurozone-focused. Again, putting this kind of mutualisation and deposit guarantee scheme into the Commission gives it another big power that is only eurozone-focused, and if we continue doing this it could hollow out those institutions and move them from EU to eurozone. There is this risk of caucusing now that the eurozone countries have a qualified majority. We saw that with the bridge loan for Greece, again a very specific and niche issue, but, fundamentally, they took a decision where the UK was not consulted; it was not in the room, at least according to the Chancellor’s coverage of events. Ultimately, there was an agreement reached, but this relied on good will from other member states. Fundamentally, the principle was that they chose this route because it was the route of least resistance for the eurozone, not taking much account of what it would do to other non-eurozone countries and the political problems it would cause for them. That is a worrying precedent. Similarly, we have seen the potential splits on single market with the ECB push on clearing houses and the clearing of euros. There are a number of potential impacts and spillovers here. Ultimately, we do not know where the eurozone is going to go. We do not know what treaty articles it will use for this integration. It does not have its own defined treaty articles or any ones that it will specifically use. That is why I think there is a need for a broad type of safeguard, similar to what David Cameron seeks in his renegotiation. To try and counter these potential legal problems and precedents, there needs to be some way to push back. I would go further than saying vocally push back; there needs to be a specific mechanism to counteract this.

Q19 Lord Haskins: The presidents are being charged all the time of ducking issues, of not grasping nettles and all this sort of stuff; but surely the political reality—this is the nub of the whole question—is that the presidents know very well that, if they do propose dramatic structural changes that require treaty change, it ain’t going to happen. It is not going to happen in the next 12 months or the next five years, because no unanimity is going to be achieved if referendums have to be called in France, Ireland and other places. The second element of it is that, if you go down that route, you create huge tensions between eurozone and non-eurozone areas. Therefore, and slightly pre-empting Lord Skidelsky’s point, what we are heading towards is non-treaty change solutions that require much better self-discipline by eurozone member states. That seems to me to be the only reality and anything that requires treaty change is not politically deliverable.

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Baroness Bowles of Berkhamsted: It is my turn to go first. There is a lot of truth in what you said. I do believe that they want to get things on treaty, but, as you say, there are problems. Once they are more comfortable with it, if they do not come inside the treaty, it will be quite interesting to start to look at what the position of the euro outs is in international law. This is not my sphere of expertise but it is of other people. As you know, some of these structures have been challenged in the ECJ by German organisations, but if you start to do things internationally that then distort the original treaty—I am thinking aloud here—it is something that I would have wanted to look at as to whether there should have to be some changes enforced to rationalise them, because the earlier treaty stands before the later ones. As I said, that is probably in the back of some people’s minds as one of the reasons why they need to basically get back on board. Things are moving. You should bear in mind that it took 100 years to get monetary union for the dollar. We have had one decade of trying to do the euro. To map out another decade of further steps is not an unreasonable thing for the presidents to have done, which is essentially what they have done. It will not be the end of it in 2025. There will then have to be another decade, because, especially following the crisis that we have had, the problem is that nobody wants to pick up somebody else’s deficit—that is still there—apart from the ones who have deficit, who quite like the idea of somebody else picking it up. That dynamic will stay. Raoul Ruparel: In terms of this fiscal discipline approach, it is very hard to see it working for a number of reasons. The transition of going from where we are now, with still very high levels of debt overhang and competitiveness problems in the eurozone, to this point of pure fiscal discipline would be, to me, incredibly painful and long. It would include depressed economic growth. If you put that on top of the crisis we have just had, the political fallout would probably be uncontrollable and I do not think many countries could stomach that. The status quo and moving around from where we are now to a purely rules-based system is probably not feasible, in my view, and some more structural changes are needed. I am not saying that has to be a fiscal union. As we have already hinted at, there are alternatives in terms of more of a private market mechanism, but even that involves significant changes in proper financial integration and clearer mechanisms for restructuring banks and sovereigns, and a proper belief that people will not fall back on their national state guarantees when a crisis hits. We do not have those three mechanisms. A rules-based system is plausible but it still requires a number of changes to get there. If you are just trying to enforce the basic rules we have now, the transition would be painful and probably cause serious political problems. Lord Lawson of Blaby: I was interested to hear Lady Bowles say that it took 100 years to get monetary union in the United States. It did not just take a long time—it took political union. It was exactly the same in Germany. It took the political union of Germany to get monetary union. It was exactly the same in Italy. It took the political union of Italy to get monetary union. I do not think there has ever been a case in history, for very good reasons, where it has not gone that way; political union has led to monetary union. That is just the historical background. Looking at what we are looking at now, may I ask both of you what, in a nutshell, is the point of it all? The Chairman: Briefly, please. That is quite a philosophical-level question.

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Baroness Bowles of Berkhamsted: As you well know, they are doing things a little backwards compared with your analysis just then. They are trying to have a monetary union before there is a political union. Although there is not a political union—some would wish it—there is a lot of political will that has been invested in the euro project, and, therefore, at the moment there is no desire among the eurozone countries to back off from that. They just want to continue further in small, uncomfortable steps. Lord Lawson of Blaby: Why? Baroness Bowles of Berkhamsted: Because that is what they have invested in politically. They believe in it. Lord Lawson of Blaby: My question was: what is the point of it all? Baroness Bowles of Berkhamsted: The point of it all is they think that it does support having a better single market—that is true—and you do not have to have currency exchanges. In my own professional practice, I rather like the fact that I only have to pay in euros instead of having to buy all these foreign currencies at the end of the month. There are certain advantages of having that common currency, and some people are more signed up to it than others. I do not think that they are going to go back on it at any time soon. Some people will always predict that monetary unions do not work, but that is not where they are. There are very few who would wish to disengage from it, and that is just a fact. You may not share it, many may not share it, but that is where they are. They just feel that, if they backed off from the euro, then that is the end of the EU as well. Lord Lawson of Blaby: Could Mr Ruparel have a go at answering my question? Raoul Ruparel: It is the fundamental question that the eurozone has not faced up to. The reason they cannot convince their electorates is because they do not have an explanation for why they are still going down this path, the point being that the path they are on now will continue to lead, in my view, to long-term economic malaise and they will have to make the argument, “We need to take these steps to get over this economic malaise”. Whether they can make that convincingly I am not certain, but if they cannot bring their populations with them then they have to face up to the fact that they will have to find a different route. If they cannot convince them that the eurozone integration will lead to prosperity, they have to face up either to losing some members or having a completely different type of union. I agree that is one of the problems. At the moment, the argument is along the lines of what Mrs Bowles has presented in that it is a negative one: “We cannot go backwards; we have come down this path and there is no route backwards”. I do not think that will be sustainable. Ultimately, if you have a continuously negative narrative of why we are doing this, it will be very hard to get the public support for it. Lord Davies of Stamford: Are not the objectives of the operation extremely clear? One is to create a zone of currency stability in the European Union so as to avoid a debilitating and very damaging foreign exchange crisis, which we are all familiar with going back before the euro was created. Secondly, it is to produce an effective single market, because, as Mrs Bowles says—Lady Bowles now, I am glad to say—the costs of currency transactions are quite significant and the foreign exchange risk is again quite a significant factor, increasing the risk and cost of business. If you want to have a genuine single market, you need to have a single currency to go with it. Are not these objectives really quite clear and transparent? Is 91

Baroness Bowles of Berkhamsted and Raoul Ruparel—Oral evidence (QQ15-26) it not the case that the European Commission particularly—but the Five Presidents as well— has shown a very commendable degree of flexibility, imagination and initiative in moving forward, which is necessary to do, despite the difficulty that Lord Haskins has referred to of changing the actual treaty? If you cannot change the treaties, you have to find some other way forward, and that is exactly what they are doing. What is more, they are taking measures they can take now in the short term and measures for which there is not yet a political consensus. They are setting it out in this document—the Five Presidents’ Report—to give people an impression of the general direction of travel and take people generally along the path it is necessary to take to achieve those objectives. The Chairman: Mr Ruparel, I think this is directed at you. Could you give a brief reply? Raoul Ruparel: That may have been the original premise, but I do not think you can really make that case after the past seven or eight years. That is a very hard case to justify, in my view. Lord Davies of Stamford: They had a financial crisis, but that is— Raoul Ruparel: The eurozone had its own crisis. It was due to structural inefficiencies and flaws in the way the eurozone was created. It was not because of financial crisis that the eurozone is where it is now, in my view. It is very hard to convince the people of the eurozone that this has delivered what it promised in terms of currency stability, and if you look at the way the financial world and other countries have moved, the UK outside the eurozone has continued to have very high levels of financial integration. It is the euro offshore centre, if you like. It has continued to be a full player in the single market. A number of other countries in Europe have avoided foreign exchange crises; they have had a lot of currency stability. Central banks and the financial system have evolved since the premise that underpinned the eurozone. Making that argument, on the evidence we have now, is quite difficult. That is why they cannot convince people of the justification of the eurozone and that is why we are seeing a lot of anti-euro sentiment, in my view. The Chairman: Lord Shutt on fiscal union, and do remember Lord Skidelsky’s question as well on that.

Q20 Lord Shutt of Greetland: We have hinted about fiscal union already, but what is your understanding of what it is? It does sound rather grand. How would it be achieved and is it likely to be achieved? We have income tax, corporation tax, VAT and all sorts of duties. Is it about parity of rates? Is it about parity of a tax base or is it about something else? What is it? The Chairman: Lady Bowles, when you are dealing with that, could you also briefly comment on whether you see the governance arrangements in terms of the balance of the European Parliament versus the other institutions to be about right, or whether you think they need to change? Baroness Bowles of Berkhamsted: If you look at what it says this advisory European fiscal board should do, it seems to me that a lot of the fiscal union is about trying to make sure, again, that they obey rules and that everybody is doing their calculations in the same way so that there is greater comparability. That is one starting point. Then they want to move further together and maybe to fund some things out of some form of joint taxation, whether that is using VAT or a fraction of other kinds. At one point, they were targeting trying to get money from the financial transaction tax for doing these kinds of things. 92

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If you go even further and into the issue of whether there is going to be a European treasury, there are lots of different ideas out there. Some of the more interesting ones are the ones that try to separate out, if you like, the current account spending and the debts and deficits that exist at the moment and say, “You have to try and sort those out under the stability and growth pact, but you can do investment spending separately to that”. We have nudged in that direction in the so-called “two-pack” rather than the “six-pack”, but it was very difficult to define what investment spending is and it has to be the right kinds of things. If you take it to its extreme—this includes all the projects that you can do through the —it is basically saying, “Let us start to do investment in European infrastructure collectively”. Of course, as soon as you do that, you have to have decision-making bodies to assist. You cannot reflect everything back to the Commission. It already has things like the European stability mechanism that is raising bonds guaranteed by the loans in the ESM. This starts to point at some of the functions that treasuries do. That is the direction in which that could go. It partly addresses some of the balance in that what has happened over the last few years— it has happened with the ECB and the Commission—is that it is becoming judge and jury on things, and so you need to get another institution in there to make sure that you make up the rules and then you decide. That is where a treasury might come in. The hardest part to balance is what you do over democratic oversight of any actual new structure such as a treasury. Do you use a part of the European Parliament that belongs to the eurozone? Giving euro out MEPs not a vote but they would still be part of it so that they could know what is going on is the model that has been churned around quite a lot over the last five years. The alternative model would be to say, “Okay, do it among the national parliaments in an assembly, especially as budgets are so close to the heart of national parliaments”. That is the area at the moment where they feel that they are being stripped naked a little of one of their major functions by everything being grabbed to Europe, at least while they are being made to obey rules. Those are the conflicting models there, and each has advantages and disadvantages. Raoul Ruparel: That all sounds like a fairly plausible model. It is likely that they would use their fiscal backing and underwriting of a high level fund to use that fund to respond to a crisis, similar to what we have with a bailout but a more formalised set-up where sovereignty is directly transferred to an extent as a joint mutualisation inside the treaties. That would involve, hypothetically again, having this type of unemployment fund, which I have already mentioned. Everyone makes small contributions or it has a joint underwriting from all the member states and can raise debt on the markets. Then, if a country gets into crisis, it receives funding from this organisation to help it respond to the crisis because it does not have its own fiscal room or because it is locked out of the markets. In exchange for that, it also commits to certain economic policy goals. Again, it is quite similar to what we have already, but in a more formalised nature, and trying to bring in a democratic point of linking it to national parliaments or some kind of eurozone parliament or eurozone congregation of parliaments. That is how I see it starting. Over time, the idea is that it then progresses towards more generalised mutualised debt issuance in a Eurobonds-type form, where the countries jointly issue debts underwritten by everyone; that moves away from creating national fiscal pressures to allow greater scope

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Baroness Bowles of Berkhamsted and Raoul Ruparel—Oral evidence (QQ15-26) and using the weight of the eurozone as a whole to issue debts. Again, that seems to me quite a long way down the line at the moment. As to the harmonisation of tax rates and bases, if you move towards the full picture of fiscal union that I have presented there in terms of issuing joint debts, that would become increasingly part of it. At the initial stage it is more in what Baroness Bowles presented, in that they raise certain taxes that are then transferred to a separate fund or a higher level institution at the eurozone level; it will not be full harmonisation but there will be elements of it. Also, I would rather see the move towards encouraging competition in tax rates. That remains important, but there is also a desire to have a level playing field. They have not quite worked out that tension yet. The Chairman: You do not envisage, even in the long and distant future, a state where there is sufficient integration where there would be direct fiscal transfers. Raoul Ruparel: It depends how you classify direct fiscal transfers, but there is a cautionary tale here. If you look at Italy, for example, transfers from north to south have not helped promote economic convergence or development. If you look at Germany, west to east, it has had the same problem. There is a feeling in the eurozone that this is not necessarily the way to go, and having those sorts of permanent transfers, as Lord Lawson suggested, requires political union and political acceptance. That is still a very long way off. Even then, if you have a mutualised fund that is providing fiscal support, it is indirect but it is clearly leveraging the joint underwriting. You get into questions such as, if the taxpayers in one country underwrite the debt going to another country, is that a direct fiscal transfer or not? That is a very existential question.

Q21 Lord Skidelsky: Could I just rephrase the question I started with? To what extent do you need fiscal union in any of the forms in which it has been described, in order to have a successful monetary union? Do you need a European-wide stabilisation fund? Do you need a euro-wide investment fund? Do you need a euro-wide enforcer of the fiscal rules? In other words, do you need a treasury? Do you need a budget? In the forms in which we have talked about them as an inevitable evolution, is that an inevitability or an evolution of something that is part of what one thinks of as a political union, or is it something required to make this specific organisation—the eurozone—work properly? Baroness Bowles of Berkhamsted: The whole project of the eurozone was founded on people obeying rules and the problem is that people have not obeyed the rules. The financial crisis and the additional debt burdens that that brought with it have just made matters worse. Greece was let in when everybody knew, really, that it was not up to speed. They thought that by driving things forward, if you like, in that political sense—even, if need be, there would be a crisis—that would then force greater integration. In my more cynical moments that is what I think anyway. The point is they need more than just obeying the rules and more to try and achieve convergence, because, otherwise, a monetary union between very divergent economies would always tend to fall apart if you do not accept fiscal transfers. Throughout the report it makes it absolutely clear that the one thing they are trying to avoid is the transfer union. They do not mind, if you like, mutualising to some extent the good will that collectively the eurozone has a strength and can borrow at lower interest rates.

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Obviously, that is building on the strength of Germany and other countries. They do not mind, possibly in some limited way, being able to do that, but, even if they were to issue euro bills or have some other stabilisation fund, it is quite clear that the entry ticket to that is obeying a load of rules. I impolitely called it a troika for all, but that is still the attitude. Of course, it becomes unpopular when it is enforcing austerity the whole time. Austerity is not exactly popular in the UK, but it is nothing like what some countries have had to go through, which is why some are looking a little more intelligently at other ways in which you can decouple the investment spending, as I have rehearsed before. Calling something a fiscal union—these are not unions— Lord Skidelsky: No, they are not. Baroness Bowles of Berkhamsted: They are actually ways not to have unions but ways to be corrective to behaviour, I guess. Lord Skidelsky: We have an International Monetary Fund. We do not call it an international monetary union just because there are rules and conditions for receipt of help or finance. Why is everything called a union? Is it because the aim of this is political? Baroness Bowles of Berkhamsted: Yes. It is a buzzword. The Chairman: First, I wanted to ask you, being conscious of the time, whether you could stay until about 11.30. Would that be possible? Could I also say that we have quite a lot we really would like you to cover, so could you keep your responses fairly short? I look to the Committee to be quite disciplined as well.

Q22 Baroness Kingsmill: There seems to have been very little mention of the role of the ECB in the Five Presidents’ Report. What are your views about its evolving role in economic governance, keeping my question short? Baroness Bowles of Berkhamsted: The idea is that the ECB should not be involved in economic governance. By necessity, it has had to be and has used provision of liquidity as, in a sense, a weapon to ensure compliance with some of the new requirements for the countries receiving bailout. The European Parliament has been very critical of the troika as a whole and some of the ECB behaviour, while acknowledging that at times if they had not done it then there probably would have been bigger problems. I did refer to them as liquidity loan sharks on one occasion because I felt that they had put countries into a difficult position by lending more than they should, and then threatening to withdraw it and collapse the country unless they signed up within the troika. Baroness Kingsmill: You do not have a very high opinion of bankers, by the sound of things. Baroness Bowles of Berkhamsted: No—actually I get on very well with the European Central Bank, but it is quite difficult to get powerful oversight of any central bank. You can haul them before a committee and you can grill them, but by and large there tends to be an imbalance of knowledge and it is quite tricky. Baroness Kingsmill: What do you see as its role? Baroness Bowles of Berkhamsted: In economic governance? Its role is monetary policy. It recognises that monetary policy for the whole of the eurozone is a crude tool, so it is looking forward to using macroprudential tools to try and help tailor the economy, maybe 95

Baroness Bowles of Berkhamsted and Raoul Ruparel—Oral evidence (QQ15-26) geographically, because you could use those with geographic variations. That is quite an interesting project to get a more responsive package. Of course, it felt that, when the euro was threatened, it had to come in and be the steel that said, “You have to obey the rules”, because it wanted to support the euro. It is not supposed to be doing economic governance per se but it had it thrust upon it. I do not think the Five Presidents’ Report was therefore deliberately giving it a role in that. The role that is for the ECB in the Five Presidents’ Report is through those macroprudential controls, which have a big economic—or potential economic—effect. Baroness Kingsmill: It is very difficult to imagine a system of financial economic governance that does not have a role for a central bank. Somewhere along the line, whether it is controlling the central bank, increasing its powers or giving it specific powers, it does seem to me that it is an essential element, an essential tool, of economic governance, as I say, whether you have to limit it or define its role in that respect. Raoul Ruparel: This is a broader question about the roles of independent central banks. I agree that the ECB had to act in the crisis because no one else was acting. I have some sympathy for it, but it has played quite fast and loose with the power that it has had and there has been no accountability or oversight of it, really. If we look at a number of examples, in the Greek crisis, the provision of emergency liquidity assistance was at many points defining whether the Greek economy would stay in or out of the eurozone. There was no oversight or accountability of this. We have seen leaks of letters sent to Ireland and similar ones to Spain, encouraging them to take certain policy approaches, which was far beyond the remit of the ECB. We have seen a significant role for the ECB in the deposit write-down in Cyprus, again enforcing losses on depositors. That was a significant issue. Also, we have seen this issue of location, policy and clearing houses for the UK, where the ECJ directly reprimanded the ECB for trying to take on a role that is not defined under its treaty obligations. While it has been forced into a role, it has coloured outside the lines on many occasions, and there is a need to have greater accountability and scrutiny of that. Exactly how that is done is an open question, but, for example, having the ability to call ECB members in front of national parliaments and national committees would be a useful one. Mario Draghi refused to go in front of the Irish banking inquiry, which I thought was a mistake given the very clear role that the ECB had played in that scenario. Also, we have seen a number of crises. The acting of the ECB is very opaque. It is now publishing minutes, which is helpful, but we have seen questions around its releases, making market-relevant comments to a select group of people and having meetings before monetary policy decisions with select market players. There is a lot of opacity to what it does and it still needs to be opened up significantly. The Chairman: Of course, we bear in mind that one of the Five Presidents in the report that we are considering is Mario Draghi, so they clearly do have a role in that regard.

Q23 Lord McFall of Alcluith: The former Governor of the Bank of England a few years ago said that the problem is that banks are global in life but national in debt. If we are going to have a banking union then we have to have them global in both, and it seems there is a rocky road still ahead on that. The European Commission’s report of 24 November envisages 96

Baroness Bowles of Berkhamsted and Raoul Ruparel—Oral evidence (QQ15-26) stages in this process, but, underlying that, is there not the need to ensure the bail-in rules in the tackling of sovereign debt issue, notwithstanding the proposal for stages? That seems to me an awfully long way off, particularly with Germany’s response to the latest proposal. Baroness Bowles of Berkhamsted: I could say yes, in a short answer. A lot has been done to try and get to the eurozone level in bank failures through the BRRD rules, which of course are the same and largely invented by the UK, but by having progressive mutualisation of the resolution fund, which was very controversial and it takes quite a while. The quid pro quo for that is to make sure that there is some kind of bridging funding there so that you do not end up with a situation that, because you are a smaller, poorer country, you have more fire sales of assets than if you were a larger, stronger country. It is limited mutualisation that is going on. The report suggests further pockets of this limited and controlled mutualisation, which is forward-looking. Once you have banks that are all on the same rules, they have been through the same stress tests and have all been recapitalised to the same level, which is what has happened with the creation of the single supervisory mechanism, there is more confidence that you do not have lurking horrible things from the past that the new mechanisms are going to pick up. It is not a perfect solution but it is the only one that could be got to. Lord McFall of Alcluith: Some would say that there is a failure of the market here and that capital has been mispriced. There is a view that those countries with higher debt should have higher borrowing costs and that should be greater in Germany. Would you support a proposal like that? Baroness Bowles of Berkhamsted: Yes. In the early days, when I was chair, it was quite a common thing in and around the time of the monetary dialogue, with the ECB in particular, for everybody to be talking about bond spreads and them saying it was a bad thing that there was not convergence because they looked at it as a criterion for the economies of the countries converging. I kept saying, “I do not want them to converge because if you are being economically unsound you should be paying a price”. I was always on the other side of that argument, but it just showed that they were focused on this convergence as, if you like, more important than market discipline. When we started getting into difficulty, there was a switch, and I discovered that more people were singing the tune of “You need market discipline”. It is going to be very difficult, even now, to get market discipline, because with so many bailout funds it is quite clear that nobody wants anybody to go under and rock the euro, so I think the markets will still run it. Raoul Ruparel: This is the crux of the question on banking union and breaking the sovereign- bank loop. For me, the fundamental issue is, if you have one of these national champion banks—hypothetically, Deutsche Bank or anyone along those lines—getting into trouble, do we really believe that the national Government would let them go under? That is the fundamental question here. That is cultural and almost an issue of national pride. I just do not believe that you can really enforce that. That is the big question about whether they can ever break the sovereign-bank loop fully, but they are taking steps to do it. This is why I think the focus on the deposit guarantee scheme in this stage is a bit misplaced. I would rather see them take more steps on enforcing the bail-in rules, making sure those bank recovery and resolution directive rules are— Lord McFall of Alcluith: The bail-in rules are theoretical at the moment. That is the problem.

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Raoul Ruparel: Exactly. They need to be transposed and tested, and we have had a number of bank failures over the past few years—Espírito Santo, for example, in Portugal. We have had issues in Bulgaria and Austria, and they have all been handled in completely different ways. These rules have not been enforced and tested properly. Of course, they had not been transposed fully but there is clearly no unified way to deal with these. There are other issues in how to deal with sovereign debt and restructuring sovereign debt. That will have a huge impact on the banking industry, and not having a clear mechanism and idea for how that works in a crisis creates a huge amount of uncertainty and furthers this sovereign-bank loop, in my view.

Q24 Lord McFall of Alcluith: I have a final question. The Five Presidents’ Report anticipates the eurozone having a treasury and debt-raising powers, and some would suggest that needs political oversight. What implications does that have for the UK? Would it be, for example, the eurozone having its own parliament or maybe, God forbid, a grand committee along the lines that we have here in England and equally problematic? Raoul Ruparel: Just to finish my previous thought on the banking union side, raising Germany is interesting because it submitted a non-paper, which has been leaked to the Financial Times, about the steps that should be taken as opposed to deposit guarantees to break this sovereign-bank loop, and it is quite interesting. I would encourage the Committee to read that. The Chairman: Can you give us the reference, please? What is the date? Raoul Ruparel: The non-paper is 8 September. I can give you the printout afterwards. I also think an issue that should be flagged up is deferred tax assets and deferred tax credits. This has become an issue, particularly in the southern European countries, where deferred tax assets, which are tax deductions created when an institution has a loss, have been converted via national legislation to direct claims on the state. For example, in Greece, these deferred tax credits, which are essentially direct claims on the state and to me a pre-emptive bailout, are worth between 30% to 40% of the bank’s tier 1 capital, and that is even after the current stress test. That is in double digit billions. Does anyone really believe the Greek Government can guarantee double digit billions-worth of bank capital? I do not think so. Danièle Nouy, the head of the supervisory mechanism, has flat out said, “We do not agree with these issues, but we cannot tackle them because they are national legislation”. These kinds of issues are ones that are really deeply ingrained in the sovereign-bank loop and it shows how hard it is going to be to break. On the oversight point, just quickly, it will create issues for the UK. I am not decided whether it creates more problems if it involves new institutions because the UK would be locked out of them, but at least the UK then has a veto over how they are created and has a role in the creation, or whether they are created inside the current institutions and hollow out those institutions to make them more eurozone-focused. There are problems in the approach but certainly questions for the UK. Baroness Bowles of Berkhamsted: I have covered a lot of the point, but it comes back to one of the first points I was making that they needed to sort out banking regulation. When we were doing CRD IV, one of the big issues for the UK and the frame of mind we had at that time was that we did not think that the other European countries, or some of them, would

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Baroness Bowles of Berkhamsted and Raoul Ruparel—Oral evidence (QQ15-26) be serious about having a sufficiently high quality of capital and various other things. Of course, in the ongoing negotiations, things to do with buffers and the creation of the banking union have upped their supervision a lot, but we are still left with this legacy that in the negotiations, for instance, to retain control of our own macroprudential policy and to have the discretion to put on the 3% additional funding, in the give-and-take we had to yield a bit on some of the issues around bank capital. The Parliament was very much on the same line as the UK here. It will be difficult to disentangle as well because that is— The Chairman: If you wanted to develop that, perhaps you could write in to us, but we do have some other things to come.

Q25 Earl of Lindsay: Can I ask how important you think the capital markets union is to achieving financial integration, completing our economic monetary union? How effective will it be in genuinely widening our risk-sharing, and will that effectively underpin or strengthen the resilience of the EMU? Beyond resilience, is there also the possibility of it increasing the quantum of investment and lending that might be achieved within either the Community or the eurozone? Baroness Bowles of Berkhamsted: The idea of the capital markets union is just an ongoing extension of what we were supposed to get with the single market in financial services, but there is unfinished business. To give it this buzzword gives it a little bit of emphasis and to move forward. The way it is presented within the report is to say, “Okay, if you have more risk-sharing through capital markets union, then there is a reduced risk of mutualisation and transfer union”, which I guess is true if you say everything is more stable. It is looking for a reason to justify capital markets as a good thing to many countries who are still deeply suspicious of them. I am sure there is an element of that that is within it. It is very important that it increases the quantum, and this is a little bit of a battlefield that is already going on, with many saying we will always be reliant on banks. There is a tendency to defend banks, even though one loves to hate them, or hates to hate them, or whatever it is. Nevertheless, everybody still comes out wanting to make sure that their banks survive because they are important for the economy. The Germans rather like their banking model and they do not really want anything taken away and being done elsewhere. So it is quite important to emphasise that this is about increasing the size of the cake and not just moving the same-sized cake around. The logic of it is, of course, that you diversify and have more people to pick up the pieces, but that has to be the logic that we have got to with bank recovery and resolution. The whole idea there is that things are spread out into the private sector instead of the public sector, so it is a kind of continuum with that philosophy. It is very similar to what we have been pursuing in the UK in that respect. We want there to be absorption elsewhere. Raoul Ruparel: It certainly can help with, for example, the transmission of monetary policy in the eurozone. It is very reliant now on the bank level because lots of the funding runs through the banking system, particularly for corporates. Diversifying that and allowing broader capital markets that can then respond to any ECB actions on rates or liquidity could certainly help transmit those actions more easily to the real economy and to businesses. In the broader picture, the point here is that this is also again another big cultural shift for many countries in the eurozone. Look at Germany: there is a huge amount of capital and 99

Baroness Bowles of Berkhamsted and Raoul Ruparel—Oral evidence (QQ15-26) deposits there but they are very risk-averse. They are all locked up, mostly in the savings banks, and so getting the capital markets union to work properly really means changing this attitude to risk and getting them to take on more risk and invest it in business or lending across borders. That will take a long time to change, in my view. So there is an existential question there. In getting towards a private system that takes responsibility or absorbs the shocks, as we saw in the US, after the crisis, the US system in the capital markets there took a lot of the risk; it was not the fiscal side. We have to remember that has developed over a long time and you do have fiscal players in there. For example, Fannie Mae and Freddie Mac are buying up significant amounts of stuff off banks’ balance sheets and that allows the markets to be broader. All I am saying is that copying these kinds of models is quite difficult and it takes a long time. The Chairman: Lord Davies, do you want to conclude briefly?

Q26 Lord Davies of Stamford: I was going to ask you whether you thought we should be a party to any of these institutions or initiatives that are arising. You have already dealt with the competitiveness authority, and both of you said that there was no harm in our having one. You differed about how much positive good it would provide. What about our being members, for example, of banking union? Why should we be members of capital markets union but not banking union? Where does that leave securitisation and developing a market in CDAs and collateralised debt obligations? Is that part of banking union? It greatly increases the liquidity of banks’ assets, or is it part of capital markets in that it provides a new instrument for savers? Which is it? Is that a sensible distinction? Why agonise about how our interests in banking union are going to be protected if we have the opportunity of joining it and have a vote ourselves? The Chairman: Could you give one-sentence answers, please? Baroness Bowles of Berkhamsted: Yes, it is called banking supervision, and, ultimately, if we are not in the monetary union, the shots at the end are by a body that we are not on in the ECB. Lord Davies of Stamford: The Danes are joining the banking union, for example. Baroness Bowles of Berkhamsted: Indeed, they may, but they are a smaller country and they see the access to these potential funds outweighing the disadvantages of loss of supervision. I do not think the Swedes will go the same way, for example, but we wait to see. I have always argued that you could do this for reinsurance-type of deposit guarantees or something like that, which you could join into if you wanted, but we would face the same dilemmas that Germany has in that we are one of the few countries that has a deposit guarantee scheme that works and can produce, whereas most of the others do not. Raoul Ruparel: For that reason, I do not think we could ever join a banking union where the ECB has the final say. It would be a huge transfer of sovereignty and power, possibly triggering a referendum lock, but let us not get into that. The capital markets union is different because it is being built as a bottom-up, breaking-down barriers, breaking-down regulation system, rather than a top-down supervisory system as the banking union is.

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The Chairman: Thank you both very much indeed and for giving us so much of your time. That concludes today’s public evidence. The Committee will now continue its meeting in private. Thank you.

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Bruegel—Written evidence (EMU0005)

Bruegel—Written evidence (EMU0005)

Disclaimer: What follows is a summary of existing work by individual scholars of Bruegel. Bruegel takes no institutional standpoint, and the opinions expressed in this document should only be attributed to the respective scholars mentioned at the top of each answer.

Issue 1: Is economic and fiscal policy coordination and surveillance working effectively in the European Union, both for euro area Member States and non-euro Member States? Is greater ‘structural convergence’ necessary to build a resilient and smooth-functioning EMU? The following answer is based on a more in-depth Bruegel Policy Contribution: “The limitations of policy coordination in the euro area under the European Semester”, by Zsolt Darvas and Álvaro Leandro. Economic and fiscal policy coordination and surveillance in the European Union is working poorly. The main instrument for economic and fiscal policy coordination and surveillance is the European Semester. We have constructed a European Semester reform implementation index (see the above-mentioned Policy Contribution for details), which uses the European Commission’s own assessment of the implementation of the European Semester’s Country- Specific Recommendations (CSRs). It shows that implementation was already weak at the European Semester’s inception, and has deteriorated since, despite the efforts made to improve the European Semester. Euro-area countries, for which policy coordination should be stronger in principle, implemented their recommendations only to a slightly greater extent than non-euro-area countries. Additionally, the implementation of European Semester recommendations was practically identical to the implementation of the OECD’s Going for Growth recommendations (using the OECD’s own “overall reform responsiveness rate”, the calculation of which is similar to our index). Overlaps between the European Semester and OECD recommendations only partly explain this similarity. Given that Going for Growth recommendations are unilateral and are not supported by any mechanism to enforce them, this finding underlines the ineffectiveness of the European Semester. Even though recommendations related to the Stability and Growth Pact (SGP) have the strongest legal basis, their implementation rate is also modest. The implementation of recommendations related to the Macroeconomic Imbalance Procedure and other recommendations is even lower. The Going for Growth index of responsiveness also indicates that the implementation of recommendations has not improved compared to the pre-crisis period.

We also concluded that recommendations issued to the whole of the euro area are not well reflected in the CSRs to member states.

These findings suggest that the European Semester is not effective in enforcing the EU’s fiscal and macroeconomic imbalance rules and economic policy coordination across European Union member states is not successful.

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In our paper we do not answer the second question of this issue: “Is greater ‘structural convergence’ necessary to build a resilient and smooth-functioning EMU?”

Issue 2: What is your assessment of the European Semester? What can be done to strengthen the implementation of Country Specific Recommendations and boost national ownership of reforms? Should the Macroeconomic Imbalance Procedure be given greater importance? There are overlaps between this issue and issue n.o. 1: we answered the first question of this issue above. As regards the second question, in the Policy Contribution cited in our answer to issue n.o. 1, we concluded that while some reforms to the European Semester might improve its efficiency and effectiveness, policy coordination in the European Union will likely continue to have major limitations. This is because there is a fundamental problem of economic policy coordination in the EU: national policymakers are accountable to their national parliaments and focus on national interests, which in many cases differ widely in different member states. There are some useful ways to improve the functioning of the European Semester, in particular through greater involvement of national stakeholders in discussions and decisions on the reform process, although we are sceptical that they will bring sizeable improvements given the problem highlighted in the previous paragraph. We see the establishment of National Competitiveness Boards as way to increase national involvement, through which reform priorities would be defined nationally. It will should increase national ownership of the reform process: recommendations from a national, independent competitiveness board will be seen as coming from inside the country, and not as an intrusion from Brussels. However, we are sceptical about whether national councils would be able to internalise the cross-border implications of the reform process. Similarly, we see the greater involvement of national parliaments, governments and social partners in the discussion of the reform process (as proposed by the Five Presidents’ Report) as a means to improve ownership of the process. Splitting the European Semester into two stages (as proposed by the Five Presidents’ Report and operationalised by the European Commission communication on 21 October 2015) is also welcome: first there will be discussions and recommendations about the euro area, and only then will CSRs be discussed and decided on, which should reflect the common challenges identified in the first stage. Some have also suggested ex-post monitoring of reform implementation by an independent EU-level “structural council”. We find this proposal worth consideration, not least because independent evaluation could improve transparency and could highlight the steps the European Commission could take to improve the cross-country consistency of CSRs. There have been proposals to move to the definition of outcome-based benchmarks when issuing CSRs, and to make them concrete, measurable and directly under the control of policymakers. We argue that while theoretically this would be a good recommendation, structural reforms cannot be measured objectively, and we also see difficulties in enforcement should a country not meet the standards by the agreed time. Also, we believe that direct financial transfers from the EU to cover reform costs and support their implementation could be problematic for three reasons. First, such financial transfers might be seen in the reforming country as “bribes” from EU institutions to enact the

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Bruegel—Written evidence (EMU0005) particular reform, and therefore the government might lose the trust of its voters. Second, this setup would reward countries which have been slow to reform: countries which have implemented the required reforms in previous years did not receive financial transfers, and doing this retroactively would be very messy. Third, financial transfers might simply not be enough to convince a large and fiscally sound country to implement given reforms. Overall, while there are some useful ways to improve the implementation of CSRs, we remain sceptical about whether major improvements can be achieved, especially concerning the internalisation of the cross-border implications of the domestic reform process.

Issue 3: What are the merits of the recommendation by the European Commission to introduce a euro area system of National Competitiveness Boards? How should non-euro area Member States participate in plans to enhance policy coordination and surveillance of competitiveness developments across the wider EU? The following answer draws from a Bruegel Policy Brief: “Euro-area governance: what to reform and how to do it”, by André Sapir and Guntram B. Wolff. Prior to the crisis, euro area countries experienced persistent unit labour cost (ULC) divergences. These were partly driven by unsustainable asset price booms resulting in overheating labour markets. As productivity and compensation became decoupled, these countries, given their membership in a monetary union, could not devalue their currency in order to regain competitiveness. These countries thus entered the crisis with a lack of competitiveness, and the only way for them to regain this competitiveness, given the setup of the Economic and Monetary Union, was internal devaluation and labour market reforms. Other countries, in turn, benefitted from the previous devaluation, but their resulting current account surpluses contributed to deflationary pressures. We believe that the euro area would benefit from a system of National Competitiveness Boards to prevent and correct substantial misalignments of competitiveness between its member countries. Since wage formation and bargaining systems are deeply rooted and difficult to change, deviations in competitiveness must be monitored and ideally corrected before they become too significant and entrenched. National Competitiveness Boards should also increase the ownership of the reform process at the national level, as recommendations would come from a national independent authority, and not only from the European institutions. They would need to be coordinated, however, to ensure a symmetric adjustment and prevent a deflationary race to the bottom. Issue 4: How should the European Commission reduce complexity and increase transparency of fiscal rules and the application of them? To what extent does the Stability and Growth Pact achieve a balance with respect to creating flexibility and maintaining credibility? Guntram B. Wolff’s answer: The European Union has reformed it rules regarding fiscal policy several times. The core of the problem remains the fact that sovereignty for fiscal policy resides ultimately with national parliaments, while a monetary union requires fiscal coordination to prevent major spillovers resulting from unsustainable fiscal policy and deflationary macroeconomic policies when monetary policy is at the zero lower bound. Unfortunately, no set of rules is able to cater for all circumstances, i.e.: it is impossible to write a complete contract. The European Union therefore needs institutions that are

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Bruegel—Written evidence (EMU0005) legitimate to exercise judgement and discretion on national fiscal policy, and make these decisions binding for national policy makers. This involves the creation of political legitimacy. In the short term, we propose the introduction of an asymmetric golden rule for public investment, i.e.: in recession times public investment shall be allowed to be funded by deficits, while in good times this would not apply. But in the medium term the appropriate institutions to exercise legitimate discretion and make it binding need to be created. Issue 5: How should the Banking Union be completed? Is there merit in the European Deposit Insurance Scheme proposed by the five Presidents? The following answer draws from a Bruegel blogpost, “What options for European deposit insurance?”, by Dirk Schoenmaker and Guntram B. Wolff, and from a Bruegel Working Paper, “Firmer foundations for a stronger European Banking Union”, by Dirk Schoenmaker. The Five Presidents’ Report calls for a European Deposit Insurance Scheme (EDIS), which would be a common deposit insurance, but does not give any details as regards its specific setup. It does say, however, that “a possible option would be to devise the EDIS as a re- insurance system at the European level for the national deposit guarantee schemes. Just like the Single Resolution Fund, the common EDIS would be privately funded through ex ante risk-based fees paid by all participating banks in the Member States and devised in a way that would prevent moral hazard”. On 24 November, the European Commission proposed the European Deposit Insurance Scheme, the contours of which look reasonable. It would start with a re-insurance system, gradually move to a co-insurance system, while finally ending with a fully-centralised European Deposit Insurance Scheme. The Banking Union can only be completed if a) banks become more international and less exposed to country-specific risk, b) if it has a full-fledged deposit insurance scheme, and c) if there is a centralised resolution authority. The introduction of the EDIS should go hand in hand with the introduction of large exposure rules to sovereign debt, in order to reduce the sovereign-bank loop. A detailed discussion of the differences, benefits and drawbacks of a reinsurance scheme versus a full-fledged deposit insurance scheme can be found in the blog and paper mentioned above. Issue 6: In what ways can the EU’s financial framework be strengthened to reduce the negative sovereign-bank feedback loop? The following answer draws from a Bruegel Working Paper, “Firmer foundations for a stronger European Banking Union”, by Dirk Schoenmaker. To reduce the exposure of sovereigns, we suggest to move the lender of last resort and deposit insurance functions to the euro-area level. It means that the fiscal backstop of these functions would no longer be at the national level, which breaks the transmission from bank to sovereign risk in the bank-sovereign feedback loop. Another element would be to enable direct bank recapitalisation from the ESM. To reduce the exposure of banks, we propose large exposure limits on sovereign holdings. Sovereign exposures in banks carry a zero risk weight and are exempt from large exposure rules in micro-prudential supervision. Large exposure limits on companies work very well to prevent banks from going bankrupt when a large company defaults on its bank loans. A similar large exposure limit on sovereign holdings would be very powerful to break the sovereign-bank loop by forcing banks to diversify their government bond holdings. Finally, it is important to create a Capital Markets Union with significant cross-border financial intermediation through capital markets.

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Issue 10: What are the advantages and challenges associated with the creation of an advisory European Fiscal Board? The following answer draws from the Bruegel Policy Contribution by Zsolt Darvas and Álvaro Leandro which we used to answer the questions in issues 1 and 2 above. On 21 October 2015, the Commission issued its decision on the establishment of an independent advisory European Fiscal Board (European Commission, 2015c).This board will provide to the Commission an evaluation of the implementation of the fiscal framework, but it will also “advise the Commission on the prospective fiscal stance appropriate for the euro area as a whole”, and “may advise the Commission on the appropriate national fiscal stances that are consistent with its advice on the aggregate fiscal stance of the euro area within the rules of the Stability and Growth Pact”. This is a very welcome development in our view and at least partly in line with our earlier proposals. The Fiscal Board should promote a much- needed discussion of the aggregate fiscal stance in the first stage. It could also improve coordination by pointing out which countries have fiscal space and should implement more expansionary fiscal policy in order to bring the aggregate fiscal stance to desired levels: this was an element that was clearly missing in the Country Specific Recommendations (CSRs). Finally, we have some concerns about the appointment of the board members of the Advisory Fiscal Board (because the European Commission has a decisive role in that) and about whether the Board will have sufficient staff to carry out its tasks. Transparency can also be an issue, given that the 21 October 2015 European Commission decision on establishing an independent advisory European Fiscal Board is ambiguous regarding the publication policy of the board.

25 November 2015

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Henning Christophersen, Sebastian Barnes, Janet Henry and Martin Sandbu—Oral evidence (QQ27- 44)

Henning Christophersen, Sebastian Barnes, Janet Henry and Martin Sandbu— Oral evidence (QQ27-44)

Transcript to be found under Sebastian Barnes.

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Professor Lorenzo Codogno and Reza Moghadam—Oral evidence (QQ56–67)

Professor Lorenzo Codogno and Reza Moghadam—Oral evidence (QQ56–67)

Evidence Session No. 5 Heard in Public Questions 56 - 67

WEDNESDAY 13 JANUARY 2016

Members present

Baroness Falkner of Margravine (Chairman) Lord Borwick Lord Butler of Brockwell Lord Haskins Lord Lawson of Blaby Earl of Lindsay Lord McFall of Alcluith Lord Shutt of Greetland Lord Skidelsky ______

Examination of Witnesses Professor Lorenzo Codogno, Visiting Professor in Practice, LSE, and Reza Moghadam, Vice- Chairman in Global Capital Markets, Morgan Stanley

Q56 The Chairman: Good morning, Professor Codogno and Mr Moghadam. Thank you for coming to the EU Financial Affairs Sub-Committee’s inquiry into Europe’s economic and monetary union. You have a list of interests that have been declared by Committee members. This is a formal evidence-taking session of the Committee and a full transcript will be taken. This will be put on the public record in printed form and on the parliamentary website. You will be sent a copy of the transcript and you will be able to revise any minor errors. The session is on the record. It is being webcast live and will subsequently be accessible via the parliamentary website.

I gather that you are not keen to make introductory remarks. Therefore, we will go straight into the session, if we may. You are both experts in your areas, and are familiar with the Five Presidents’ Report and the actions proposed by the European Commission. Perhaps you could give us a brief overview of your assessment of the report and the actions proposed, particularly in the shorter-term but of course later we will go into the longer term. I am particularly interested in whether you think that economic and monetary union is sustainable in the longer term, whether the proposals in the report to strengthen the euro and its sustainability go far enough, and what other things you believe we should do in terms of the sustainability issue. Professor Codogno, would you like to kick off? Professor Lorenzo Codogno: The report claims to be pragmatic and ambitious. Indeed, given that the five Presidents are very experienced people with a very deep knowledge of 108

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European politics, and that the language is carefully drafted not to upset anybody, you can certainly say that that is the case. However, if we look at the history of European integration and take stock of what the crisis has suggested to us, it is fair to say that it is notable for a lack of ambition. It should be much more ambitious than it is, particularly on some aspects. It gives the misleading perception that there is plenty of time for the eurozone to fix its problem, which I do not think is the case. Basically, the eurozone needs to speed up the process of integration. It makes sense, particularly for the countries that share a common currency, to make sure that Europe proceeds with the speed that is necessary. There are also issues related to a number of topics that were taken out of the report or were not touched on in an appropriate way. I refer to countercyclical policies, for instance, or policies that are aimed at achieving risk sharing among member states. There is a lack of attention to how to achieve structural reforms in Europe; rather, there is a lot of attention on that but only from the angle of monitoring and of deepening the existing tools and instruments without introducing any additional things. For instance, in the previous report, the Four Presidents’ Report, there was the idea of contractual arrangements, which has totally disappeared—for many good reasons, maybe, but that is missing. Finally, the focus is still very much on monitoring and compliance, particularly with the fiscal rules, which, again, is quite important but is not enough. Reza Moghadam: My assessment is a little more positive. I think the Five Presidents’ Report goes in the right direction. One has to recognise that the process of integration in Europe requires political support; it cannot simply be forced from the centre. The report recognises that there is a balance to be struck between moving towards greater integration, which is necessary, and garnering political support. Therefore, its approach, which is step by step, is a pragmatic one, but I think it is a practical one. Does it touch on all the right issues? There I agree with Lorenzo. Let me tell you from my perspective what I see as the key areas where the eurozone needs to make progress. The first area is completing the banking union. When I was at the IMF in 2012, we put the idea on the table and, frankly, I was pleasantly surprised by the speed at which the eurozone moved to put some of the key elements in place. It was a time of stress and crisis and therefore the motivation was higher, but enormous progress was made within a year and a half. Is that progress complete? Far from it. You still see fragmentation of the banking system across the eurozone. You still see that credit growth. Although it has started to grow by very small amounts, it is not uniformly so. Credit is contracting in a number of countries, particularly in the periphery. So banking union is very far from complete. There has been enormous progress with the single supervisory mechanism, but you need a single resolution mechanism to back that up, and that single resolution mechanism is incomplete because it requires something that is politically very sensitive and difficult: that is, risk sharing. There are some minor elements in place but there is no mechanism for central funding for potential resolution across the countries. The numbers are very small. You certainly do not have a deposit guarantee system across the eurozone. Those things, in my view, impede the effective operation of the banking system. What are the other important issues? For example, in the build-up to the eurozone crisis we saw the build-up of imbalances. You see it clearly in current account imbalances and, to some extent, in debt and fiscal imbalances. There are really no mechanisms to prevent those. Those imbalances have improved over time. The imbalance procedure is under 109

Professor Lorenzo Codogno and Reza Moghadam—Oral evidence (QQ56–67) discussion by the eurozone Ministers, but it is just a discussion; there is no actual preventive action. Another area in which I would say that progress is being made—it is recognised in the report—is the capital markets union, generating proper lending not just through banks but through the capital markets, where I work now. Progress is being made on that. It is far too slow, but at least it is recognised in the report and things are moving forward. Fiscal risk sharing is a very sensitive area across nations. There has been very limited progress on that front in terms of completing the monetary union. Finally, I very much agree with what Lorenzo said about structural reforms. This is not an issue for the periphery of Europe. It is an important issue for the core of Europe. There are many initiatives on the table that have not come to fruition. The services directive has been there for a long time. There are a number of areas where it is possible to make progress on structural reform and enhance growth in the eurozone, but progress on those is too slow.

Q57 The Chairman: Thank you. We are going to cover some of the things that you have mentioned as we go along, Mr Moghadam. Professor Codogno, you talked about a lack of ambition and so on. Several witnesses have suggested to us that the end of stage one being 2017 was driven by political imperatives, particularly elections in two of the significant countries—France and Germany—in 2017 before the White Paper comes out. Do you think that the fact that we are not going to see the White Paper, with more concrete proposals, until after these politically sensitive events in France and Germany will be a real impediment to proceeding with economic and monetary union? Professor Lorenzo Codogno: To some extent yes, because the first stage is called “deepening by doing”, which effectively means taking care of the leftovers, in my view. All the political capital has been put on completing the banking union. That is the key project, which in itself would be a major achievement but is certainly not enough. Clearly, there is now a lot of opposition to any kind of risk sharing or mutualisation on the part of Germany and of other countries. The idea is that first you need to achieve convergence—the reduction of risk—in order to share, which effectively means postponing integration to a later date. The Five Presidents’ Report reflects this attitude, and it is probably fair to say that by waiting a couple of years, which happens to be during a time of elections in Germany and France, there might be a chance—certainly, it is not a guarantee—to move the process in the direction of integration. My guess is that even after 2017 there will be a kind of step-by-step approach. There will not be a big bang.

Q58 Lord Lawson of Blaby: I thought the professor made a very important point about the neglect of structural reform and microeconomic reform. What lies at the heart of this is the question of what this is all about: how can we strengthen the European economy, which has been underperforming? That is partly because the single currency is actually a negative, but I think that is a minor factor. The major factor is the lack of structural reform. The Government of which I was a member, who inherited a very badly performing economy, put structural reform first. We had a huge range of structural reforms and on the whole they were pretty successful. This has not happened in the rest of Europe. In a sense, this is a diversion, because it is not designed to make the European economies work better; it is designed as a path towards political union. There is nothing disreputable about that, but that

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Professor Lorenzo Codogno and Reza Moghadam—Oral evidence (QQ56–67) is what it is designed for. All the measures here are designed to deal with the problems of a malfunctioning monetary union. Therefore, to me it is a cause of sadness that while our European partners have found structural reform difficult—as you know, politically it is extremely difficult and controversial—they are now not even trying to do it, although they are paying lip service to it, because of this huge diversion of effort to try to make the single currency work and to preserve the steps towards a single European finance ministry, which of course makes sense only in the context of political union. Is it the case that not only is there not enough emphasis on structural reform but that structural reform actually runs counter to the idea of putting together a better-performing economy? Professor Lorenzo Codogno: I partly agree with that. Probably it is too strong to say that it runs counter to it. I do not think there is enough effort going in the direction of structural reforms. In the near term, all the effort is going in the direction of strengthening the macroeconomic imbalance procedure, which is a very strange animal, actually, because it is not clear what it is aimed at. On the one hand it should aim to prevent dangerous imbalances in the economy. On the other hand, it is really a way to put pressure on the reform process through the back door, because it is a formal procedure and puts real pressure on countries to deliver. Having said that, the macroeconomic imbalance procedure is probably not enough to achieve major structural reforms in Europe. We saw that even during the crisis not many Governments were able to deliver deep enough structural reforms to solve the structural issues. So, again, more needs to be done. In the Four Presidents’ Report, there was an emphasis on the possibility of introducing contractual arrangements: that is, some kind of formal contract between the country and the rest of Europe, by which if you introduce major structural reforms, you get some benefits, such as risk sharing or more flexibility. That has disappeared, for very specific reasons. It was not very much supported, not only by the core countries, which perceived it as a way to push for some form of mutualisation, but also by the periphery because it was perceived to be forced into a programme. It was perceived like a memorandum: you have to do this. So it was not very much liked by anybody. Now, the Five Presidents’ Report introduces the idea that in the second stage there are some benchmarks. A country should try to achieve convergence of its economy, like when there was convergence for the entry into monetary union before 1999. There is little detail in the report so we will have to wait for the White Paper but there is a serious issue here in terms of general equilibrium. You cannot achieve goals in all different aspects of the economy at the same time, and that will be very challenging. I am puzzled by the approach that has been decided. I would guess that from a political point of view there was no chance to get anything better. The Chairman: Mr Moghadam, do you agree with that? Reza Moghadam: Very briefly, it would be unfair to say that there is not much emphasis on this issue. I have attended many meetings of the eurozone Finance Ministers. There is focus on it. It is a difficult issue. Why? Because there is a short-term cost, against a long-term benefit. That is a big challenge for the Governments. Bodies such as the IMF and the OECD have tried to calibrate the positive impacts that come over time, but of course it is difficult for the Governments to accept the short-term costs that it entails. We have to acknowledge that there has been progress. Some of it has been achieved under duress. The countries on

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Professor Lorenzo Codogno and Reza Moghadam—Oral evidence (QQ56–67) the periphery—Portugal, Spain, Italy, Ireland—have made progress, not as much as independent observers would have liked but there has been progress, and the markets have responded to that progress. The funding of these countries has transformed itself over the past three years. The more difficult issue in the core countries such as France and Germany is: is there enough progress being made and is there enough peer pressure, because this is not enforced at the European level, to make that progress? That is where it is much more difficult and where there has not been as much progress, despite the fact that everyone acknowledges the long-term gains; the short-term costs are preventing the Governments from taking action.

Q59 Lord Butler of Brockwell: My question follows on from this. Is it a fair criticism of the Five Presidents’ Report that, perhaps because of the German and French electoral cycle, it concentrates too much on what might be described as a German approach—or perhaps even a Frankfurt-Brussels approach—to these issues? What I mean by that is a lot of concentration on countercyclical policies rather than on policies to promote growth; a failure to produce practical or acceptable measures to deal with banking union; and talk about structural reforms but not much in the way of how to achieve them. Is that a fair criticism: that it is too German-Franco centred? Professor Lorenzo Codogno: As I said before, the perception in Germany and in a number of other countries is that you have to achieve convergence before any sharing or mutualisation. I think the Five Presidents’ Report makes the right noises not to upset these countries. At the same time, it leaves open the possibility of steps in the direction of integration in the future, which is positive. But, again, it has to be discussed in a couple of years, not now. The dimension of structural reforms is certainly missing. I agree that effort has been made over the past few years, but probably not enough. I chaired the committee that was in charge of the macroeconomic imbalance procedure in 2010-11, so really we developed the procedure. We were in charge of analysing member countries’ progress on reforms, and I can tell you that it has been very difficult to achieve consensus on a number of issues. The competitiveness councils, which were launched by the Five Presidents’ Report, might achieve a bit more, because the issue is also about attaining ownership of the reform process at the national level of the reform process. You might have a more independent, non-politicised view of reforms by having these kinds of councils. That is one possibility. The other thing that is missing, in my view, is positive incentives. Now, we have only negative incentives in that you penalise a country for not doing something, but I think we should give positive incentives: if you do something, you achieve something better, such as more risk sharing. There is a suggestion in the report that we might go in this direction, but it is postponed for the future. Reza Moghadam: Very briefly, I am very conscious that we are sitting in a political body with many eminent politicians. The political reality in Europe also requires some form of consensus and consensus building in order to make the reforms last. That makes it complicated. It requires not only France and Germany but everybody to come to a common view. Therefore, there are compromises. That is the reality of bringing sovereign countries to a common purpose. As independent observers, or as people looking at it from a UK point of view, we might not see as much progress as we would like, but one has to recognise the setting. Good or bad, progress requires everybody to be on board, so it is not constructive or 112

Professor Lorenzo Codogno and Reza Moghadam—Oral evidence (QQ56–67) helpful to point at individual countries. Each country has its constraints, and those constraints are put on the table. When you are moving, and Europe has moved, towards forms of risk sharing—for example, the setting up of the European stability mechanism and the setting up of a small form of risk sharing in terms of the single resolution mechanism— these require broad political support. Therefore, they are imperfect because they take all the constraints on board. Structural reform is particularly difficult, because it has to be implemented at the country level, and each country has different shortcomings in what they need to do. Also, as some have said, it is not an explicit part of monetary union. One has to recognise these shortcomings. It does not mean that Europe does not need to move on these fronts; it needs to move. But we have to understand that unless you have domestic political support for this, progress will be slow. Lord Butler of Brockwell: I have one final question, if I may. My question was really about German-French influence. Do you think that these proposals take too little account of the sensitivities of what I call the poorer countries, the weaker economies, in the EU? Italy, for example—I address this question to Professor Codogno—has been particularly critical of the approach in the Five Presidents’ Report. Does that indicate that it is not really balanced when it comes to the concerns of the EU members? Professor Lorenzo Codogno: It is difficult to say. There are a number of issues, and the attitude might be different depending on the issue. Italy has always pushed for more pro- European, pro-integration policies. In that regard, the report may be a bit disappointing. Again, it does not push the issue forward in a way that might be desirable. At the same time, even in Italy there are growing movements that are increasingly Eurosceptic or openly against European integration, which is a bit risky, in my view. Over the past few years we have seen a very deep economic and financial crisis throughout Europe. Now, there might be a lagged effect on politics and social matters as a result of the economic crisis, so it might become even more difficult to achieve integration in a number of areas. The lack of appetite in different countries is also, to some extent, a result of the crisis and the way the crisis has been addressed and resolved. So we need relaunch of the idea of Europe, with positive messages that might convince not only the national parliaments but the electorate that it is a convincing, credible story that can achieve benefits for all countries, otherwise it might be very difficult to take decisive steps in the direction of integration in the future. One example, which is very close to the interests of the UK, is the single market, which is one of the big missing pieces of integration, because despite all the efforts in the past, particularly in the service sector and energy, not much progress has been achieved. That probably has the most important potential for enhancing growth in Europe, which would be achievable without major upheaval in the institutional framework. It is just a matter of doing it. The Chairman: Mr Moghadam, you wanted to come in on that briefly. Reza Moghadam: The single market point is very important, and the capital markets union could have the same impetus for reform. But in terms of countries’ interests, I recall when the Five Presidents’ Report came out that one of the strongest criticisms of it came from Germany. It is in the nature of these reports that they try to take different constituents’ view

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Professor Lorenzo Codogno and Reza Moghadam—Oral evidence (QQ56–67) into account, which means that you please nobody and you have criticisms. The criticism was not simply from the periphery or Italy; it was also from Germany about risk sharing.

Q60 Lord Skidelsky: I would like to take up the point about the asymmetry of the adjustment process of the macroeconomic imbalances. You have the fiscal imbalances and the current account imbalances, and they are connected, but I will take up the issue of the current account imbalances. Keynes remarked in 1941 that adjustment is compulsory for the debtor and voluntary for the creditor. That is quite a good summary of what is going on, because if you approach the thing from the microeconomic point of view, as indeed Lord Lawson does, then of course you are driven to structural adjustment as being the thing that needs to happen, and structural adjustment is a debtor problem, a debtor country problem. Surplus countries do not have to have any structural adjustment; they are doing fine. So to what extent is a monetary union sustainable in which the onus of adjustment always falls on the weaker members? Reza Moghadam: That is an excellent point. This goes to the heart of one of the key issues of crisis management. If I have one major criticism of the crisis management, it is this asymmetric adjustment burden in terms of macroeconomics. The problem is that fiscal policy to a large extent is country-specific, despite the stability and growth pact, because the stability and growth pact leaves a lot of flexibility for individual countries, but we did not have during the crisis, and still do not have, a more aggregate macroeconomic view in order to translate that into what it means for each country. It has been bottom-up and it has been driven by individual targets and by adjustment at country level, precisely because of what you say—it is being driven by concerns about debt and market access rather than a macroeconomic point of view. The debt level of the eurozone is lower than the United States’ but the dispersion is very high. Some countries have extremely high debt, some have very low debt. You could have leveraged these differences during the crisis to have a more appropriate and measured response, but the way the monetary union was put together, especially before the recent changes that were made to the mechanism, made the adjustment process somewhat more painful for the debtor countries than it needed to be. Professor Lorenzo Codogno: I certainly agree. The current account issue is a tricky one. You can easily argue that a surplus is not as dangerous for financial and economic stability as a deficit, but at the same time if you look at the area overall and you feel that there is a need for policy co-ordination in order to achieve the goals, you need to recognise that there should be symmetry. Otherwise you end up in a situation like the one we have experienced over the past two or three years. The adjustment has come only on one side, as you mentioned, and this has introduced some kind of deflationary bias for the whole area, and we have to recognise that. So, indeed, the adjustment should come from all countries. In the Five Presidents’ Report, there is enough emphasis on policy co-ordination, although it does not say much about how to achieve it. Again, that is postponed to the second stage. Some kind of policy co-ordination is absolutely necessary. Lord Skidelsky: But no recognition of symmetry. Professor Lorenzo Codogno: No, no recognition of symmetry, although I have to say that if you look at the excessive imbalance procedure, the Commission is now much keener than in the past to push even countries such as Germany to do something about the surplus. To be fair, the Commission has always pushed for that in the past, but a number of countries 114

Professor Lorenzo Codogno and Reza Moghadam—Oral evidence (QQ56–67) strongly opposed it, not just Germany. Now we are getting closer to the point at which some adjustment is required also from countries in surplus, so I think it is coming. The Chairman: Thank you. We need to move along. Lord Haskins.

Q61 Lord Haskins: These issues look a little different in this country in terms of the referendum coming up. One of the four issues that the Prime Minister has on the table is the relationship between eurozone and non-eurozone countries. It seems to me that in the original concept of the euro, the assumption was made that eventually the euro would apply right across the Union. It is clear now that that is not going to be the case. Do you think that the report in any way addresses the permanent situation developing between eurozone and non-eurozone countries to enable the single market, particularly in this country, to develop as it should do? I agree with your comments about the disappointing failure to widen the single market. Do you think that the Presidents are addressing this issue in a way that would satisfy our Prime Minister? Professor Lorenzo Codogno: I think the whole issue is delayed, because, as you know, in the first stage it is not taken fully into account. The key moment will be when there is a treaty change. My personal view is that the UK would be much better off being at the table at that time to discuss how to rearrange everything rather than being outside, but for now the discussion has not yet addressed this. It will be addressed at some point, not before 2017 but, I hope, soon after that. But my guess is that it will not happen soon; it will take a while. Reza Moghadam: At the European meetings that I have attended it is probably the case that the emphasis is often on issues faced by the eurozone rather than the EU. To change that you need a strong voice for non-eurozone members. The way the European system works, the discussions are usually first among the eurozone members and are then widened to non- eurozone members. Therefore, the interests of the eurozone members are addressed first. Strong voices are needed at the table to widen the discussion. That has not happened over the past few years, in my experience at least. It is an issue. But, again, from what I have seen in Europe, there is a very strong interest in and recognition of the benefits of the EU as a whole, rather than the eurozone, but given that the crisis was a crisis of the eurozone and many of the issues to do with integration affect the eurozone first, it has been natural for that discussion to take place among those members, but the voices of those outside have not been heard strongly. The Chairman: What institutional safeguards might be required, from your perspective? Reza Moghadam: For example, the discussion on banking union was instructive here. The discussion was initiated first among the eurozone members, but some of the eastern European countries, such as Bulgaria and Romania, which have banking systems that are very much integrated with the eurozone, and countries such as the UK, which are financial centres, played a very constructive role in changing the initial proposals in order to make sure that everybody’s interests were taken into account. Frankly, during that discussion the eurozone members were quite understanding about the concerns and the benefits for the wider Union, and many of the proposals that were made by non-eurozone members were accepted. It is an issue of dialogue and bringing the issues to the table in a constructive way, and bringing constructive proposals to the table.

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The Chairman: Broadly, do you accept that there is a genuine concern within the United Kingdom that caucusing by the eurozone is bound to damage the United Kingdom’s interests? Reza Moghadam: I absolutely understand the concern. I tried to explain why that process has come about. But I also believe that the United Kingdom can and should bring its concerns to the table. I have seen that when that is done in a constructive dialogue, the UK is a very effective force. Lord Haskins: Are you suggesting that the Government have not been sufficiently keen to put their position on the table? Reza Moghadam: I am not saying that. I am suggesting that a positive approach, when the views are expressed in a constructive way, does have an impact. The UK has a strong weight in Europe when it uses that weight. Lord Lawson of Blaby: May I put a particular example? It is not party political. The present Government have expressed the strongest possible objection to the financial transactions tax. They could not have put it more strongly. They are trying to use legal means as well as political pressure. Yet the European Union continues to propose the financial transactions tax. This is a matter of deep interest to the United Kingdom because of the importance of London as a global financial centre. I do not think you could say that the United Kingdom has not tried to influence matters. It has tried and failed. Reza Moghadam: Let me give you examples of where they have succeeded. For example, on the voting structure, the UK proposed, and succeeded, in getting double majority voting. Lord Lawson of Blaby: For a short time. Reza Moghadam: But they succeeded. You are right about the financial transaction tax, but fortunately it has not been implemented yet. In the financial sector, which I work in now, obviously there can be arbitrage if one country does not implement it. It will probably fail as a proposal, so you are correct that there is concern about this, and rightly so, but that proposal has not really got off the ground. There have been others where the UK has made proposals that have succeeded. Professor Lorenzo Codogno: From what I can tell, the UK usually punches above its weight in European committees, so it is doing a good job. But you also have to acknowledge that throughout the crisis it became a matter for the eurozone. The countries that put the money on the table were the eurozone countries, so inevitably the UK was on the fence, so to speak. That is inevitable; you have to face it. It is certainly correct to say that there have been some failures. You mentioned the financial transaction tax. I fully agree with you. By the way this, for me, is in contradiction with the capital markets union. It needs to be addressed in the future. Again, you also have to consider the other side of the coin, which is that the eurozone crisis was addressed by eurozone countries.

Q62 Earl of Lindsay: Could you expand briefly on the importance of the capital markets union and the role that it is intended to play? I noticed, Mr Moghadam, that you mentioned your disappointment at the slow progress that has been achieved so far on capital markets union. What are the difficulties in achieving capital markets union, and how optimistic are you that they will be resolved, and resolved within a sensible timeframe?

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Reza Moghadam: In very simple terms, companies raising finance in the United States use both the capital markets and the banking system, and in some ways the capital markets probably dominate. In Europe, financing is predominantly done by the banking system. Post- crisis, the banking systems are weak, as is their ability to extend credit both because of the regulatory concerns and because of the strength of the balance sheet. Also, looking ahead at their ability to have return on capital, they are constrained. The European companies will find it difficult to obtain credit if there are no other sources of credit available, particularly when you move down the sizes and you talk about small and medium-sized enterprises. I work in capital markets now, and there has been a shift in companies trying to access capital markets, so it is happening. But it is very difficult because, unlike the United States, if you are raising capital across jurisdictions you have the rules and regulations of many countries to deal with. That makes it very complicated. One issue is therefore simplifying, for example, the bankruptcy rules across nations. The standards vary a lot across Europe. That is a complicated process that goes beyond the competence of, for example, the European Commission. It can recommend but not enforce. It is very much a matter for individual countries. There are also other regulatory issues. As a result of the crisis, the regulatory charges on securitisation, for instance, are very high, so if you are going to the market and you are a number of small companies, if a bank like ours wants to take them to the market you have to securitise it somehow. That is extremely difficult because of the costs and the legal processes across Europe. There are many impediments. The good thing is that across the EU right now—this is an EU-wide issue, not a eurozone issue—there is recognition of the benefits of this, but given the political environment, steps are being taken in a gradual way to improve capital markets access. I wish it could be faster. Some of the regulatory things could be changed quite quickly; some steps have been taken towards that. If you want to issue equity in the US, the procedure is very simple; there is one regulator. In some countries in Europe it is extremely complicated; the prospectus process, for example, is very complicated in a number of countries. There are practical things that can be done to improve this that are not so controversial to do. It takes time to bring the consensus of different nations together. The availability of credit is a key issue. Professor Lorenzo Codogno: If I might add to that, I do not suggest that the capital markets are less risky than bank financing. They are not. However, we know that the situation in Europe is the exact opposite of that of the States. Most of the financing to the economy comes from the banks—more than 80%, if I understand correctly. So it makes sense purely from a diversification point of view to shift. There is now wide consensus in Europe on moving in that direction. That does not mean necessarily that we are going to achieve the same balance that the US has. There might be good structural and cultural reasons for maintaining a different model, but starting with the capital market financing that we have at the moment in Europe, it makes sense to move in that direction. Having said that, I think the capital market union is also somewhat unambitious, because it has started very slowly. It is a massive and very difficult job, because you have to harmonise different systems and so on, but it has started slowly. Let me give you an example. One of the probably easy things that can be achieved over the near term is the so-called prospectus. Achieving a single prospectus is very important, but would you recognise that as a major reform if it was done in a single country like the UK? It would be perceived as a technical 117

Professor Lorenzo Codogno and Reza Moghadam—Oral evidence (QQ56–67) issue, not a major reform. You have to move to a second stage. By a second stage I mean the philosophy of the Five Presidents’ Report, which is about moving from rules to institutions. In the case of the capital markets union, we are still missing an institution to take care of the project. The Commission cannot do it, because it is not in charge of all the aspects of this process. Lord Skidelsky: Perhaps I could ask a supplementary question. Whether it is a capital union or a banking union—let us take the idea of a banking union—how do you weight the benefits of a more efficient allocation of capital, which is what banking union can achieve, against the risk of banking collapse, which is what we experienced in 2008-09? Obviously, you have to make the banking system more secure before you can have a banking union. Do you think that enough has been done in the way of improved regulation to make a banking union feasible in the terms in which people are talking about, or is it just rhetoric?

Q63 Lord McFall of Alcluith: Perhaps I might add to that because it goes to my question. It is the main question. I have listened to the points you have made about the banking union. In my mind is the concept of a hugely complex jigsaw puzzle. You have said that there is no deposit scheme across Europe. There is no agreement on risk sharing and mutualisation. There is no central treasury for fiscal transfer, which is essential. There is no single resolution mechanism—that is far from complete. Fragmentation exists across countries—that is a reality. Credit contraction is a feature, especially in the periphery. Yet all political capital, as you have said, has been focused on the banking union. We have bet the house on it as a result of that. So is it not wildly optimistic to consider that we could have an efficient and comprehensive banking union that makes the financial architecture safer and works in the interests of all countries? It is a bit of a fantasy at the moment. Reza Moghadam: I will answer both questions. All those constraints that you mentioned are correct, but you also have to weigh against that the progress that has been made on supervision. This is an area I have been closely involved with. The single supervisory mechanism that has been put in place is necessary and the work that has been done is impressive. It is extremely difficult, but I have been impressed both by the speed with which this was put in place and, more importantly, by the thoroughness of the SSM’s new supervisory responsibilities. For me, the issue is about making that effective by putting in place the shortcomings that are there. Now, a number of these shortcomings are addressed in the Five Presidents’ Report, but they come into effect slowly so one hopes there is no major problem going across borders in the next few years. If there is, there are some mechanisms in place. The question is: are they adequate? They are certainly a lot better than what was there. Something that we did not witness, fortunately, during the financial crisis was a major banking crisis going across countries—a big bank with problems that needed to be resolved across borders. There were a number of small banks, and the process of the resolution of those was very complicated and some of it is still going on, but we did not face a major bank problem across borders. The SSM needs to ask whether the European nations are able to resolve a major bank across borders. We are moving towards that direction, but some of the building blocks are not yet there. On the question of capital market union versus banking union, they are related, but what is important here is that you have European corporates that are creditworthy and could access 118

Professor Lorenzo Codogno and Reza Moghadam—Oral evidence (QQ56–67) the capital markets. There will be appetite from investors from invest in them, but the infrastructure to support them is not there. It is an alternative to the banking sector, which, although strengthened, is not going to be strong enough to generate the kind of credit that you need to support a growing European economy. Professor Lorenzo Codogno: We have to acknowledge that there has been progress over the past few years in achieving integration in Europe, particularly in some areas. Banking union is probably the area where the achievements are tangible. Indeed, the ECB has been very effective and has done a very good job of improving surveillance. But we also have to acknowledge that it is incomplete. You mentioned the deposit insurance mechanism, which is still missing. Although I am pessimistic about risk sharing and mutualisation going forward, deposit insurance is one area where I think it is feasible to achieve some kind of agreement within a decent timeframe. The rationale is overwhelming. There is a very strong case for that. The proposal that was put on the table by the Commission in November is very reasonable and pragmatic; starting with some kind of reinsurance is the way to go. I am quite optimistic that, given the political capital that has been put on banking union, this can be completed. Then there is capital market union. Together, they are absolutely essential to achieve a better allocation of capital within the area. By the way, this is linked also to current account balances. Some countries might have imbalances that are reasonable because they need capital. It is better for the whole Union to allocate capital towards these countries. For example, Poland used to have a current account deficit. It still has a current account deficit, but for a good reason because they are rebuilding the infrastructure and the productive capacity of the country, and it is through foreign direct investment. That is a positive allocation. It is a positive imbalance within the EU. Lord McFall of Alcluith: Deposit insurance is just one leg of a complex architecture—I think you would admit that. From the UK point of view, although the capital market union project involves all EU member states, the banking union is limited to the EMU members and those non-euro area member states that opt to join it. Would you consider that such a division between the ins and outs may in the longer term lead to the creation of market barriers between members and non-members, which could be to the disadvantage of the UK? Reza Moghadam: I do not think that will necessarily by the case. In a way, the building blocks have been in place for the past year or so. I do not see extra fragmentation between eurozone members and non-eurozone members of the EU. If anything, there is quite a strong understanding in mainstream Europe that places such as the UK, but also a number of other countries that are not members of the eurozone, such as Sweden or some of the eastern European members, have strong financial systems that need to operate within a broader system. There is an understanding from that perspective. Of course, it is an evolving situation and the regulations will evolve over time. One needs to make sure that the non- eurozone EU members’ interests are clearly stated and observed.

Q64 Lord Borwick: In the scrutiny of the respective roles of the ECB and the national authorities in the governance of the banking union, do you think that the ECB is being held to account properly by the European Parliament? Is the lack of connection between some of the decisions that you have talked about that need to be made in future and the people of

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Professor Lorenzo Codogno and Reza Moghadam—Oral evidence (QQ56–67) various eurozone countries developing into a growth of minority parties in those eurozone countries, implying a problem for the future? Professor Lorenzo Codogno: I think there is a growing anti-Europe sentiment in many countries in Europe, which is indeed a trap, in my view. In terms of democratic accountability, it is probably fair to say that the ECB has done quite a good job of trying to communicate and report to the European Parliament whenever possible, and I think this situation has improved over time. I do not think that is a real issue at the moment. But the issue of democratic accountability will come back when there are treaty changes. That will be a big issue. Lord Borwick: You are implying that there are lots of things that need to be done but the people have not been brought along with those arguments. Indeed, the Five Presidents’ Report talks about a whole list of things that must be achieved but not about how the people will be persuaded. All the indications are that people are diverging from this list of changes that must be made, which you have described as being too slow and that must be accelerated. This is highly likely to lead to rejection of these treaty changes in the future. Professor Lorenzo Codogno: I would say that it needs to be properly addressed in order to pass the test. You are right that there is an issue. Even the Five Presidents’ Report reflects the concerns that there is not enough democratic accountability, representation and so forth. I will give you an example. As things stand, the so-called Treasury Minister for the eurozone in the future would be the head of the Euro group. That is not an elected position and it does not go to the European Parliament for confirmation, which is pretty odd, so it needs to be changed. That is just one example of the kinds of problems that are still open. I am sure that they have to be addressed in future, because otherwise that dimension would be missing.

Q65 Lord Lawson of Blaby: What is your understanding of the term “fiscal union”? Reza Moghadam: Probably some form of risk sharing across the members of the eurozone, which is probably the most controversial issue. Risk sharing is at the heart of some of the political opposition. Union necessitates risk sharing, essentially. Lord Lawson of Blaby: I am glad to hear you say that, because it gets close to the heart of the issue. There has been a great deal of muddle, as we have discovered in previous witness sessions of this Committee. Many people talk about fiscal union as if it means every country in the Union pursuing the same expansionary, or contractionary, fiscal policy. Clearly, that makes no sense whatever, as you indicated—quite correctly—in earlier answers. If fiscal union means anything at all, it must mean that you have to a considerable extent—not totally, because there will be local taxation—a single taxation system and a single benefit system so that the transfers that are necessary do not have to be argued about and voted on; they are automatic, in the sense that the more successful countries in the eurozone will generate a greater amount of tax revenue and the less successful ones will receive a greater amount of benefits. That is what happens in every monetary/fiscal union—the United Kingdom, the United States or wherever. This is clearly what is meant. I think that Germany likes to call it a transfer union and it is opposed to it. Would you agree that we will never get the monetary union to work satisfactorily unless there is a corresponding fiscal union of this nature?

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Reza Moghadam: In the long run, I agree with that. In a way, it was recognised at the outset, when the EU was put in place, but instead of the issue being addressed head on, safeguards were put in place, such as the SGP and the limits on debt and fiscal deficit, which many countries did not observe—in fact, it is difficult to see who did observe those norms. Those were a political compromise in order to keep fiscal policy independence in each country. Of course, a successful monetary union ultimately requires some form of fiscal risk sharing. It is moving towards that, but in a gradual way. Politically it is extremely sensitive to go there. We are likely to see halfway houses, as we have seen, or in the time of crisis you will have risk sharing. Initiatives such as lending through the European stability mechanism are a form of risk sharing put in place during emergency times, so you could patch it like that at the time of crisis, but ideally you need to move towards more explicit forms of risk sharing. That would actually reduce the risks of crisis. The Chairman: I recall John Maynard Keynes’s saying that “In the long run we are all dead”. How would you define the long run in terms of eventually getting there, if you think that it is going to be incremental? Reza Moghadam: Going back to some of the questions that you raised regarding the Five Presidents’ Report and the implementation timetable, I would not take that report as a blueprint for where Europe will go. There have been many of these reports. Ultimately, there will be political compromises among countries. The Five Presidents’ Report is a proposal by the Commission, so it is a basis for discussion, but ultimately there will be political compromises among countries. The nature of the eurozone and the EU in general is that there will be incremental progress. I do not think that you will see a transfer union in place in the next five years, but you will see steps towards it, such as the deposit insurance scheme that Lorenzo mentioned being built up over time. I think that one has to accept in Europe that progress will be incremental. Professor Lorenzo Codogno: Achieving fiscal union and possibly political union at the end of the process is absolutely essential, in my view. It is a key ingredient for making economic and monetary union sustainable in the long run. Having said that, I am not suggesting what you suggested, that there should be some kind of transfer union. Transfers should be seen in the context of risk sharing and in the context of providing facilities to compensate for asymmetric shocks that might happen in the area. They should not be perceived as permanent transfers from one area to another. I do not think that that should happen. Again, achieving risk sharing and some kind of mutualisation is inherently part of monetary union. Lord Lawson of Blaby: I am sure that you are right. It is the clear purpose of the exercise: for monetary union to be successful, fiscal union is required and fiscal union requires political union. The notion, which we will come back to, if we have time, that the European Finance Minister should be an unelected official is clearly problematic, to say the least. I do not see what your objection is to a transfer union, however, because a transfer union does not need to be explicit; it is implicit. In any political union, transfers happen all the time. In fact, most of them are not recorded. They are implicit in the system. Professor Lorenzo Codogno: But if there are permanent transfers, that means that there is a problem that needs to be addressed—there are structural issues at stake and these have to be addressed first. I am not saying that there will not be transfers, as any union has

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Professor Lorenzo Codogno and Reza Moghadam—Oral evidence (QQ56–67) transfers, as you say. Sometimes they are implicit and sometimes they are automatic, but if they are permanent transfers from one area to another, it means that you have a problem. Lord Lawson of Blaby: Let us take your own country. On the whole, in economic terms, northern Italy is much more successful than southern Italy. I would be surprised if therefore there are not permanent transfers going on from northern Italy to southern Italy. That is the nature of a single country. Is this problematic? Professor Lorenzo Codogno: You picked the right example. In Italy we have permanent transfers from one area to another. Has it been a successful story? No, it has not. It basically means that you have structural problems in one area of the country, which need to be addressed through structural policies; otherwise, you end up in a situation where you have permanent transfers. But permanent transfers should not be the rule; they should be the exception or should compensate for shocks. But if there are permanent transfers, it means you have a problem. You have to address the problem from the point of view of structural policies. The Chairman: Perhaps I could press you for clarification. What you are foreseeing as fiscal union is that it is underpinned by a stabilisation rationale rather than a distribution rationale. There is a desire to move towards it in order to bring about convergence in the longer term and so on, not because of the transfer union envisaged by Lord Lawson. Professor Lorenzo Codogno: Yes. I agree 100%.

Q66 Lord Shutt of Greetland: Returning to the eurozone, what is your view of what might now be needed for the effective governance of institutional development? Indeed, where does democratic accountability come in? Professor Lorenzo Codogno: It is a very tricky issue. I am an economist so I might not be perfectly qualified to answer that question from a political point of view. But I think pieces are still missing. In order to have full democratic accountability and address the democratic gap that is perceived to be in place in Europe, probably you need some kind of fiscal capacity in the centre and the European Parliament has to be in charge of deciding on a number of issues. The European Parliament is elected and therefore you probably address some of the issues. It is the intergovernmental approach in Europe that sometimes contradicts democratic mandate. Lord Shutt of Greetland: Would that be a two-tier European Parliament? Professor Lorenzo Codogno: There might be ways to address that. I would not be surprised to see a European Parliament that deals with eurozone matters and a European Parliament that deals with EU matters, in different formats. Why not? Reza Moghadam: You have put your finger on a very important issue. What happens in a monetary union is that essentially you cede power to the centre. You do that through a democratic process. You decide to give certain powers from your Government to the centre. That is one democratic process. The question is the sustainability of that over time— whether the sovereign nations find that acceptable in practice. The second issue, as you correctly point out, is that through the crisis the European Parliament has been the body that has provided democratic scrutiny. The question one needs to ask is whether that is the appropriate body. Given that you have a two-tier system, can you have a section of the

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European Parliament or does this concept of European accountability need to be rethought? Unfortunately, among the nation states the European Parliament is not viewed as a strongly democratically accountable body, as national parliaments are. It is a legitimate issue that needs to be sorted out over time. It is a very good question.

Q67 The Chairman: Before concluding, Mr Moghadam, perhaps I could press you briefly on the role of the IMF in any future eurozone crisis management framework. As you know, that has been much debated recently. Reza Moghadam: In what respect? The Chairman: In the respect that the IMF has come out with a clearly divergent policy from that of the ECB and eurozone Governments and institutions in terms of Greece, but also externally in the rest of the world the criticism of the IMF and its involvement in the Greece situation as having been dictated by the fact that the head of the IMF is a representative of a eurozone member country. Reza Moghadam: Fortunately, I no longer have to defend the IMF but I can give you my own views. The Chairman: Given your background, it would be interesting to hear your thoughts. Reza Moghadam: The IMF is, and I am sure will remain, an international body. Its involvement in the European crisis has been helpful in two respects. First, it has brought a more international perspective to the table. I have seen that in practice. Whether it is the Brazilian chair, the UK chair or the US chair, they have been able to express views about the operations in the eurozone through the IMF bringing that to the table. The IMF has also benefited from the fact that it has a tradition of independent staff and analysis. That has been helpful in bringing another point of view, correct or not, to the table. It is correct that the management of the IMF is politically appointed and has been European. To be frank, that is an issue of governance. I worked with the last three heads of the IMF very closely. I was chief of staff to two of them and was appointed by the last one to deal with the European crisis. From what I have seen, they have been very attentive to the views of the IMF staff and the wider IMF membership. The governance issues are separate. For me, the fund has provided a constructive force in the European crisis and a reasonably independent point of view. I am sure, like with other crises—I have been involved in the Asian crisis and the emerging market crisis—there are lessons to be learned from the European crisis. But the fund has also been good at self-analysis—for example, through the Greek crisis—and looking at lessons. These lessons have not always been welcome in Europe but it has been necessary for the IMF to look at them because of its global perspective. For the future, the IMF came to the table at a time when the European Governments and system did not have sufficient crisis bodies to deal with the situation. Many of those are in place. The financing and advisory voice that the fund has provided may not be as necessary going forward but the fund needs to provide an independent point of view, both through surveillance and crisis management. I think it will remain valuable whether it is in Europe or elsewhere. The Chairman: Thank you very much indeed. That concludes today’s public evidence session. The Committee will now continue its meeting in private.

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Sir Jon Cunliffe and Andrew Bailey—Oral evidence (QQ186-194)

Sir Jon Cunliffe and Andrew Bailey—Oral evidence (QQ186-194)

Transcript to be found under Andrew Bailey.

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Dr. Marek Dabrowski—Written evidence (EMU0010)

Dr. Marek Dabrowski—Written evidence (EMU0010)

1. Introductory remarks 1. This note has been written in response to the UK House of Lords European Union Committee’s Call for Evidence on ‘Completing Europe’s Economic and Monetary Union’. The opinions presented here represent solely the view of their author and not necessarily the institutions, which he is affiliated with. Thus, these opinions can be attributed publicly to the author only. 2. The author of this note is not an expert on financial sector and financial industry and, therefore, will not be able to answer part of the Question 16 related to the potential impact of new initiatives on the city of London. Similarly, not being an expert on the UK economy and UK governance system my opinions on the potential impact on the UK will remain of rather general character. Nevertheless, I will try to address the problem of how the initiatives aimed at completing Europe’s Economic and Monetary Union may change a relative status of non-Euro area EU member states versus those, which adopted the Euro. 3. Taking into consideration author’s background (international macroeconomics) the comments presented in this note will concentrate on economic content and mechanisms of actual and potential future EU legislation rather than its legal aspects. 4. This note is divided into ten sections, which deal with the following issues: general characteristics of the ‘Five Presidents’ Report (Section 2), fiscal rules and fiscal discipline (Section 3), convergence, jobs and growth (Section 4), the European Semester and related mechanisms (Section 5), Macroeconomic Imbalances Procedure (Section 6), Banking and Capital Market unions (Section 7), prospects of the Fiscal Union (Section 8), external representation of the Euro Area in international financial institutions (Section 9) and relations between the Euro area ‘Ins’ and ‘Outs’ (Section 10). 2. The ‘Five Presidents’ Report and its implementation 5. The report on ‘Completing Europe’s Economic and Monetary Union’ (see Juncker et al, 2015) called popularly the ‘Five Presidents’ Report (henceforth referred as the Report) summarizes the debate on the Deep and Genuine Economic and Monetary Union (EMU). The debate was launched by publication of the European Commission’s Communication on ‘A Blueprint for a Deep and Genuine EMU’ in November 2012 (see European Commission, 2012). 6. In comparison with the 2012 Communication, the Report is less ambitious but, at the same time, less controversial in presented ideas and more realistic in terms of its implementability. For example, the ‘Five Presidents’ Report does not contain proposal of debt mutualization presented in the 2012 Blueprint. It would further undermine fiscal discipline on national level, already compromised by several bail- outs of the troubled countries and continuous breaching of fiscal criteria established by the Treaty on Functioning of the European Union (TFEU) and the Stability and Growth Pact (SGP) – see Section 3. 7. All measures, which are to be adopted in the Stage 1 (between July 1, 2015 and June 30, 2017) as ‘Immediate Steps’, do not require changes in the EU Treaties. They can 125

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be implemented through either EU secondary legislation or the Commission’s own decisions. This cannot be said about the Stage 2 (‘Completing the EMU Architecture’) that will require changes in the Treaties although the time horizon proposed (until 2025) makes this potentially feasible (if accepted by all EU member states). 8. The subsequent Commission’s Communication ‘On steps towards Completing Economic and Monetary Union’ (henceforth referred as Communication) (European Commission, 2015a) and other enclosed documents (to be discussed in the subsequent sections of this note) aim at implementation of the Stage 1 measures proposed in the Report. 3. Fiscal rules and fiscal discipline 9. Fiscal stability of EU member states whether members of the Euro Area or not should be considered as an important European public good preventing the entire EU and its common market from cross-country contagion and negative impact of excessive fiscal imbalances on financial sector and financial markets. Rapid increase in public debt was the basic cause of the financial crisis experienced by Euro area peripheral economies since 2010, which triggered the entire debate on an EMU architecture. 10. Although at the end of 2015 fiscal imbalances in the EU and EMU look slightly less dramatic than in 2010-2012 (except Greece) they have not disappeared. On the contrary, the number of EU member states in which general government (GG) deficit exceeds 3% of GDP and GG debt stays above 60% of GDP, is still substantial (Dabrowski, 2015a). Situation can deteriorate again in case of adverse economic shock or inevitable increase in interest rates, which remain now on a historically low level. 11. The large number of EU member states, which have problems in meeting the Treaty’s fiscal criteria creates a serious collective action problem within the entire EU. Despite reinforcement of the SGP in 2011, obliging EU member states to internalize Treaty’s fiscal criteria into their national constitutions and secondary legislations, and signing the Treaty on Stability, Coordination and Governance in the EMU (the Fiscal Compact) there is little improvement so far if any. The so-called corrective arm of the SGP (the Excessive Deficit Procedure (EDP)) has been used rather leniently; for example, financial sanctions against offenders have been never applied. 12. An even more dramatic challenge concerns market discipline, which was assumed in the Treaty as the main incentive mechanism to ensure prudent fiscal policies on a national level. Circumventing the Article 125 of the TFEU (the so-called ‘no bail out’ clause) aftermath the Greece’s debt crisis in 2010 created the dangerous precedent. It made all official creditors to Greece hostages of a limited reform commitment of the subsequent Greek governments (Dabrowski, 2015b) and force them to offer Greece subsequent bailouts (the recent one in July 2015), the typical moral hazard problem. 13. The Report does not offer any new ideas of how to rebuild market discipline based on credible threat of sovereign default within the EU and EMU and how to increase effectiveness of the SGP. The Communication promises ‘improving transparency and reducing complexity of the current fiscal rules’, revamping the European Semester (see Section 5) and few other technical measures (like publication of the SGP vade mecum) at the Stage 1. They may be useful (depending on details) but they will not address fundamental weaknesses of EU fiscal rules and return market discipline

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compromised by the rescue programs to troubled countries. The expected revue of the SGP legislation should not cause its diluting in the name of higher ‘flexibility’ (it is flexible enough). 14. At the Stage 2, the Report proposes incorporation of the intergovernmental agreements - on the European Stability Mechanism (ESM) and the Fiscal Compact – into the EU Treaties. This could be a useful step from the point of view of consistency and transparency of the EU governance framework but as such, it would not increase fiscal discipline. 4. Convergence, jobs and growth 15. The Report tries to address the key weaknesses of the European economy (apart from fiscal imbalances), i.e., its slow growth (or stagnation), high unemployment and insufficient competitiveness. This requires acceleration of structural and institutional reforms aimed at increasing flexibility of markets for goods, services, labor and capital. However, the EU competences in this area are limited to issues related to the EU internal market (i.e., movement of goods, services, labor and capital flows between member states), external EU trade relations and some general regulations in respect to employment and social policies. All other regulations remain in national domain. 16. To circumvent this formal obstacle the Report and Communication propose further development of various mechanisms of indirect and largely ‘soft’ pressures on national policymaking, which include surveillance, peer review, policy coordination and mandatory expert involvement. This concerns the already existing European Semester and Macroeconomic Imbalance Procedure (MIP) and creation of new advisory bodies on both national (national competitiveness boards (NCBs)) and EU level (European Fiscal Board). 5. The European Semester and related mechanisms 17. The European Semester that was initiated in November 2010 is an annual cycle of policy consultation between individual member states and the European Commission and the Economic and Financial Affairs Council (ECOFIN). It combines the role of preventive arms of the SGP (Section 3) and MIP (Section 6), i.e., the surveillance role in policy areas where the EU has some decision powers with soft policy coordination in other areas, which belong to member states’ prerogatives but according to the Article 121 of the TFEU remain ‘…a matter of common concern’. Country specific recommendations (CSRs) prepared by the Commission and approved by the ECOFIN serve as an instrument to influence national fiscal, economic and social policies. 18. The experience gained so far demonstrates that both European Semester and CSRs have a limited impact on decision-making process on a national level, especially in large member states (Darvas and Leandro, 2015; Gros and Alcidi, 2015) even if sometimes they provide useful benchmarks for the national debate and peer pressure on worst-performing countries. This failure can be explained by accountability of national policy makers to national parliaments and electorates and lack of decision-making power (or sanctions for non-compliance) on the EU level in respect to many issues covered by the CSRs. From the national perspective, both the European Semester and CSRs look like intrusive mechanisms short of democratic legitimacy. As result, there is no progress in coordination of national policies in comparison with the pre-2010 period, i.e., before introducing European Semester.

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19. Both the Report and Communication propose changes to European Semester’s annual timetable, reducing the number of CSRs and similar pragmatic modifications. Indeed, they may help in simplifying and streamlining policy dialogue and make CSRs better tailored to countries’ specifics. However, they may be unable to strengthen incentives on national level to observe those recommendations (they will be even more intrusive than before) under the current division of competences between the EU and national authorities. 20. The similar comment applies to the idea of NCBs. They may help in professional strengthening of national debates on microeconomic reforms and income policies but they can hardly change political economy and politics of reform processes on a national level (see Gros and Alcidi, 2015). 6. Macroeconomic Imbalance Procedure 21. The MIP was introduced by the EU secondary legislation in 2010-2011 as the part of so-called Six-Pack, in reaction to European debt and financial crisis. Formally, it aims to monitor current account imbalances of member states, and factors and policies, which determine them and member states’ competitiveness5. Similarly to the SGP, it has the character of surveillance procedure backed by the corrective arm, i.e., the Excessive Imbalance Procedure (EIP), including possibility of using financial sanctions against non-complaining member states (only in respect to EMU members). However, practical implementation of the MIP raises two kinds of problems: conceptual and related to division of competences between the EU and member states. 22. On the conceptual ground, its focus on monitoring countries’ current account balances raises serious doubts (see Dabrowski, 2015a). In the highly integrated area of unrestricted capital movement such as the EU, current account balances and real exchange rates remain outside effective control of national authorities even if country has its own currency. Furthermore, having balanced current account (what seems to be preferred by the MIP scoreboard indicators) is not always necessarily the evidence of macroeconomic health and makes sense. Both historical and contemporary evidence suggests that individual countries can become, for various reasons, capital exporters or capital importers on a sustainable basis (depending on their long-term saving rate and in-country investment opportunities). Moreover, the catching-up growth assumes permanent capital flow from higher-income to lower- income countries. 23. Other indicators used by the MIP scoreboard may be debatable from the point of view of international specialization of individual national economies. For example, some countries serve as the international financial centers for the entire EU or even to the outside world, so they can record higher rate of growth of credit to private sector. Some indicators are hardly controllable by national governments, at least in short term, because they are determined by market forces. The concrete reference values, which define the zones of vulnerability, can also raise doubts. 24. Furthermore, most of these indicators as well as policy issues analyzed by the MIP scoreboard, Alert Mechanism Reports (AMR) and In-Depth Reviews (IDR) belong to the sphere of national competence, for example, the entire area of labor market and social policy regulation. This makes the MIP and even more the EIP intrusive from the

5 See http://ec.europa.eu/economy_finance/economic_governance/macroeconomic_imbalance_procedure/index_en.htm 128

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point of view of the national sovereignty, similarly to the SGP and European Semester, and hardly enforceable (also given conceptual doubts discussed above). 25. The Report declares further strengthening of the MIP as an instrument to influence member states’ microeconomic and structural policies. From the conceptual point of view it would make more sense than dominant focus on current account balances (see above) but there is unsolved problem of the MIP intrusiveness (from the point of view of national sovereignty and current division of competences between the national and EU level) and enforceability. 7. Banking and Capital Market unions 26. The Report puts correctly the emphasis on completing the Banking Union at the Stage 1 and starting building the Capital Market Union. Both are important for increasing capital mobility and private risk sharing within the Euro area and completing the single financial market for financial services within the EU. They will also have a positive impact on both macroeconomic and financial stability in the EU and Euro area. 27. While the Capital Market Union project involves all EU member states the Banking Union is limited to the EMU members and those non-Euro-area member states that opt to join it. Such a division between ‘Ins’ and ‘Outs’ may lead, in longer term, to creating market barriers between members and non-members. 28. To complete the Banking Union there is necessary to adopt the European Deposit Insurance System (EDIS), the third, still absent pillar of this project. However, to ensure its right functioning and eliminate moral hazard risk respective safeguard measures must be adopted. They should include sufficient ‘bailing in’ measures in case of bank resolution mechanisms (within the Single Resolution Mechanism), proper functioning of the Single Supervisory Mechanism, and departing from the regulatory practice of assigning zero risk to government bonds. 8. Prospects of Fiscal Union 29. Fiscal union can be defined, in very broad terms, as transfer of part of fiscal resources and competences in the area of fiscal policy and fiscal management from the national to supranational level. Using such a definition, one may conclude that the EU is already a sort of fiscal union albeit the shallow one (the EU budget centralizes ca. 1% of its GNI). Apart from common budget, the EU fiscal union includes cross-country fiscal transfers, some elements of federal taxation, partial tax harmonization, fiscal discipline rules (see Section 3), fiscal crisis resolution mechanism and federal bailout facilities (see Dabrowski, 2014 for detail analysis). There are few additional fiscal integration mechanisms and facilities within the EMU, related to fiscal discipline rules, bailout facilities and (forthcoming) Eurozone-wide deposit insurance and banking-crisis resolution facilities. 30. The very existence of monetary union does not require parallel fiscal or political union. There are several historical and contemporary examples of monetary union of sovereign states, which do not involve other forms of integration (for instance, the Western African Economic and Monetary Union or the Central African Economic and Monetary Community). Also on the ground of an optimum currency area (OCA) theory there is no definite arguments on necessity of fiscal transfers within a monetary union.

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31. When discussing economic rationale of closer fiscal integration within the EU and EMU, the theory of fiscal federalism can serve as primary guidance helping to determine ‘which functions and instruments are best centralized and which are best placed in the sphere of decentralized levels of government’ (Oates, 1999, p.1120). In practical terms, it requires a functional analysis aimed at identifying those policy areas and public goods where centralization of competences and resources could either offer increasing returns to scale or help address cross-border externalities. 32. Apart from minor changes in fiscal surveillance procedures (see Section 3), the Report proposes at the Stage 1 creation of the new advisory European Fiscal Board6. This may be a useful initiative from the point of view of providing a formal expert platform for discussing EU- and EMU-wide fiscal policy stance and problems. The same concerns strengthening EU and Euro area dimensions in the European Semester. However, as far as the size of the EU budget remains on the level of ca. 1% of its GNI it is unrealistic to think about any Union-wide autonomous fiscal policy stance (in the sense of countercyclical fiscal policy). The Union-wide stance will remain just a sum of national fiscal stances driven by national interests and national business and political cycles. As discussed before, an active coordination of national policies, especially in respect to budgets, is a formidable task, difficult to accomplish within the current division of competences (which can be modified only by the Treaties change). 33. According to the Report, a macroeconomic stabilization function for the Euro area to cushion large macroeconomic shocks should be set up at the Stage 2. The details of such a mechanism and scale of fiscal resource centralization has not been determined in the Report. 34. As history of other fiscal federal arrangements suggests development of macroeconomic stabilization function usually follows fiscal centralization determined by other factors or needs (increasing returns to scale or dealing with common externalities) and not vice versa. Such sequencing may also happen within the EU and EMU, for example, by strengthening the Common Foreign and Security Policy, common protection of EU external borders, common asylum policies, etc. 9. External representation of the Euro area 35. The proposal to move gradually towards the common representation of the Euro area in the International Monetary Fund and other international financial organizations may help in streamlining governance in these organizations and strengthening of Europe’s position in global decision making processes (actually it would make sense to involve all EU members into consolidated representation instead of limiting it to EMU members). However, it will have no impact on intra-EU and intra-EMU economic governance and has nothing to do with democratic accountability and legitimacy. 10. Euro area ‘Ins’ and ‘Outs’: EU of two speeds 36. Introduction of the common currency that is not used by all EU member states had to lead to their internal differentiation into two categories: those, which decided to

6 It was already created by the Commission decision of October 21, 2015 (see European Commission, 2015b). 130

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introduce Euro (‘Ins’) and those, which either decided to retain their own currencies7 or did not manage to meet formal EMU membership criteria (the so-called Maastricht criteria) yet (‘Outs’). A common currency due to its economic role (in fact, this is an important component of the common market because it eliminates currency exchange costs and exchange rate risk) and necessity to complement monetary union with other forms of integration (regardless their detail architecture which might be debatable) have led inevitably to Europe of ‘two speeds’8. 37. The process of completing the EMU, even if not very ambitious, especially in the Stage 1, must lead to further deepening of internal division between ‘Ins’ and ‘Outs’ unless ‘Outs’ will opt-in to participate in some projects addressed primarily to the EMU members like the Banking Union. 38. The desire of the UK government to renegotiate some of its EU membership terms and conditions, which will lead in practice to more opt-outs, will further deepen the above-mentioned diversification of membership statuses and various speeds of integration processes within the EU. 39. The same effect will result from reluctance of some member states (including the UK) to deepen integration within the EU (including changes in the Treaties) even if the cost-benefit analysis speaks in favor of such deepening. Reacting to inability to reach a consensus regarding either new EU legislation or changes in the Treaties countries interested to move ahead can either use mechanism of or sign intergovernmental treaties outside the acquis (as it happened in case of the Fiscal Compact). This will lead not only to further differentiation of individual countries’ membership statuses and increasing marginalization of ‘Outs’ but it will also make the EU governance system even more complicated and less transparent than it is now.

References: Dabrowski, M. (2014): Fiscal or Bailout Union: Where Is the EU/EMU’s Fiscal Integration Heading?, Revue de l’OFCE, No. 132, April, pp. 19-49, http://www.ofce.sciences- po.fr/pdf/revue/132/revue-132.pdf Dabrowski, M. (2015a): Monetary Union and Fiscal and Macroeconomic Governance, European Economy Discussion Papers, No. 13/2015, September, http://ec.europa.eu/economy_finance/publications/eedp/pdf/dp013_en.pdf Dabrowski, M. (2015b): Five Lessons on Greece, Bruegel Blog, July 17, 2015, http://www.bruegel.org/nc/blog/detail/article/1687-five-lessons-on-greece/

Darvas, Z. and Leandro, A. (2015): Naughty students or the wrong school: why is the European Semester proving ineffective?, Bruegel Blog, November 18, 2015, http://bruegel.org/2015/11/naughty-students-or-the-wrong-school-why-is-the-european- semester-proving-ineffective/

7 In this note I will skip discussion on legal nuances of non-participating in the common currency project. Two EU members (UK and Denmark) have a formal opt-out clause in the Treaty. Others who are formally obliged to join the EMU at some point do not hurry with meeting membership criteria and do not apply for membership. 8 Actually we have Europe of ‘many speeds’ because some EU members states do not participate in the , common justice and home affairs policy and are subjects to other exemptions from the acquis communitaire (temporary or permanent). 131

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European Commission (2012): A Blueprint for a Deep and Genuine EMU. Launching a European debate, Communication from the European Commission, COM (2012) 777, November 28, http://ec.europa.eu/archives/commission_2010- 2014/president/news/archives/2012/11/pdf/blueprint_en.pdf

European Commission (2015a): On steps towards Completing Economic and Monetary Union, Communication from the Commission to the European Parliament, the Council and the European Central Bank, COM(2015) 600 final, October 21, Brussels, http://www.ec.europa.eu/priorities/economic-monetary-union/docs/single-market- strategy/communication-emu-steps_en.pdf

European Commission (2015b): Commission Decision of 21.10.2015 establishing an independent advisory European Fiscal Board, C(2015) 8000 final, October 21, Brussels, http://www.ec.europa.eu/priorities/economic-monetary-union/docs/single-market- strategy/decision-efb_en.pdf

Gros, D. and Alcidi, C. (2015): Economic Policy Coordination in the Euro Area under the European Semester, CEPS Special Report, No. 123, December 2015, https://www.ceps.eu/system/files/SR%20No%20123%20Economic%20Policy%20Coordinatio n%20under%20European%20Semester_0.pdf

Juncker, J-C. et al. (2015): Completing Europe’s Economic and Monetary Union, European Commission, June 22, http://ec.europa.eu/priorities/economic-monetary-union/docs/5- presidents-report_en.pdf Oates, W.E. (1999): An Essay on Fiscal Federalism, Journal of Economic Literature, Vol. 37 No. 3, pp. 1120-49

14 December 2015

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Professor Paul De Grauwe and Alex White—Oral evidence (QQ179-185)

Evidence Session No. 16 Heard in Public Questions 179 - 185

WEDNESDAY 10 FEBRUARY 2016

MEMBERS PRESENT

Baroness Falkner of Margravine (Chairman) Lord Butler of Brockwell Lord Davies of Stamford Lord Haskins Earl of Lindsay Lord McFall of Alcluith Lord Shutt of Greetland Lord Skidelsky

Examination of Witnesses Professor Paul De Grauwe, John Paulson Chair in European Political Economy, LSE, and Alex White, Director, Country Analysis, Intelligence Unit

Q179 The Chairman: Good morning, Professor Paul De Grauwe and Alex White. Thank you for agreeing to give evidence to this European Union sub-committee’s inquiry into Europe’s economic and monetary union. You have a list of the interests which have been declared by Members of the Committee. This is a formal evidence session and a full transcript will be put on the public record in printed form and on the parliamentary website. You will be sent a copy of the transcript so that you can revise any minor errors. This session is also being webcast live and will subsequently be accessible via the website. With your permission, I suggest that we do not go into introductory remarks but move straight on to the session. Could both of you give an assessment of the Five Presidents’ Report and the short-term actions it proposes, as well as longer-term sustainability? Professor Paul De Grauwe: Thank you very much. First I want to say how pleased and honoured I am to be here. I appreciate that the Five Presidents’ Report is certainly a move forward, but only a small one. It is a tiny step which indicates the direction in which the eurozone will have to go, which ultimately in my view has to be towards some kind of political union. Some indication is given in the report about how to do that, but it falls far short of what is necessary. There are a couple of interesting ideas in it, in particular the proposal from the European Commission for competitiveness boards, which some member states already have. It is a good idea but there is also a potential drawback. By focusing too 133

Professor Paul De Grauwe and Alex White—Oral evidence (QQ179-185) much on competitiveness in its narrow sense, such as the development of wages, one can easily become trapped in a deflationary spiral where everyone watches national wage developments and then tries to reduce them relative to their neighbour. In no time you are in a deflationary spiral that prevents countries’ economies growing. We have already seen some of that. So while I think that there are positive elements in the proposal, there are also dangers. What is lacking in the Five Presidents’ Report is some form of institution that can take a bird’s-eye view and function as a stabiliser at the level of the eurozone. If something like that is not in place, the net effect of these competitiveness boards might well be further low growth and stagnation in the eurozone. That is why I have a guarded view about it. The proposal for a banking guarantee in the form of a bank deposit insurance mechanism for deposits is a good idea, but it will be very difficult to implement. The Chairman: We will come on to that shortly. Alex White: Thank you very much for the invitation to appear before the Committee. I agree with much that Professor De Grauwe has said, but we have a slightly different nuance of view about the overall direction that the Union is attempting to take here. In essence, Professor De Grauwe is correct to say that this is not a solution. This does not take us to an end point that looks sustainable and fit for purpose over the very long term. At the same time, however, it is our view that this is pushing too far in terms of the political capacity of the Union and its member states as regards the delivery perspective over the short to medium term. More broadly, if we look back at the journey that the Union has taken since the introduction of EMU, we can see from the vantage point of today that its introduction at the time that it took place and in the manner that it was done, and with the institutions that were in place at the time, was an error. It was an error in terms of the economics, and that error has been much discussed. It was also an error in terms of the politics for two reasons. It created a set of expectations and institutions that were without clear leadership, which goes to Professor De Grauwe’s point about a lack of leadership at the European level. It also moved too quickly before there was a European demos to support a lot of the initiatives that lay behind what was imposed in 1999 and 2000. When we look at the Five Presidents’ Report and at some of the initiatives which preceded it, they appear to us to be an attempt to correct the first error, which was the economic error of the timing and the institutions involved in the creation of EMU, and they do so at the risk of conflating and worsening the political error: moving too fast and going beyond what the European polities and voters are prepared to accept and implement. The Chairman: Professor De Grauwe, perhaps I may come back to you briefly in terms of European leadership. What do you envisage? Professor Paul De Grauwe: Leadership here, in my view, means more than having a strong president or strong people in place. The Chairman: Institutionally? Professor Paul De Grauwe: It means something institutional. The Chairman: Something like a eurozone Treasury? Professor Paul De Grauwe: Yes, in the true sense of a Treasury, which is an institution that has the power to tax and to spend and is embedded within a democratic decision-making process. That is what a true Treasury is, not some kind of institution where Ministers of 134

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Finance come together and talk to each other. That is not what we need. We have enough institutional features to make all this possible, so it really should be about some form of transfer of sovereignty. I am aware, of course, of what Mr White is saying, which is that the political background to this is not in place to make it possible, but as an academician I would say that these are the necessary conditions to make it sustainable in the long term. There is today an illusion in Brussels that we have now achieved or we are close to achieving the institutional framework that would allow us to have a sustainable eurozone. That is a big mistake. We do not have it. We have to move forwards much more radically, and that is precisely the problem because no one wants to do it. The Chairman: Because of treaty change. Professor Paul De Grauwe: No. I agree that it requires treaty change, but the political will in all of these countries is just not there to make that move. In the previous discussions about Eurobonds or even the deposit insurance mechanism, there is no willingness to move in that direction, let alone towards a true Treasury. The Chairman: That brings me neatly to Lord Butler’s area.

Q180 Lord Butler of Brockwell: Professor De Grauwe, you said at the outset that you think that banking union is a good idea, but that you are sceptical about whether it can be delivered. I do not want to put words into Mr White’s mouth, but I think that you are also sceptical about whether some of the developments in the Five Presidents’ Report can be delivered, probably including this one. If it cannot be delivered, is there some alternative form of insurance or support that could take its place in the short term? Professor Paul De Grauwe: Of course there are many different insurance schemes, but the banking union is key to maintaining stability in the eurozone. We have some elements of a banking union today, as you know, but parts of it are not yet workable. In particular, as we mentioned earlier, the common deposit insurance mechanism has gone nowhere, while the resolution mechanism lacks credibility. I would like to stress another element about the banking union. A real banking union presupposes some kind of fiscal union. At some point, you need an institution with deep pockets that in a time of crisis is capable of resolving it. If you do not have that, a banking union has no credibility. Some people say, “Okay, let’s have a banking union so that we don’t need a fiscal union”. I say no to that. A banking union can function only if it is embedded in or part of a fiscal union. That is what you need in a time of crisis: someone who has the capacity to raise taxes and fund rescue operations. We now have the resolution fund, but it lacks credibility because its capacity to act in times of crisis will be limited. Lord Davies of Stamford: But surely the European Central Bank can provide protection for the banking system. Professor Paul De Grauwe: The ECB can certainly do that, but of course here one likes to make a distinction between liquidity problems and solvency problems. The ECB is the right institution to step in at times of crisis in order to take care of liquidity problems, not solvency problems, at least in theory. I know that it is difficult to make that distinction in practice, but we should not overload the ECB and make it responsible for dealing with banking crises, including saving banks by recapitalising them. That does not seem to me to be the role of a central bank. A central bank is there just to make sure that when solvent banks are hit by 135

Professor Paul De Grauwe and Alex White—Oral evidence (QQ179-185) illiquidity they receive the right liquidity. Again, we need a Treasury that is capable of doing all the other things. Lord Butler of Brockwell: Before bringing in Mr White, you said that you cannot have a banking union without a fiscal mechanism. Can I put the question the other way around? Would a stability mechanism be sufficient and make a banking union unnecessary? Professor Paul De Grauwe: Do you mean the existing ESM? Lord Butler of Brockwell: Yes, I am developing the point here. Professor Paul De Grauwe: I do not think so, because again when you face a banking crisis of the kind that we experienced, especially in 2008, the ESM is not sufficient. It is too limited and will not be able to deal with a crisis. As a result, if it were to happen again, we would face the need for another back-stop. A back-stop for the ESM would be necessary because on its own it would not be sufficient. Lord Butler of Brockwell: Thank you. Mr White. Alex White: I agree with much of what has been said, but I think we need to avoid taking a binary view on policy developments at the European level. It is simply not the case that we either have a fully functioning banking union with all the bells and whistles one could imagine attached to a fiscal union or we have nothing. If we look at what the Union has delivered over the past four years, since the high point of the crisis in 2012, we have the ESM and all the mechanisms around that; we have the reinterpretation or the restatement of the ECB’s mandate with OMT. On the banking union side, we have the implementation of the SRM and the SSM. That is not a perfect system, and Professor De Grauwe is right to say that a lot more needs to be done, but part of the danger of the approach that has been set out in the Five Presidents’ Report is that it distracts a little from what the Union has already achieved. If we compare the progress on banking union which has been developed over the past three and a half years with the length of time it took to build the European Coal and Steel Community, the Common Market and the other major European institutions, actually the Union is doing pretty well in delivering. While accepting many of the points that Professor De Grauwe has made, we need to keep that in mind. There is reason to believe that the Union is better equipped to deal with a situation with similar issues to, while not being a repeat of, 2008 to 2010.

Q181 Lord Skidelsky: As a follow-on to the banking union question, which involves considering the role of the ECB, I want to ask Professor De Grauwe another question. Ever since Bagehot, it has been understood that a central bank should as the lender of last resort; that is, it should be prepared to lend to solvent banks at a punitively high rate of interest. The ECB is not a lender of last resort in that sense. Therefore, should it be? In order to play that role, should it also have a fiscal back-stop? That is the implication of what Professor De Grauwe is saying. Is the obstacle to developing the ECB as a lender of last resort the lack of a Treasury or are there other obstacles? How would you progress from there because there is an implication in some of what Professor De Grauwe has said that there are certain necessary conditions for making the eurozone work, but those conditions are not in place? The political will to put them in place is lacking and therefore logically the eurozone cannot survive.

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Professor Paul De Grauwe: That is a very deep question which I have also been struggling with. Recently I read Ben Bernanke’s book which goes into great detail about what was done in the US. The Chairman: Is that the one about the Great Depression? Professor Paul De Grauwe: No. This is his more recent book, but I have forgotten the title. What struck me was the degree of co-operation between the Federal Reserve and the Treasury. Lord Skidelsky: And in the UK as well. Professor Paul De Grauwe: That is right. Of course in theory it is easy. I mentioned the central bank taking care of the liquidity problems and the Treasury taking care of the solvency problems, but in practice when you look at this you just do not know; you guess— this bank may be solvent and liquid, but it could also be insolvent. Therefore, since you have this uncertainty, the central bank and the Treasury must work together because each time one does something it has implications for the other. As you mentioned, Lord Skidelsky, that is lacking in the eurozone. We have a central bank, which I would argue is quite powerful, but there is no comparable Treasury with which you can decide in a crisis what to do with a particular bank and who will do what to handle the uncertainty about liquidity versus solvency. That is one of the weaknesses of the eurozone: the absence of a common Treasury that has the capacity to deal with solvency issues, and we will continue to struggle with that problem. It also leads to a situation where the actions of the central bank lack credibility because we are never sure whether it will be able to act. Take the OMT programme, which was a great thing in 2012 when Draghi came out with his promise to act in times of crisis in relation to government bond markets. Then last year came the Greek crisis. The ECB said, “We don’t want to use OMT”, and we had a new crisis. Here we have something and we are not really sure whether the central bank will be willing and able to act in times of crisis. Alex White: My interpretation of the OMT and President Draghi’s statement at the time was that it was a commitment to defend the euro. It was not necessarily a commitment to defend the existing composition and membership of the euro area. That is an important difference and something which came out in the Greek crisis last year. Lord Davies of Stamford: It was based on sustainable and realistic policies being adopted by the member states, when Greece was adopting irresponsible policies or rejecting the restructuring. It was not sensible for the ECB to buy its bonds. Professor Paul De Grauwe: Somebody must judge whether it is responsible or not. You might say that it was not an existential problem, but if some countries exit it then becomes an existential problem. The Chairman: Mr White, you were interrupted. Alex White: There is certainly a very interesting debate to be had about whether the exit of an individual member leads to a broader collapse of the Union. It is not our view that it does; it is our view that it creates a severe challenge but it does not lead to the end of the Union. More broadly, with respect to Lord Skidelsky’s question on the ECB and the lack of a common Treasury, we like to ground our analysis in reality, and the reality of the situation is that the prospects for a eurozone Treasury appearing in anything like the foreseeable future

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Professor Paul De Grauwe and Alex White—Oral evidence (QQ179-185) are effectively de minimis. We need to start from that point and from the acceptance of that political reality. Obviously that puts the ECB in an invidious position, which we have seen throughout the crisis. There is no obvious solution to that. We exist in a world where the ECB backstop through the OMT is there on the table, but the conditionalities around it, its usage and its terms are ill defined. We have the steps that we have spoken about with respect to banking union. This helps, but obviously it is not a full solution. Lord Skidelsky: Just one last thing. The implication of what you are saying is that there is no realistic possibility of a Treasury, but there is a realistic possibility of the eurozone shedding members. Alex White: There is no realistic probability of a Treasury in the near term absent a further systemic shock, which potentially might be delivered by the exit of one or more members. That could in theory generate the political capital necessary to take further steps towards more substantive integration. Lord Skidelsky: There are lots of ifs there. Alex White: Yes, lots of ifs. The Chairman: Professor De Grauwe, the miracle of Professor Begg and the internet combined tell me that the Bernanke book is called The Courage to Act: A Memoir of a Crisis and its Aftermath.

Q182 Lord Davies of Stamford: Professor De Grauwe, you are saying now that the euro really is not viable without a common Treasury, as you put it, as part of the fiscal policy. That has not always been your view, has it? At the time of Maastricht treaty you wrote a good and influential book that I read and enjoyed which said that the project was perfectly viable without it. Professor Paul De Grauwe: Did you read my book? Lord Davies of Stamford: Yes. You said in it that the project could go ahead without the necessity for fiscal union. Professor Paul De Grauwe: I think I said in my book that without a political union, it was a high-risk project. Are you referring to my textbook on the economics of monetary union? Lord Davies of Stamford: I think so, yes. It was the one you produced at the time of the Maastricht treaty. Professor Paul De Grauwe: The first one was published in 1992 and the conclusion in that book was that we are taking a big risk in doing this because it is unfinished business, in particular if political union is not part of it. That was my analysis at the time and I do not think that I have changed it that much, although of course the detail has evolved. Lord Davies of Stamford: My memory is that you thought it was perfectly responsible to go ahead with the project without fiscal union, knowing that it was a desirable thing that might come later, but that it was not necessary as a prerequisite for a successful monetary union. The Chairman: Perhaps you could direct us by saying what you think about it now. Lord Davies of Stamford: Yes, let us talk about what you think now. Do you think that the reason for having this common Treasury, or fiscal union as you have just described it, is in

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Professor Paul De Grauwe and Alex White—Oral evidence (QQ179-185) order to have a mechanism for dealing with asymmetric shocks, or is there a need for permanent structural transfers within the Union greater than we now have through the structure funds and comparable with those that exist within individual member states? Professor Paul De Grauwe: The traditional view has been that a common budget functions as an insurance mechanism. You centralise the budget and as a result, when there are asymmetric shocks, you have automatic transfers from countries or regions that are experiencing good times to those experiencing bad times. That is one part of it, but for me it is not the most important one. The more important part is that we need a budgetary union so as to be able to consolidate at least a significant part of national debt into common debt. What we have seen with the crisis is that when we move into a recession, financial markets typically get nervous about some of the member countries. A recession hits different countries in different ways. Some will be hit very badly with increasing budget deficits and accumulated debt while for others that is less so. That was the pattern we saw in the sovereign debt crisis. In those conditions the markets become very destabilising. They dump the bonds of those countries they are suspicious about and they move on to countries which they consider to be safe havens. As a result, instead of markets stabilising during a recession, they typically will be destabilising the system, forcing some countries into excessive austerity precisely at the moment that you do not want that and moving other countries into good times, thus intensifying conflicts within the Union. That is the more fundamental reason why we need a fiscal union. We have to consolidate national debts so that these destabilising capital flows within the Union are eliminated. That, in my view, is the more fundamental reason why we need it. The financial markets cannot be trusted to stabilise a system like the eurozone during recessions when everyone is nervous. In the boom times, everything is fine, but markets become fearful and panicky in recessions, which destabilises the system. Lord Davies of Stamford: I think we all understand that argument. How do you deal with the moral hazard aspect of that? Professor Paul De Grauwe: Moral hazard can be dealt with only if you have a system of controls, which means another step towards political union. You cannot do it if you maintain full sovereignty at the level of the member states; then you cannot solve the moral hazard problem. It makes no sense to consolidate debt and keep national sovereignty because then you maximise the problem of moral hazard. In order to solve that problem, you have to move towards political union. Lord Davies of Stamford: Since that is unlikely to happen, the eurozone faces the inevitability of a fatal existential crisis. Is that your view? Professor Paul De Grauwe: I do not want to be a doomsday thinker, but that is indeed a conclusion that one may draw. Lord Davies of Stamford: I am going to look at your book again because I do not remember getting that impression when I read it some 20 years ago. The Chairman: We need to move on. Professor Paul De Grauwe: I too will re-read my own textbook. Alex White: I was just going to say for the record that that is not our view. While the Committee may not like this, our view is: continue to muddle through for as far as the eye can see. Those who are saying that the eurozone will inevitably collapse need to make a case 139

Professor Paul De Grauwe and Alex White—Oral evidence (QQ179-185) for the context in which that collapse will happen and the context in which more muddle- through will not be available to policymakers. It is very hard to think of the policymaker who is going to take the decision to unwind the Union or to take an irrevocable step that has the effect of unwinding the Union. Our perspective is “more muddle-through” with some of what is discussed in the Five Presidents’ Report happening over time, but measured in periods of decades. The Chairman: Can I ask for clarification that, when you refer to “our view”, you are talking about the Economist Intelligence Unit? Alex White: Yes, that is correct. Lord Butler of Brockwell: Could the collapse happen through a political route because parties get into government for whom the Union and the results for unemployment are not acceptable? Alex White: Yes, that is certainly a risk. Obviously the political experience in Greece has been a salutary lesson, but even in Greece we have seen a Government that presented themselves as radical while in opposition and being prepared to consider the possibility of exit in extremis, but ultimately they buckled under pressure from the rest of the Union. It is worth bearing in mind that even in the countries worst affected by the crisis, like Greece, support for membership of the euro area is still above 70%. In the medium term the country we have the greatest degree of concern about is Italy. Italy is the country where dissatisfaction with euro membership is the highest. It is an advanced and complex economy that would have choices outside the eurozone and it has a political system that is fragile, to say the least. That is a core area of our concern, and absolutely it is a risk.

Q183 Lord McFall of Alcluith: Adair Turner has been talking today about a possible Brexit. He said that it would cause major destabilisation at the global level and would have implications for Europe. What is your view? Alex White: On the implications of Brexit, our view for the record is that it will not happen, although we think it might be narrow. Professor Paul De Grauwe: You are an optimist. Alex White: An irrevocable optimist, yes. We think that the consequences would be serious for the UK and very serious for the rest of Europe. The implications for Europe are effectively that the spell would be broken, as it were. The idea that a member can exit is similar to the logic around exit from EMU. It creates that possibility in the minds of policymakers elsewhere in the . Obviously the UK is an important contributor to the European project, to the single market, and to everything that goes with that. An exit of the UK would provoke some very large existential questions for the EU. I do not think that within that we believe that EMU and the issues we are talking about now would be particularly affected; it is the EU itself that is more under threat from a British exit. Professor Paul De Grauwe: I agree with most of what Mr White has said. I certainly would not make a forecast about whether Brexit will happen because it is too difficult. My view on the political and economic implications is as follows. The economic implications of a Brexit will be limited. As soon as a decision is made to leave the European Union, the UK Government will have to start negotiations with the EU to come to an agreement on trade

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Professor Paul De Grauwe and Alex White—Oral evidence (QQ179-185) relations which would not be that different from what exists today. In that sense, economically it might not make much difference. Politically, of course—the point that you made—it makes a lot of difference because it would be the first time that someone has pulled out of the European Union, and that of course has huge political implications which may destabilise the Union. In that sense it is more of a political problem than an economic one. Alex White: Perhaps I may come back very briefly on the economics. The distinction we like to make is between transition costs and steady-state costs. An exit from the Union will impose significant transition costs because of the uncertainty around what the trading relationship would look like. Those transition costs will be imposed over a number of years and they will be meaningful. But they are separate from steady-state costs. If we were to take a UK that was outside the EU in 20 years’ time, there is no reason to suspect, given proper market access, that it would be economically in a worse position than a UK that was in the EU. It is the transition process that is problematic. Lord Davies of Stamford: Two other factors might be mapped out. One is that by being members of the EU we have access to around 45 other trade agreements with countries and groups of countries around the world. We would lose those, so there would be a trading gap. Secondly, investors, both British and foreign investors here—American and Japanese— have made it clear that they do not like investing in a capacity directed at the single market except in a country that is a full member of the Union and therefore has an influence over ongoing legislation and can take part in changes in regulation and so on. Otherwise they have no influence over the process of legislation and regulation that affects their businesses. Alex White: Those are both good points. The Chairman: Before we go any further, this is not particularly pertinent to our inquiry. I am conscious that you will both have to leave shortly and it is also highly political. So unless you have very brief and cogent answers relating to the Five Presidents’ Report, let us move on. Lord Skidelsky: Have we reached question 5? The Chairman: I want to get to it, so I suggest that we move on.

Q184 Lord Haskins: The question is whether the European Semester procedure has done any good. We have heard different views about it. Some people are rather disappointed in it because it is a process in which countries arrive at a meeting, speak warmly to each other, and then go away and forget about it when they get home. In other words, it has not achieved the co-ordination of fiscal policies that it was meant to achieve. Is that fair or unfair? The Chairman: Professor De Grauwe, why do you not start first on that one? Professor Paul De Grauwe: Surely it has been a disappointment. Let us look at the economic performance first. Members of the eurozone have been worse off on average in terms of macroeconomic performance than the EU countries outside the eurozone. That is just something that one observes. Especially since 2008, there has essentially been stagnation in the eurozone. Real GDP in the eurozone is now, eight years later, at the same level as it was in 2008, while in the UK and the rest of the European Union we have had growth—not fantastic, but certainly a recovery—which has been totally absent in the eurozone. That is

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Professor Paul De Grauwe and Alex White—Oral evidence (QQ179-185) something that one should worry about. Is it something structural? Is it because of bad policies? One can also argue that it just so happens that those who were in power did the wrong things, but I believe that it has something to do with the way macroeconomic policies are set up—the fact that there is no institution which can work as a stabiliser at a level of the eurozone and everybody is doing their own thing. As a result, we have not seen any recovery. That is the problem. If we do not get away from this, in the end it will turn round public opinion. You mentioned that 70% are still in favour, but if we go on doing this, public opinion will change. When the others deliver better than we do, in the end people will say, “That is not what we were told would happen”. Alex White: I agree with all of that. On the specifics of the European Semester, let us put this in the context of what the Union has been doing more broadly. We have had a range of initiatives—the European Semester, the two pack and the six pack—but none of these is perfect and they have not produced strong outcomes in terms of fiscal discipline, co- ordinated fiscal policies or any of the things that would address the problems that Professor De Grauwe identifies. Having said that, the discipline of having to review budgetary procedures and fiscal policy with other members is helpful. We need to get away from constantly comparing the current environment to a fully perfect Union. We are simply not in that world. Having that there is better than nothing and having a process in which countries are “named and shamed” is helpful. Some degree of co-ordination, while not as desirable from an economic perspective as full convergence, is better than none. The Chairman: Briefly, before I come to Lord Skidelsky, do you both believe that the lack of national political buy-in is one of the hurdles? Alex White: One of the great mistakes that has been made in response to the crisis is for national leaders not to own the European response and to put the blame on the European institutions. Certainly one could have seen from countries such as Germany and France a more active policy.

Q185 Lord Skidelsky: There is nothing in the Five Presidents’ Report about current account imbalances—there is no pressure there on the creditor countries. Just from an academic point of view, although this is also a realistic question—that seems to be the way in which these things are divided up—there is surely a case for revisiting Keynes’s proposal for an international clearing union, which was not accepted at Bretton Woods. However, it would impose on both creditors and debtors symmetrical sanctions, which would come into play more automatically beyond certain thresholds. It does not seem to be on the agenda, but it is an obvious thing to do. Alex White: First, you are correct to say that it is not on the agenda. Secondly, there is a lot of sense in the proposal. The question at the European level is whether we involve European institutions and supranational institutions. For example, there might be a greater role for the IMF to play in Europe, but that is politically challenging. I think that it is a very creditable idea, but we are not there in terms of it being on the agenda. Professor Paul De Grauwe: There is of course the macroeconomic imbalance procedure, which gives the European Commission the authority to put pressure on countries to change their policies. That is not fully symmetrical because, as you know, the thresholds for imbalances are asymmetric, in the sense that the threshold for the deficit countries is 4%

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Professor Paul De Grauwe and Alex White—Oral evidence (QQ179-185) and for the surplus countries it is 6%, so it is not fully symmetrical. The more basic problem is again political. The European Commission has the authority to go to Germany and the Netherlands, which have very large current account surpluses, and tell them to do something about it, which must mean in this case, “Increase your spending”—otherwise one cannot reduce a surplus. But that is very difficult for the Commission to do, because in these countries having a surplus is considered to be a reflection of virtuous policies. Why should we, as Germans or Dutchmen, change our policies, because these have been virtuous? The Commission is powerless. We have the institutional infrastructure to deal with it, but politically the European Commission is paralysed. It can only go to deficit countries, to which it can say, “You have a deficit and that’s wrong”. It can blame them and say that they are wrong to have a deficit. It cannot go to Germany and say that it is wrong to have a surplus, as it would say, “What? We are right”. Alex White: That political culture will only change over a period of decades, if it does at all. Professor Paul De Grauwe: The solution should be a symmetrical one. The Chairman: Professor De Grauwe, I am conscious that we are one minute over your Cinderella hour, so I think that we have to draw the meeting to an end. Professor De Grauwe from LSE and Alex White from the Economist Intelligence Unit, thank you very much for giving evidence to us today.

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MEP Anneliese Dodds—Written evidence (EMU0006)

MEP Anneliese Dodds—Written evidence (EMU0006)

This submission is made in a personal capacity

1. I welcome this opportunity to submit evidence to the Sub-Committee, and have endeavoured to answer some of its pertinent questions below. The submission reflects my experiences since my election in spring 2014, and particularly my discussions with colleagues from Eurozone countries. It is not, however, intended to represent the viewpoint of my political party or group.

Q1 Is economic and fiscal policy coordination and surveillance working effectively in the European Union, both for euro area Member States and non-euro Member States? Is greater ‘structural convergence’ necessary to build a resilient and smooth-functioning EMU?

2. As the Sub-Committee will be aware, the aftermath of the economic crisis led to the creation of a number of both Eurozone and EU-wide measures. These include the European Stability Mechanism, the Semester process, the revision of the Stability and Growth Pact, the Intergovernmental Treaty on Stability, Coordination and Governance, the so-called 'two- pack' on fiscal monitoring, the Macroeconomic Imbalances Procedure and steps towards banking union.

3. All of these reforms were introduced as part of a process which at times was rather ad hoc, reflecting the extreme economic pressure on member states and the EU as a whole. While the measures have undoubtedly had a number of positive impacts, internal demand remains low within the EU, and severe imbalances remain between North and South. These imbalances have arguably been exacerbated by what has effectively been a process of competitive wage devaluation across Southern Europe.

4. A more flexible interpretation of the Stability and Growth Pact, as well as the recognition of the need for greater investment through the European Fund for Strategic Investment (EFSI), should help to create both a less formulaic and more targeted approach to structural reform, and to boost demand.

5. Nonetheless, these will not be sufficient to fill an investment gap which has been estimated at 1.5 trillion euros up to 2020. (If all goes to plan, EFSI will contribute 315 billion euros of additional investment). Clearly there have been many discussions at EU level concerning whether a Eurozone fiscal capacity could be created, including a borrowing facility, to deliver public investment. It is also important however to focus on the prospects for ensuring higher levels of private investment. The current Commission's focus appears to be on removing barriers to capital market finance, particularly in order to foster investment in SMEs and infrastructure (the so-called 'Capital Markets Union'). I believe it is equally important not to underestimate the significant differences both across and within member

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MEP Anneliese Dodds—Written evidence (EMU0006) states when it comes to the provision of bank finance, nor the importance of regulatory stability (for example, within renewable technologies) for encouraging private investment.

Q2 What is your assessment of the European Semester? What can be done to strengthen the implementation of Country Specific Recommendations and boost national ownership of reforms?

6. The European Commission has maintained that it is essential to streamline the European Semester process. While this is to be welcomed, it is important that key indicators of long- term economic sustainability are not pruned away and continue to be subject to examination. In this connection, a number of groups including the 'European Semester ', a collection of civil society organisations, have maintained that the new streamlined Semester process appears to abandon many of the aspirations of the Europe 2020 process.

7. In addition, there appears to be a gap in coordination between economic and social developments which has been exacerbated by some of the approaches taken within the European Semester, particularly in its new 'slimmed down' incarnation. To remedy this, some have suggested the creation of a Social Imbalances Procedure which could be allied with the Macro-Economic Imbalances Procedure, which could help reinforce corrective policies when social indicators (such as unemployment or poverty) reach problematic levels. It would also be sensible to involve Ministers other than just Finance Ministers more meaningfully within the European Semester process, given the relatively wide remit of the latter.

8. In addition, despite the European Semester covering issues including wage levels, the role of social partners has been reduced in decision-making over the years, particularly within countries that were highly indebted but also more generally due to the European Semester's coverage of issues including appropriate wage increases and the extent of collective bargaining. Commissioner Dombrovskis, the European Commission's Vice President for Euro and Social Dialogue, has vowed to ameliorate this when I have challenged him on this point, but I have personally seen little evidence of this new approach.

9. Finally, some interesting analysis has been provided by the Bruegel think tank, released earlier this month, which indicates the relatively low rate of implementation of Country Specific Recommendations. This fell from implementation of two out of every five recommendations in 2011 to less than one in three in 2014, according to their 'implementation index', with Eurozone countries not much better 'implementers' than non- Eurozone countries. The think-tank also concludes that although the CSRs consistently promoted reform of services sectors, they were less consistent, at least in relation to the five largest Eurozone economies, in prioritising 'aggregate fiscal stance' and investment goals. Politicisation of the CSR process, with some areas and/or nations appearing to be accorded greater or lesser public attention by the Council, is likely to reduce its perceived legitimacy.

Q9 What could EU institutions have done differently in the context of the instability in Greece in 2015 to respond to the escalating funding crisis?

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MEP Anneliese Dodds—Written evidence (EMU0006)

10. Arguably the EU contributed to Greece's problems in 2010, by leaving the country exposed to speculative pressures. The initial rescue package implemented by the 'Troika' of the European Commission, IMF and ECB was far too abrupt, leading to a dive in Greek demand which it has still not recovered from, and an increase rather than reduction in Greece's debt.

11. Many felt that the negotiation this year of a new deal offered an opportunity to right some of these wrongs. Unfortunately however, rather than the Greek process being guided by the normal principles of EU economic decision-making, any semblance of a 'community' approach was abandoned, especially at the late stages of the negotiations. It was unclear to many where proposals were coming from if not Wolfgang Schäuble, not least recommendations concerning pension reforms and privatisation. A more 'normalised' process would avoid the perception (and potential reality) that some Member States dominated proceedings, which arguably created more intense political problems on the Greek side, and delayed resolution of the situation.

Q15 How should democratic accountability be enhanced if decision making is pooled across the euro area? Is democratic legitimacy weakened by the complexity of the crisis management framework?

12. My answer to the second question would be yes; which then behoves me to try to answer the first question. A number of different reform options have been put forward by the Socialist and Democrat group, to which Labour MEPs adhere within the European Parliament. These include much more thorough and extensive discussion of Country Reports within national parliaments; an ability for national parliaments to amend and adopt national reform programmes and stability and convergence programmes; an increased role for the European Commission within the Eurogroup of finance ministers, mirrored by greater accountability to the European Parliament; and a change to the European Stability Mechanism such that it becomes a Community instrument.

13. Ultimately however, for many European citizens, output legitimacy (i.e., how the institutions actually perform in delivering sustainable, and more equitable, economic growth) will be far more important when it comes to enhancing democratic accountability. It is therefore essential that policy change is the focus, and not merely shifting responsibility amongst different groups of politicians for what can appear to be a rather bureaucratic process of economic surveillance.

Q 16 How will the UK and other non-euro area Member States be affected by initiatives put forward by the European Commission and Five Presidents’ report?

14. The UK's continued involvement in economic policy-making is necessitated by the close linkages between the effective functioning of the single market and that of the economic and monetary union. Developments in the Eurozone will inevitably affect the economies of non-Eurozone countries, and these spillovers must be acknowledged in the design of political institutions. It is positive to see an acknowledgement of this in the UK government's

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MEP Anneliese Dodds—Written evidence (EMU0006) position on EU economic policy-making, even if it does appear to be inconsistent with the former's view in relation to Scottish MPs voting on English laws, where they appear to suggest a clear delineation of interest is feasible. 15. As with other Labour MEP colleagues I have, in accordance with the need to preserve our influence, consistently resisted attempts within the European Parliament to hive Eurozone issues off from general economic decision-making, as would occur, for example, if a separate 'Eurozone' committee were to be created, which might operate in parallel to the Parliament's Economic and Monetary Affairs Committee (currently, and rightly, the latter covers Eurozone economic issues as well as economic issues affecting non-Eurozone countries). I also view it as essential for British MEPs and governments to participate meaningfully, as a 'constructive friend', in processes and debates which relate to Eurozone governance. It is essential that this meaningful engagement continues into the future, in order to build the trust necessary for British arguments to be heard at European level, whether they relate to the City of London or other aspects of the UK's economy.

25 November 2015

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Commissioner Valdis Dombrovskis—Oral evidence (QQ158-166)

Commissioner Valdis Dombrovskis—Oral evidence (QQ158-166)

Evidence Session No. 14 Heard in Public Questions 158 - 166

WEDNESDAY 27 JANUARY 2016

Members present

Baroness Falkner of Margravine (Chairman) Lord Butler of Brockwell Lord Davies of Stamford Lord Haskins Lord McFall of Alcluith Lord Shutt of Greetland ______

Examination of Witness Commissioner Valdis Dombrovskis, Vice-President for the Euro and Social Dialogue, European Commission

Q158 The Chairman: Vice-President Dombrovskis, thank you so much for seeing us and agreeing to give evidence to us today for our inquiry into completing Europe’s economic and monetary union. As you know, this session is on the record, and we will take a verbatim transcript of proceedings which will be published in due course. You will, of course, have the opportunity to correct any minor errors or misunderstandings.

Commissioner, given your pivotal role in this area, how do you see the proposals in the Five Presidents’ Report contributing to strengthening the euro and its long-term sustainability? Valdis Dombrovskis: First, good afternoon, my Lords. Welcome to Brussels. Thank you for your interest in Europe’s economic and monetary union. I will start with a short introduction and then will be available for your questions. Indeed, it must be noted that a lot has been done to strengthen Europe’s economic and monetary union since the crisis to put it on a more solid footing, to make it more resilient, but it is also clear that economic and monetary union is not complete and more needs to be done. This is one of the key areas on which the European Commission intends to work in the coming months and years. The Five Presidents’ Report, which was published last year, presents a vision and a road map for how to complete economic and monetary union by

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Commissioner Valdis Dombrovskis—Oral evidence (QQ158-166)

2025 in two stages. It is an ambitious yet realistic approach, and the stage-based approach basically differentiates between those steps that can be implemented without delay within the existing framework and others that will require more time. In essence, we believe that this gives a clear direction to the evolution of economic and monetary union, and will be important in renewing and strengthening confidence in Europe’s economy and single currency. To outline some of the work done since the crisis, fiscal and macroeconomic surveillance has been substantially strengthened, and we hope that in future it will better prevent crises through sound fiscal and structural policies. In the case of shocks, member states would need to be able to absorb those shocks internally. Resilient labour markets, flexible product markets and sufficient fiscal buffers would allow automatic stabilisers to play their full role and help to stabilise the economy. Some larger shocks may need to be shared within the economic and monetary union, both in the public and private sectors, and the Five Presidents’ Report provides some guidance as to how this can take place through institutional strengthening, setting up the euro-area fiscal stabilisation function, and advancing financial sectors through the banking union and capital markets union. We believe that this also enables us to reduce the need for public sector risk-sharing. On 21 October, the Commission put forward a package of initiatives to follow up the Five Presidents’ Report, focusing on stage 1. While developing and working on those proposals, we recognised that the future of economic and monetary union is important for all EU member states, whether ins, outs or pre-ins. Everything for the euro area therefore needs to be done transparently and through an inclusive process involving, wherever possible, all 28 member states, especially proposals that have direct links to the EU internal market. Those proposals would be open to all willing member states to join. To increase the democratic legitimacy of EU economic governance, the European Commission will ensure frequent engagement with the European Parliament and national parliaments. That is being done, primarily, and we intend to do so increasingly through the European Semester, which is the main instrument of our economic policy co-ordination. Moving to the second stage of the Five Presidents’ Report requires thorough preparation and we need to shape a consensus among member states on the way forward. We are now launching a wide public consultation on the second stage of the Five Presidents’ Report, and we intend to create an expert group in mid-2016 which will further explore the outcomes of the consultations and preconditions and proposals for longer-term action. We intend that the outcome of this debate and the work of the expert groups will feed in to the Commission’s White Paper, which we intend to present in spring 2017, where we will outline more detailed proposals for stage 2 of the Five Presidents’ Report. Thank you very much. I will stop the introduction here. I am ready for your questions.

Q159 The Chairman: Thank you. You mentioned the consultation and the expert group that you are about to establish. Are you able to give us an idea of the main elements that you expect to come out in that White Paper? Valdis Dombrovskis: As you know, the Five Presidents’ Report is divided into two stages. Stage 1 is until mid-2017 and stage 2, with more far-reaching proposals, is from mid-2017, with a view to complete the work by 2025 at the latest. This consultation and this expert

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Commissioner Valdis Dombrovskis—Oral evidence (QQ158-166) group would concentrate on the proposals outlined in the Five Presidents’ Report for the second stage. I have already mentioned, for example, the euro-area fiscal stabilisation function and euro-area treasury, and ways to make the process of convergence more legally binding. One of the main ideas of the Five Presidents’ Report is how to restart the process of convergence within economic and monetary union, which has unfortunately stalled since the crisis, and how to make sure this is convergence towards best practice and best performance. The Chairman: In broad brush, as you have mentioned, they are quite ambitious, and you have said that you expect the White Paper to come out in spring 2017. We accept that there are going to be two big political events in the same year, the German and French elections. Do you expect the White Paper to be on time, or might it be delayed until the completion of those quite significant elections? Valdis Dombrovskis: We are not currently adjusting our plans or work with a view to different elections, because in a union of 28 countries you always have elections of one kind or another in some of the countries. This timeline is already outlined in the Five Presidents’ Report and we intend to, wherever possible, stick with this timeline.

Q160 Lord Haskins: In dealing with these issues, you are going to have to reconcile different interests across the 28. I will name three. There are the different aspirations or the different realities between the ins and the outs. There are the different surpluses and deficits that sovereign states are running. For example, the Germans are running a big surplus. Everybody talks about deficits, but nobody talks about surpluses. Surpluses can be as big a problem as deficits in dealing with the issue. There are also the different labour market behaviours across the 28. To make the single market and the euro work effectively, these somehow have to be much more in harmony than they are at present. How is the Commission going to deal with those types of issues? There are many more. Valdis Dombrovskis: Of course, when deepening the EMU, we will need to address a number of questions, and already in this year’s European Semester we are taking the approach of paying more attention to the euro area’s aggregate economic and fiscal performance. This is one of the reasons we advanced the publication of the euro-area recommendations and published them together with the results of the annual growth survey in November, contrary to previous years when they were published together with country-specific recommendations. This was done exactly with a view to allow for better discussions on appropriate euro-area aggregate economic and fiscal positions, and to reflect this thinking in country-specific recommendations for euro-area member states. Indeed, you mentioned surplus as a form of macroeconomic imbalance and that is exactly what is being recognised by the macroeconomic imbalance procedure. Large and persistent current account surpluses, for example, are also seen as macroeconomic imbalance. That is why countries such as Germany and the Netherlands, for example, are also in the macroeconomic imbalance procedure and, among other things, have been advised to stimulate investment and the demand sides of their economies. Of course, they recognise that there are two sides of the coin. On the labour markets, I would emphasise that labour markets are more directly linked with the EU internal market, so it is not limited to the euro area. From that point of view, this is

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Commissioner Valdis Dombrovskis—Oral evidence (QQ158-166) something that needs to be dealt with at the EU 28 level, especially taking into account that free movement of labour is one of the four fundamental freedoms of the European Union. The Chairman: Could I follow up on that? You have mentioned Germany and that running a current account surplus constitutes as much of an imbalance as having a deficit. How do you put it into effect? Do you put in a penalty? Is it a penalty or exhortation? How do you get the Germans to deal with that problem? Valdis Dombrovskis: Regarding our macroeconomic surveillance, as you know we have a macroeconomic imbalance procedure where we assess different member states’ performance and whether or not they have macroeconomic imbalances. In the case of excessive macroeconomic imbalances there is also a possibility to put member states in an excessive imbalance procedure, which foresees a more intrusive surveillance process. It must be said that it has not been done so far and Germany has not been found to have excessive imbalances. If Germany is found to have imbalances requiring decisive policy action, the ways to address this imbalance are addressed in a country report and in a country-specific recommendation to Germany. When I was mentioning those recommendations to stimulate investment and to look at the demand side of the economy, this is exactly what is reflected in country-specific recommendations—but, as the name suggests, those are recommendations, not orders. We see a way to improve the implementation of country-specific recommendations, because it has been, generally speaking, relatively weak. We see that we can improve the implementation through more engagement with member states through more dialogue, so reaching more common understanding on what challenges we are facing. Indeed, we see that all the European Semester-related documents are also increasingly becoming part of the national policy debate. The surveillance process is gaining strength and prominence in member states’ discussions. As I was mentioning in the case of excessive imbalances, there are also mechanisms for more intrusive surveillance. Lord Haskins: But in this context, this seems to some of us to be crucial to this working. The failure of EMU the first time was that the stability pact was partly ignored by large numbers of countries, including France and Germany, and the Commission did not have the power or the will to do much about it. What is going to be different this time around to make sure that these sorts of disciplines are enforced? Valdis Dombrovskis: A number of things have been done since the crisis to strengthen economic and fiscal governance. The creation of the whole European Semester cycle is an outcome of this development. We know that a number of new legislations have been adopted, including the so-called six-pack and two-pack regulations, and basically the macroeconomic governance framework is shifting from where it was before to correct some gross policy mistakes and towards more preventive surveillance. There is quite tight fiscal surveillance, not only in the corrective arm of the stability and growth pact or in the excessive deficit procedure but also in the preventive arm. Member states are required to reach their medium-term budgetary objectives, which are defined as structural budget deficits not exceeding 0.5% of GDP or, in some cases, where member states have low and sustainable public debt, up to 1% of GDP. There are possible actions that can be taken in both the corrective arm and the preventive arm of the stability and growth pact to make sure that member states are complying with the requirements. All in all, this 151

Commissioner Valdis Dombrovskis—Oral evidence (QQ158-166) regular annual surveillance is having an impact on the member states, and average budget deficits and, by now, average public debt in the euro area are declining. We still have substantial issues with public debt, because it is still around 90% of GDP in both the EU 28 and the euro area, whereas in the treaty 60% of GDP is seen as a safe level. We continue to work especially with those countries that have excessive deficits and high public debt levels, and that is why we are continuing to have fiscally responsible policies as one of our three economic policy priorities. Lord Haskins: I certainly think that the semester approach is very good and very satisfactory. One of the witnesses we have seen said that Ministers from member states come here and engage with them and find them very interesting, and, when they go home, they throw them away. Valdis Dombrovskis: I would not agree with that assessment. We see member states correcting their fiscal behaviour and often doing so on the advice of the European Commission. Clearly, the European Semester process is having an impact on member states’ fiscal behaviour. I could get into specific examples from our experience or the previous Commission’s experience with this fiscal and macroeconomic governance, but it is probably not exactly the topic of today’s inquiry. In the assessment of the Commission, however, we are seeing a clear impact on member states’ behaviour. The Chairman: You say that, Commissioner, but we constantly come up against, for example, Italy telling you it is not going to conform, as France did for several years. How will you get Germany’s Mr Schäuble to change his policies through just a dialogue from Brussels? Valdis Dombrovskis: Those three countries are in different procedures. Let us go through those briefly. France is in excessive deficit. Indeed, it has been granted an extension on the deadline to correct its excessive deficit. There have been quite serious debates on this. The Chairman: Italy? Valdis Dombrovskis: Let me finish with France, and then I will move to Italy and Germany. Of course, it also came with conditions. France had to deliver additional fiscal effort last year and has to meet its budget deficit targets this year and next to correct its excessive deficit. It must be said that France clearly met by a margin its budget deficit target last year. It presented a budgetary plan aiming to meet its fiscal target this year. There is also a clear commitment made in public statements from the French Government to correct its excessive deficit as foreseen in 2017. There is one problem with the French approach: they are concentrating on meeting the nominal targets. Of course, in excessive deficit procedures, that is the first thing you look at. At the same time, however, they are falling short in terms of the required structural effort. Indeed, they will have to make more structural effort in the 2017 budget to meet France’s 2017 budget deficit target. As the excessive deficit procedure is designed, as long as member states are meeting their nominal targets, we are not discussing the stepping up of the excessive deficit procedure. Italy’s budget deficit is also on a declining trajectory. However, it must be said that Italy has come with additional requests for the use of flexibility clauses in the stability and growth pact. We have been making it clear in our opinion on Italy’s draft budgetary plans that we

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Commissioner Valdis Dombrovskis—Oral evidence (QQ158-166) will returning to assessment of those requests in the spring, but of course those clauses in the stability and growth pact come with certain conditions. In terms of the investment clause, Italy will have to demonstrate what additional EU co-financed investment it is undertaking. In the case of the structural reform clause, it will have to demonstrate what major new structural reforms, on top of those for which Italy already asked for flexibility in last year’s budget, it is undertaking. In both cases, Italy will have to demonstrate how, after the temporary deviation from its fiscal path, it will speed up its adjustment in the coming years, because that is what is outlined in the Commission’s communication on making the best use of the flexibility within the existing rules of the stability and growth pact. There was an additional request on the refugee crisis. The refugee crisis approach, which has been communicated to the member states—and it applies not only to Italy—is that it will be evaluated ex post on a case-by-case basis, assessing what additional significant expenditure member states are facing on top of what they had been spending in previous years. Then it will be recognised according to the stability and growth pact clause about unusual events beyond government control. We are expecting to return to the discussions on Italy’s budget in the spring, and I do not expect very easy discussions. On Germany, on the fiscal side it must be noted that Germany is found to be in compliance with the stability and growth pact, both with regard to deficit and debt rules. In the case of Germany, we are assessing its macroeconomic imbalances, namely its large current account surplus, and advising it to use some of its fiscal space to stimulate investment and the demand side of its economy. Germany has responded already throughout the previous year with several additional investment packages for both central and local government, as well as with contributions through the development banks, through the KfW, to the Investment Plan for Europe or Juncker investment plan. We will also be reassessing Germany’s performance this year, because Germany is also one of the countries for which we are doing an in-depth survey.

Q161 Lord Shutt of Greetland: We have come from the UK, and you will have spotted that we are not members of the euro. What assessment have you made of the impact upon the UK of the Five Presidents’ Report? Indeed, do you think that other non-euro states have aligned interests with each other and, in particular, with the UK? Valdis Dombrovskis: First, on the impact on the UK, stronger economic and monetary union is in the interests of both euro-area and non-euro-area member states. This is incidentally also the opinion publicly expressed by the UK Government. We understand that different member states are in different situations. As I mentioned, we have ins, outs and pre-ins, so it is important, when we undertake initiatives to strengthen economic and monetary union, that we do it in a way that is open and transparent to non-euro-area countries while preserving the integrity of the internal market. As I was outlining as a principle, initiatives related to the EU internal market should be dealt with at the level of EU 28, because it is in the interests of all member states. So far, it must be said that the UK has played a very constructive role in our discussions on deepening the EMU. There has been constructive UK support, for example, on creation of the banking union, the single supervisory mechanism and the single resolution mechanism, and those issues were discussed and decided by all EU member states. Banking union is one of those examples where an initiative that is primarily there for the euro-area countries is open to non-euro-area countries.

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On whether non-euro-area member states have some aligned interests, yes, they do, in the sense of the EU internal market preserving its integrity. But then we must recognise that member states have different traditions, histories and political systems, so there may be different positions in different situations. Also, member states have different positions vis-à- vis the euro area. We know that all new EU member states are legally bound to join the euro area. There are no deadlines or enforcement mechanisms associated with this, but still it is a treaty obligation, whereas countries like the UK or Denmark have opt-outs. Even then, the UK has a floating rate and Denmark is part of exchange rate mechanism II. It is pegging its currency to the euro. There are different situations, but one can agree that all member states are interested in financial stability and economic growth. We believe that non-euro member states are interested in a strong and stable euro, as indeed euro-area countries are interested in stable currencies in non-euro-area countries.

Q162 Lord McFall of Alcluith: Commissioner, you mentioned that the European Semester is the main instrument of economic policy. If we look at the financial crisis commencing in 2008, we see that eurozone real demand is roughly 3.5% lower than it was in the fourth quarter of 2008. How effective do you think the European Semester has been and will be in driving reform in eurozone and non-eurozone member states’ macroeconomic imbalances and fiscal policies? Should the system put more pressure on creditor countries? If it should, what type of pressure should be put on them and is there a realistic means of doing so? Valdis Dombrovskis: There are quite a few questions. First, the financial crisis indeed had a strong negative impact on Europe’s economy, but this negative impact was not limited to the eurozone. Indeed, most EU countries were experiencing financial and economic difficulties. A lot of important steps have been taken since then to strengthen economic and monetary union, and already now we have an economic and monetary union that is more resilient and able to withstand economic shocks. As I mentioned, this fiscal and macroeconomic policy co- ordination cycle, the European Semester, has been concretely introduced since the crisis, so economic and fiscal surveillance has been strengthened quite substantially. The European Stability Mechanism has been created to help euro-area member states with financial difficulties, and it has been outlined that this comes with a strict policy and reform conditionality. The banking union has been created both to reduce the risks in the banking system and to ensure that taxpayers are not first in line to pay for banking system mistakes, and the European Central Bank is using its monetary policy tools to their full potential and is now pursuing a common monetary policy. Indeed, we have already seen this stronger, more resilient economic and monetary union during the recent Greek crisis. It was a very turbulent and eventful first half of the last year, yet we saw very little in the way of spillover effects on other euro-area member states and the stability of the euro area was not questioned. This was different from what we saw in 2010 and 2011, when we saw problems in one country triggering problems in other countries. You mentioned some of the macroeconomic data. It is true that Europe and the euro area are still recovering from this financial and economic crisis. Our economic policy priorities, which are outlined in the annual growth survey, are exactly meant to strengthen this recovery and overcome the negative consequences of the crisis. That is why this year we 154

Commissioner Valdis Dombrovskis—Oral evidence (QQ158-166) basically built on the existing economic policy priorities of facilitating and promoting investment, including the Investment Plan for Europe, through having a focus on structural reforms to modernise and strengthen the competitiveness of our economies while still pursuing fiscally responsible policies. We believe that by pursuing those priorities we can strengthen the economic recovery and job creation in Europe and the euro area. To come specifically to the question of structural reforms, this is one of the key questions. Something that is, by the way, often emphasised by the European Central Bank when discussing quantitative easing or other measures is that you cannot solve structural problems in the economy with monetary policy tools alone. It is necessary for structural reforms to be done at both EU and member-state level. In terms of strengthening the recovery at EU level, we are concentrating mainly on completing the EU internal market, especially in areas like services, energy or the digital single market. At member-state level, different member states are facing different problems, but some of the recurring issues are questions related to: well-functioning labour markets, so finding the right balance between flexibility and security, using the concept of flexicurity; the long-term sustainability of social and pension systems, given the ageing population; the functioning of goods and services markets; and, in some cases, opening up closed professions. There are different issues in different member states, and that is what we are outlining in our annual analysis in our country reports, and that is what we are pinpointing in our country-specific recommendations. Lord McFall of Alcluith: You mentioned the country reports. You were Prime Minister of Latvia at the beginning of the financial crisis and had to face that crisis as Prime Minister. I have to say that you did that very successfully. Were there any recommendations emanating from Brussels at that time that were any help to you? Valdis Dombrovskis: With regard to that experience in Latvia—we are moving away from the topic of today’s discussion—in 2008 Latvia was severely affected by the global financial and economic crisis. Due to a number of domestic factors before the crisis, like an overheating economy, macroeconomic imbalances and a worsening structural fiscal balance, Latvia was one of the hardest hit countries in 2008 and 2009. In 2008 Latvia had also applied for an international loan programme to the European Commission, the IMF and several bilateral lenders. The policy conditionality of this programme was outlined in the relevant documents, like the memorandum of understanding with the European Commission, letters of intent with the International Monetary Fund—and, of course, we had been in a process of intense discussions with the lenders. At the end of the day, we managed to reach an agreement and strategy that allowed Latvia to recover quite quickly. In the second half of 2010, Latvia was back to year-on-year growth, and in the following years it was one of the fastest-growing EU economies. One of the important elements in this—here one can make some comparisons, for example, with the Greek experience—was that in Latvia we had a front-loaded programme, meaning that we had already done the bulk of the adjustment and structural reforms during the crisis, especially in 2009. Of course, it was a very difficult adjustment, but it allowed us to regain financial stability quickly, which allowed us to return quickly to economic growth. Greece was following a different strategy; it was trying to delay that adjustment, basically using the Keynesian argument that fiscal adjustment, austerity, is bad for economic

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Commissioner Valdis Dombrovskis—Oral evidence (QQ158-166) growth—which is no doubt true, but the point was that by postponing the adjustment Greece was also postponing the return to financial stability. Without financial stability, it was not able to return to economic growth. From that point of view, we saw that the result was a deeper and more protracted recession and the need for adjustment not becoming smaller but bigger. In terms of fiscal adjustment in percentages of GDP, by now Greece has now done more than Latvia did during the crisis years, but it is getting much less credit for that. Lord Davies of Stamford: Why? Valdis Dombrovskis: Because we saw this protracted recession, and because we saw a certain loss of confidence in the Greek economy from the creditor side and the investor side. Eventually Greece had to do more, but it is a fact that the public perception was that somehow not enough was being done. Also, we saw in 2014 that Greece was back to economic growth. It had quite good job creation. It was delivering on fiscal targets. It was tapping financial markets. We were discussing with the Greek Government at the time how, with the help of some kind of precautionary programme, Greece would return to market financing. Political developments led it elsewhere, and while at the beginning of last year our forecast was 2.5% growth for Greece, now we know there was hardly any growth at all last year. Once again, we clearly see this link between financial stability and economic growth. Greece lost financial stability once again in the first half of 2015, to the extent that it had to close down its banks, and it had a heavy negative effect on economic growth. Of course, it also showed the other side of the coin. If Greece keeps its programme on track and successfully concludes the first programme review, which is basically starting now, there is a good chance that the Greek economy will be able to recover quite quickly. We saw in 2014 that the fundamental preconditions for economic recovery are there. By restoring financial stability and confidence, Greece can get back to growth quite quickly, and one can expect some positive surprises on the economic growth side. Lord Davies of Stamford: Is no bailout or debt forgiveness required, in your view? Valdis Dombrovskis: As you know, Greece is now in its third programme. There is an agreement that is also reflected in euro group conclusions that the question of Greek debt conditionality will be addressed after successful completion of the first review. Greece’s creditors and other eurozone countries are ready to address this question and look at and address debt conditionality while excluding a nominal haircut. That is the current state of play.

Q163 Lord Haskins: Commissioner, coming back to the five Presidents’ letter, written by five very distinguished people, it has not been properly tested in the consultation process. Nevertheless, our impression, I think, is that it has been reasonably well received—as far as it goes. The problem is that there is no beef with this proposal up to 2017. The problems arrive thereafter. We have picked up evidence that there will be quite severe opposition particularly to structural reform in certain labour markets and, to an extent, to financial discipline. Within the Commission, being an EU institution, there are different voices coming out. How do you propose to work your way through, on the one hand, getting the Commission to speak with one voice—this is in phase 2—and then getting the Parliament to speak with one voice, and finally getting the Council to speak with one voice? Can you see your way through that?

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Valdis Dombrovskis: To come back to the Five Presidents’ Report, I mentioned that it has an ambitious yet realistic approach. By “realistic approach”, I mean exactly that there are different opinions among different member states and different stakeholders about what is the best way forward. Regarding stage 1 of the Five Presidents’ Report, it has all in all been received relatively well. In December the European Council tasked the Council with following up on the initiatives in the first stage of the Five Presidents’ Report quickly. The Dutch presidency has quite ambitious plans for this and I hope there is going to be good progress during the Dutch presidency. That is the first stage. On the second stage, when I mentioned the process of public consultation, this is exactly with a view to building a consensus on the way forward. Clearly, we are aware there are different views and different assessments. That is why we are having this process of public consultation. We will be engaging closely with the member states and an expert group will take an in-depth look at the proposals and the outcomes of those consultations. But one thing seems to be emerging already: on the one hand, there is a demand for more solidarity, risk-sharing and mutualisation, while on the other there is a demand for more control and more sovereignty-sharing, if you like. If we are going to deepen economic and monetary union, those two elements, risk-sharing and sovereignty-sharing, will have to go hand in hand. The more we engage in risk-sharing, the more important it is that all member states involved in those mechanisms follow the same rules. That is why we will need to find a balanced approach between those two tendencies. Lord Haskins: But we have been told that there is not much space, under present treaty arrangements, to carry out the next phase of structural reform. We are almost certainly going to face treaty change in phase 2, are we not? Valdis Dombrovskis: That is certainly possible. That is also recognised in the Five Presidents’ Report: that those more far-reaching proposals outlined in stage 2 may require treaty change. Lord Haskins: Are you are confident we can win that argument? Valdis Dombrovskis: If we look at some of the proposals in stage 2, they seem to go beyond the scope of the current treaty. In this case, the Commission has to be ready to propose relevant treaty changes and justify them.

Q164 Lord Davies of Stamford: Mr Vice-President, you have been giving us an upbeat message and things appear to be going positively in the European Semester, in Greece, and so on. What about your progress on banking union? Are you optimistic that there will be agreement on a mutualised retail deposit reinsurance system such as has been proposed, despite the very well-known opposition of a rather large and important country in the Union? Valdis Dombrovskis: First, I have one factual comment on the European Semester and Greece. It must be noted that Greece and Cyprus are not subject to the normal governance procedures of the European Semester. Those are programme countries, which means that their governance is done through the programme documents. Lord Davies of Stamford: I said you were bullish about the European Semester programme and about Greece, not the two together. I did not suggest that.

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Valdis Dombrovskis: Okay—very good. Sorry for that. To move to the actual question on the banking union, a lot of work has been done already. The single supervisory mechanism is in place. The single resolution mechanism is in place. The single resolution fund has started to work. Agreement was reached at the end of last year for bridge financing for a single resolution fund, so we are able to move forward. But when the banking union was created, there had already been discussions on its third element, which is a European deposit insurance scheme. This is exactly what the European Commission is now putting on the table. We have filed a legislative proposal on the creation of a European deposit insurance scheme using a gradual approach and starting with a system of reinsurance. It is clear that this proposal has received a mixed welcome. Some member states very much favour this proposal and are willing to move forward; some are more hesitant or reluctant. Lord Davies of Stamford: The Dutch presidency has taken it up, which must be encouraging. Valdis Dombrovskis: Exactly. The Dutch presidency is taking it up, and Germany’s argument is on the question of sequencing, about which I have been in extensive discussions with Finance Minister Schäuble. Before we engage in additional risk-sharing, we need measures to reduce risks. We will need to discuss the exact sequencing. In any case, we are proposing, alongside our legislative proposal on a European deposit insurance scheme, to take and assess measures to reduce risks in our banking systems. To avoid moral hazard and so on, it is important that member states implement existing agreements, meaning the bank recovery and resolution directive and the deposit guarantee schemes directive, and this is exactly a precondition that we put in our proposal: only those member states that had done their homework, so to speak, by transposing the directives and had fully funded national deposit guarantee schemes, to the extent prescribed by the directive, will be eligible for the European deposit insurance scheme. I believe there are a number of elements in our package that help to address the concerns raised by Germany and several other countries. The Chairman: Commissioner, how are you doing for time? Valdis Dombrovskis: Time is running out, gradually. The Chairman: Do you have 10 minutes more, potentially? Valdis Dombrovskis: My agenda seems to be busy. The Chairman: We were under the understanding that you would be with us until 4.30 pm. Valdis Dombrovskis: Our programme says 4 pm. The Chairman: I see. Valdis Dombrovskis: Let us stick with 4.15 pm—so we have seven minutes—and be efficient. The Chairman: In that case, Lord Davies, do you want to pick up on fiscal union? We see that as quite important.

Q165 Lord Davies of Stamford: Yes, I would. Mr Vice-President, there are three basic views about fiscal union, as I understand it. First, there are the hardliners, the disciplinarians, who think that all that needs to be done is a very telling and tough structural reform programme, and very tough limits on fiscal deficits and sanctions and so forth, and that is the end of the story. Then there are those very generous-minded people concerned with solidarity and other concerns, who think we should have a full transfer union, rather as individual member 158

Commissioner Valdis Dombrovskis—Oral evidence (QQ158-166) states currently have. Those in the third category think a full transfer union is not necessary—or indeed desirable, probably—because it would create dependency syndrome. It is necessary to have the public sector contribute to the stabilisation process by developing some stabilisers to use in the case of asymmetric shocks. For that purpose, a number of ideas have been put forward, including one that we heard about this morning from Bruegel, about a reinsurance fund to reinsure national unemployment funds against cyclical unemployment increases. Another suggestion made by the Ghent Financial Law Institute is for an EU-based mini IMF working on similar conditionality principles, providing liquidity when it is required in a crisis and so forth. What do you think of those proposals? What are their merits? What are their chances of being adopted? Do you have any ideas for developing a mechanism so that there would be some public sector contribution to stabilisation in the event of asymmetric shocks? Valdis Dombrovskis: First, on the question of fiscal union, according to the understanding outlined in the Five Presidents’ Report, fiscal union will have both elements you have mentioned: a sound fiscal and macroeconomic governance framework, ensuring that member states follow the same rules, and potentially moving towards more joint decision- making at the EMU level. It would also imply a euro-area fiscal stabilisation function to help deal with large asymmetric shocks. Both elements will need to be in place. On how exactly this fiscal stabilisation function should be made, we know that this issue is still being debated. For example, the Five Presidents’ Report mentioned the European Fund for Strategic Investment as a possibility. Of course, we cannot just copy and paste the fund as it is, because its decision-making is non-political. Projects are evaluated based on their merits and so on. But the idea that you use investment as a fiscal instrument to deal with asymmetric shocks is a very valid one. An idea mentioned in the four Presidents’ report was this EU-wide, or euro-area-wide, unemployment guarantee scheme. At this stage, this proposal has not been evaluated much more deeply. Part of the broad consultation process and the work of the expert group will be to assess the most relevant methods of fiscal stabilisation. You mentioned this European IMF. This certainly is not a scientific comparison, but we have the European Stability Mechanism exactly to assist euro-area member states in financial difficulties. From that point of view, a big step has already been taken.

Q166 The Chairman: In the concluding two minutes, I might just go to governance. Do you see the existence of the eurozone being more formally reflected in the institutions? For example, do you foresee a eurozone parliament? How do you see the interests of non- eurozone countries being protected? Valdis Dombrovskis: With regard to the institutional settings, we see this being part of stage 2 of the Five Presidents’ Report. For example, there could be more functions for the president and possibly permanent president of the euro group. Normally, from the Commission’s point of view, we are not going deeply into discussing the working methods in other EU institutions, so this question should still primarily be addressed to our colleagues in the Council. Regarding the European Parliament, as President Juncker has outlined, we already have a European Parliament, and this can also act as a parliament for the eurozone, adjusting its working practices. From our side and that of the Five Presidents’ Report, we do not see proposals for setting up another euro-area parliament. We think the European 159

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Parliament can play this role, addressing the concerns of euro-area countries and providing democratic oversight of the euro-area policies. The Chairman: Commissioner, thank you so much. This concludes our meeting. You have been very generous with your time and we very much appreciate your having taken the time to discuss this very important matter with us. Valdis Dombrovskis: My Lords, thank you very much for your visit and for your interest in those economic and monetary union developments. As I said, part of our agenda of deepening the EMU also means deeper engagement with European and national parliaments.

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European Economics Financial Centre—Written evidence (EMU0009)

European Economics Financial Centre—Written evidence (EMU0009) by Prof. H. Scobie on behalf of European Economics & Financial Centre

1- Deepening the European Monetary Union for those member states within the Euroarea could be a worthwhile cause to overcome some of the difficulties of managing the single currency area. However, those EU member countries outside the Euroarea should be watchful of some of the problems that have arisen already that could continue in the future when the deepening of the EMU occurs.

2- The first issue to be addressed which has direct implications for the City of London is highlighted in the paragraph below in a section of the Five Presidents Report headed “Democratic Accountability, Legitimacy and Institutional Strengthening”. It states:

“At the height of the crisis, far-reaching decisions had often to be taken in a rush, sometimes overnight. In several cases, intergovernmental solutions were chosen to speed up decisions or overcome opposition. Now is the time to review and consolidate our political construct – and to build the next stage of our Economic and Monetary Union.”

3- The origins of the financial crisis go to the United States when the failure of subprime mortgage lending had emerged. These loans were bundled, then securitised and sold to funds in Europe and elsewhere – hence started a financial crisis that affected the global economy. That is not to say that there were no other areas of mismanagement in Europe. Following these developments a mountain of regulations have been imposed on European financial institutions including the City of London. These regulations have slowed the operation of day-to-day tasks considerably and have made difficult the ability of the financial sector to operate effectively.

4- The regulations advanced so far do not help the consumer either. They have become counterproductive in the sense banks are not willing to lend much to consumers or SMEs.

5- While sometimes regulation can be necessary and if there is wrong-doing, it has to be punished, the whole of the financial industry cannot be used as a scapegoat for the irresponsible or at times fraudulent behaviour of a few. In simple common sense terms, since public opinion has turned against the financial services sector, they have to endure excessive regulations and discrimination against them.

6- At present financial market participants have to read masses of regulation and translate them in practical terms in their day-to-day operations.

7- The onus placed on smaller firms by the excessive burden of regulation puts them at an unfair disadvantage. Whereas the larger financial institutions can afford to employ an army of lawyers and compliance officers to work on the new regulations, smaller firms cannot 161

European Economics Financial Centre—Written evidence (EMU0009) afford this luxury. Thus, their market professionals, for instance their fund managers, have to spend a great deal of their time (which otherwise would be devoted to portfolio selection) - trying to understand the legal text of these documents which are often incomprehensible. These regulatory documents are written by lawyers for lawyers and are hard to decipher what their actual message is. Moreover, the new rules have substantially reduced the ability of financial firms to make profit and pay high taxes to the government as they used to do.

8- The Five Presidents Report also states as one of its objectives a deepening EMU plan to boost competitiveness. This is in line with the UK government’s stated objective as part of the reforms requested by the UK prior to the referendum timetable before 2017. Therefore, pursuit of this objective is beneficial for Britain.

9- An area of concern in the work of the EU is surveillance. The Five Presidents Report states:

“Euro area governance is well established for the coordination and surveillance of fiscal policies.”

10- Sadly the surveillance in the Euroarea has not been working effectively and has impeded the recovery in the Euroarea. Below is an example witnessed by the unemployed youth in Europe.

11- In 2013 the European Council allocated a sizeable fund for member states to help with their youth unemployment.During the subsequent months and years the European Economics & Financial Centre has tried to work with many Labour Ministries in different Euro-area member countries toward creation of youth employment. The Centre offered these Ministries proposals to help with Youth Unemployment. At the same time, worked with a large number of graduates across the EU who were unemployed and were keen to adopt EEFC’s Scheme for Youth Employment, entitled “Work Ticket”. EEFC attempted to work with at least 6 member states’ Labour Ministries.

12- Besides EEFC’s proposal the Centre together with the young graduates tried to find other forms of help from the labour ministries. None of the graduates received any help whatsoever despite their numerous efforts and were totally disappointed and demoralised. Hence large youth unemployment remains in continental Europe. Indeed there has been little surveillance as to what happened to the funds allocated for youth unemployment by the European Council.

13- In this respect if the UK government were to be asked for new funds by the European Council for new schemes in the future, in the process of deepening the EMU there is a likelihood of poor surveillance and the UK could receive little benefit from it.

14- Finally it has to be said that he European Central Bank is the only organisation in the Euro-area that has been working effectively and efficiently. Its operations have been managed well, given the difficulty of managing the diversity of 19 member states with 25 Governing Council members. Their policy-makers have good interaction with the financial community in the City of London. On the whole the presence of the ECB is a plus for the

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Euro-area and the UK. If a future Euroarea Treasury could operate as efficiently as the European Central Bank then its establishment would benefit both the Euroarea and the UK. It will help avoid financial crises caused by budgetary mismanagement of different member states.

3 December 2015

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Markus Ferber MEP and Kay Swinburne MEP—Oral evidence (QQ82-91)

Markus Ferber MEP and Kay Swinburne MEP—Oral evidence (QQ82-91)

Evidence Session No. 7 Heard in Public Questions 82 - 91

Members present

Baroness Falkner of Margravine (Chairman) Lord Butler of Brockwell Lord Davies of Stamford Lord Haskins Earl of Lindsay Lord McFall of Alcluith Lord Shutt of Greetland ______

Examination of Witnesses

Markus Ferber MEP, Vice-Chair, ECON (DE, EPP) and Kay Swinburne MEP, ECON Member (UK, ECR)

Q82 The Chairman: Can I welcome you, Ms Swinburne? Thank you for agreeing to give evidence to this inquiry into completing Europe’s economic and monetary union. As you know, this session is on the record and we will take a verbatim transcript of proceedings, which will be published in due course. You will of course have the opportunity to correct any minor errors or misunderstandings. I wonder if I might kick off. We are slightly pressed for time, so we thought that Mr Ferber could join our discussion when he arrives. I wonder whether you could give us your assessment of the Five Presidents’ Report and the actions introduced in the shorter term by the European Commission in its document of 21 October. In doing so, I wonder if you could also cover the long-term sustainability of the euro in your response. Kay Swinburne: That is no problem at all. Thank you for the invitation. It is good to come back. It is the second time I have given evidence to you in Brussels, along with a couple of times in the House of Lords itself, which shows that you are coming from both sides. It is nice to see you and for a Committee to take an interest in what we do here. It is nice that the UK engages. I can tell you that you are the House that engages, as opposed to the other one, which is a little more difficult to get to talk about some of the issues we deal with here. In terms of the work here, I am able to talk from the perspective of being a co-ordinator on one of the political groups. The European Conservatives and Reformists Group is now the third largest in the Parliament. We have a significant number of members on the ECON committee. I can talk both collectively for them as a group but also individually for me as a British Conservative Member, where my perspective is probably a little more about how we

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Markus Ferber MEP and Kay Swinburne MEP—Oral evidence (QQ82-91) make sure that what the eurozone does, and what the non-eurozone members get affected by, is clear and distinct. That is not always clear within the documents that are produced. A particular example of that would be the Five Presidents’ Report. The Five Presidents’ Report is very clearly aimed only at the eurozone. It is clearly a eurozone document; it is clearly about the EMU and what actions they have to take, but often it interchanges “Europe” with “the eurozone”. Some of the language is a little problematic at times, and it should be a lot more carefully used. More than that, because it was quite roughly put together in terms of that language, it is now potentially being misused. Certainly, in the ECON committee, it is referred to in the context of “the 28” quite often, which causes us some frustration. If we get sloppy in allowing this to be used for single-market purposes rather than specifically the eurozone, it could be problematic going forward. It is a slight criticism, to put it into context. The issue for me is that the Five Presidents’ Report is just that: it is five individual men, in this case, who have sat down and written a report. It is not a democratically accounted for document. The individuals concerned may have had a mandate from their individual institutions by being a president, but they did not have a mandate to write this report. It is very clear, from the Parliament’s perspective, that what President Schulz has written here is what President Schulz felt, not what the Parliament thinks. Actually, that causes me some concern. It is a democratically elected house and for it not to have come before us, before it was given as the Parliament’s view, is particularly problematic. Even though I agree with much of the content of the document and the aims and ambitions for the stability of the eurozone, the way in which it has been undertaken leaves a lot to be desired. Sadly, the democratic house is the one that has the biggest democratic deficit in getting to what has been put into it. Markus Ferber may have a slightly different take on it, but it concerns me that that is the case. The Chairman: I can see Mr Ferber has arrived. Mr Ferber, join us here. I am sorry to interrupt you, Ms Swinburne. Do continue. Kay Swinburne: My biggest issue in the way it has been constructed is that five individuals and their teams have constructed it and brought it together. But, if it were a Commission document, as we would normally get a draft from the Commission, it would have to have been impact-assessed and it would have to have had a cost-benefit analysis to it. You would have to have done all the risk assessments on it. As it is five presidents acting in their capacity as presidents, it has had none of those things done to it. If we have to take this as a document, I question whether it has the legitimacy that we might want a document to have. Lord Haskins: Why did they do it that way? Kay Swinburne: It was for speed: they felt it was important that this came out quickly. It was important for them to have a united front. If you had to take it through the Parliament, with 750-odd Members, I suspect that united front would not have been quite so united. That would be my interpretation. Lord Haskins: Is the Parliament quite divided about it?

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Kay Swinburne: The Parliament is divided about it, not just along national lines but along political lines. We have a socialist President right now and he has a particular view, which may or may not be shared by others. I suspect that Mr Ferber here will have some views, given that he is a fellow countrymen and in a different political party. Markus Ferber: But I am not a socialist. Kay Swinburne: Yes. There are some weaknesses here and, therefore, it is unfortunate that they took this route. A Commission document has the legitimacy of the treaties to bring forward initiatives and then for us to work in a democratic way on them. For me, that would have been stronger. The Chairman: Could I stop you there to pick up something you have said? The way we look at it, it seems that the Five Presidents’ Report is a road map; it is a general overview of the direction of travel. When and if this is translated into specific measures, of course at that point there will be impact assessments, will there not, when it becomes legislation? Kay Swinburne: Yes, on individual pieces of legislation. The Chairman: In that sense, your concern about impact assessments will be dealt with further down the road, will it not? Kay Swinburne: Yes, but it is a very difficult way to go if you have already decided the direction without having any form of impact assessment as to the direction of travel you are aiming in. I would have liked those to have been at least tested before they set the very definite direction of travel.

Q83 The Chairman: Mr Ferber, good afternoon. I am Kishwer Falkner, Chairman of this Committee and its inquiry into deepening economic and monetary union. The question we had started on with Ms Swinburne was an overall assessment of the report and whether you think the follow-up paper of 21 October has significant things it says or omissions. Also, could you give us an overview of whether you believe this points towards the right things we need for the long-term sustainability of the euro? Markus Ferber: First, thanks for the question. Secondly, I am sorry for being late, but I had a so-called shadow meeting on the European Semester and I had quite a similar fight, which was a right-left issue, on how the economy can be improved and how macroeconomic imbalances can be reduced. You can imagine the left is asking for more state, more state and more state, and I am coming from the other side, the right side, which is asking for more responsibility for member states to adjust their systems. That is why it was not possible for me to leave in time. I am sorry about that. On the concrete issue, to be honest, this so-called five Presidents’ report is something that is in the sky. Of course, those five presidents have responsibility, but none of them ever asked their structures. Mr Schulz never asked the Parliament; Dijsselbloem never asked ECOFIN; Juncker never asked the commissioners; Draghi never asked anyone. That is known. It is in his mandate that he is not obliged to do so. Tusk did not ask the Heads of State. But now it is in the world. There are these lovely procedures in Brussels—I am sorry for saying this— whereby, if something is born, it is like Christmas Eve: everyone says, “Wow, a new baby is here”, but no one knows how to deal with it. That is one of those challenges.

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To give you one idea, when we had responsible Commissioner Hill in our committee presenting the EDIS, the deposit insurance scheme, I asked him what had changed since the hearing when he said that in 2019 he would make some proposals according to the existing legislation. He said, “Well, we have the Five Presidents’ Report”. So it is alive. It is not recommunicated to any of those five bodies represented by those five presidents, but it has an impact, and that is one of those crucial issues about how things sometimes develop here. Therefore, for me it is a study or a paper—we have a lot of them, from economic structures, trade unions or whomever—but it is up to us as politicians at the end of the day to go to conclusions. Therefore, it is good that the Parliament and Council, as co-legislators, can do whatever they want beyond the Five Presidents’ Report. That is our obligation. For us, it means that, on the EDIS, which is the only concrete legislative proposal for the moment, we will stick to what has been agreed. That means that member states first have to establish deposit guarantee schemes, and then we will take a look at that.

Q84 Lord Shutt of Greetland: You have both had a similar tale, in a way. You are concerned that this report has not evolved from democracy. However, it says that democracy and legitimacy have to be one of the four pillars of their report and how it goes forward. If it is important, how is that happening? Do you see that working well? What is the balance between the European Parliament and the national Parliaments? What about the ins and the outs, as far as the euro is concerned? Are we going to have two Parliaments or a little section of the Parliament that just deals with this issue? How do you see this? Kay Swinburne: The ECON committee has already discussed at length in the last mandate whether it was legitimate for non-eurozone members to have an equivalent vote on the committee on eurozone matters. It was debated at length whether we would go down the President Schulz route of establishing a separate committee for the eurozone, which would exclude non-members of the eurozone from being full members of that committee. The committee voted to exclude that as a possibility, and it was decided fairly strongly that it should all be done within the mandate of the ECON committee as a whole; that no member should ever be excluded from being a participant in any matter concerning the European Parliament; and that to discriminate in any way would be inappropriate. That decision was taken in the last mandate and was supported by the whole plenary. I would hope that that idea has been squashed once and for all within the European Parliament. There was the intention of creating this two-tier system, which was rejected by all political groups, unless your recollection is any different. Lord Shutt of Greetland: Is that because the thinking is that the outs will be in tomorrow or the day after? Kay Swinburne: The issue is that the vast majority, bar two countries, already have an obligation to join as and when their criteria meet the requirements, and they already follow all the rules of the EMU in order to be potential future members, so to exclude that group would have been inappropriate. But it was also felt that to create a special circumstance for those two countries that have an opt-out from using the currency would be inappropriate. It is very much in that line of discussion where our Prime Minister in the UK is currently negotiating: to make sure we have this ability to have more than one currency recognised. If 167

Markus Ferber MEP and Kay Swinburne MEP—Oral evidence (QQ82-91) two countries have a permanent opt-out, you cannot always refer to just a single currency. You will always have to have arrangements that include those who do not use the euro as the currency of their choice.

Q85 Lord Haskins: Coming back to the first question, you did not answer the question we are really interested in: is the EMU sustainable in the long term? If it is, does the Five Presidents’ Report help in any way to make it sustainable? Markus Ferber: It is more a political issue than a question on the content. In the German Parliament, we sometimes have the same discussion as ECON had in the last period as to whether a European Parliament representing all 28 member states, and not only those 19 joining the monetary union, has the right to decide. It is not yet an official proposal, but I always have this discussion with my colleagues in the national Parliament in Germany, for example. On the other hand, if you look at the treaties, in the EMU, the Council or the Eurogroup decides unanimously and the Parliament has only the right to give an opinion. If you speak about this democratic approach, all the things that are linked only to European monetary union are legitimised by national Parliaments, not by us. For example, the European stability mechanism was never an issue in our committee; it was never an issue in the European Parliament. It was an issue in 19 national Parliaments. It is the Deutscher Bundestag which agreed on the ESM, never the European Parliament. If you look at the treaties, what is a European responsibility and what is a national responsibility is clearly defined, especially on those things that are fully, 100%, linked to the European monetary union. On the other hand, even before the British Prime Minister brought up this point, we tried to deal with it in the way that those general rulings that have an impact not only on the monetary union but on the single market as a whole should be done as a single-market issue, where we have full legal rights—that is, the European Parliament, together with the Council. Of course, that applies to 28 member states, whether they are ins, pre-ins, opt-outs or whatever, or even if they do not know whether they will become a member of the European Union. There are a lot of possibilities. Our approach was always not to have this distinction between the ins and the outs, but to say what is of importance for the single market. To come back to the actual proposal, of course a deposit guarantee scheme on a national level, with national responsibility, is needed in the single market, not an insurance scheme. Therefore, whether it is of benefit for the EMU or not, it has to be done as there is a need for the single market. That is a good approach. The Council did not always follow it, but in the main files we treated it as a single-market issue for all 28 member states. Kay Swinburne: The very direct question is: is the EMU sustainable? Yes, I think it is, because it is a political project above all else. Where there is political will and the intent to maintain it and keep it, it will be there. We have seen over the last few years that, when it gets very difficult, people find solutions and are prepared to take moves they might not unless circumstances are against them. We are going to see that time and time again, because, ultimately, this was not an economic construct; this was a political project from the very outset. It is recognised as such here. 168

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None of us would start with a clean sheet of paper and devise what we have currently. We all know that. Everybody who has participated in any of the discussions here knows that. But, yes, it is sustainable, because of the politics behind it. Lord Haskins: It took the 2008 crisis to make politicians concentrate on the failures of their original attempts. Kay Swinburne: There are not many national politicians who, without the financial crisis, would have taken some the moves they did. It focused people’s minds as to what was important and what they wanted to see continue. Ultimately, the politics of it were that they wanted anybody who was an existing member of the eurozone to be maintained as a eurozone member.

Q86 The Chairman: Mr Ferber, do you believe that it was merely, or principally, a political issue rather than an economic one? Markus Ferber: Of course, you have to come from the birthday, which was the Maastricht Treaty, and the negotiations on the Maastricht Treaty started in the late 1980s. Coming from Germany, of course it was the time of unification, although there never was an official link, to be honest. Chancellor Kohl and the Finance Minister Theo Waigel—he is a good friend of mine; he comes from the same region as I come from—always said that there was never an obligation for Germany to deliver the Deutschmark on a European level. However, if you consider the mood of the late 1980s, it sought to construct a political union, which the Maastricht Treaty failed to do, and a monetary union, in which it did not fail. From birth, it was a political concept, and its birthday is the Maastricht Treaty. This part of the treaty has never been changed by all the other treaties later on. That is the first point. Secondly, the decisions were taken from 2010 onwards after the bankruptcy of Greece. It was not the financial crisis; it was the single-market issue. We did a lot of legislation, but, starting from 2010 onwards, when Greece was bankrupt and we had the decision to keep it in or throw it out, it was visible that it was a political concept where member states are granting things they never would have agreed to in a treaty, to be honest. Coming from Germany, although we are one of the beneficiaries of the single currency, we would never agree a treaty which says, at the end, we have a bail-in procedure—although it is said that there is no bail-in. We would never have agreed to spend €22 billion from the German budget to guarantee a stability mechanism that gives credits or loans to other eurozone states and all this stuff that has been established. Therefore, I fully agree with what Kay said: it is a political concept. If there is a need for it, euro member states agree to deliver what they would never have delivered voluntarily. I think it is sustainable, because they know what to do and they did what was necessary. The Chairman: And they will do whatever it takes from now on. Markus Ferber: This wording came in a phase when member states had already agreed to €500 billion in the ESM. It was clear that no national Parliament of these 19 was willing to grant more money, but, on the other hand, there was still some pressure on the euro via Greece. It was the European Central Bank that then made a statement, saying, “If the states are not able to deliver more, we are able to deliver more—whatever it takes”.

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You have to see it together with the EFSM and the EFSF, the first stability mechanism in 2010, the European stability mechanism, and then the last bazooka. That was the time the markets asked for a bazooka. I am sorry for using this word; it was not invented by me. It came from the financial world. The bazooka was created by the ECB. “Whatever it takes” is the bazooka. We have €500 billion safe, and whatever it takes above that the European Central Bank is ready to deliver. See it in this context, please. Do not see it as standalone.

Q87 Lord Davies of Stamford: How successful has the European Semester been so far in enforcing greater budgetary discipline and contributing to the reduction of risk and the stabilisation of the eurozone? Markus Ferber: To be honest, we have not been very successful in the European Semester, because the European Semester tries, with the country-specific recommendations, to ask member states, especially in the macroeconomic area, to change things that they have decided. These did not fall from heaven. There was a decision from national Parliaments to do it this way or that way. Now there come these country-specific recommendations, saying, “You are doing this wrong”. What is the normal reaction of all member states? They say, “We are not doing it wrong. You do not understand us”. They do not change their policies. That is one of the main problems. The second problem—now I have to speak politically—is that we have a commissioner from France who was Finance Minister in France in a period when France should have established reforms and did not. If you look at the actual economic forecast from the European Commission, it is really blaming France for not doing any reforms. Surprisingly, we have a French commissioner, who campaigned for the French president—he was the leader of the campaign and then he was Finance Minister—who is not putting pressure on the most crucial country. The crucial ones are not Greece or Cyprus. The most crucial one is France and number two is Italy. As they are large member states, as they are founders of the European Union and as you need them for a lot of other problems, the Commission is not fulfilling its obligations. In this game, the Commission is the referee, and the referee has to give a yellow or a red card: “You are doing wrong”. That is how we changed the stability and growth pact. Under this revised qualified majority, the referee says, “You should get yellow”, and then the Council can say, “No, this time it is not a yellow card”. The old rule was that the Council says, “We are giving you a yellow card or a red card”. We changed that, and now the referee is not going into his pocket and pulling out the yellow card, or even the red, for France: “Stop this and this”. If the referee fails, you have a problem. That is the main problem I have. If Mr Juncker says, “We are a political Commission, so we decide on political circumstances”, it cannot play the role of a referee, because the referee has to be neutral and stick to the rulings. Therefore, we have to invent something. Germany is thinking about how, for example, structures that have already been established—such as this independent economic advice, which is a part of the Commission— can be strengthened. We need an independent structure that is able to give a yellow card or a red card. That is the main problem we see at the moment: the Commission is not fulfilling its role.

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The process as a whole is something we could develop in a way that—as you asked about the European Semester—really allows us to make bad developments visible as early as possible. The idea of the semester is to make problems visible before they create a mess. The old stability and growth pact said, “The member states do their budgets and after the year we look at what happened”. In Greece, as we learned, they did whatever they wanted to do and it had nothing to do with the rulings, but we saw it too late. Therefore, we need an independent structure that says, “You are doing it right. You are doing it wrong”. That is the problem I see at the moment: the Commission is not fulfilling this obligation. Lord Davies of Stamford: The Commission has responded to that line of questioning or criticism, first, by bringing forward the whole process and intervening earlier in the annual cycle and, secondly, by suggesting the creation of this European Fiscal Board, which would be independent of the Commission in my understanding. Does that meet your requirements or not? Is it sufficient? Markus Ferber: No. Lord Davies of Stamford: If not, do you think we should go further? If so, how much further should we go and in what direction? Kay Swinburne: The Parliament proposed bringing the timings forward. It came from the Parliament, not the Commission. Markus Ferber: Yes, but the problem is about what is going to happen at which stage. The European Semester idea is to check, even in the long run, before a problem occurs, whether they are on the way to creating a problem. Therefore, we have to think whether these country-specific recommendations are really the right tool. It is about the competence of the member states to adjust their systems. Lord Davies of Stamford: What would the right tool be? That is what I am trying to get out of you. How would you do it better? You have made a lot of very trenchant criticisms. Markus Ferber: To give you another idea, which I do not support, some member states are now asking for fiscal capacity, which means asking for additional money from Europe or the eurozone to create a eurozone budget. I fully disagree with that; Germany disagrees with that concept, but we will have discussions in the house as well. Lord Davies of Stamford: Do you have any concrete proposals? Markus Ferber: Yes, a concrete proposal is to say, “You have to do something in your state that has a volume of whatever”. For example, France might say, “We need a volume of about €40 billion a year”. The response might be, “But it is your decision, as the French Republic, with your national competences, as to how you will organise that to achieve this volume at the end”. That would be more concrete—because you can really check it—than these country-specific recommendations. For example, every year in Germany we are told we have to change our vocational training; on the other hand, we have the lowest youth unemployment. I do not know why we have to change it. I am sorry, but the Commission is not able to give me an explanation for that, to put it the other way around. The Chairman: Mr Ferber, I am advised that I need to reiterate to you, as you might have missed that section, that we are on the record. 171

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Markus Ferber: Yes, I know that. The Chairman: I very much appreciate your candidness. We are getting a good picture of the debate. Markus Ferber: I know that. The Chairman: I am very glad we are here, but I am told I just have to let you know that. Markus Ferber: I have it directly in front of me. The Chairman: Yes, indeed. Markus Ferber: Do not worry. The Chairman: Ms Swinburne, do you agree with most of that? Kay Swinburne: I am slightly less harsh than Mr Ferber. The initial semester analysis, for the first couple of years, has been poor. I think it has been recognised and there have been moves to improve and to beef up the teams involved on the ground, going into each member state. I understand the quality of the individual assessors who produce the country-specific reports is improving. In certain areas, I have feedback from experts, particularly economists, saying they think there is an improvement in those who are coming to discuss and have dialogue. There is more of a willingness to understand the underlying issues, rather than just the superficial statements and statistics they can gather. As we know, in the UK we always have the issue about housing. We know we have a shortage of housing. Reiterating it in every country-specific report does not help. There seems to be some form of criticism of every action we take to try to improve the situation. That also does not help. To now have a level of expertise going in is a little better; that is, not just talking about the absolute number of houses required, but looking at the underlying factors that are limiting it, realising where the limitations are and, therefore, maybe being less critical and more constructive in their remarks on other areas. There has been a strengthening in the process; there has been a beefing-up of the teams; the expertise has improved. It is going to be a while before we see that come through as improved quality in the output. I suspect the problem with these is that we see the output only every year. If they do not have it quite right the first time they try, it is another year before we see the output again. It is a difficult thing to be too critical, given that we know they have made some changes, and they needed to make them. I am with Markus Ferber here that they needed to make them, but I am a little more cautious that maybe they have some of it a little better than they did.

Q88 Lord McFall of Alcluith: Kay, you mentioned earlier that when things get difficult we see political movement. The European Parliamentary Research Service has shown that few country-specific recommendations are followed. How big a problem is this for the credibility of the whole governance process? Kay Swinburne: It is a problem, and it goes back to what I have just said: they were not specific enough in the early days of the semester. Lord McFall of Alcluith: What do we need to do now?

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Kay Swinburne: What has happened is that they have improved the quality of the economists and the people going in to do the country-specific visits. I understand the dialogue is of a much better calibre and far more granular than it previously was. Therefore, I would hope that means the next CSRs coming out will be far more relevant to the market they are referring to. That would be my hope. If they do not have it right, they have to go back to the drawing board and start again. The metrics they were using were not appropriate, and I think they have gone and revisited those. I just hope what they are now proposing is going to work this time around. Lord McFall of Alcluith: Are you as optimistic as that, Mr Ferber? Markus Ferber: I am an optimist by birth. I hope I can keep that, even working here. I have been here for more than 20 years as a Member of the Parliament. Seriously, yes, this is the right way to improve it. On the other hand, we have to take care that, with this more granular approach, we are not judging too many competences of member states. Macroeconomic policy is still in the hands of the member states, and that has to be taken into account. We have different ways of financing social security. You have a tax finance system and we have a contribution finance system, with all the implications coming out of that. You want to keep your system and we want to keep our system. You would never agree if Brussels was asking you to change it; we would never agree. But, inside the system, maybe you can make some adjustments. Sometimes it is like the process of a company asking one of the Big Four to give them advice. They know what to do, but they need pressure from outside to do it. We should deal with the European Semester like that. You know you have some imbalances, you need to do something, and you take that outside advice showing that you have to do it. It is not about saying, “Why the hell is the Commission dealing with our problems?” That way, you will do it right, as with the external advice a company asks for from outside, although they already know what has to be done. Lord McFall of Alcluith: Both of you seem to give your evidence as if you are outside the process, commentating on it. I am interested in what you could do as parliamentarians, what the Parliament could do to get a grip on it and take some ownership of this, rather than waiting for things to happen and then, four years later, hey presto, we have not moved. We have to be more granular. Kay Swinburne: Part of the reason changes have happened is because the Parliament, through the ECON committee, does an own-initiative report every year. There are two annual own-initiative reports, one on the AGS, the annual growth survey, and the other on the semester. We have an annual report on both of those, where we have a rapporteur and a full negotiating team, who put together a report. They are often critical, depending on who the rapporteur is and whether the political meaning comes out. Those get done on an annual basis. That is our opportunity to basically look at that year, particularly the country-specific reporting, and say, “Is it relevant? Is it having an effect? Is it granular enough?” We have been putting pressure on through that process. We also have various things we do, including the inter-parliamentary meetings, which are coming up now, where we as the committee will sit with our parliamentarian colleagues from national Parliaments to discuss key topics. Certainly, AGS and semester are always key

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Markus Ferber MEP and Kay Swinburne MEP—Oral evidence (QQ82-91) topics on that agenda, and they will always be key talking points within the debates we have in that inter-parliamentary space. There are some big things we are taking part in. Do we have a direct role? No. We have a scrutiny role, which we are trying to engage in. When it comes to co-legislation arrangements, we obviously help set these up, but we are now in a role where the annual report is probably the main instrument we have. At any point, though, we could do an own-initiative report, if we felt there needed to be more drastic action, where we would, as a committee, come to the position of calling on the Commission to alter course. At the moment, I do not think there is much appetite. There is more of a feeling from the centre and left of the house that this needs to be given time to be seen to be working before we are too critical of it.

Q89 Lord McFall of Alcluith: The European Deposit Insurance Scheme was briefly mentioned there. I know Germany says treaty change is necessary in order to implement greater risk-sharing plans, but how confident or otherwise are you that we can get a solution to this problem and break the negative feedback loop present between sovereigns and their banks? Markus Ferber: If you look at the existing directive, only half the member states have implemented it, although the implementation date was July last year. If you carefully read what has been agreed, at the end of the day, when all 28 member states have proper systems in place, fully equipped, fully financed, then we can discuss an insurance mechanism. The Commission is now proposing that those that have already established national systems should stop paying into the national system and start financing a new structure, and the others that have not yet done anything should do the same. That is not appropriate. I am fully in line, as is Germany, with the idea that was agreed in the last period: to say that every member state starts and, if they have well-equipped systems, then we can base a reinsurance system on that. The other thing is, if you really want money to be transferred from one system to another, according to our German understanding, it is a bail-in procedure, which can only be done unanimously, not with a qualified majority in the Council. That is what Germany will ask for, and we will even go to the court.

Lord McFall of Alcluith: It seems a perfect negative feedback loop, because the information is that the recommendations under the European Semester are poor. That has been acknowledged. But it has fallen since the European Semester’s inception. Given that background, you are saying, “Only half of the members have signed up. Wait until we have the perfect day, when everyone is signed up. Then we are going to make some movement.” It is a yellow-brick road approach to it, is it not? Kay Swinburne: They have all signed up. It is just that they have not actually implemented it. They are signed up. They have committed to doing so. Lord Haskins: That is one thing. Lord McFall of Alcluith: There seems to be a clause in here that we are waiting to get a perfect state, if you do not mind me saying that. Markus Ferber: What is a perfect state? Lord McFall of Alcluith: You are going to hang back, because you do not see it coming soon.

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Kay Swinburne: The Commission should now be enforcing the implementation. It has the mechanism by which to do so. Banking union is three pillars. It is not just the deposit guarantee scheme. Lord McFall of Alcluith: I understand that. Kay Swinburne: We have not yet had time to really absorb the big link between the sovereign and funding of the banks. The supervisor was key to all this. With the SSM, and with the ECB taking that key role, we should not underestimate how completely and utterly transformational that is, how important it was for the system that it happened and how much resistance there was from individual member states to losing it, for the very reason you outline, in terms of breaking that link. That was seen as the crucial point of breaking that link: the single supervisor. We have that established. It is working reasonably well. In terms of scrutiny, we hear from colleagues who sit on various panels scrutinising it that it seems to be working very effectively right now. There is room for improvement, but it is working effectively as a new organisation. The SRM is also now functional. That whole resolution mechanism is the next tool for any of those banks that do not make it through. If this all fails, you then need the deposit guarantee scheme. To look at it in isolation may be a little unfair, because these have been two big pillars. It has taken a huge amount of political sign-up to get this far. Actually, if they both work, we will not need a deposit guarantee scheme; we are not going to get the failing institutions because we will have already had the early indicators and then the intervention by the ECB through the SSM. Lord McFall of Alcluith: It is a bit of a rosy perspective. That is why I have focused on Markus. Germany is the big issue here. Markus, how far down the line are we talking about this being up and running with the 28 fully oiled? Will it be, say, five years or seven years? Markus Ferber: The plan was for it to be by the end of this century—I mean decade, sorry— by 2020. 2019 was the date to check whether the systems are properly functioning, but, as Kay said, the deposit guarantee scheme is one pillar, and there are three pillars on which the banking union is founded. Lord McFall of Alcluith: Do you see the German veto prevailing? That is my last question. Markus Ferber: First, we have to clarify whether there is a veto possibility. If you have a qualified majority, you cannot veto if you are alone. Our estimation for the moment is we have only one or two small member states that are with us, which is not a blocking minority. In that case, we will go to the court and the court will decide whether it is a single-market issue with qualified majority or a bail-in issue with unanimity among the Council. Do not ask me what the outcome will be. The Chairman: Lord Davies, did you want to come in on this point? Lord Davies of Stamford: Yes. I am very concerned by what I think Markus has just told us. Perhaps colleagues already knew, but I did not. Germany is going to insist that, before any drawing is made on an eventual reinsurance fund for retail deposit insurance, there should be unanimity; in other words, there should be an individual veto. That seems inexplicable to me, unless the intention is to sabotage the whole project, because the whole purpose of this reinsurance scheme and the mutualisation is to establish credibility in normal circumstances, so you do not have people much more worried about placing a deposit in Romania than in 175

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Germany and you therefore do not have a higher cost of capital in the more problematic member states or weaker member states, which would be perverse. Markus Ferber: Yes, but it is easy to resolve. Lord Davies of Stamford: Let me finish, please. The Chairman: Mr Ferber, as you answer, I am conscious of the time. Could you just give us a very brief answer? Then I want to move on. Markus Ferber: If there is a change of the Commission proposal, there will be a change of the German position. I do not see the need for this proposal. That means we should come back to what has been agreed, which is the German position that member states create these deposit guarantee schemes nationally for their system. Lord Davies of Stamford: Markus, do you accept that if there is an individual veto by one country the whole scheme has no credibility, because in a crisis people would say, “Well, the Germans will veto this, so therefore our bank deposit is not actually being backed by the European Union as a whole; our bank deposit merely depends upon the solvency of our national Government”? So you are back to square one. Markus Ferber: While nothing is agreed, the existing directive is in force. Nothing is written down; the existing directive is in force. I am asking member states like the Netherlands, where they are not implementing it, to do so. The Chairman: Thank you. If there is anything more or you have any other ideas on that one, we would be delighted if you would write to us.

Q90 Lord Butler of Brockwell: Could I come on to European capital markets union? Is that possibly a more realistic route towards completing the union? As a possible alternative to some of the others, would it be a more realistic route towards achieving either the banking union or the fiscal union? Kay Swinburne: For starters, I do not see the CMU project as being a eurozone project; I see it as a project of the single market. It is very much the 28, not however many members may be in the eurozone at that particular point in time. Fundamentally, no, I would not agree with that. However, there are many things here. From the regulatory reaction we have had since 2007–08, in terms of capital being held by our banks and the way in which we have now instructed them on a global basis to hold more capital and therefore, for the stability of the system, taken some of the liquidity out of it, it has become apparent that Europe was over-reliant on bank lending, particularly within its SME sector and its medium-sized sector. We need to find more diverse alternative streams of funding. For me, the crux of capital markets union is finding out how we make capital markets funding relevant to all 28 countries. It is easy to sit in the UK, with the City of London there as a beacon of capital markets, and think that everybody understands why capital markets funding is important. Other member states do not have advanced capital markets; many of them do not have any funding streams other than basic stock exchange listing and would never think to use a corporate bond issuance or any other mechanism to get funding into their real economy. It is important that we understand that, for the 28 to feel the relevance, we have to put systems in place to help them understand what they might actually take part in. 176

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We are looking at some very innovative platforms occurring in places such as Estonia and elsewhere, where they do not have a traditional culture of capital markets. They are now looking at things like private-placement platforms, crowdfunding and other peer-to-peer platforms, and various fixed-income products that can be used across platforms electronically. There are some fascinating advances happening. CMU should be there to facilitate it; it should be there to stimulate it. It should get people thinking about what they can do as an alternative to an over-reliance on the banking sector for all types of funding going forward. If we free up some of those large growth companies and larger entities that need to raise hundreds of millions of pounds, or euros, from bank balance sheets and bank lending, we should then have more capacity in the bank loan book for the SME sector and those smaller companies, for which it may not be ever appropriate to go to the capital markets, but which need that source of funds to come. This is about rebalancing the way in which we finance the European growth strategy. It is important that we see a way forward on that for the 28. Markus Ferber: CMU is—and this is what the Parliament asked for from the very beginning—a project for all member states. It is a single-market issue. It has nothing to do with European monetary union; it is nothing to do with the euro. It should create a single market for all these financial needs we have. To give you an easy example, as a German working here, I am not allowed to buy a house with my German bank, but I will never find a Belgian bank to finance my house. As I am with a local bank, they say that outside this area they do not do financing, as they do not know anything about the circumstances in Belgium or the legal situation. However, for the Belgian banks, as my income goes to my German bank, they will not finance me because they do not have any information on my income. This is to give you an easy example, not to mention financing companies, especially those that do not have access to the financial markets for the moment, which is a crucial thing. Lord Davies of Stamford: Would the proposed directive deal with that problem specifically? Markus Ferber: I hope so. I do not think so, though. Kay Swinburne: The CMU is a strategy, which will be implemented through various directives and regulations. Markus Ferber: The CMU is an issue for 28 member states, so it is really a single-market issue. We do not have a single market in the financial world as the United States is a fully integrated financial market. We do not have that, and we need it, on a European level, not a euro level. The Chairman: Mr Ferber, would you accept that it is also very helpful to the eurozone? Markus Ferber: No, it is not a eurozone issue. The Chairman: But it facilitates the embedding of economic and monetary union. Markus Ferber: No. Kay made some remarks and I may add something. A well-developed financial market like the UK market will benefit more from access to the continental model than the continental model itself will benefit from access to other markets, to be honest.

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Q91 Earl of Lindsay: Can I ask you both what you think full fiscal union or fiscal union will mean in practice? How important will that practice be and how will it operate? Will it involve a full transfer union if it is properly to support the EMU in the long term? What sort of oversight and democratic accountability could be exercised to link its practice with the European people? Markus Ferber: I am not in favour of the concept of fiscal union. The Chairman: Please tell us what your reservations are, briefly. Markus Ferber: Your second part already tries to solve a problem I do not want to create. Earl of Lindsay: Please explain. Markus Ferber: I am sorry, but I cannot answer the second part as it is not my concept. Therefore, I am really a fan of the US system. Every level—local, regional, state and federal— has its obligations and its finance tools to fulfil the obligations. This system would create a European mess. Coming from a country like Germany, we have so-called Länderfinanzausgleich. I cannot translate this word. It is the exchange of money between the 16 Länder, which weakens the strong and strengthens the weak. Transferring this to the European level is an unacceptable concept for me. I appreciate the approach in which you have responsibilities on a European level, on a national level, on a regional level and on a local level. You have to give each structure its access to fulfil these obligations. The fiscal union creates a mess of responsibility, which means that, in the end, no one wants to pay but everybody wants to get the money. I do not like that system. The Chairman: Ms Swinburne, did you have any closing remarks in that regard? Kay Swinburne: Certainly talking to my colleagues in Parliament, we are not yet politically close to fiscal union acceptance. There is a lot of resistance to it. As the pressure is easing in terms of us returning to a slightly more normal situation with regards to the economy, the incentives will disappear. It will take the next crisis for us to get closer to any more fiscal union. That is my personal view. Interestingly, in the Five Presidents’ Report, they had three descriptors of what it is not. They said it is not a permanent transfer between countries; it should not undermine incentives for sound fiscal policymaking; and it is not an instrument for crisis management. Markus Ferber: But they did not say what it is. Kay Swinburne: They did not say what it is, and that is the critical point here. Nobody knows what would be politically acceptable. If I had three economists in a room, I would have at least four different answers as to what it should be. We are back to the original problem of when the euro was constructed and the EMU was devised. Nobody really knows what the endgame is. We are continuously pushing at the envelope to find out what is acceptable at any particular point in time for people to have a more stable macroeconomic environment. Earl of Lindsay: You do not see this going very far very fast, then. Kay Swinburne: As you have seen over time, it goes very slowly when there is no crisis. When a crisis of one kind or another appears, there seems to be an increased speed of progress.

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Markus Ferber: We have to take care that there is democratic legitimacy as well as responsibility if you are not able to spend the money. If that is broken—and this is my concern with a fiscal union—you are doing something really wrong. I do not see how Germany could agree on a treaty change in a direction that would allow systems such as the Länderfinanzausgleich. Kay Swinburne: I would also say that this is not specific to Germany. There are many other countries that have severe reservations. Markus Ferber: I know Germany best. I am sorry about that. The Chairman: Thank you. We are slightly over time, so I have to bring this session to a conclusion. Thank you. That concludes the public part of the meeting. The Committee will meet in private from now on.

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David Gauke MP and Jonathan Black—Oral evidence (QQ195-204)

David Gauke MP and Jonathan Black—Oral evidence (QQ195-204)

Transcript to be found under Jonathan Black.

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Sylvie Goulard MEP and Gunnar Hökmark MEP—Oral evidence (QQ92-100)

Sylvie Goulard MEP and Gunnar Hökmark MEP—Oral evidence (QQ92-100)

Evidence Session No. 8 Heard in Public Questions 92 - 100

TUESDAY 26 JANUARY 2016

Members present

Baroness Falkner of Margravine (Chairman) Lord Butler of Brockwell Lord Davies of Stamford Lord Haskins Earl of Lindsay Lord McFall of Alcluith Lord Shutt of Greetland ______

Examination of Witnesses Sylvie Goulard MEP, ECON Member (FR, ALDE) and Gunnar Hökmark MEP, ECON Member (SW, EPP)

Q92 The Chairman: Thank you, Ms Goulard and Mr Hökmark, for agreeing to give evidence today for our inquiry on completing Europe’s economic and monetary union. As you know, this session is on the record and we will take a verbatim transcript of proceedings, which will be published in due course. You will, of course, have the opportunity to correct any errors or minor misunderstandings. I also appreciate, Mr Hökmark, that you have to go promptly at 5 o’clock. We will try to get through as much as we can in this session. My apologies for starting a little later; our previous session overran.

I wonder whether I can kick off by asking you both to give us your overview of the Five Presidents’ Report and the new measures announced on 21 October in support of that report. In particular, looking at this overall, do you believe the euro area will become more sustainable in light of that? Were there any omissions in the report that you would wish to see corrected? Gunnar Hökmark: Thanks very much for inviting us. It is a very interesting time at the moment. My simple view regarding the European economies is that we are in a period where we have seen a rapidly emerging global economy, supplying and offering new competition of a kind that we had never seen before. It is a fundamental change. Without misusing the word “paradigm”, you can say it is a paradigmatic change. It has a number of 181

Sylvie Goulard MEP and Gunnar Hökmark MEP—Oral evidence (QQ92-100) consequences. We see, for example, something that is a problem for more or less all central banks: inflation is becoming lower and every economist is worried about inflation coming down. Normally, it was always a problem when inflation was coming up, because that was a sign of economic weakness. We tend to read it in the books of Keynes. The books of Keynes were very simple: they said that, when the economy is lagging behind or losing speed, if you stimulate it—you put a little more gasoline, so to speak, in the economy—by increasing the demand side, you thereby achieve inflation, which is a sign of increased demand, and suddenly the machine starts going again and people get employed, et cetera. In the last 10 years, we have seen that this is not really working. That has very much to do with how the global economy is changing the opportunities for and the role of central banks. If you meet with very rapid new supply, which puts your competitiveness under stress, of course the best thing is not to perform a policy where you are increasing taxes and increasing your own wages and production costs. If you increase the demand side of our economies—and they are quite big, because all European economies have deficits, which is, in our normal reading, a way of stimulating the economy—then you are increasing the demand, but, if you are not competitive, you are increasing the demand for someone else’s products. Then you have the negative current accounts, which is, in reality, the core of the economic crisis, more or less, in most European countries, in and outside the eurozone. To be short on this point, this means I am more relaxed about the proposals from the five Presidents. I do not see that these are solutions to that. Some of them are relevant; some of them are relevant for the eurozone as such in other ways, but not as a way of solving the acute economic problems we have, which mean we need to recover competitiveness. In that sense, I fear sometimes that the report is creating an alibi for not doing the things we need to do. The Chairman: Indeed. Ms Goulard? Sylvie Goulard: First of all, I am sorry, but I do not disagree so much with you on your starting point. We can spend a lot of time being inward-looking but, if you look at how the world evolves, the key question is not so much the differences between the eurozone and non-eurozone; it is the competitiveness of this continent and it is the capacity to innovate in order to stay at the top in many fields. This is the first point. The second point is this: if you remember, this report was adopted during the Greek crisis in June. There was a political message in adopting this report, saying, “We want to continue. We want to defend the integrity of the eurozone and we also want to make reforms”. Of course it is not enough as such. We do not have inflation, but we have inflation in the number of Presidents in the report. The next one might be the six Presidents’ report. We now need to deliver, and to deliver bold reforms, not only for the eurozone, because we have one institutional set-up for all 28 member states of the EU. The Chairman: Do you both see this, essentially, as a political project? What is your view on what the report says about governance and the institutional framework it sets out? Gunnar Hökmark: If I may be a little heretical, I would say that, while everything we do is political, there is a tendency in this house, as in most other parliaments, to have a higher level of interest in the architecture and the design of an institution than the policies that come out of it. I feel that, if we look at the European economy, the difference here is not between euro-ins and euro-outs, because we saw the same pattern in a number of different 182

Sylvie Goulard MEP and Gunnar Hökmark MEP—Oral evidence (QQ92-100) countries. It is very easy to blame the euro. We had a meeting with the Minister of Finance for Cyprus yesterday. He was very clear, saying, “For us, it was not the currency; it was the wrong policy”. If you spend too much, it does not do more damage because of the currency. This is a very core, simple way of defining the problem. If you look all over the Union, when the UK entered into deficits, it was obviously not because of the euro. When Latvia, which was at that time pegged to the euro, entered into deep problems, it was not because of the euro; it was because they lost control of their spending. But they were also able to come back, and they made a lot of courageous and decisive changes. In some way, I see that the eurozone as such needs some rules that are relevant for the currency. That is the backstop regarding banks, the single resolution mechanism and, to some extent, the single supervision mechanism. However, that does not mean that, for example, a discussion about capital markets is related to ins and outs. We all need functioning capital markets. It is a good thing to be a little more relaxed about the currency, but a lot of politicians all over Europe, in or out, love blaming the euro for their problems. It is easier for those who were in government, who spent too much. They can say, “It was the euro”. It is easier for those who dislike the euro to say, “It was the euro”. Every time you do that, you miss the core problem. If you perform the wrong policies, things will move in the wrong way; if you perform the right policies, you will tend to move more in the right way. Sylvie Goulard: I am a little bit puzzled by the use of the word “political”. If you ask me whether European integration is a political project going beyond the single market, I am sorry to disagree with the presentation made by your Prime Minister, because it is, and has always been, since the beginning, more than just a single market. You can read the Schuman Declaration again. Of course, the euro was one of the ways that was conceived, at least, after the fall of the Berlin Wall, to increase the links between the members. There is a political goal. If you look at the way the European Council is making decisions, the role it is playing now is at a very political level. It is at the highest political level, with the representatives of all our countries at the highest level. Here, I am a little puzzled. It is a political discussion, which means that very often you do not take the right decisions and you do not make the right policies. I do not know what you really mean by “political”. If it means it goes beyond the currency, beyond the economy, beyond the single market or free-trade area, the answer is yes. By the way, the crisis—and not only the crisis of the eurozone but also the lack of progress in the single market, with the 28 member states—is amazing, because even when we produce the rules it is very difficult to make sure they are implemented. The Chairman: That is the reference. That is what we were searching for. Sylvie Goulard: You mean the second aspect? The Chairman: Yes, the latter. The framework is established for several things. It always has been since the Maastricht Treaty, but the member states disregard, ignore or wilfully pursue policies that are contrary to the agreements. Sylvie Goulard: Not only in the economic field. The Chairman: That is what we meant by “political”. That was the thrust of my question. Sylvie Goulard: If “political union” means a way to violate the treaties, I am not in favour of a political union. 183

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Q93 Lord Haskins: Mr Hökmark, I understand your views about the euro. What would your position be on Sweden and the euro going forward? Gunnar Hökmark: I am a friend of the euro, and I am very market-economy orientated. It is a good thing to have the same currency. I know a lot of my close allies in the UK do not have the same instant feeling. Once again, though, I bring it down to the idea that it is a mistake to blame currencies for problems that are caused by political decisions. To some extent I am an economist, and I have never understood these discussions about “optimal currency union”. I do not know whether Sweden is optimal for anything. We have the north with the forest industries; we have with the service industry; and we have Gothenburg with the shipping industry, et cetera. It is much more a matter of adapting policies to the reality. My experience is that, for a long time during the 1970s and 1980s, when to some extent the main problems of the European economies were founded, in the times of stagflation, inflation and devaluation were a way of leaving the room by the back door instead of taking responsibility for the decisions you needed to take. What happened was that European Governments did not take the responsibility. The whole Lisbon process was, in this sense, lost: the goals were good, but you were not forced to fulfil them, because you could always leave the door open for devaluation. When France and Germany did that, it opened the door for others because it was easier at the time. That is why I believe in stricter rules. I am a supporter of Sweden joining the euro, especially when things are sorted out a little more. Sylvie Goulard: As a footnote, you are committed to it, as one of 26 member states. This is a very important point to make, above all in front of British people. You do not have a eurozone with 19 member states and the EU 28. You have the EU 28 with two member states having an opt-out and 26 committed to join, which was part of the conditions for accession. Gunnar Hökmark: We are committed to it, but I would like to underline that Sweden is one of the few countries that are fulfilling another thing we are committed to, which is the stability pact. I would like to remind my colleague that not all countries do that. Sylvie Goulard: You know my battle in France on that. The Chairman: We are familiar with the agreements, but there are question marks over the pace at which all those 26 will come in. Indeed, some might question whether they will all come in. Q94 Lord Shutt of Greetland: It is quite interesting. We heard from a couple of your colleagues an hour or so ago who, at this stage in the meeting, were telling us that this Five Presidents’ Report was a gift that had come down upon them and nobody in the Parliament had had anything to do with. Therefore, there was a sense of, “How legitimate is it?” and so on. Yet, in this report, it very much talks about democracy and legitimacy and so on. Where do you stand on this? Is it moving in a way such that it and the matters connected to EMU are becoming more democratic and legitimate? Gunnar Hökmark: The problem in Europe is that, as soon as we refer to things that are happening in the European Union we always say, “The European Union is responsible”. We never say, “Sweden is responsible”; we say, “A political majority is responsible”, if you see what I mean. We have a very clear division of responsibility when we talk about our normal, 184

Sylvie Goulard MEP and Gunnar Hökmark MEP—Oral evidence (QQ92-100) national politics. As soon as there is a proposal coming up inside the framework of the European Union, it is always the European Union that is to blame. As you say, it is a democratic process. This is a proposal that has come up, which is a function of a lot of discussion in the different political groups, but it is for sure under discussion and it will not be a decision until member states and the Parliament accept it. A lot of water will flow along the rivers of all the European capitals before that is done. Sylvie Goulard: I just wanted to say that it is the five Presidents’ report—no more, no less. They do not speak on behalf of the institution they are chairing; they speak for themselves. On the other hand, it does not mean that they cannot properly identify some issues, of which one is democracy. Four years ago, I wrote a book with on these issues9. I fully share the idea that we need to improve democracy in the European Union. The fact that this might be said by a group of people who are not democratically elected does not seem to me to be an argument not to read the report.

Q95 Lord McFall of Alcluith: How has the report played at home? Does it pay sufficient attention to the needs and interests of the home countries? The Chairman: What are your interpretations of how it is seen in France and Sweden? Sylvie Goulard: I can tell you that in France last year we were preoccupied with other subjects. There was not a huge discussion around the Five Presidents’ Report. On the other hand, I am quite sure that part of the increase in support for populist parties has to do with the frustration created by the lack of democracy. It is very difficult, because you will never have people in the street fighting for democracy at a European level, but you cannot say that it is not something feeding the negative feelings towards Europe. The Chairman: Mr Hökmark, what is the debate like in Sweden? Gunnar Hökmark: If you ask anyone in Sweden what they think about the Five Presidents’ Report, or the five chairmen’s report, they will wonder which chairmen. In Parliament, this has been a subject of discussion for the relevant committees. It is a rather relaxed discussion. We do not believe in these national competition boards, for example. Regarding fiscal union, we think taxation issues will be a national competence for the foreseeable future. It is rather a pragmatic point of view. There is no feeling anywhere that here is a solution to the problems. Some things can be relevant for the euro and some countries as such, and some things can be a good discussion for us all, but not very much more than that. Lord McFall of Alcluith: Do the proposed next steps in the report pay enough attention to non-euro area countries? Are political and national institutional safeguards needed? Gunnar Hökmark: If you have a currency, you need to have special institutions for that currency. That has nothing to do with the economic policy as such. That has to do with the safeguarding of the currency; that is the backstop regarding banks and some other institutions, as we have seen emerge lately. That is good and relevant, but the main problem the report is addressing is the overall economic policy. The overall economic policy is the only way of dealing with the different instabilities we have in Europe. That is not done by financial regulations; that is done by a healthy economy working, growing and employing people. In that sense, it is dangerous, and I am very much opposed to this, when people

9 Sylvie Goulard and Mario Monti, De la démocratie en Europe (Paris: Flammarion, 2012) 185

Sylvie Goulard MEP and Gunnar Hökmark MEP—Oral evidence (QQ92-100) sometimes talk about dividing the eurozone from the rest, or the rest from the eurozone. In reality, it would create new borders and new fragmentation, which we have invested a lot in avoiding. If you take the internal markets or the financial markets, the strength of these markets lies of course in the fact that we have them together. It is very important to differentiate what is really a banking union issue from an issue for the Union as such.

Q96 The Chairman: Could I press you a little on the Swedish position on the “E” in economic and monetary union, the economic part of it? In your engagement with the discussion in the eurozone, do you see it more as a single market or do you see it more as a deep economic union, even if you are not ready to come into it right now? Gunnar Hökmark: Your question is too advanced for me. First of all, I would say that, if you had a referendum or a proposal to the Parliament today, it would be a no, for different reasons. For the time being, there is no popular support for the euro. There is also a rather broad understanding that there is a need for the eurozone countries to come to stability and to deal with their problems and show they can be dealt with. If you are asking me about those who, from a long-term perspective, are supportive of this, I would say that the “E” is a deepening of the economic integration that comes along with the internal market. If you have a single market, it is quite a good thing to have the same currency. We have good experiences of having the same currency in Sweden, in the north and the south. Being relaxed, that applies to the single market that is now emerging. Sylvie Goulard: One should remember that we are all living in the European monetary union. That is the reason why you have British MEPs voting on euro area questions, et cetera. You can agree or disagree with it, but the current framework is a single framework for everybody. That is the first remark I wanted to make. The second one is this: there is a big difference, in my opinion, between what we want to achieve and what might happen. I really believe that no one wants new fragmentation or to split the Union, but my experience from the ECON Committee, of which Gunnar is also a member, is that sometimes you take a decision because it is necessary, like the banking union. It was necessary to consolidate the eurozone; it was part of the big package. Then, of course, you suddenly face the fact that you might have 19-plus member states on one hand, and then the others. Even if the intention is not to create a gap or a new dividing line, it might happen. We should be more honest about this with each other. You cannot make the sovereign choice not to be part of the euro and then complain that you are not in the majority or the driving seat. You are free to join. This is a contradiction, and we have to make sure that we all accept the consequences of the decisions we take. It is possible to be in; it is possible to be out. But, at a certain point, the way the eurozone evolves or what is required for the banking union creates a dynamic, and you are part of it or you are not. Gunnar Hökmark: I very much agree with that. Of course, we are all a part of it. The stability pact applies in different ways to the member states. When we use the phrase “banking union”, it is important to remember that the banking union is not really dealing just with the eurozone. It is mixture of things. The SSM and the single resolution mechanism are, yes, but the bank recovery and resolution directive is applicable to us all. I was responsible for that

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Sylvie Goulard MEP and Gunnar Hökmark MEP—Oral evidence (QQ92-100) and I dealt a lot with the British Government, as well as other Governments, when we were trying to get that in place. Lord Haskins: You could argue that the British would be the biggest beneficiaries of banking union. Gunnar Hökmark: Yes, you could argue that, for very many different reasons. Lord Haskins: It is the biggest criticism that goes on within Britain: that these financial markets are not as open as they should be, and banking union would resolve a lot of the criticisms in Britain. Gunnar Hökmark: That is a view I certainly can share. Just now, we are trying to make progress on the banking structural reform, which involves the British Vickers legislation. A lot of the things we talk about under the theme of banking union are, in reality, finalising the single market on financial affairs. Sylvie Goulard: Here, if I may, we are in the field of the single market. Some member states—the UK with Vickers, the French and the Germans—adopted legislation. Is it really a good solution that we adopt national legislation in something that can be identified as a single-market issue? It is the other way round. We are now obliged to take into account the fact that we have national legislation, although our common goal would be to create a level playing-field.

Q97 Lord Davies of Stamford: I have agreed with everything that Mme Goulard and Mr Hökmark have said so far. I particularly agreed with you, Mr Hökmark, when you said that the fiscal crises we have had were nothing to do with the euro. Certainly, a country that borrowed as much as Greece would have had a fiscal crisis whatever currency it borrowed it in, as I remember saying at the time on several occasions. In the European Union, we have now introduced a series of initiatives designed to make it less likely that we have that sort of fiscal crisis again: the two pack, the six pack and the European Semester. How would you rate the success of those initiatives so far? By “success”, I mean the extent to which they reduce the risk of further fiscal crisis in the future. Should more be done and, if so, what? That was three questions, really. The Chairman: Answer briefly, please, if you could. Gunnar Hökmark: The two pack and six pack have done a lot more than one sometimes imagines. They are part of the recovery in a number of our economies that have been driven, supported and incentivised to lower their debt and their deficit. We can see the emergence of development not only in Spain and Portugal but also in the Baltic states. It is very clear that this has emerged. It also has importance for a number of other countries that are dealing with deficits, because it is certainly felt that you cannot increase the deficit as easily as you could before. That is one of the best steps we have taken to put a strong stability pact in place. Regarding the European Semester, it is good and it is worthwhile that we look at broader economic circumstances, currency accounts and a number of other issues, although they are not binding in the same way. In spite of the fact that very few are living up to the rules of the new stability pact, it is still creating a framework in which you are stimulated to reform and do the right things, instead of avoiding them. Lord Davies of Stamford: Do you have any further suggestions as to what we might do?

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Sylvie Goulard MEP and Gunnar Hökmark MEP—Oral evidence (QQ92-100)

Gunnar Hökmark: It would be good if we could see that we are living up to the regulations we have before we have new regulations. Sylvie Goulard: I was one of the rapporteurs for the two pack and the six pack, so I know them quite well. First of all, the goal was to rebuild trust. To a certain extent, you have what is in the package and the fact that the package was adopted. They are two different things, but it was absolutely necessary at the time. The second interesting element in the six pack is the new procedure for macroeconomic imbalances. We look beyond just budgetary rules; we give the Commission the opportunity to look at the real economy. Here we come back to the point you made at the beginning: the real economy matters. Take the exchanges with member states like the UK. I do not remember the name of the independent organisation in the UK that evaluates the Government’s hypotheses for budgetary rules. The Chairman: The Office for Budget Responsibility. Sylvie Goulard: This was introduced here. The European Parliament introduced the role of the national parliaments in the semester. You have small improvements, but each of them is not completely uninteresting. The two pack provides a framework and a programme for the countries, because previously there was absolutely nothing. It was a fair-weather system, in which there was no idea that a member state could come into a programme. This was also important. I would not say it is a masterpiece, but some elements of it were useful. If I had one wish, it would be, first of all, to respect it—and I battle in France for that—and, secondly, to simplify it. The system is too complicated. When rules are too complicated, the legitimacy of the rule is not there. We observe too much flexibility in the way the Commission is applying these rules, in my opinion. I really believe we need to go towards balanced budgets and reduce the debt, so I am not happy with the use of flexibility. Gunnar Hökmark: I very much share that view. If I could add one thing that could be done, it would be—I do not remember whether it is the two pack or the six pack—stronger requirements on national budget legislation. That can be developed, in the medium term and long term, to ensure you have surpluses. That is hinted at now in the legislation, but— Sylvie Goulard: It is in the macroeconomic imbalance procedure. Gunnar Hökmark: Yes, that could be clearer. Sylvie Goulard: The speed of it should be taken into account. Gunnar Hökmark: That could be very good, because if you have zero or if you are minus two and you are entering an economic crisis, you can have whatever regulation you want. It does not help. The regulation as such is playing the most important role at times when the weather is good.

Q98 Lord McFall of Alcluith: We have had a discussion with a German colleague before on the European deposit insurance scheme. It seems Germany is a roadblock to that. If I can summarise what he says, it is that we should wait until all 28 countries have it up and running smoothly; then we have reduced the possibility of risk and we can get on with it. It seemed to me that that is an awful long way off. It is a bit of a dream. Is there a harder edge to it? Do you see that European element being adopted quite soon?

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Sylvie Goulard MEP and Gunnar Hökmark MEP—Oral evidence (QQ92-100)

Sylvie Goulard: Being one of the rapporteurs, I hope so. Once again, we have to go back. When the Heads of State and Government decided to create the banking union, the third pillar was this deposit scheme. The second element is that the monopoly of initiative is with the Commission. We have a text. I know the sensitivity of the topic in Germany. This morning I had all the German banks in my office. On the other hand, many of their concerns are legitimate and not German. We should not put a flag on this. The question is: how can we make sure that we find a serious system? If we all share the idea that we will finance the economy and allocate the resources in a better way with more circulation of capital, then we should make sure that this pillar exists one day. It is the modalities and the rhythm that we then have to work on. The Parliament is there to have this discussion in public, examining all the pros and cons. We should stop saying, “Germany is going to block”, because we are in the co-legislation field. The Commission is making the proposal and the deal will be made between the Parliament and the Council. Each member state has the right to express its view, but the others also have something to say. Once again, it is a mistake to look at it as a German problem. There is a problem of trust; there is a problem of member states with very high debt; there are links between the banking system and the debt. Let us try to play down the national element and look carefully at all the topics included in this file. Gunnar Hökmark: My view would be that I agree that this is not an especially German issue. I share it in the same way. This is about the banking union or, really, the single rulebook project. The deposit guarantee scheme was part of that. We have the legislation, but the deposit schemes are national. There is a value in that, which should not be underestimated. We have been talking a lot about freeing the banks from the sovereign, but you also need to consider that it is maybe not good to free the sovereign from the banks, in terms of having a responsibility. Here, we are relying on the macroeconomic development in each member state. You can have a sort of moral hazard if you are not wary of the problems you can create. How you deal with your national economy has a huge impact on the status and the health of the banking sector. For the time being, I prefer that we have deposit guarantee legislation in place, and it is good that it is national.

Q99 Lord Butler of Brockwell: I want to ask about the capital markets union. First of all, this is a very important step in producing greater integration of the economies of the whole 28. Also, perhaps it is a more practicable step than some of the other measures we have been talking about, in view of the difficulties of those. Gunnar Hökmark: I agree. In reality, the capital markets union was established under the treaty of Rome, with the freedom of capital. I think we are creating too many unions in the Union. I like to remind my colleagues that we already have a union: it is named the European Union. It includes the freedom of movement of capital. Anyway, it is a good thing that the initiatives we are taking create better opportunities for cross-border, well-functioning capital markets and for deepening the markets. A good point of departure is to remember that we already have well-functioning capital markets in the European Union, which are rather deep. Let us use those experiences and what we can learn from them to avoid regulating in a way that we are undermining the good and well-functioning capital markets we have. The initiative of the commissioner, Lord Hill, is very good. Overall, we are very supportive of that, from our different perspectives. 189

Sylvie Goulard MEP and Gunnar Hökmark MEP—Oral evidence (QQ92-100)

Sylvie Goulard: We are supportive. I agree with you that the goal is financing the economy; it is not to create a union. In terms of public opinion, the saying used to be, “Nobody can fall in love with the single market”, but even less with the capital markets union, which is not clear to many people. It is important to boost investment, because we have not yet reached the pre-crisis investment level, which is very worrying because it is a lasting phenomenon. We need to invest. We need to make sure that start-ups and new companies find new financing. I know that for Lord Hill it is a step-by-step approach. At this stage I cannot say that simply the prospectus directive and some progress towards securitisation deserve the name “capital markets union”. These steps are minor. I want to be a little provocative here, because we are too polite. For example, there is a very strong tax incentive in the way you use the money. In France, we have l’assurance vie, which is getting a huge amount of money for tax reasons. One day, at least in the eurozone, we will also have to consider that, if you want to boost certain types of investment, you have to have the proper tax incentives and not ignore this aspect because it is difficult. I know it is not easy. You also have all the procedures for what the Americans call chapter 11, et cetera. If you invest, you know you can get rid of something that is a failure as quickly as possible. Bankruptcy laws are part of a well-functioning capital markets union. Lord Butler of Brockwell: Even so, would you not agree that the progress towards it has to be a step-by-step approach? It is not something you can achieve by waving a wand in the next few months. Sylvie Goulard: Of course not, but, on the other hand, I must be clear that I am really convinced we pay a high price in Europe for not making things properly. We always do too little, too late. It is complicated. For example, we do not have a budget in the European Union. What we have is not a budget, or, at least, with this budget we cannot finance what we pretend to finance. At a certain point, I prefer to go in front of my voters and say, “You want A. I will do everything necessary to get to this point”, not, “Well, one day, step by step, in the long run, we can get there”. If you look at all our concerns from China or America, we might be a little older and a little less future-orientated than other economies. I want to deliver what is right. I really believe if we need to boost investment, we should dare to open the chapter of tax. Gunnar Hökmark: May I be not at all impolite but have a different view? The most important thing for a capital markets union or a well-functioning capital market is that investors like to invest in it. The attraction of that is dependent on the policies in our countries and in the Union. Of course, we see the differences. In countries where there is a high level of regulation, bureaucracy and taxation, you get less, and in others you get more. I do not want the discussion about a capital markets union to create a belief that you can circumvent the economic reality. Sylvie Goulard: That is not what I said. Gunnar Hökmark: Well, maybe. I do not know. We have this lack of investment of between €400 billion and €500 billion on an annual level. At the same time, this is related to the fact that we have more liquidity than ever in Europe. It is between these that we need to get things working. We also need to get things functioning well and working on the ground. Most of that has to be done in the member states. It has to be local policies and national

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Sylvie Goulard MEP and Gunnar Hökmark MEP—Oral evidence (QQ92-100) policies, and then we can open up the preconditions on a European level. We can do a lot, but the main efforts must be made by the member states. Lord Haskins: The reason that is being held back is the lack of demand in most of the national markets, particularly in Germany. Germany is not encouraging consumer expenditure. If Germany encouraged consumer expenditure, you would see the investment elsewhere. Sylvie Goulard: Last year they introduced a minimum wage and they have adopted a new plan for investment. I can agree with you up to a certain point. If I may, though, we do not disagree, but you cannot explain to me why people are investing so much in Luxembourg. I am sorry, it is not because of the size of the market or the quality of the environment. It is for tax reasons. At least inside the eurozone, we have a situation that is like nudity on American TV: we do not want to discuss it. Gunnar Hökmark: That is very true. Luxembourg can only be Luxembourg because Luxembourg is Luxembourg, if I may phrase it that way. The Chairman: We are running a little short of time. In completing this, I wonder if I can put one specific question to you very briefly. Do you have an appetite, given what you have just said, for European-level supervision, eventually, of capital markets? Sylvie Goulard: With the first supervisory package, we already created the authorities—EBA, ESMA, et cetera—in order to have a single rulebook. I do not know what you mean by “European”. The Chairman: I mean direct supervision at EU level. Sylvie Goulard: Once again, I want to deliver what makes us credible worldwide. If our procedures are too complicated and we have to change scale, I would prefer to change scale and compete with the Chinese and the Americans.

Q100 Earl of Lindsay: On fiscal union, can I ask you what you think it means? When might it become a reality? Does a full transfer union need to be a part of fiscal union if it is going to help underpin EMU? Also, especially as you are parliamentarians, do you think additional democratic accountability needs to be built to take account of fiscal union? Sylvie Goulard: I fully share your vision that there is a link between the answer to the first question and the answer to the last one. The reason why I am in favour of changes in the eurozone towards more accountability and more democracy—and not the intergovernmental, opaque way of dealing with it—is you cannot have a budget without having the accountability. This is something we have learned from you. In my opinion, we need a budget in the future. Of course, we then have to discuss which types of policies we want to finance. For example, labour mobility is, in an optimal currency union, something we could finance together. Then you have many other options. Some people are talking about unemployment allowances. I do not want to enter into these details, but it is perfectly clear that in the long run, first of all, we need political power to discuss with the ECB, because independence does not mean isolation. Until now, we have taken the independence from the German system, in which there was a federal Government, and we are surprised that the ECB is sometimes feeling a bit alone. We

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Sylvie Goulard MEP and Gunnar Hökmark MEP—Oral evidence (QQ92-100) need a political power, and a political power needs some means. That also includes budgetary means. I do not whether it will happen; I do not know when it will happen. But, from an intellectual point of view, to avoid this discussion is not helpful. If you then ask me about “full transfer union”, I do not know what it means, because in all federal states you always have budgets at the state level—be it in the United States or be it in Germany—and a complicated relationship between the federal and non-federal levels. There are many options. There is not one option that is a nightmare and the situation today is a dream. Earl of Lindsay: As a direction of travel, the federal definition of fiscal union would be the one you would like to see. Sylvie Goulard: I would prefer to explain to people that we build something solid with strong accountability and a definition of competences that makes sure that some competences at the national level remain at the national level. At the federal level, we should have very limited competences, but, when we claim we do something together, we should have the means to do it together. Gunnar Hökmark: A lot of people are sure they know what fiscal union is until they are asked what it is, and a lot of people want it until they get it. I am pro having a fiscal union regarding the stability pact, with clear rules on balanced public spending. But, as soon as we enter other steps, you are in some way bringing up decisions about spending that are better on either a local or a national level. That is very much because our different welfare societies are looking very different. The Swedish welfare society is very different from the Romanian one, I can disclose, and from the UK one, et cetera. It is a common concept. In that sense, I am a federalist. Not in the way it is used in English or Swedish, but I am pro that we are very strict on defining where the competences are. A lot of the discussion on fiscal union seems to me to be more centralistic than in the true meaning of the word “federalist”. Earl of Lindsay: Is the United States a model that we can learn from in terms of developing fiscal union? Sylvie Goulard: The funny thing is that, if you read The Federalist Papers, the inspiration of the Americans was Europe. It is very funny. They were Europeans moving to the US and trying to invent something. They took their inspiration from Greek times and from the Saint- Empire romain germanique. It is not a model to duplicate. I always stress in my speeches that you cannot complain that you are not as strong as the US, that you do not have strong leadership in the world, that you do not have a defence system, a strong trade policy, et cetera, and then refuse to pool sovereignty in some fields where the US did. You cannot compare yourself with states if you refuse to be a state. Accept being in the second class. In tomorrow’s world, maybe we will still be somewhere in the first or second class, but I wonder where we are going to be in 30 years, or where my children are going to be in 30 years. Will we have a say in tomorrow’s world if we do not unite? I mean simply a say. Have you seen the story of the renminbi by the IMF? Have you looked at the figures? It is very interesting. The renminbi was introduced for special drawing rights. Who gave space to the renminbi? The pound and the euro did. This is today’s world. We will have to give up part of our power, and we will be kicked out if we do not.

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Sylvie Goulard MEP and Gunnar Hökmark MEP—Oral evidence (QQ92-100)

Gunnar Hökmark: The US is not a model, because we have to have our own model. The society of the United States is so very different, because of heritage, culture and tradition. There is another form of welfare state, another way of looking at how you finance college, universities, pensions, et cetera. It is leading you the wrong way in the discussion. Lord Haskins: And social mobility. Gunnar Hökmark: Yes, social mobility and the language. Spanish is opening up many doors in the US, and there is English, of course. We need to start from where we are and try to do a lot of the things we are discussing here. As you have noticed, we have different views on a lot of things, but we also agree that we need to make Europe stronger in a number of areas. We need to model ourselves in our own way for that. The Chairman: Thank you very much. This now concludes the public part of the meeting and the Committee will meet in private for a few minutes when you have left. We are very grateful for you taking time out to come today. It has been a very interesting session. Gunnar Hökmark: Thank you very much. Sylvie Goulard: What about the elephant in the room? Please stay. Gunnar Hökmark: Yes, you are very important to us.

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Sylvie Goulard MEP—Supplementary written evidence (EMU0011)

Sylvie Goulard MEP—Supplementary written evidence (EMU0011)

Dear Sir/Madam,

Thank you for the opportunity you gave us to have an exchange with members of your House. Please allow me to submit some additional written evidence, further to the hearing organised in Brussels this week, as I did not have the English version of the Treaty with me during the hearing.

One point puzzles me. The possible questions which were sent in advance, as well as several of the questions which were asked during the hearing, all seemed to be based on the understanding that economic and monetary union only applies to the euro area. As clearly stated in article 3 (4) of the : "The Union shall establish an economic and monetary union whose currency is the euro."

This unity is the reason why there is only one institutional framework foreseen.

A change to the current legal framework would have to be undertaken through a modification of the Treaties.

Yours faithfully,

Sylvie Goulard, MEP

5 February 2016

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Megan Greene, Professor Erik Jones and John Peet—Oral evidence (QQ68-81)

Megan Greene, Professor Erik Jones and John Peet—Oral evidence (QQ68-81)

Evidence Session No. 6 Heard in Public Questions 68 - 81

WEDNESDAY 20 JANUARY 2016

Members present

Baroness Falkner of Margravine (Chairman) Lord Borwick Lord Butler of Brockwell Lord Davies of Stamford Lord Haskins Lord Lawson of Blaby Earl of Lindsay Lord Shutt of Greetland Lord Skidelsky

Examination of Witnesses Professor Erik Jones, Professor of European Studies and International Political Economy, Johns Hopkins University, Megan Greene, Chief Global Economist at Manulife Asset Management, and John Peet, Political Editor, the Economist

Q68 The Chairman: Good morning. I welcome Professor Erik Jones, Megan Greene and John Peet to the EU Sub-Committee’s inquiry on completing Europe’s economic and monetary union. We are delighted that you were able to come. You have a list of interests which have been declared by Members. This is a formal evidence-taking session of the Committee and a full transcript will be taken. This will be put on the public record in printed form and on the parliamentary website. You will be sent a copy of the transcript and will be able to revise any minor errors. The session is on the record and being webcast live, and will be subsequently accessible via the parliamentary website. I take it that you have no introductory opening remarks to make and that we can go directly into questions.

I will kick off. You are all familiar with the Five Presidents' Report and the actions subsequent to that, proposed by the Commission. In general, do you think the report does enough to strengthen the euro and its long-term sustainability? I wonder whether you might also tell us if there are significant omissions that you think need to be in there. Also, what are the really important things that we need to look at when the White Paper comes out in early 2017? In all of that, would you remember that our particular interest is the sustainability of the euro

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Megan Greene, Professor Erik Jones and John Peet—Oral evidence (QQ68-81) but also its impact on the United Kingdom. Perhaps, Mr Peet, I might ask you to kick off, since you will have the political overview as well as the economic overview. John Peet: Thank you very much, Lord Chairman. I make two comments in response to your question. The first is that my experience is that the European Union moves in response to crises. The perception around Europe is that the euro crisis is dormant at the moment and that there are other issues—migration, terrorism and, indeed, the British debate about Europe—that concern European leaders more. So I do not expect things to go fast in this area. I think it will be more a case of muddling through with what we have got and taking only small steps. I do not think the Five Presidents' Report will lead to early action. Also, there are things in it that some countries, most notably Germany, will continue to resist. Germany is continuing to resist common deposit insurance and the completion of the banking union. On the substance of what is there, I think the euro can probably muddle through without substantial change. But it is an unsatisfactory situation because the banking union is not complete, there are not sufficient arrangements for the co-ordination of fiscal policy and there are not strong enough incentives for the members of the eurozone to make structural reforms, the absence of which led to the crisis much more than fiscal profligacy. So I do not think it is in a satisfactory situation but I expect it still to muddle through. Megan Greene: There are a few things missing from the report. The ECB is a central bank that has had one hand tied behind its back. That is not really addressed in the report in terms of the ECB stepping in to boost demand. I also think there is a focus on having collective decision-making on the fiscal side. I do not think that is necessary or worth burning political capital over, because it will never happen, in my view. Finally, there is no mention of countercyclical fiscal policies, which I think are absolutely necessary. I would rejig the priorities of the report and make the financial union piece the most important. Part of that is for cross-border exposure and flows, which is embedded in the capital markets union. The one thing really missing from the report is an asset pool deep and liquid enough to withstand investors pulling capital, or mutualised debt. Eurobonds need to be in there. I know that Eurobills were in the previous version. There is no political appetite for them but I think they are absolutely necessary. Professor Erik Jones: I second everything that Megan has just said. The underlying idea to the report—that there is something missing—is probably right. We need a financial union and we need something to stabilise Europe’s financial sector. I think that the proposals in the report to do that go a long way, and these are the same types of things that we have seen developed inside countries as capital markets have integrated inside countries. This is an important step forward. There are a lot of whistles and bells in the report that are not very helpful. The fiscal advisory directive is not very helpful and the competitiveness councils are probably not very helpful. The Chairman: When you say the fiscal advisory directive, do you mean the fiscal boards? Professor Erik Jones: Yes, the five-person fiscal board that is supposed to supervise the adherence to the rules and explain this to everyone. I think if they simplified the rules, that would be more effective than creating this kind of institution.

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Megan Greene, Professor Erik Jones and John Peet—Oral evidence (QQ68-81)

Lord Davies of Stamford: Why would that board not be effective and why would the individual competitiveness boards not be effective? Professor Erik Jones: The fiscal board is not going to be effective because the reason why the rules have not been abided by is the political determination at the national level, and that is not going to change. We are seeing that right now in Italian Prime Minister Matteo Renzi’s insistence on greater flexibility being given to his Government. That kind of political problem will be there whether there is a five-person supervisory board or not. The idea that we will get more abidance because of that board is a political fiction. Unfortunately, it is not going to influence facts on the ground. As for the competitiveness boards, the issue of structural reform is an important one. This was not a crisis of competitiveness for these countries. If we look at the movement and the real effect of exchange rates and decompose that into its component parts, we would find that most of the countries we accuse of having lost competitiveness, such as Greece, actually did not. They suffered from a very different dynamic, and that is the dynamic that Megan was trying to address. It has to do with the rapid financial disintegration when you move capital across borders, which is great, but it builds up a lot of net foreign exposure, and if you liquidate all those assets at once and pull the money out, you end up with countries like Italy, Spain, Portugal and Greece that have no liquidity in their economies. That is what brought them down, not the loss of competitiveness per se.

Q69 Lord Lawson of Blaby: Before we get into too much detail, although the detail is highly relevant, I do not dispute that, may I ask each of you a prior question? What, in your view, is the purpose of economic and monetary union, in a nutshell? John Peet: I think that Lord Lawson was involved in the early discussions about economic and monetary union. I think it was primarily a political project. It was there in the Werner report in 1972 as a political project to accompany the European Union. There was a view that if you moved towards European economic and monetary union that would be a big step towards political union. Indeed, Mario Draghi has called the euro a large step towards political union. I think it was also connected with the unification of Germany, the desire to underpin the single market and a desire on the part of France in particular not to be beholden to the deutschmark. They thought that EMU would be a way of getting French as well as German hands on the single currency. Politics is probably the most important answer. Lord Lawson of Blaby: I agree. I am sorry, I must not interrupt because I am inclined to hear what Ms Greene and Professor Jones have to say. Megan Greene: I agree that it was a political project. That is partly why the eurozone exists intact today. If it had not been a political project and there were not political commitment to it, countries would have been allowed to drop out—which we have not seen happen. I would also highlight that it is an economic project, too. It is why Europe can compete globally and has any weight on the global stage whatsoever. If you do not have the European project and European countries tried to compete individually, they could not corner for themselves as much of the very elusive aggregate demand that we find globally. Professor Erik Jones: I have to disagree. Many people thought that it was a political project but deep down inside it is an economic one. It is an economic project with a very specific 197

Megan Greene, Professor Erik Jones and John Peet—Oral evidence (QQ68-81) purpose introduced in the Padoa-Schioppa report of 1987: to stabilise cross-border capital flows and prevent them from inducing unnecessary exchange rate volatility. Political things may have been put on to this—I have written a lot about this—but I had the good fortune to work with Daniel Gros and Niels Thygesen in the late 1980s and early 1990s. They informed the Delors committee and were completely oblivious in their work to the politics of this project. The economists I knew that worked on the single currency in the late 1980s and early 1990s never thought about the political implications. In fact, we were asked by the German Bundesbank precisely to study what the political preconditions would be for a stable monetary union. Since that question was exposed, I would argue that this was an economic project that had political implications which were very poorly understood. Lord Lawson of Blaby: May I follow this up? I think it is obvious that if economists are asked their views they will talk about the economics, but you mentioned the Delors committee. I knew Jacques Delors very well and he was absolutely clear in his line that it was a political project. I was rather surprised to hear what you said.

Q70 Lord Butler of Brockwell: You said that the 2008 crisis was not a competitive one. None the less, there are great competitive problems and very high unemployment in the weaker economies of the EU, and there are likely to be further incidents of capital volatility. Do you agree? Do you believe that it is tolerable for these to go on indefinitely and is it likely that the euro will survive all of them? Professor Erik Jones: I do not think this is tolerable. I just came from a meeting of bankers attached to the City. They speculated that we might see the re-introduction of capital controls not just in Europe—we have seen that in Iceland and in Cyprus—but in other parts of the globe as well. These cross-border capital flows are having a tremendously disruptive effect. That is all the more reason why you would want to do the type of things that Megan alluded to in the context of financial union. I was struck by Henning Christophersen’s testimony before this Committee, where he indicated his desire as a banker in Denmark to see Danish banks engaged in a European banking union because that is necessary to stabilise the single market—not the single currency, because Denmark will retain its own currency. John Peet: I was going to respond to the point about competitiveness that Lord Butler raised because I do not quite agree with Erik Jones. The loss of competitiveness was a significant issue in the euro crisis for several countries, particularly the southern Mediterranean ones. What happened to their unit labour costs compared with Germany was more important than fiscal profligacy as a source of the tensions that led to the euro crisis. We are seeing quite a lot of improvements in competitiveness, including in southern Europe, but the issue for the eurozone as a whole is not really competitiveness as such but imbalances within the system. That is demonstrated particularly by the continuing very large current account surplus in Germany compared with other countries. That seems to generate a situation where we have very low growth and not enough employment in many countries. Lord Butler of Brockwell: None the less, your view is that the euro will muddle on. John Peet: I think it will probably muddle on because one lesson of the last five years is that it is generally agreed that the costs of going back and breaking it up could be very large and therefore that is something everybody wants to avoid. Every time the issue of whether

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Greece should leave the euro came up, all sides—the Greeks and the creditor countries— decided that it was too risky and preferred to find some way of muddling through. Lord Butler of Brockwell: One final question: what about the political and social consequences of those symptoms, particularly the high unemployment? John Peet: That is an issue. Obviously, both the European Union and the euro require political assent to continue. If it becomes generally thought in countries such as France and Italy in particular that the single currency is leading to a situation of low growth and high unemployment for a long time, then we can expect the politics in those countries to change towards a situation where people say, “Maybe this project is not worth supporting”. If the euro does not find some way of generating more growth and employment than it has done in the past, the political consent for the project to continue may be withdrawn.

Q71 The Chairman: Professor Jones and Ms Greene, both of you mentioned the importance of financial union. Can we be confident that that will mitigate the financial instability and disruptive capital flows that we experience at the moment? Professor Erik Jones: If we had risk-sharing such as a pooled deposit insurance mechanism, that would inspire confidence. I remember being in Belgium the day that Deutsche Bank changed its status from subsidiary to branch and published a full-page ad in the Flemish newspaper saying, “Move your money to Deutsche Bank and it will be covered by German deposit insurance”. We have to level the playing field in that context and I would apply that to resolution funding as well. The point that Megan made about a single risk-free asset is equally important and that is obviously missing from the report. Megan Greene: Yes, if this is done half way so you make it easier to have cross-border flows then it could increase volatility. You see that in good times there are lots of cross-border flows and in bad times everybody withdraws their capital back to their home country banks, and you have a balkanisation of the banking system. That is exactly what we saw during the crisis and that is what caused the sudden stops in the periphery. If you do this without an asset class that is big and deep enough to withstand those challenges, it will increase volatility. Volatility is not just an issue for Europe. I highlight that Mario Draghi said, “Hey, get used to volatility; it is here to stay”. It will be a key feature in the global economy over the next five to 10 years.

Q72 Lord Borwick: Would you talk for a moment about the direct and indirect effects on the UK of the EMU? Whether it is a political or economic project, it does not appear that Britain has bought into it. What effect do you think these future steps will have on non-euro states? John Peet: The issue of the relationship between euro ins and outs is the most important part of the current negotiation that David Cameron is conducting, even if it is the most difficult one to get across to voters and the public. If it becomes clear that the real project here is not the European Union but economic and monetary union, that raises the question of what precisely “out” countries such as the UK should do. Having put it on the table, the British Government are likely to get worthwhile assurances that Britain’s interests will be taken into account by the “in” countries. There will be “out” countries for quite a long time to come. Something can be done to reassure the “out” countries that they will not be

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Megan Greene, Professor Erik Jones and John Peet—Oral evidence (QQ68-81) discriminated against in any way, but that issue is worth a lot of attention by the Government. That is what I would say. Lord Borwick: Sorry, you are saying that it will be taken into account, but what happens in the event that it is not taken into account and they regard the political necessity of whatever action they are going to take in the future to be more important than taking it into account? John Peet: We have the double majority system inside the European Banking Authority, which was a way of protecting the interests of “out” countries. We had what happened when the eurozone tried to make use of the European Financial Stability Facility and the Chancellor of the Exchequer objected and that was put right, in a sense. There will be some kind of formal declaration, which I think will take a legal form, about the importance of not undermining the single market and of the eurozone countries not acting against the interests of non-eurozone countries. How much you can rely on this will, I suppose, be a political issue. Lord Lawson of Blaby: There are two aspects to this, are there not? First, what precisely are the guarantees or assurances? Secondly, will they be embodied in a treaty, because unless they are embodied in a treaty they can always be changed? John Peet: You can get it in a legal form. You can get declarations and commitments that take some legal form, short of a treaty. But I assume that the Government hope to achieve some form of agreement that will, when and if there is a subsequent treaty, be incorporated into that treaty. Megan Greene: One of the shortcomings of this report might be its naïve view, in my view, that all EU members will become eurozone members. That is realistically not the case and so has raised the hair on the back of the UK’s neck. Clearly, as I mentioned at the beginning, financial union is the key piece of this report. On that front, the UK stands only to benefit. In fact, Lord Hill has been banging the drum on capital markets union for ages. It is the same for banking union. The UK could really benefit from that, along with TARGET2-Securities. It is in the UK’s best interests to sign up to it. Professor Erik Jones: I would like to pivot off this allusion to TARGET2-Securities. If there is one great contribution that the euro made during the recent crisis, it was not through the existence of the single currency but through the existence of the underlying payment mechanism between central banks, called TARGET or TARGET2, which provided instant and infinite balance of payments financing for those countries that got in trouble. The recent comment by Yves Mersch was that there is no reason why the next evolution of that mechanism could not be made a multicurrency mechanism for sharing resources between central banks. That would complement very nicely the recent European Court of Justice ruling that allows for euro clearing to take place as part of the single market within the City of London. If, instead of a swap agreement, you had access to the standing facility for sharing liquidity between central banks, that would improve the stability of the City of London. There are real possibilities for improving the situation using the architecture that has been put in place.

Q73 Lord Skidelsky: What do you understand by fiscal union? I want to concentrate particularly on the role of stabilisation or countercyclical policy. Is it your view that the incomplete character of the eurozone, its lack of a sovereign state, imposes tougher 200

Megan Greene, Professor Erik Jones and John Peet—Oral evidence (QQ68-81) restrictions on fiscal policy than would be enjoyed by a sovereign state, especially one that has its own central bank? If so, is there, in your view, a macroeconomic justification for the rules of the growth and stability pact as it is now understood? Professor Erik Jones: That is an excellent question. The fiscal framework that is applied within the euro area is completely optional. It is not necessary. They adopted this fiscal framework for political reasons: to reassure the German Government at the time and, increasingly, to abide by German Constitutional Court decisions about the validity of the single currency as a commitment to be made. But it is optional. You could have a monetary union without that fiscal framework, and within that monetary union without that fiscal framework the situation might be improved. Depending on what rules you write for how markets treat sovereign debt instruments, the situation might be improved for countries. As a matter of fact, during the 2000s, by being part of the single currency, countries such as Italy were able to borrow at incredibly low rates, maintaining very high levels of debt. That would be possible, but that was more about the way the debt was treated in terms of financial market regulation and the elimination of currency risk. Monetary union could allow for very lax fiscal policy—decide as you will what kind of fiscal framework you want to introduce. Lord Skidelsky: But is that a lax fiscal policy on the part of all states, or just some? Professor Erik Jones: That is an interesting question. My argument is that they should have different rules for different countries. Small countries should not be trying to use aggregate- demand management techniques based on fiscal policy because there is too much leakage into other countries. They should have very tight rules for small countries. But, as we saw in the early 2000s, a big country like Germany wants to use fiscal policy and so it should be able to. Megan Greene: For countries that have no control over their monetary policy or currency, countercyclical fiscal policies are all you have got. One shortcoming of this report is that there is this idea that you need to centralise fiscal policy and make it more rules-based. I do not think it should be rules based; I think fiscal policy should be determined on a case-by- case basis. And that is not to mention that it will never happen politically, so I am not sure what the point of burning all your political capital on this is. John Peet: If I may say so, the politics of this question is extremely difficult. I call this the MacDougall question. In the original MacDougall report, it was suggested that monetary union would not work unless there was a central fiscal capacity. I think he mentioned possibly a budget of the size of 7% of GDP, which is seven times as big as the current European Union budget. It has been clear from the very beginning that Germany will not accept that. The Germans believe that if you did that, it would become a transfer union that would involve permanent transfers from Germany to other members of the eurozone. What has gone wrong with fiscal policy in the eurozone is that it has too much of a deflationary bias, because the pressure has always been on countries that have large deficits to reduce their deficits and there has been no pressure on surplus countries to offset that. I am not sure whether I think that countercyclical fiscal policy ever works terribly well but, in the eurozone, there has been pro-cyclical fiscal policy, which I think has been very damaging.

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Lord Skidelsky: Just one follow-up question. In contrast to the United States, one of the questions is that there is a reference to the US fiscal constitution, notably the balanced budget rules governing states and the scale of transfers from the federal budget to lower- tier government. Are their rules similar to those imposed through the growth and stability pact on the federal government in the United States? Professor Erik Jones: This point about the United States is really important, because there is such misunderstanding about how American fiscal policy works, particularly on the transfer side. Federal transfers go to state governments that match the money that they receive. So states that invest more in receiving transfers will get more transfers per capita. Massachusetts has a much higher income per capita than Texas, but it also has a higher transfers per capita than Texas. We could do the same in the comparison between New York and California. There is this idea that the US federal fiscal system stabilises income through the tax and transfer system, but that is not what happens. In many respects, it exacerbates the differences, which explains also why those parts of the country that reputedly benefit from the transfers—the south and south-west—absolutely hate the federal Government, because they do not see the benefits that they are reputedly getting. Lord Skidelsky: That is the transfer system. Professor Erik Jones: That is the transfer system. Lord Lawson of Blaby: They would be worse off without the transfers, would they not? Professor Erik Jones: Yes, but the amount they pay in relative to the transfers is significantly more than for richer states such as Massachusetts and New York, which are even better off with the transfers that they receive. If we had that kind of political dynamic in Europe, you could only imagine the secessionism that that would breed. We see that already in countries such as Spain, Belgium, Italy and all the rest, but it would be on a continental scale. Lord Skidelsky: What about the other side of it, which is the fiscal rules of the federal Government? Are they comparable? Are there equivalent fiscal rules binding the federal Government on their budget balance and things of that kind? I am trying to probe the rationale. You said that it was optional but of course it represents the fiscal philosophy of Germany, and also the need to keep some control when there is no central treasury. Professor Erik Jones: The only binding rule that we have is the debt ceiling. All the other rules are written in normal legislation. But we have a very curious congressional structure where they vote revenues and expenditures, and then they also vote a separate rule for how much debt the Government are allowed to borrow. That is the binding rule and unfortunately that led us very close to the brink of default in August 2011. Lord Skidelsky: So that is the binding rule, not limits on deficits and things of that kind? Okay.

Q74 Lord Davies of Stamford: I would like to go further, as we have two American economists here, on the contrasts between the European Union and the fiscal and monetary union in the United States. I am very glad that Professor Jones corrected what I believe to be a common error in this country, which is to suppose that the United States has a very effective fiscal union with a larger degree of automatic stabilisation through public expenditure. I do not think that is the case, because—I think I am right—welfare

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Megan Greene, Professor Erik Jones and John Peet—Oral evidence (QQ68-81) programmes, for example, which are an obvious source of automatic stabilisation within member states of the European Union, are a state responsibility and not a federal one in the United States. Similarly, though Medicare was originally a federal programme it has now been devolved to the states, as has Medicaid. A lot of these programmes that are regarded as automatic fiscal stabilisers in the EU and individual member states—which they are—do not operate in that way in the United States. Then you have some flexibility even within the existing fiscal union rules for individual member states to run deficits up to a certain amount—1% of structural, 3% of cyclical and so forth—whereas in the United States I think I am right that at least 48 or 49 states have balanced budget rules so there is no opportunity there for flexibility.

My instinct—can you tell me whether I am wrong on this?—is that the United States is an example of very effective automatic stabilisation not through the public spending system but through the capital markets so that savers in Texas will hold claims on California or Massachusetts, and vice versa. If the oil or cattle price goes down very badly, Texas will not do so well on that but it benefits because it invested in high technology stocks in Massachusetts. That is a very simplified version of how this works but that mechanism seems to work very well in the United States. We have drawn the conclusion from that that we need a capital markets union in the European Union. Is that a fair summary of the situation? What chance do you think we have of achieving that degree of automatic stabilisation through the capital markets, such as you achieved after 200 or 300 years, in the European Union? Megan Greene: I agree entirely that a huge shock absorber in the US is the capital markets union. That is why when the price of agricultural land in Kansas tanks, nobody else is really affected. That is something that I have argued for in Europe for ages. On the fiscal union piece, Erik mentioned that states are better off with fiscal transfers than they would be without them. If we were to try to construct an optimal currency area from scratch, would transfers to a fiscal union be on the list? Yes, absolutely, but that will not be agreed in the Eurozone. There is no way Germany will ever accept transfers, particularly off the back of its own experience with reunification. In thinking about what is politically possible, we absolutely do not need that in order to get close enough to an optimal currency area to have the eurozone be sustainable. Lord Davies of Stamford: My point is that—I think I am right on this—the receipt of federal funds by states in the United States is about the same, as a proportion of the gross domestic product in the state concerned, as receipts of structural funds in the European Union. It is a very small amount of money in relation to GDP. My general point is that the state is not important here; the private sector and capital markets are. If we all agree on that interpretation of replicating your great success, what chance do we have in achieving the cross-holdings of diversified portfolios throughout the European Union that would give the same degree of stabilisation? Megan Greene: I will take a quick stab at this and then pass it over. One key difference between the US and the eurozone is that the US mutualised sovereign debt and Europe did not. You do not have such a big asset class. US Treasury bonds are the biggest, most liquid asset class in the entire world. We do not have anything close to that in Europe. As long as you do not have mutualised debt, a capital markets union and making it easier to transfer

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Megan Greene, Professor Erik Jones and John Peet—Oral evidence (QQ68-81) money and pull it back will increase volatility and instability. That is the lynchpin: if you do not have that it does not work. But is there political support for eurobonds? Not really. Professor Erik Jones: I think Megan has put her finger on it. Let us not forget that we had in the United States a project of making it possible to share financial resources between New York, California, Massachusetts and Texas. When we did that, we gave birth to the savings and loan disaster because the banks that shared these resources were all underwritten by deposit insurance schemes run at the state level. They were chartered at the state level as well. What we had to learn in the United States is that chartering banks at the state level that do business across the integrated US financial economy is a bad idea because the states could not bail them out ultimately, and had to appeal to the federal Government for assistance. That was us learning what Europe is going through right now with banking union. For this to work, you would have to make it more challenging for people to speculate across borders. This is the point that Megan made. Banks need risk-free assets for their routine treasury operations but in the context of a crisis even these so-called risk-free assets are not the same from one banking jurisdiction to the next. In Europe, they are all Italian debt, German debt or Spanish debt so people start selling these instruments and buying others. That is why you have negative-yielding bonds in Germany. We do not do that in the United States. If we could short North California and buy New York, in the context of the Bank of America scandal the US would have blown apart. We would never have been able to maintain the integrity of the financial system. Because we have this common, risk-free asset that everybody can use we are able to contain the kind of pressures that financial markets and a capital markets union engender. Lord Lawson of Blaby: May I go back to the main point, following on from what Lord Davies said? That surprised me. Mr Peet referred to the analysis in two of the reports all those years ago. That seemed to me to be perfectly valid analysis. He said that, in short, you cannot sustain happily a common currency—it might be sustained, but unhappily and in an underperforming way—without a much greater European tax system and spending system so that you get these transfers. He pointed out that that is the case in the United States, unlike what Lord Davies said, that these transfers are substantially more than in the European Union at present, and certainly more than in this country—which is, if you like, a monetary union between England, Scotland, Wales and Northern Ireland. The transfers there are very substantially greater. I understand that Germany does not want a transfer union. That does not mean it will not happen but it may not. If it does not happen, I would have thought that the eurozone is likely to continually underperform. I would be grateful for your views on that. John Peet: On this interesting contrast with the United States, I do not quite go along with Lord Davies’s analysis that fiscal transfers play no role in the United States. I think they do. Lord Davies of Stamford: I did not say they play no role, but their role is often exaggerated. John Peet: That may be true but they do play a role, and that can be quite a significant one inside the monetary union. In a sense, this goes back to how Hamilton set up the US Treasury in the first place, assuming the debts of the states in exchange for creating a federal budget and risk-free asset. That is a weakness in the eurozone. But there are, of course, other things that matter in the United States. We all talked about the capital markets being very important. The capital markets are insufficiently developed inside the eurozone. Capital 204

Megan Greene, Professor Erik Jones and John Peet—Oral evidence (QQ68-81) markets seem to function as a risk-sharing mechanism inside the United States and it would be desirable to have that in the eurozone. America also tends to have more liberal and deregulated labour markets. People move more freely inside the United States. Those adjustment mechanisms are also a help in the United States, and they tend to have been missing in the eurozone—although some progress has been made on structural reform, as I said. But I think the political objection to fiscal— Lord Davies of Stamford: Migration flows within the European Union are pretty considerable. We have been arguing about Poles and Romanians for the last 15 months in this place. John Peet: I believe the flows are much bigger in the United States. People genuinely move from Texas to New York far more freely, partly because of the common language and so on. I go back to the point that I think we all made: the politics at the moment seem to be such that setting up a system that would entail fiscal transfers within the eurozone is not likely to happen—although I believe it would be desirable. The Chairman: Professor Jones, would you like to send us anything that you have written on the differences between the United States and the EU in this regard? That would be really helpful. Let us move on to economic policy.

Q75 Lord Shutt of Greetland: We learnt from you this morning that the economic and monetary union may be a political or economic project. Is there a need to achieve a resilient and sustainable union in this? What co-ordination is required among EU and eurozone member states? Megan Greene: On economic union, the approach so far has been that there needs to be co- ordination and everyone needs to look a bit more like one another, but actually everybody needs to look more like the northern states. Unfortunately, that is partly why Germany has such a huge current account surplus. You have razed off any kind of domestic demand in the weaker states as a result of that. Going back to the conversation earlier, competitiveness features pretty heavily in the economic union piece. There has been a maniacal concentration on price competitiveness that has been pretty misplaced. We need to see a much more symmetrical adjustment. In any case, if within a monetary union we all try to make ourselves more competitive relative to everybody else, that beggar-thy-neighbour strategy ends up being a race to the bottom. Lord Lawson of Blaby: What people really mean by competitiveness is productivity, efficiency and all that kind of thing. That is not a stupid objective, is it? Megan Greene: No, it is not a stupid objective. Yes, there are many different ways to achieve price competitiveness gains. One is to open up labour and product markets. That is a slow- burner. A much faster way is to go ahead and cut wages and pensions. That is the route that the weaker countries have pursued because it was the fastest, most efficient way to hit strict, difficult fiscal targets. I think that has been an unfortunate approach to this crisis, and one that needs to change. Continuing to focus on price competitiveness is sort of baking an internal devaluation into the adjustment. I would argue against that. The Chairman: Would you include structural reforms in that analysis?

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Megan Greene: I think structural reforms are probably over-emphasised. They are important, of course, but they take a long time to bite and to start supporting growth. Nobody knows how long they take but you might say on average five years. Spain’s labour market reforms have taken about that amount of time to start supporting export growth. I am not sure how much time we have given the political and social dislocation in Europe, particularly now in the light of the refugee crisis. Lord Shutt of Greetland: So what would you advise? Megan Greene: I think you should forget about the entire competitiveness piece, and setting out competitiveness tsars in every country. That is not the most important bit. Some kind of co-ordination is absolutely necessary but it needs to symmetrical. It cannot just be the weaker countries trying to look like the stronger countries. They need to meet in the middle. John Peet: I agree with that last point, certainly. There is a problem that adjustment is imposed on deficit countries and not on surplus countries. The eurozone is suffering from insufficient demand. That is a problem generated particularly by Germany, which is not doing enough to increase demand. But I do not quite agree with Megan about structural reforms because they are important. If you lose the ability to devalue your currency and you lose your monetary independence then you need structural reforms to make your economy more flexible. I am not sure “competitiveness” is the correct word to use here but flexibility is very important. I also believe that although labour market reforms, which are very important to get down unemployment, may not produce quick results, product market reforms can produce quite quick results—services liberalisation can, in particular. Those are things that are very desirable in their own right and they could help to increase demand and consumption inside the eurozone. I would advocate pursuing structural reforms more rapidly than is happening at the moment, including in Germany.

Q76 Lord Skidelsky: Germany’s surpluses are mainly with non-European countries. In fact, to get a balance within the eurozone the deficit countries would need to run surpluses with Germany. How do Germany’s surpluses outside the European Union affect the balance of supply and demand within the European Union? John Peet: I think the total size of the German surplus, which now runs at 8% of GDP, has the effect of, if you like, a deflationary bias on the whole world, and that affects the eurozone. The consequence of the adjustments that have taken place in the eurozone in the last seven or eight years is that the whole of the eurozone is now moving into substantial current account surplus. I think I am right in saying that the eurozone now has a bigger current account surplus than China. I am not sure that that is necessarily a bad thing because for an ageing continent that might be desirable, but I think the way that happened also had the effect of reducing demand and, possibly, growth inside the eurozone. The Chairman: We have not heard from Professor Jones on this yet. Then I will take other members of the Committee who caught my eye. Professor Erik Jones: I just want to emphasise that productivity growth is far more important than market flexibility or any of that other stuff. Productivity growth is achieved by redeploying capital from places where it is in surplus to places where there are surplus opportunities for investment. That is what we did in the 1990s and early 2000s. To throw some data into this, if you look at the way the European periphery worked at the start of the 206

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1990s, there were 10 million manufacturing workers in Germany and 10 million manufacturing workers in Portugal, Italy, Ireland, Greece and Spain. By the end of the 1990s, Germany shed 1.7 million workers as a consequence of unification but the peripheral countries of Europe kept all their manufacturing employees. By 2007, Germany shed another 800,000 manufacturing workers but the peripheral countries of Europe kept all 10 million of theirs. Over that 17-year period, 40% of the manufacturing workforce retired and was replaced in peripheral Europe—why? It was because the cost of capital had gone down so low that they were able to enhance the productivity of those workers, make them more productive and therefore contribute more to the economy. This is what the development model was supposed to do. We put that in reverse in 2007. We pulled all the capital out and threw all these people into unemployment. That is the thing that we have to fix. We have to get the capital back into these countries. You do not do that by exporting capital from the euro area to the rest of the world. On the contrary, you put the euro area at risk of losing the principal of those capital flows in emerging markets such as China, Brazil or South Africa; or, even worse, in asset classes in the United States such as student loans and other things that Europeans should not invest in. But they are investing in those because they cannot get any reasonable rate of return in Europe. The Chairman: So how do you do this? Professor Erik Jones: We need to restart capital market integration in Europe as it is the capital market disintegration that caused this problem. You do that by doing all the things that Megan alluded to at the beginning: you need to restore confidence in intra-European finance so that instead of Germans investing their money in Brazil they invest in Greece, Spain, Ireland and Portugal again. The Chairman: But is not the logic of the allure of the emerging markets or places that are perceived to have a better return on investment that investors will choose those options rather than intra-Europe investment? Do you have any legal, institutional or architectural suggestions for how to do this? Professor Erik Jones: But the institutional suggestion is banking union; it is the creation of a single risk-free asset so that when people become afraid they do not have to pull their money across countries. They can leave it in the country but somewhere safe. John Peet: May I add one point to this discussion? At the moment, I believe that German political and economic leaders are proud of their very large current account surplus. They think it is a sign of strength. Actually, over the years a lot of Germany’s current account surplus—which has then led to large exports of capital—has been wasted. It has been foolishly invested, some of it in America and some in Greece and other places. Their current account surplus has not done Germans any good at all. It would be desirable for Germans’ own standard of living to reduce the current account surplus. Lord Shutt of Greetland: We have been addressing throughout our inquiry matters to do with the EU and the eurozone. You are almost suggesting that we are wasting our time and that we should be talking about Germany. Megan Greene: No, I do not think that is the inference at all. Germany is at the helm of a lot of the policy because it is the biggest economy and therefore gets a big say. But things such 207

Megan Greene, Professor Erik Jones and John Peet—Oral evidence (QQ68-81) as the banking union, the capital markets union, are pan-European solutions. Germany may or may not like bits of them but they are pan-European. On “Won’t investors try to find yield in the emerging markets where it is higher, rather than invest in Europe where yields are negative?”, I would not underestimate home bias. Right now, the home bias is within national boundaries but if you had eurobonds it would be in Europe. That would be pretty powerful.

Q77 Earl of Lindsay: I just want to come in on capital markets because it has been mentioned a number of times, not least in terms of the benefits of shock absorption and responding to the way crises currently cause unhelpful flows of funds. Do you think that there is any realistic prospect of seeing capital market integration, the capital markets union, within a timescale that would support what the Five Presidents’ Report is trying to achieve? If not, what are the obstacles to prevent a proper integration of capital markets? Megan Greene: This is why I said at the beginning that I think the priority should be re-jigged to make this number one. It will take a bit longer than the timescale in the Five Presidents’ Report but a number of things are impeding the development of capital markets union. A lot of it is down to legislation. The Chairman: When you say it will take a lot longer, the end timeframe is of course 2025. You see it taking it longer than that, do you? Megan Greene: Yes, I think so, unfortunately. You have things like property rights and the legal enforceability of cross-border property rights that need to be addressed first. That will take some time. Lord Lawson of Blaby: Would Mr Peet like to comment on this? John Peet: I think Lord Hill quite correctly made building a capital markets union his top priority and he appears to have the support of all his fellow Commissioners, so I think there will be progress in this area. People see it as a desirable thing. But, as Megan Greene said, quite a lot of regulatory changes need to go with it. It is possible that some countries will start to say we need to have regulation of capital markets at European not national level. That will be resisted by many countries, including probably this one. It will take time. Lord Lawson of Blaby: And what about the Chairman’s question about whether the 2025 deadline or objective of the Five Presidents’ Report proposals is likely to be attained? What is your view on that? John Peet: It is nine years off. You can do quite a lot in nine years. As I said at the beginning, I do not expect much to happen in the immediate future and certainly not this side of the French and German elections. Then there is an Italian election. But after those are through, and particularly if the eurozone continues to suffer from low growth and high unemployment, I think the pressure to improve the situation will intensify. It could be possible to have a much more functioning capital markets union by 2025, yes. Lord Lawson of Blaby: But their objectives go far beyond capital markets union. If I recall, they include a European Union or eurozone treasury. John Peet: Yes, and I would not expect that to happen by 2025—if ever.

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Lord Davies of Stamford: I want to come back to the comment of Professor Jones and Ms Greene that one reason why you cannot replicate the very effective capital markets transfers of the United States in the European Union is the absence of a market in the liabilities of the federal system. I think that is wrong; it is not a problem. It seems to me that currency risk is a problem and a big obstacle to holding diversified portfolios. But currency risk has been eliminated by the existence of the euro in most of the EU, so that was an important way forward. I agree that it is necessary to have so-called risk-free assets for both the banking system—indeed, to have open market operations between the banking system and the Central Bank—and savers, who need something which they consider to be the absolute bottom of the risk profile. But there are in the European Union so-called risk-free assets: they are called bunds. You could say that they extend also to liabilities of other member states with AAA ratings. I think those are the problems but they have been resolved in the euro area. I do not think the existence of a market in liabilities of the federal Government is itself a factor here; at least, I am not persuaded of that yet. To come back to the issue that in the United States you cannot short Massachusetts or South California, of course you can: you can short the municipal bonds in that particular state. You can short that state not merely by going short of the equities or liabilities issued by the private sector in that state. You can also go directly to the public sector through the municipal bond market, which is very liquid. So I do not agree with that either. I just throw those two points out as a provocation to you to come back on if you would like to. The Chairman: If we could just take Professor Jones and then I want to move on. Professor Erik Jones: The point I was trying to make is probably best made through an illustration of what happened to Italy in the summer of 2011. Italy’s position in the TARGET2 system for exchanging liquidity between central banks was a surplus or credit position of about €8 billion in June 2011. Between June and September, it went from an €8 billion surplus to about a €100 billion deficit. That should have been a balance of payments crisis in any story but it was not: it was automatically accommodated by TARGET2. The reason that took place is that about 8% of the stock of Italian sovereign debt was liquidated by foreign investors over those three months, and 8% of a stock of a debt that is more than 100% of GDP is a lot of money to pull out of a country at one time. That is the problem. When it did that, it not only pulled that debt out of the country but also damaged all those Italian banks which had their portfolios stuffed with Italian sovereign debt. You can short Texas government bonds but the Texas banks will not be holding those bonds, so it is not the same effect as it was in Italy when all the money was sucked out of the country. When all the money got sucked out of the country, those banks literally stopped lending to the private sector. Our SME sector in my part of Italy, which is very profitable and productive, found itself denuded of capital. It could not even get working capital except by deferring wages to its own employees. Lord Davies of Stamford: I will not repeat myself; I will think about your point very carefully. The Chairman: Lord Davies, we are going to move on. Lord Davies of Stamford: But Chairman, have we commissioned a report by Ms Greene and Professor Jones into the contrast between American capital markets and the European

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Megan Greene, Professor Erik Jones and John Peet—Oral evidence (QQ68-81) capital markets, and the aspirations we have for the European capital markets? That would be a very useful document because that goes right to the heart of this whole issue. The Chairman: We would be very grateful to have any more evidence that you may wish to draw up. I am not sure I am in a position to commission a document from you. I suspect that would be rather too expensive for the House of Lords. If we could move to banking union, Lord Butler wanted to pick up a couple of points.

Q78 Lord Butler of Brockwell: Yes, Mr Peet said at the outset that he did not expect much progress to be made on banking union. In view of the German opposition to the proposals for the European deposit insurance scheme, that seems to be right. Do the other witnesses agree that this is an area of the Five Presidents' report where we are likely to see very little progress? Megan Greene: Unfortunately, that is probably right, particularly in terms of the common deposit insurance scheme, which is absolutely essential to a banking union. I have no doubt about that but I also have no doubt that Germany will do everything it can to oppose that. Unfortunately, although there are great proposals on banking union in this report, politically it is difficult to see how they would see the light of day. Professor Erik Jones: Just as a little factoid, they tried to write progress on deposit insurance into the draft. It appeared in the first draft of the European Council presidency conclusions, circulated in December. Deposit insurance was pulled out of that draft. By the second draft that got circulated it was already gone. So even before the meeting—a week before it—they had decided that they were not going to make progress on this issue. The other thing, just as a little factoid, is that they do not even have a common deposit insurance system in Germany. The different types of German banks have different deposit insurance. That is the biggest part of the problem. Sparkassen and Landesbanken do not want to get implicated in a European system because they have their own preferential arrangements. Lord Butler of Brockwell: Is this just a problem of what happens before the German elections or does the objection lie more deeply than that? Your answer implies that it lies more deeply. Professor Erik Jones: Yes. Megan Greene: Yes, it is not a question of an upcoming election and pandering to the electorate. This is deeply embedded in the German psyche. German voters do not ever want to bail out Greek banks. Lord Butler of Brockwell: Thank you. I do not think there is any more to be said on banking union for the moment.

Q79 The Chairman: I just have a little question. We are now presented with plans for these very incremental steps on re-insurance, co-insurance and so on. Do you see that taking off, working and solving the problems we are trying to address? John Peet: I go back to the point I made right at the beginning: I do not expect much to change so long as the markets seem reasonably calm and people, including those in Germany, can believe that there is not to be a fresh outbreak of what is called a eurocrisis.

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The political resistance inside Germany and some other countries such as Austria to anything that looks like German taxpayers having to bail out other countries will continue. Professor Erik Jones: I think what John said about other countries is quite important. The Netherlands are dead set against deposit insurance. When I ask people in the Netherlands why that is, they say, “We don’t want to bail out any Italian banks”. I always say, “Okay, name one major Italian bank that went under during the crisis and one major Dutch bank that didn’t—because all the Dutch banks failed. So wouldn’t it be the Italians bailing out the Dutch?” Their answer is always, “No, we just don’t have any political support for this. Even if you could make a rational argument for how this would help us, it is just not going to work”. The Chairman: Are they even opposed to just re-insurance, whereby the national bank steps in first? Professor Erik Jones: They are opposed to anything that smacks of a risk transfer that goes down on to depositors. Lord Davies of Stamford: Has this re-insurance system been agreed? I would be interested to hear what you think about it. Over time, it would solve the problem. The Chairman: I asked about what had been proposed but is not yet agreed. Professor Erik Jones: I think it would be instructive to look at the collapse of Fortis. Fortis had a giant plan for how it would be resolved since it was a tri-national bank. The first thing that happened when Fortis got into trouble was that it took that giant plan and threw it right out the window, and then ripped Fortis apart into national units. We can design these institutions and we might achieve some incremental progress in them but there has to be real political will to make them work, particularly in the context of crisis. I just do not see that at the moment.

Q80 Lord Haskins: To come back to the issue of governance, Professor Jones, you said you thought that this project in total was led for economic rather than political purposes. Yet in the innocent days pre-entry there were some very sound political criteria laid down, which were ignored by the politicians in the case of Italy, Spain and Greece. Once the union got going and the stability pact was there, sound economic reasons why that stability pact should be applied were ignored. Had they not been ignored, the world might be a different place from what it is now. We are now, however, in a situation where we say something must be done and governance must be strengthened. We hear proposals that the European Parliament should in some ways be given greater powers to ensure that rules which are laid down are applied. Maybe there is another option but it does not come to mind. It seems a pretty worrying situation if we are to rely on the European Parliament to make sure that all this happens properly. Megan Greene: I highlight that the first two countries to not comply with the stability and growth pact were Germany and France. It was not a weaker country issue necessarily. I also highlight that the only country that ticked all the boxes for eurozone membership was Luxembourg. Germany certainly did not. One problem with trying to set up rules such as these, and having a rules-based approach, is what stick you will use. Right now, if you were to punish a country for fiscal profligacy you would fine them but that is pretty counterproductive. That is the biggest issue. There is no stick that is really effective and that is why countries do not comply with these rules. This measure apparently has more teeth 211

Megan Greene, Professor Erik Jones and John Peet—Oral evidence (QQ68-81) but I think that when there is trouble they will be pretty relaxed about it as well, particularly now that we see big countries such as Italy and Spain pushing back on their fiscal targets. Lord Skidelsky: Presumably, countries pay attention to fiscal rules. In a way, it is a sort of name and shaming if not done through a fine. A code of behaviour comes to be accepted. The real issue is whether the fiscal rules are appropriate. Megan Greene: Yes, and I am not saying it is necessarily a bad thing that these rules are not considered to be written in stone. Spain’s budget deficit was 5% of GDP last year. That is a big reason why Spain is growing. Nobody seems to really notice this—and will not until the European Commission throws a big stink about it. Actually I think it is quite a good thing that often, these fiscal rules are bent—but then I do not argue that we should have a rules-based approach. Lord Davies of Stamford: The real sanction is the collapse of the government bond market in cases of excess deficit. Then you have to pay much higher rates on your new debt. That is a real pressure on Governments. Megan Greene: It should be but now you have the ECB stepping in and essentially saying that it will be the lender of last resort. You have the “Draghi put”, which means that markets are not putting pressure on these countries. Professor Erik Jones: Just to clarify, the fiscal issue may have been relevant in the Greek case but it was not relevant in the Irish case. For most of 2009, Irish bonds traded at higher yields than Greek bonds. In that sense, we have to be careful in assuming that failure to abide by fiscal rules generated this crisis. What generated this crisis was financial market disintegration in the context of a very profound economic shock from the United States. Lord Davies of Stamford: It was excessive lending in the case of Ireland, on the part of the private sector. Professor Erik Jones: In Ireland, the issue is in the private sector but in Portugal it is both private and public. In Spain it is in the public sector. It is in different sectors in every country. Lord Haskins: But in Ireland’s case, the Irish Government could have taken steps to deal with the problems in front of them but they did not. Lord Lawson of Blaby: They made it worse.

Q81 The Chairman: Can I press you, in concluding, on what other democratic accountability arrangements need to be in place? We have been pretty good at identifying what went wrong and in looking through the Five Presidents’ Report at what they want to do. But they are rather weak on democratic accountability. How might we improve on that? John Peet: That might be an insoluble conundrum. I do not think that the European Parliament provides sufficient democratic input into the European Union as a whole, and certainly not into the arrangements of the eurozone. The European Central Bank has a relationship with the European Parliament and Draghi testifies in front of the European Parliament but I do not think that that generates the democratic consent process that you see inside a single country, such as this one. But I do not think that anybody has come up with an alternative. I do not think Europe is ready for the election of the European Commission, the European Commission President or the European Council President

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Megan Greene, Professor Erik Jones and John Peet—Oral evidence (QQ68-81) because there is not a common demos inside the European Union. So we have a system that has now created a single currency and elements of a political union without the democratic underpinning that is, in the long run, desirable. It may arrive in due course but I do not think it is there yet. I am not sure that anybody has come up with a good solution for that. The Chairman: I should ask members of the Committee if they have any concluding thoughts. Well, thank you all very much for coming. That concludes today’s public evidence session. The Committee will now continue its meeting in private. Thank you very much indeed.

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Roberto Gualtieri—Oral evidence (QQ101-107)

Roberto Gualtieri—Oral evidence (QQ101-107)

Evidence Session No. 9 Heard in Public Questions 101 - 107

TUESDAY 26 JANUARY 2016

Members present

Baroness Falkner of Margravine (Chairman) Lord Butler of Brockwell Lord Davies of Stamford Lord Haskins Earl of Lindsay Lord McFall of Alcluith Lord Shutt of Greetland ______

Examination of Witness Roberto Gualtieri MEP, Chair, ECON (IT, S&D)

Q101 The Chairman: Mr Gualtieri, thank you for agreeing to give evidence to us today for our inquiry into completing Europe’s economic and monetary union. As you know, this session is on the record and we will take a verbatim transcript of proceedings, which will be published in due course. You will have the opportunity to correct any minor errors or misunderstandings.

We of course met in Luxembourg and I am delighted to see you here again. I wonder if I might kick off by asking you for an overview in your opinion of the Five Presidents’ Report and the actions introduced additionally in the short term by the European Commission. In your response, I wonder whether you would give us an overview of the sustainability now, given the architecture and the institutions we have in place, of the euro. Roberto Gualtieri: Thank you. It is a pleasure and honour for me to be heard by the House of Lords European Union Financial Affairs Sub-Committee for your inquiry into economic and monetary union. The economic and financial crisis has shown that the existing legal framework of economic and monetary union has a considerably high level of inbuilt flexibility, which allows the EMU to adapt and respond to major crises, as has been the case during the crisis. This inbuilt flexibility could be further explored. I would be prudent in considering EMU sustainable, 214

Roberto Gualtieri—Oral evidence (QQ101-107) because it has proved able to address a more major and bigger crisis than we have had in decades. Having said that, the current framework or construction of the governance of EMU is far from optimal and should be strengthened. In this respect, the Five Presidents’ Report is an important document that indicates a number of relevant actions and tracks. Generally, I have a positive assessment of the Five Presidents’ Report. Of course, I notice that there is a big gap between the short-term measures and the long-term measures. The short-term measures are important and necessary but probably not sufficient to significantly improve our governance, and the long-term measures—I will come back to the treasury—are very, very ambitious. Personally, I think, in order to have a concrete and, at the same time, ambitious and realistic road map, we should also think about an intermediate step between the more short-term and less ambitious measures and the more ambitious long-term measures. The Chairman: Do you see political obstacles to achieving these proposals? Of course, I appreciate that you chair the Economic and Monetary Affairs Committee of the European Parliament, which is a very serious role, but I am also recalling that you are Italian, and the Italian Government have their own issues with some of this occasionally. I wonder whether you could reflect on your experience as well. Roberto Gualtieri: The main obstacle is the insufficient consensus about a higher level of fiscal transfer and risk sharing. This insufficient consensus produces suboptimal economic policy answers and, paradoxically, is de facto more costly and more intrusive than a reasonable level of higher fiscal transfer and risk-sharing would be. This is a paradox, but it is the case. I will come back to that; I think you will ask more precise questions on it. We already have risk-sharing and fiscal transfer. It would be wrong just to say, “You have it”, “You do not have it”, “You have it in full” or, “You have none of it”. It is a matter of degrees. A reasonable increase of both things would probably avoid the more costly and more intrusive mechanisms that we have already seen in practice. The reason for this lack of consensus is probably in the contradiction between the European dimension of those policies and the still predominant national dimension of politics, which is an element, of course. This process is an evolution, because, as the Parliament, for instance, has more of a role and more of a prerogative, citizens will learn that it is important. For instance, what we decide on in ECON now includes banking union. After the next election, the press will probably pay far more attention to who is elected, because those people will not just make resolutions but will have decisive powers over very concrete things. Over time, the process will allow a reduction in the contradiction between politics and policy, but we currently have this issue. On the intermediate measures, I have some comments, but you are probably going to ask one or two questions about that. I am ready for them.

Q102 Lord Shutt of Greetland: Yes, we note that you are chairing the Economic and Monetary Affairs Committee. You hinted about the whole business of legitimacy, accountability and so on. Is having a committee like this and you chairing it enough, or should there be more accountability as far as looking out for the EMU is concerned?

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Roberto Gualtieri: For instance, if you refer to the accountability of the ECB’s monetary policy, it is quite strong. We are very satisfied with the level of accountability of the ECB vis- à-vis the ECON Committee. We have regular monetary dialogue with President Draghi; we also have a very strong level of parliamentary oversight of the ECB as a banking union with the SSM. However, the level of democratic accountability of the European Semester is, in my opinion, still insufficient. It is also very weak at the level of accountability over the macroeconomic adjustment programme and financial assistance, which is the intergovernmental leg of the EMU governance. We are working to improve in both the semester area and the financial assistance area. We will create a financial assistance working group within ECON—that has been decided by the Conference of Presidents a few days ago—in order to provide full oversight of the macroeconomic adjustment programme for Greece, though not only Greece. We are pushing for an inter-institutional agreement with the Commission for an answer about our role in the semester. Lord Shutt of Greetland: You have non-EMU members. You have British people on your committee. Is that how it should be? Are you happy with that? Roberto Gualtieri: This is an important point. I have very strong views on this issue. The innovation of the Lisbon treaty, which makes the Members of the European Parliament representative of the citizens of the Union, is a positive one. This currently would prevent any discrimination on the grounds of nationality within the European Parliament. That is why it is neither possible nor necessary now to have a division of the Parliament on national lines, excluding some Members for certain areas. So far, we have an asymmetric dimension. For instance, some parts of the two-pack and the six-pack legislation are only for the euro area. The legal basis is Article 136 of the Treaty in conjunction with Article 121.6. Article 136 means that in ECOFIN only the euro area Ministers vote for that. On the Council side, the two-pack, for instance, has been voted on only by euro area members but in the Parliament it has been voted on by everybody, because according to the treaty and our rules we cannot say, “No, you cannot vote for this”. This imbalance, so far as we are in the area of legislation and general rules, is positive; it is not negative. It is not a democratic shortcoming. All the euro area decisions have an impact on the non-euro area members. The fact that in the Parliament a non-euro area member can participate in the process of decision-making and debate on some euro issues is not negative. It is positive. It creates a kind of check and balance. Of course, when and if, as I hope, we have fiscal capacity of the euro area and a euro area budget, in co-operation with the ESM within the Treaty, and we have to deliberate on the allocation of this fiscal capacity only for participating euro members, that would be the time to have not a permanent differentiation of the Parliament—I am against a euro area Parliament—but, exactly as it is in ECOFIN, where only euro area Ministers vote on some legislation, the same would apply to the Parliament. However, the time would be only if and when we have a fiscal capacity for the euro area. As far as our current oversight function is concerned, I am a supporter of the fact that we are the Parliament of the Union and, at the same time, the Parliament for the EMU. Non-euro area members contribute to our activities.

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Lord McFall of Alcluith: Perhaps I could pick up a point there. If I remember correctly, the Five Presidents’ Report called for a central treasury. Given that it is calling for a central treasury, some non-eurozone members, then, would be excluded. That would result in differentiation for the Parliament. How would you overcome that? Roberto Gualtieri: This is exactly the point I raise. When we have to make a treaty change in order to have this fiscal capacity and then a treasury, it will then also be time for a specific arrangement whereby those specific actions connected to this function are voted on by participating euro area member countries. However, until we arrive at that point, any legal differentiation—which, by the way, is prevented by the current treaty—would be neither possible nor desirable. Lord McFall of Alcluith: How has informed opinion in Italy reacted to the Five Presidents’ Report? Roberto Gualtieri: I have not seen a big debate in public opinion about the Five Presidents’ Report, to be frank. Lord McFall of Alcluith: Are you worried about the Five Presidents’ Report or about public opinion? Roberto Gualtieri: The Italian Parliament and the Italian Government have welcomed the report. They are also presenting proposals to implement it. Today, the Italian Finance Minister presented his proposal for an unemployment benefit scheme to the European Parliament. That proposal is implicitly compatible with the Five Presidents’ Report and it develops some parts of it. In general, opinion among the Italian public and the Government is in favour of deeper euro area integration, but it is also common in my country—and this is my position—that we are strong supporters of the single market and the strong role of the UK and the non-euro area in the Union. In this sense, a differentiated integration tool should be used not to create two camps, but to have two circles, let us say, where the broader Union dimension should be preserved in its constitutional framework and its main achievements, including the single market. Those countries that share the currency and create economic and monetary union should have to provide enhanced governance, but that has to be done within the Union and legal framework. That is my constitutional vision. I produced a report about multi-level governance in the last mandate. The Chairman: You were a member of the Constitutional Affairs Committee of the Parliament, yes. Roberto Gualtieri: Yes, I was a co-ordinator. Along with Rafał Trzaskowski, I was the rapporteur for Constitutional Problems of Multi-Tier Governance in the EU, where we addressed exactly this issue about how you can, at the same time, avoid discrimination against non-euro area members with full respect for the Union framework and allow differentiated and deeper integration on some elements.

Q103 Lord Haskins: As you are probably aware, we have a little local difficulty in Britain in the next few months in terms of a referendum. Roberto Gualtieri: I have heard something about it.

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Lord Haskins: It coincides with the fact that this Committee is probably going to produce a report, in all likelihood, about three weeks before the referendum. As you know, 90% of the population will have read the Five Presidents’ Report from cover to cover and be waiting for the House of Lords report with eager attention to give them guidance on how it will affect the UK. What would you say to the Great British public about the impact of this and, indeed, broader aspects of the euro on the UK economy and the UK way of doing things? Roberto Gualtieri: A well-functioning, stable and strong euro area is also in the interest of the UK. At the same time, for the UK to be a strong part of the Union is in the interests not only of British citizens but also of all European citizens. I am a strong supporter of avoiding walls, let us say. That is why, for instance, in my parliamentary vision, I am against the idea of national discrimination. It is very important that British MEPs have a say in all the legislation of the Union via the European Parliament, including euro area issues. As a witness to law-making in financial markets, I have to say that UK representatives in the Parliament and the Council can be very effective and contribute towards ensuring that legislation is in the interests of the Union, including the interests of the UK, which has a very strong financial industry. To have a strong European Union with a more integrated euro area is a win-win solution. It benefits both, but of course this requires that euro area integration is done in a way that does not negatively affect the single market and the rights of non-euro area members. It also has to be done only in areas where it is necessarily required. For instance, I fully agree that— to quote Osborne or Cameron; I will remember later and we can correct it in the minutes— the area of macroprudential matters, where there are different competencies and the competencies of the Bank of England are fundamental in that area, should be fully safeguarded. In general, in areas that are beyond the remit of EMU, euro area members should not create a kind of cartel that discriminates against others. So far, I do not see this happening. In general, when it comes to EU legislation about financial markets, I have to say that I have admiration for the capacity of the UK to contribute to the definition of this legislation in a way that safeguards its interests. That is what is happening. That is why I find the case for Brexit, if I might be allowed to enter into this, a little contradictory in respect of this safeguard of British interests. Currently, the UK is one of the most capable countries at safeguarding its interests. If Britain were to leave and no longer sit at the table where those rules are made, it would be more difficult. Those rules might take into account the interests of a country with which you have an agreement, like Norway or others, but they are no longer sitting at the table where the rules are made. Lord Haskins: We are getting the feeling that a lot of the proposals in the Five Presidents’ Report are not really to do with the euro itself but are to do with the way national economies should be run, whether they are in or outside the euro. I mean things like capital markets union and all that sort of stuff. Roberto Gualtieri: Capital markets union is a project not for the EMU but for the Union. By the way, it is a project that has been presented by a British commissioner. It is not of minor importance that the Financial Services Commissioner comes from the UK. Clearly, the CMU

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Roberto Gualtieri—Oral evidence (QQ101-107) project is a project that would strongly benefit a country specialised in financial services, but this requires Britain being part of the EU, because there would be no CMU in the way Commissioner Hill is defining it if the UK were no longer a part of that. CMU should not be confused with EMU. EMU is the specific conduct of fiscal and economic policy with enhanced co-ordination for those countries that share a currency. That requires some specific tools that should, of course, remain valid for countries that are part of economic and monetary union. There are broader dimensions of the single market, freedom of movement of capital, rights and the rule of law, which are at Union level. A member state can happily keep its currency, have stronger sovereignty over monetary policy, as is the case currently, and conduct fiscal policy in a less constrained way than those countries that are part of the EMU. The Chairman: Professor, given that you have said that, assuming there is no UK exit from the EU, is the UK likely to be helpful in completing EMU, unhelpful or simply detached? What is your prediction? Roberto Gualtieri: I appreciated the article in the Italian press that was co-signed by the Italian and British Foreign Ministers. While, of course, they have different views on a number of things, they agreed that it could be of mutual benefit to have a stronger, more integrated euro area in the framework of a strong, robust single market in a well-functioning and reformed Union. The two dimensions can mutually reinforce each other. It is a process that goes beyond this specific so-called renegotiation. It is a process that will have to continue in the framework of the Five Presidents’ Report’s implementation. I am sure that we could create exactly this multi-tier mechanism as a long-term and strong solution for the EMU and the EU.

Q104 Lord Davies of Stamford: I was going to ask you, Mr Gualtieri, what you thought about the European Semester, but you have already answered that you feel it is on the whole a favourable, positive development, and, if there are shortcomings to it, they are being addressed. You also referred to intermediate measures that you thought could be taken between the initial measures taken on the back of the crisis and the long-term vision. My impression was that you had in mind an extension of the European budget in that context, but I am not sure that is what you were referring to. Can you tell us what those intermediate measures are, as specifically as possible? Roberto Gualtieri: Yes. We are elaborating a number of proposals. Some of them are proposals of the Parliament; some are more proposals that I am stressing. For instance, we suggest the introduction of convergence guidelines for the EMU. We suggest more binding targets for convergence of economic policy and, on the other hand, to have a fiscal capacity for the euro area in order to provide some incentive to this convergence and perform some function. For instance— Lord Davies of Stamford: Let me just stop you there for a moment. To what extent would you like to see the fiscal capacity extended? Do you want to go to 2% or 3% of GDP? What kind of range or multiple do you have in mind? Roberto Gualtieri: I am a supporter of gradualism in policy, because I think only gradual things work. First, we have to build an embryo of fiscal capacity, which would probably be

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Roberto Gualtieri—Oral evidence (QQ101-107) more limited. It should increase and reach a certain dimension, but I cannot to give figures, because we are working on that. Lord Davies of Stamford: Let me put it this way. Would it reach a dimension that would become relevant in terms of automatic stabilisation of fluctuations in the economy? Roberto Gualtieri: It is very difficult to give a figure now. You can have a significant function without having an enormously big fiscal capacity. Staying below 1% of GDP, you can already perform some automatic-stabilisation functions. We have the ESM. Lord Davies of Stamford: We are already at 1%. Roberto Gualtieri: On top, yes. 1% is the Union budget. The Union budget is now slightly below 1%. I am talking about what we put on top, additionally. Lord Davies of Stamford: Less than 1% in addition is what you had in mind, yes. I understand. Thank you. Roberto Gualtieri: Of course, in the medium term, EMU could benefit from an enhanced or higher level, but we can start to perform significant functions staying below that figure. Lord Davies of Stamford: What would those functions be? What specific programmes did you have in mind? Roberto Gualtieri: There are two elements in particular: an enhanced investment capacity and, on the other hand, an automatic stabiliser, in particular to address conjunctural, not structural, unemployment. Those two are the most significant functions. Lord Haskins: Do you mean something like the steel crisis? Roberto Gualtieri: Yes. That would be fiscally neutral in the medium to long term, but it could address cyclical unemployment and benefit requirements and help absorb shocks. I am a strong supporter of private shock-absorption capacity. Capital markets union and banking union can and will significantly enhance our shock-absorption capacity. It does not have to be either only or mainly a public function. The private side is very relevant. But it cannot be only private. Even for those who take the famous US example, they have this, but they also have the other one. I am saying that we have to build our CMU and banking union not only as a tool for having at an EU and EMU level an enhanced shock-absorption capacity, but also, at the same time, we have to enhance our public shock-absorption capacity. By the way, in part we already have done, because we have the Union budget with the cohesion policy, which already makes fiscal transfers. It is just an issue of dimension, not an issue of the thing in itself, which is not new. Since the crisis, we have created the European financial stabilisation mechanism. It is in the form of loans, in this sense, but it can contribute to absorbing shocks. We already have some tools, but we need to streamline and improve them. The Chairman: The conversation has gone, to quite a deep extent, into fiscal union. I wonder if I could bring in the Earl of Lindsay to cover that area now. Could I also clarify something? When you were talking about stabilisation capacity, you were emphasising it for shock absorption but not for structural issues. Take the steel example. Roberto Gualtieri: No, I said both.

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Lord Haskins: Steel is very relevant, because the problem exists in Italy, Germany and the UK in particular. The Chairman: It is structural. It is not cyclical. Lord Haskins: It is something that needs a European solution, because it is a problem right across the three countries. We are struck by state aid. There is a resistance to state aid. Nobody can do anything, because of state aid rules, without an intervention from the EU. Roberto Gualtieri: I fully agree.

Q105 Earl of Lindsay: I wanted to pick up on two useful references you have made in your answers about fiscal union. Your first useful reference was to how parliamentary scrutiny might be adapted, as it were, to oversee fiscal union. In a sense, you have given us a more detailed definition of what fiscal union means than appears in the Five Presidents’ Report. Are you able to give us an insight into what you think will emerge as the intended formula for fiscal union? Are you able to share with us whether there will be sufficient appetite and consensus to deliver it, or whether you think there will be quite serious pushback? Finally, do you see full transfer union being desirable in order to underpin the long-term stability of EMU? Roberto Gualtieri: To make a forecast and to have a political programme are two different things. Of course, a political programme has to be realistic. At the same time, a politician cannot do anything based simply on forecasts. I would distinguish the two things. As I said, there are some political constraints that make it more difficult to make strong, bold moves towards what would be a more rational, in my opinion, and more optimal solution in terms of cost and risk-sharing. At the same time, we are moving forward nonetheless. While I am a realist in terms of knowing that a number of the measures are not very likely to be taken in the short term, I am more confident about the fact that we are not blocked. We are in an interesting evolutionary process. I expect that it will be gradual. We can distinguish three steps within this. The first step is making use of the current instruments we have. The instruments we have, such as the flexibility within the stability and growth pact, for instance, or the macroeconomic imbalance procedure, and the tools we have, including the ECB, the EIB and so on, could allow us to evolve towards a more consistent fiscal and economic policy at EMU level. Of course, that would not radically transform the normal state fiscal and economic policy, but it could be more consistent than the current one. This path could then create the conditions for measures in the second step, which are those that could be taken within the current treaties but would require legislative changes. For instance, I spoke about convergence guidelines for the streamlining and simplification of the stability and growth pact, the building of an embryo of fiscal capacity within the Union budget, and the enhancement of our investment capacities, by making use of the tools we have and making a new legislative text. Then there is the third step, which is treaty change. I do not think we now have consensus for treaty change, but if we are able to deliver better results in terms of recovery and positively address the big challenges—we are not talking about it, but that includes the

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Roberto Gualtieri—Oral evidence (QQ101-107) refugee crisis and migration—we can create the conditions for treaty change and have a more sound, effective and efficient construction of governance for EMU within the Union. We have these three steps. I expect and hope—and I am working for this—that we will make full use of the tools we have in order to create more consistent conduct of fiscal and economic policy. For instance, now we have this new concept of the aggregate fiscal stance of the euro area. If you look at this in connection with the flexibility of the stability and growth pact and the macroeconomic imbalance procedure, it could create the conditions for more consistent and effective conduct of fiscal and economic policy. Earl of Lindsay: Do you want to see full transfer union as part of fiscal union? Roberto Gualtieri: I have some difficulty using the words “full transfer union”, because, as I said, it is just a matter of quantity. We already have a transfer union; we already have some fiscal transfer. There are the conditions for enhancing the level of fiscal transfer and risk-sharing gradually, in parallel with the strengthening of our convergence and budget rules. The two things could arrive in parallel and gradually evolve: first, by making use of the current set of rules; secondly, by having legislative changes within the current treaty framework; and, thirdly, by arriving at treaty change. The Chairman: Professor, you say “gradually”. What time horizon are you thinking of? Roberto Gualtieri: I hope the White Paper of the Commission will identify a road map with some legislative measures to be taken within the current legislative term and a road map for treaty change. The Chairman: When you say “current legislative term”, do you mean by 2019? Roberto Gualtieri: Yes.

Q106 Lord Davies of Stamford: Mr Gualtieri, on the matter of transfer union, what conclusions do you draw from the Italian experience? My understanding is that since the 1950s you have been subsidising Puglia, Calabria, Sicily and Sardinia at the expense of Piedmont, Lombardy, Friuli-Venezia Giulia and Veneto, et cetera, in the north. Has that been a happy experience or have you created a sense of dependency that has actually produced the evil you were trying to remedy? The Chairman: You do not have to declare which part of Italy you are from. Roberto Gualtieri: I am from Rome, so I am in the centre. Whenever you have more than one person, you have some degree of transfer union: in a family, a city, a region or a state. I would avoid being ideological on that. If you ask me not about the concept of fiscal union but about the policy for the south of Italy, you have to look at different historical moments and you will see different results. Of course, the policies can have different natures. You can have fiscal incentives; you can have more investment; you can have different mechanisms and tools that can work differently according to which stage of history you are at. Cohesion policies are relevant policies that benefit everybody in general. Of course, they have to be efficient and effective. They have to work. If you look at East and West Germany, they worked. If you look at some cases in the south of Italy, they worked. In

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Roberto Gualtieri—Oral evidence (QQ101-107) other cases they did not work, but the fact that sometimes those policies did not work well is not a good argument not to have them. You have to find the correct policies that work. Lord Haskins: At the time Italy joined EMU, was there not a suggestion that a lot of these internal problems in Italy would somehow miraculously be solved by the single market? That has not happened. Roberto Gualtieri: The single market was before. Lord Haskins: I meant the single currency. Roberto Gualtieri: You keep asking me about Italy, but I am a representative of the Union here. The Chairman: Indeed, yes. I stressed that at the beginning. Roberto Gualtieri: I am also from Italy, so I am happy to answer as an Italian, although I am not talking on behalf of our Government, even if I am of the same party as my Prime Minister and share his views. I would say that being part of an economic and monetary union has benefits for Italy in general. Of course, sharing a currency does not solve all the problems. There are measures that need to be taken at national level. The current Government are engaged in a very strong set of structural reforms, which are proving to be very effective, by the way. If you look at labour market reform, it is providing jobs—and good jobs. On the other hand, of course, we need the currency to be managed well and to conduct a good economic policy. Clearly, it has not always been the case. During the crisis there has been a clearly political trade-off, which was driven more by political considerations than economic ones, between allowing financial assistance to member states—EFSM, EFSF and then ESM, the ECB and outright monetary transactions—on the one hand and, on the other hand, an enhancement of the fiscal stability and growth pact framework, which in itself is a good thing but which resulted in pro-cyclical fiscal policies, which proved not to be effective. This was more a political trade-off than the conduct of sound economic policy. Of course, this did not benefit Italy, because it did not benefit Europe in general. That is something that can and must be correct, but this does affect the fact that having a single currency has improved the strength and resilience of all participating members, including Italy.

Q107 Lord McFall of Alcluith: As a Scottish MP for 25 years and someone living in Scotland, I am very much aware of the economic and political grievance agenda, so I would say to you that we have things in common. The message I have for you, as you probably know, is that it will never go away. That is the issue. But I would like to get your guesstimate on the EMU. 2025 is the nominal date for the completion of EMU. Roberto Gualtieri: What do you mean by 2025? The Chairman: The Five Presidents’ Report sees the road map going up to 2025. Roberto Gualtieri: 2025 is the year, yes. I am sorry. I understand, yes. Lord McFall of Alcluith: Looking to that date, how much fiscal union do you envisage by then? Roberto Gualtieri: By 2025, I envisage more than we have now. 223

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The Chairman: That is a very political answer. Lord Davies of Stamford: The Union budget will be what proportion of Union GDP by that stage, in your estimate? Roberto Gualtieri: Maybe the Union budget, to the happiness of a strong UK in a reformed Union, would not be much higher; but maybe we would also have, on top of that, a higher euro area fiscal capacity. Lord McFall of Alcluith: Could I refer you to the European deposit insurance scheme? We have asked other witnesses about the position of Germany, which seems to have the most reservations. Do you consider that building blocks are required in order to get to the end point there? For example, that could mean increased measures of financial risk being a necessary precondition for risk-sharing. At the end of the day, do you envisage this being adopted? If it is, how would we prevent moral hazard in the euro area? Roberto Gualtieri: First, the current Commission proposal on EDIS is very gradual. Even when we arrive, at the end of 2024, at mutualisation, we are talking about only a very limited percentage. It is not open-ended; it is 0.8%. On top of that, the current rule for the bail-in of shareholders and debt holders is for juniors, seniors and depositors above €100,000. I fail to see how this is an incentive to moral hazard. That would mean that a bank would be giving loans not in a sound way because they would say, “Okay, we will have to be bailed in. We will lose everything, but we will save deposits for 0.8% below €100,000, so we will be happy”. To be serious, the current recovery and resolution provisions are a very, very strong ingredient against moral hazard. I do not see that ensuring the same level of protection of deposit across the banking union would enhance this moral hazard. Having said that, of course risk reduction should be done in parallel with risk sharing. First, we should be reminded that we have the single supervision and single resolution, which are also strong elements of risk reduction. Of course, we need full implementation of BRRD; we need implementation of the current provisions. It is obvious that we cannot do something more if we do not do what we are doing. Then there is the specific issue, which is implicit in this debate, of calibration of exposures to sovereign debt by banks. As is written in the Basel report, concentration limits can be considered, but that has to be in the framework of international discussion and decision in the Basel Committee. I would strongly discourage the frontloading of measures at the EMU level, because that would create imbalance. This is a sensitive thing. To consider this a precondition is clearly something that is not acceptable and will not happen. I agree that we have to start this discussion and be part of the Basel discussion in this remit. This does not prevent that. The ECB is also coming forward with proposals. If we have to start with discussion, I say yes. If we have to change the order of things—this is not just me—it simply will not happen, because it is not reasonable. Having said that, I am confident that we can work on EDIS. We have ordinary legislative procedures, so the Council and Parliament can amend the proposal. I am confident that we can address and solve problems. I am relatively confident that we can conclude this legislation in a reasonable timeframe.

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The Chairman: Thank you, Professor. I understand that you have other pressing appointments, so may I thank you so much on behalf of the whole Committee? It has been a very useful session. We have been hugely enriched by your agreeing to meet us today. Thank you. This now concludes the public part of the meeting. Roberto Gualtieri: Thank you.

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Hans Hack, Guntram Wolff and Fabian Zuleeg—Oral evidence (QQ118-128)

Hans Hack, Guntram Wolff and Fabian Zuleeg—Oral evidence (QQ118-128)

Evidence Session No. 11 Heard in Public Questions 118 - 128

WEDNESDAY 27 JANUARY 2016

Members present

Baroness Falkner of Margravine (Chairman) Lord Butler of Brockwell Lord Davies of Stamford Lord Haskins Earl of Lindsay Lord McFall of Alcluith Lord Shutt of Greetland ______

Examination of Witnesses

Fabian Zuleeg, Chief Executive, European Policy Centre, Guntram Wolff, Director, Bruegel, and Hans Hack, Managing Director at FTI Consulting Brussels

Q118 The Chairman: Mr Zuleeg, Mr Wolff and Mr Hack, thank you for agreeing to give evidence to us today for our inquiry into completing Europe’s economic and monetary union. This session is on the record and we will take a verbatim transcript of proceedings, which will be published in due course; you will have the opportunity to correct any minor errors or misunderstandings. We have started a little bit late, so I would like to go straight into things, if I might. I wonder whether all three of you could give us a brief overview of your understanding of the Five Presidents’ Report and the shorter-term actions proposed by the European Commission. In doing so, perhaps you could comment on your perspective on the euro’s longer-term sustainability and if you think there are significant political obstacles to achieving what is proposed in the report. Lord Butler of Brockwell: Chair, when our speakers first speak, could they just identify themselves, because we do not have name places? The Chairman: Indeed. Mr Wolff, would you like to kick off? Guntram Wolff: Yes. My name is Guntram Wolff. Thank you very much for having me today. I run the European think tank Bruegel. We are coming out with a paper this week called One Market, Two Monies: the European Union and the United Kingdom, where we look

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Hans Hack, Guntram Wolff and Fabian Zuleeg—Oral evidence (QQ118-128) specifically at the current negotiations with the United Kingdom but take a more long-term view. That is not the topic of today’s discussion, which is why I only mention it here. The Chairman: We will be coming to it a bit later in the questions. Guntram Wolff: Right, so let me quickly say a couple of words on the Five Presidents’ Report. Essentially, the report has two phases, the first phase and the second phase. The second phase is quite weak in terms of what is being put there. It mentions all the right things that are in the discussion—fiscal union, democratic accountability and so on. The long-term elements are all there without being very concrete and so it is up to political discussions what will happen there. The time horizon is 2025, and my sense is that people at the political level think that this is very far away still and so no concrete progress has to be made at this stage. There is a reflection, though, at least in some quarters, that perhaps we should be a little bit more specific on some of the concrete issues ahead of the big elections in 2017—the French election and the German election—and then, of course, at some stage, also the European Parliament election. There is no final political decision, but my gut feeling currently at the moment is that, given all the other ongoing political issues, in particular the refugee crisis, political capital is very much in different quarters at this stage. Then there are the short-term issues. The big debate this year concerning the eurozone will continue to be on banking union, where we have a proposal for a European Deposit Insurance Scheme on the table. Overall, this proposal is done in a smart way, in the sense that it proposes to start with a reinsurance model and eventually to move to a full insurance model. There are a lot of questions about whether Germany buys into this or not, so let me be straight on this. The resistance is very large in Germany; that is very clear. At the same time, I also hear important messages that, especially if combined with a risk reduction approach, it is possible to introduce that system. The discussion at the moment is really about whether we should have deposit insurance plus risk weights for sovereign debt or large exposure rules for sovereign debt. There is already an agreement forming that those two things are connected: we get deposit insurance on the one hand and, on the other hand, we get risk reduction. Personally, I favour risk reduction through large exposure rules, not risk weights. It raises all kinds of questions. The Chairman: We will be coming to that in a little while. Mr Hack. Hans Hack: My name is Hans Hack and I am head of the financial services part of FTI Consulting, which is a consulting firm here in Brussels that helps companies deal with EU legislation. Before that, I worked for the Dutch Government for 10 years, at the Ministry of Finance and as a permanent representative just across the street. I agree with much of what was just said in this introduction. On the short-term actions, you do see progress. For example, on EDIS, you do see that countries that were initially as hesitant as the Germans have become much more positive—not least the Dutch, who are chairing the negotiations right now and have made it a priority to progress. So I see significant chances to progress the short-term actions. If you ask about the long-term viability and the long-term projects, indeed, it is relatively undefined and attention is elsewhere, but I find one aspect of that quite relevant and that is how member states will start to own procedures around, for example, the European Semester. What do I mean by that? Until now, there was always an implicit agreement

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Hans Hack, Guntram Wolff and Fabian Zuleeg—Oral evidence (QQ118-128) between member states that it is the European Commission that comes out with its assessments and recommendations and member states then have a bilateral discussion with the European Commission about whether they were right or wrong. It would be a significant game-changer if that were to become a multilateral discussion whereby member states openly discussed with each other the pros and cons of their economic policy and the value of those country-specific recommendations. There might be a chance that that will happen, because I have heard the Dutch Government quite clearly state that they want to focus on that in the European Semester in the next six months—to break that implicit agreement a bit and get that discussion going between member states. We will see how that turns out, but that could be a significant change in how the systems operate and could lead to more co-ordination of economic policy. Fabian Zuleeg: I am Fabian Zuleeg; I head up the European Policy Centre, which is another Brussels-based think tank. I agree with much of what has been said, so I am not going to repeat it. It is a useful report in that it has the right terms. What is worth emphasising is that the political buy-in into the report by the member states was not particularly convincing. They welcomed the report, which is, in my view, a way of saying, “We have noted it, but we are not intending to do anything with it”. The big question of what will happen in the longer term with the recommendations in the report is not addressed. While you could have some discussion around some of the specific solutions, as much as they are specific in the report, it is much more important to recognise that the political will is not there at the moment to progress in that direction. In the longer term, we will need to have some form of political deal, particularly between France and Germany, on the way forward, which will not be easy before the elections, so we are not going to see much progress. In the shorter term, we have had the proposals from the Commission about revamping the European Semester in line with the Five Presidents’ Report. I am not sure that this will really make such a big difference to how the European Semester works. It is not working at the moment, which is a major concern that we have. One of the key planks of the whole new governance does not seem to be performing very well and maybe there will be more pressure from some of the member states. But, so far at least, it does not seem to engender any change within member states’ policies, which ultimately is the purpose of the country-specific recommendations. We should also not forget Greece—not in the sense of the structural issue, but there are some Greek-specific issues that will have to be addressed in the coming years. I do not think we should wait until we have another crisis in Greece before we start addressing those. We also need to make progress on banking union, but I am not going to go into any more detail, because it has already been mentioned and there are more questions later on. To wrap up with the question about how sustainable the euro is, I would not expect the euro to collapse any time soon, but if those structural issues are not addressed we can be fairly certain that some sort of crisis will recur. Then the question is how you deal with that crisis and whether the eurozone is robust enough to again find political consensus and the countries can pull themselves together to take whatever actions are necessary. We should recall that when it came to the crisis with Greece last summer it was a very close call, so maybe we should not risk doing this again. But, at the moment, there is very little action that makes me feel confident that we will not.

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Lord Butler of Brockwell: Could I just ask Mr Zuleeg to be a little more specific about the Greek-centred questions that he sees coming up in the next two or three years? Fabian Zuleeg: There is the ongoing discussion about the debt level in Greece and what will happen with it in the long run: whether at some point in time there will have to be some form of debt forgiveness or postponement into the future. It is not necessarily an immediate problem, because the way the debt repayment is happening now is not a particular burden on the Greek economy, but it is a long-term question that remains unanswered. The more acute question is going to be how well Greece performs in relation to the support package, which has been very strongly emphasised as being the last. What happens if we get to the end of this support package and Greece still needs support? For me, that is the big question, which we have not really answered. Guntram Wolff: I have two quick remarks on Greece. The first is on debt sustainability. We clearly still have far too high a goal for a primary budget surplus and there will have to be an adjustment. From a political point of view, let me make a broader point. In the Greek financial crisis there was a lot of talk about how we need to keep Greece in the euro for geostrategic reasons, because it is our outside border to the EU. The current refugee issue raises lots of doubts about this question, in the sense of whether or not we believe that this is really the outside border or whether, in fact, the fences will be in Macedonia or elsewhere. This raises all kinds of questions and, certainly in the capital of my home country, Germany, I see a lot of sentiment that says that this is really changing the whole game, so I would warn that this is an issue to take into account. Lord McFall of Alcluith: Could I ask if the migration crisis will spill over into economic issues and economic policy? Will there be trade-offs? Guntram Wolff: The direct spillover is not very big. The fiscal costs of the migration crisis are quite limited. Undoing Schengen would be costlier. There, we end up with something like, perhaps, a two-digit billion number and then there is the big psychological dimension that you would undo a significant integration step, which raises all kinds of questions in other policy areas.

Q119 Lord Shutt of Greetland: Not unsurprisingly, we are concerned here about the UK and we look forward to this paper, One Market, Two Monies. I do not think one of those monies is Swedish, but we nevertheless hang on to other outs as well. What impact is all this going to have—the direct and indirect impacts of all these actions identified by the Commission to complete EMU—on non-euro member states and particularly the UK? Guntram Wolff: Thank you for that question. Let me consider the long-term issue that you raise, which is: if the eurozone takes additional integration steps, what are the consequences for the outs? The fundamental question is whether euro integration steps will have an impact on the operation of the single market, of which the UK is a member. Let me put in parentheses that no matter whether the UK is inside or outside the EU the question is the same, because the access to that market is of fundamental importance. The governance is different, but the access to the market is fundamental. The eurozone deepening will involve three major markets: banking markets, capital markets and, potentially, labour markets. A defining feature of all these three markets is that these are not just some random, free-floating markets; they are fundamental for our economies 229

Hans Hack, Guntram Wolff and Fabian Zuleeg—Oral evidence (QQ118-128) and they are characterised by very heavy government regulation, government intervention and implicit or explicit fiscal arrangements. If you believe that we will go forward with deeper integration in the eurozone—and there is a big question mark here, but let us assume we will do this—there will be, at some stage, the creation of new governance mechanisms to cope with the deeper integration of the eurozone. Then the question arises: will these governance mechanisms, be it institutions, stronger euro group meetings—you can think of different ways of organising this—be a problem for the UK and other outs? The bottom line here is that, in order to come to a sustainable arrangement, one has to find a way to protect the minority against the majority of the eurozone. Conversely, of course, the eurozone also needs some form of protection against the veto of the minority. The minority should not be able to veto major steps that are necessary. This whole discussion is already starting to be quite concrete. Let me give you one example, which relates to the discussion on capital markets union, where the Five Presidents’ Report contains a clear statement saying that deeper capital markets will require a European capital markets supervisor. This is a clear reference to an institution, while Lord Hill’s proposal on capital markets union carefully avoids any reference to a supervisor. Already within the Commission you see that there are different lines of thought around what it takes to deepen capital markets and they are fundamentally different because of the different logics of monetary union and the single market. Our paper will be published this week. The Chairman: We look forward to it. Mr Hack, you wanted to come in on that. Hans Hack: I just want to say something about whether the interests differ or not. So far, the UK’s approach has been to let the eurozone sort out its own mess, if I can put it that way. But of course it is in the interests of the UK as well that the eurozone does do that and sets up sustainable institutions to have that economic growth. If you look at some of the longer-term or shorter-term points in the Five Presidents’ Report, I would see more alignment than differences in terms of what they are trying to achieve. For example, we still have to see how national competitiveness councils will work and what influence they have, but the basic idea would be to have external experts assess the governance policies from a competitiveness point of view. I tend to think that that is something that would be in alignment with the UK’s view on how an economy should be managed, so I do not immediately see a disconnect between the interests of the UK and those of the eurozone and what those countries are trying to achieve through the Five Presidents’ Report. Of course, what is a certain risk is a two-speed Europe and how that impacts, but Mr Wolff has dealt with that aspect. Fabian Zuleeg: I have a couple of points. Firstly, there needs to be recognition that greater stability in the eurozone directly benefits the UK, so the question of what is in the national interest of the UK, whether it is blocking something that might have a specific negative impact on the UK but has a positive impact on stability in the eurozone, needs to be questioned. Secondly, we already have a multi-speed Europe and the big question going forward is: even if we are seeing more integration in the eurozone, is that going to involve all eurozone countries or are we moving more towards a model where groups of countries will go ahead and integrate particular issues? For some of those areas of integration it might well be in the UK’s interest to join them. There is an argument about whether banking union would make more sense with the UK inside, from a UK perspective—the question of

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Hans Hack, Guntram Wolff and Fabian Zuleeg—Oral evidence (QQ118-128) whether it is really just the eurozone or is it going to be some form of combination of countries. We also have other things on the table, like the financial transactions tax, which is not carried by all the eurozone countries. There will be different models of integration. It is very unlikely that we will have one master plan for the eurozone that will advance integration in a uniform way. Finally, I want to put down a marker that, while there is a legitimate concern of the UK around eurozone integration and what that might mean, we should also recall that when it comes to single market regulation the single market is, by law, qualified majority voting. That means there is the possibility for countries to block, but there will be no possibility, in my view, that a particular country will get a veto on single market legislation for particular sectors. Sometimes when you hear the debate in the UK there is this idea that this means that the UK will get a veto on anything that affects the financial sector. Politically, this is an impossibility.

Q120 Lord Davies of Stamford: I would just say that the Prime Minister has not asked for such a veto and the Government do not expect one. What is your concept of fiscal union? What do you think is the minimal degree of fiscal union that is necessary to establish a sound basis for monetary union and can that minimal degree of fiscal union be achieved within the context of the present treaty without treaty change? Fabian Zuleeg: I am not a particular fan of the term “union”. We throw the word “union” around a lot in many different contexts. A union implies a very high degree of integrated policy-making, which I am not sure fiscal union always refers to. There are some minimal requirements in something that you would call fiscal union: some form of risk sharing, some mechanisms to deal with ex ante and ex post shocks. A transfer element is an essential part of fiscal union. Lord Davies of Stamford: Permanent structural transfers exist in other states. Fabian Zuleeg: Yes. I mean a permanent mechanism. It does not necessarily imply that it would be permanently in one direction or permanently to the benefit of certain countries, but a permanent mechanism. The key thing for me is that, if we are talking about fiscal integration, we have to talk—and here I do use the word “union”—of some form of political union. Fiscal integration is getting too close to the key issues of sovereignty within member states, so there has to be some form of democratic accountability, and a mechanism that allows constitutional courts across the eurozone to sign off on some form of fiscal union. That is a major challenge. It does not necessarily mean there is only one specific way that that could be designed, but there has to be something in there about how you make that democratically accountable.

Lord Davies of Stamford: So your answer to my question is that the degree of fiscal union necessary for the viability of monetary union cannot be achieved without treaty change. Fabian Zuleeg: In my view, it cannot be achieved without treaty change. We will have to have a round of treaty change. There are things that can be done before treaty change but, in the end, if we are talking about anything approaching a political union, it clearly requires treaty change.

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Guntram Wolff: Thank you for that question. My first point is that it is quite unclear what “viability of monetary union” means and what that term really refers to. Is it meant in the sense that political support in all countries will continue to be there to stay in the euro or is it in the narrower sense of fiscal backstop mechanisms to prevent a break-up at the level of monetary integration? I would argue that, in terms of the viability of monetary union in a more political sense, we will need more integration in order to strive and have better economic performance. Currently, we are surviving; we are not breaking apart with the mechanisms we have, but we are not really striving. That is my first point. My second point is that when we think about fiscal policy, we have basically three old functions from Musgrave: allocation, distribution and stabilisation. For allocation, it is very difficult to think about public goods that are genuine eurozone public goods. Defence, Schengen, all these things are for the EU or different combinations of countries, but not eurozone public goods. Therefore, on the public goods side, I would argue that there are very few public goods beyond financial stability for which we need a banking union with a fiscal backstop. On redistribution, we are clearly not at a stage where we want to have large redistributions around the union, where money flows from one country to another. Living in Belgium, I can tell you that even countries like Belgium are under a heavy strain because of this. That leaves me with the stabilisation question, and here the important point to understand is that stabilisation means that you have to have significant budget spending items and they are all at the national level. Ninety-eight per cent of government spending is national. In other words, if we talk about stabilisation policy, we are talking about national fiscal policies and how we can ensure that the sum of the national fiscal policies makes sense for the eurozone as a whole, as well as that each national fiscal policy makes sense for that individual country. It is very much about co-ordination of these national fiscal policies and we need to step that up, improve it, and get a more symmetric notion there that considers the area-wide fiscal stance. That co-ordination will probably be extremely difficult, which is why I currently have a preference for adding an element of additional risk-sharing to what we have. We currently have the ESM as a risk-sharing mechanism and as a way to prevent excessive austerity in countries that lose market access. We need something on top of that and I would do that quite automatically, perhaps something like an unemployment reinsurance model. Lord Butler of Brockwell: Does it follow from that answer that you think that the fiscal board proposed in the Five Presidents’ Report is a necessary step forward and do you think it will be effective? Guntram Wolff: It is a good and necessary step forward. Whether it will be effective we will see, but the first problem is already that its independence relative to the European Commission is not totally clearly defined; let me put it that way. It will be extremely important for the new fiscal board members to, early on, announce that they will make their recommendations very public and have a public press conference to have an impact on the debate. Of course, a fiscal board or fiscal council is never the authority that takes the decision. It can only advise. That is what fiscal councils do and I hope that they will push the debate a bit in the direction of a euro area fiscal stance and the better co-ordination of national fiscal policies.

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Q121 The Chairman: I wonder if I can pick you up briefly on the fiscal stance. Do you think that there are explicit ways to arrive at such a stance? How do you see the direction of travel? Guntram Wolff: How do we co-ordinate the national ones? The Chairman: Yes. Guntram Wolff: What we need to make sure, especially in exceptional times when monetary policy is really constrained—and I am in favour of QE but it may not be sufficient to do the job—we have to find a way of saying that certain countries have to spend more and increase their deficits, while others that already have quite a problem with fiscal sustainability continue with a gradual fiscal adjustment path. The Chairman: Thank you. That is a very clear hint, we think, to the country you come from. Mr Hack wanted to come in, then I will bring you in. Hans Hack: I will be brief. The fiscal union part is very much linked to the political union part and that is where the greatest challenge lies. There is a lot of talk about the expenses side of fiscal union, but on the income side there is also a great challenge. One of the greatest challenges of this whole report and what might be missing is more integration of labour markets, taxation, even healthcare systems. If the fundamental economic policies differ too much, it will make it very difficult to integrate. It is carefully crafted to not touch directly on those areas and this is where the treaty change comes in, because that is where the powers of the European institutions to do something are very limited. Fabian Zuleeg: I wanted to make a brief comment on fiscal councils and those kinds of mechanisms. I agree with Guntram that they are useful; they can help to create greater transparency and maybe engender some discussion. What we are fundamentally not addressing comes back to the political question. What we are fundamentally not addressing is that the political decisions linked to fiscal policy are still accountable at the national level. They are not accountable at the European level, so it is very difficult unless you have a country in extremis, which does not have the choice any more because it needs support at the European level. For those countries that are in a normal political situation, it has proved extremely difficult to encourage co-ordination. The Chairman: So how would you get the Germans to run down their surplus a little bit? Fabian Zuleeg: The big question, which also goes into some of the other questions, is that it is very difficult to make progress if we are looking at it single issue by single issue. This is a way of getting the narrow national interest to the forefront of the debate. If you are discussing a particular issue, then it is very difficult for Germany. For instance, for Germany to address the export surplus it immediately creates a political backlash, which immediately creates political problems at the national level. We have to look at this as a much bigger package that even goes beyond EMU, where we are looking at what it is we can give and take across a number of different areas to get more structural long-term solutions where countries also transfer some of the sovereignty in these areas to the European level, which they are not willing to do. The Chairman: Do you see that happening after 2017?

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Fabian Zuleeg: I do not think you should ask an economist to make predictions. For the first time in a long time, Europe is truly at a crossroads. We can decide to continue to try to muddle through, which is what we have been doing for a number of years, or we will have to face the very difficult question of finding a big structural solution. It is not necessarily clear what that structural solution is, not least because we would also have to discuss that kind of thing with populations. This is not something that you can simply install. If we are looking at a treaty change process, we are talking about a large number of actors being involved down to referenda in a number of different countries. It is a very involved process, so clearly we are not going to do that in the short term and there is no appetite for having any of this kind of discussion in the short term. Whether the political constellation is more favourable in that direction after 2017 is a possibility, but it is not a certainty. Lord Haskins: Are you not really hitting at the nub of the issue, which is the lack of political leadership across the EU? If you go back to the 1980s, the big countries had a strong common understanding and agreement about where they wanted to get to. Today that common understanding simply does not exist. Fabian Zuleeg: I agree.

Q122 Lord Davies of Stamford: As Mr Zuleeg said, there is little appetite at the moment, in the immediate future, for treaty change. Therefore, we need to look and see what can be done without treaty change to stabilise monetary union as far as possible. One of the most interesting risk-sharing or stabilisation measures being talked about is the Bruegel proposal for a common reinsurance of our unemployment fund. I gather you have devised something that addresses the potentially serious problem that you would otherwise have of reverse incentive. You do not want to have taxpayers or premium payers in virtuous countries with no unemployment rates subsidising high structural unemployment elsewhere, so you have to find a way of avoiding that. I gather you have succeeded in doing that and I wonder if you could tell us a bit more about how your proposal would work. Guntram Wolff: Thank you for that question. The idea of an unemployment reinsurance model is to keep unemployment insurance at national level, as it is, but in the case of a large shock there would be a reinsurance payment to that country’s unemployment insurance, coming from a common fund. That shock would be clearly defined; let us say an increase in the unemployment rate by two percentage points or three percentage points—one can discuss that. As is usually the case with insurance, every country would have to participate because otherwise you just get the bad risks. You would have to make sure that there are certain minimal conditions that need to be fulfilled on the labour market side. I would also ask for variable fees for the different countries depending on some objective criteria— insurance premia depending on more or less objective risks. That is the way of designing it, but the broader question is: what if we do not get the fiscal union and the adjustment that we would all like to have? What is important to understand is that we have the ECB currently buying a lot of sovereign bonds. My take is that, if we have another financial assistance programme, like an ESM programme, because despite these sovereign bond purchases a country runs into trouble, at this stage it would be quite important to ensure that the private sector somehow stays on the hook. The proposal to increase the maturities of sovereign bonds once you start an ESM programme is something we should very much keep in mind. It is a soft form of debt restructuring because, if debt 234

Hans Hack, Guntram Wolff and Fabian Zuleeg—Oral evidence (QQ118-128) needs to be restructured, it is not a good idea to put the burden, five years later, on the public sector, as we have done in Greece. If we do something similar to what we did in Greece, for a big country, it will be very difficult to survive that. That is why, if we have a problem of that sort, we need to find a mechanism for keeping the private sector on the hook and one way would be to automatically extend the maturity of all sovereign bonds. The Chairman: Is this a publicly available paper? Guntram Wolff: I can send you some material on unemployment insurance. The Chairman: Thank you. That would be very helpful. I am conscious of time, so will you be very brief, Mr Zuleeg? Then I will go to Lord McFall. Fabian Zuleeg: I will be very brief. I just wanted to say that it is not only about treaty change. The political will to take even those steps that can be done without treaty change is not there because, ultimately, we are facing the prisoner’s dilemma at the heart of this. It is about the trust between those member states that can provide this support demanding to see the reforms, the action on the ground in the countries that need the support, and those countries saying, “We cannot do those reforms without the support”. The other thing we are seeing, with respect, is part of the UK disease. We all know what we have to do at the European level, but we cannot do it because we cannot sell it to our populations.

Q123 Lord McFall of Alcluith: How effective will the European Semester be in driving macroeconomic adjustment and economic and fiscal policy co-ordination in Europe? I am thinking particularly of creditor countries and what means you would have to ensure that they do reform in that area. Mr Hack, you mentioned the National Competitiveness Board and that external experts would look at that, but some would suggest that, if it is just external experts, we are not going to get very far because the political buy-in is missing from that, as it is missing from the European Semester as well. How do you ensure that this National Competitiveness Board is not just words on a page but meaningfully contributes to the form, design and implementation? Hans Hack: There is not that much detail on how this National Competitiveness Board would work or be structured, but there are some examples and I will turn to one that I know well in the Dutch situation, the Central Planning Bureau. It sounds a bit communist era, but it is more of an independent economic institution that calculates and projects what the economic effects of different policy measures would be, and it does that for political programmes in the run-up to elections. It is very well respected. It is independent, but it is institutionalised to a certain extent, because it assesses the national budget in a forward-looking way and that is taken on structurally in policy discussions in the Netherlands. It is still an independent board, but it has some sort of anchor to the political system. If you structure it in that way—I am not saying that that would be the model for every member state—there is the possibility that that would have an influence. I do agree with you that you need political buy-in, so you need to structure those competitiveness boards in such a way that they have that political influence, but they are going to be experts. It is not politicians who run the Central Planning Bureau in the Netherlands.

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Lord McFall of Alcluith: We have the OBR, the Office for Budget Responsibility, in the UK and it is independent under Robert Chote. In the last budget it found £27 billion, which the Chancellor bagged, and there is a view politically that “Wait a minute, this is money that was just behind the sofa that has come up and has been convenient for the Chancellor”—so I see problems in the future for the OBR if things like that continue. Is there a case for, say, the OBR, rather than being accountable just to the Treasury, being accountable to the British Parliament, so that the assessment it makes is available to the whole of Parliament? My experience, including with one of the committees in the past, has been that it is very hard to understand the figures for individual departments and how you tie that up. Indeed, Paul Johnson, who is a director of IFS, came to Parliament a month or so back and said that he could not understand it. If we cannot understand that, there is a huge problem there and, therefore, we need some game-changer to ensure that there is more transparency, which would lead to more accountability. Is the OBR initiative one you think that could have some traction to it? Hans Hack: I would be very careful in advising the UK how to structure its institutions. Lord McFall of Alcluith: Well, is it a good subject for a think tank? Guntram Wolff: One reaction is that the United States has the Congressional Budget Office, which is very independent and plays quite a big role in the congressional debate, as far as I can see from here—so that may be an interesting model. Here, the competitiveness boards have more of an aim of influencing not just the parliaments but also the trade unions and the wage negotiators, so it is a bit of a different aim. There, the Belgian example is often evoked. Belgium has the Belgian Competitiveness Council that issues guidelines on what it thinks is an appropriate development of wages, given the productivity developments that it sees. These are non-binding, but the wage partners see it. It is a number that is out there that is computed from data that independent individuals compile. There are lots of questions that arise from this, especially if there is wage differentiation across sectors, at sector-level and even industry-level wage bargaining processes, but at least it is a way of informing the public debate. One of the problems of monetary union is that countries came to monetary union with very different approaches to the wage-negotiating process. The Italian system, for instance, always had very high wage rises and eventually relied on a nominal devaluation of the exchange rate. Every 10 years, Italy had a nominal devaluation. If you look at the gap between wage development and productivity in Italy, it is very significant. The question is whether we can create some mechanisms whereby these debates happen a little more prominently and people are aware that they do not have their own central bank any more but monetary union, and there are certain stability criteria that you need to take into account. Fabian Zuleeg: Very briefly, one of the things we need to consider here is the European dimension of this. This is not about better governance at the national level. It is a question of how that improves European policy co-ordination. My suspicion is that this will work well in countries that have the culture, the history, the background of doing this already, and it will not work well in those countries where it is not present. Unfortunately, it is in those countries where we need it most. I would not expect too much from this, certainly not in the short term, because we are talking about cultural changes, which are much longer term.

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Q124 Earl of Lindsay: Can we go back to the plans for completing banking union, which you touched on in your first answers? We particularly wanted to tease out the difference between what the five Presidents think should happen and what you think will happen, given that we do not live in a perfect world and there are certain hard realities that political pressures bring to bear in the shaping of final plans. You touched on how you think the German resistance to a European Deposit Insurance Scheme might be reduced through risk sharing and risk reduction. Is it a realistic ambition to achieve that risk sharing and risk reduction in order to make EDIS something that could be supported by Germany and those other countries that are nervous about it?

Mr Wolff, in the paper that you issued earlier this month you talked about the need for a European deposit insurance and resolution authority. How effective do you think such an authority could and would be? In terms of financing, you also talked about reinsurance being a key ingredient of making the insurance scheme function, but would such an authority also need access to bridging finance provision, as anticipated in the Five Presidents’ Report? Can we just pick up on the remaining aspects of banking union plans that we have not touched on, but also on what you think really will happen in practice rather than what should happen in an ideal world? Guntram Wolff: Thank you for the question. The first point is that economists are not political forecasters. We are much better at saying what should happen than in predicting political processes. Even for the insiders, and I saw that you talked with Thomas Wieser, it may be very difficult to predict. That is my first point. The second point is that we have had a number of important steps on banking union already, including the creation of a common supervisor, but I have to say that the office of supervisor itself is still very young. It has only been there a year and it still faces a number of obstacles, which I had hoped were already overcome. Let me give one important example, which is national ring-fencing. A little naively, I thought that ring-fencing would end very quickly. To explain, national ring-fencing means that deposits and capital are kept in the banks of the country concerned and cannot be shifted, in the banking group, across borders. That is something that was introduced at the height of the crisis. I thought that having a single supervisor means that the supervisor looks at the banking group as one group, say UniCredit or whatever, looks at the capital of that group and allows it to shift capital and deposits across countries, across borders. Apparently, they still face very big difficulties in doing this, because the majorities are not always there. An excuse in the supervisory board that is often made is: “We cannot do it because the deposit insurance remains national and so we cannot allow you to shift deposits somewhere else because my deposit insurance is still liable for this”. There is an inconsistency here and most people see this inconsistency between a centralised supervisor and a still relatively strong decentralised system. Will it happen and how quickly? I am fairly confident that it will happen, but it will take time. There will be a substantial transition period. It will not be in the next two, three or four years. We are talking more about a five to 10-year transition period. That is the period during which, gradually, risk weights or large exposure routes for sovereign debt will be introduced and, simultaneously, an insurance component will be built up. That is the way I see it and I still think the overall logic goes in that direction. The political support will eventually be there, but perhaps I am too optimistic.

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Earl of Lindsay: With that and your article, do you desire to see that as a Europeanisation of the banks? That will be part and parcel of that. Guntram Wolff: That is the ultimate aim, yes.

Q125 Lord Butler of Brockwell: Do you see capital markets union as particularly relevant to the euro or something that is more a matter for the 28 as a whole? Hans Hack: The initiative is based on some of the lessons learned from the euro crisis. In that sense, it is maybe born from the euro sovereign debt crisis, in a way, because it is very clear that Europe is too dependent on bank financing and, in the current situation, that is something that is holding back recovery and there needs to be more diversification of funding mechanisms. In its aim, though, it is certainly something for all 28. It is something that some countries that are not part of the euro could be very helpful contributors to, including your own. It is also not a project that will change dramatically in two or three years. 2019 is being set as the end, but that is certainly not the end of the capital markets union, because the ultimate aim is to change the way businesses look at funding and to increase the mix of funding from venture capital and seed capital all the way to private placement regimes for bond buying. That will take time, because it is traditions that need to change, but this is something that is valuable for all 28 and we need the expertise of all 28 to get there. One aspect that we need to bear in mind when looking at the CMU is that there is a risk that, if you integrate further, it will lead simultaneously to raising fences to the rest of the world. Very often, if you harmonise legislation regarding capital markets there is also an equivalent regime that raises the bar for external financiers to enter Europe. That is a risk that is not being discussed enough in the context of the capital markets union. We need to make very clear that one of the aims is to make the internal market for capital work better, but also with the participation of non-European entities in that. Therefore, we need to be very careful in the design to allow third-country participants into the capital markets union. That is not what you asked, but I thought it was an important point to make. Fabian Zuleeg: It is a useful long-term development, but it touches on some areas that are very difficult to deal with at the national level, particularly when you are talking about legal frameworks and the specificity certain countries have developed over time. This will be a slow process and it will be a process where you need to get buy-in from the countries. It is not something you can impose; you have to get some kind of agreement over time, so it is going to be tricky. The nature of the thing is advancing reasonably well, but it is certainly not something that will happen in the short term. Changing legal systems within the national system will take a lot of time, so 2019 is optimistic.

Q126 The Chairman: Can I briefly come in and ask if you agree that, when it comes about, as it develops, it will also reduce the level of risk in the eurozone itself? Guntram Wolff: It should achieve risk-sharing across borders. Let me make two quick points on this. The first one is that the shift towards capital markets is very welcome. Recent economic research by Pagano, for example, has shown that it is beneficial for economic growth and for systemic risk, so we should have that shift. The second point is that yes, the eurozone needs deeper capital markets much more urgently than the outsiders, but that

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Hans Hack, Guntram Wolff and Fabian Zuleeg—Oral evidence (QQ118-128) does not necessarily imply that the outsiders will suffer from this. On the contrary, they can actually benefit by being the hub that provides these services. The Chairman: It could be a win-win. Guntram Wolff: Absolutely, but then it depends on the governance. The Chairman: That is an important point. I am conscious of the time. Would you be able to stay for another five minutes or so? We just have to wrap up with a few questions. Is that acceptable? Lord McFall wanted to come in and then Lord Haskins.

Q127 Lord McFall of Alcluith: What we are seeing in Europe at the moment is that the economic losers are in revolt against the elites and there is a big issue here. As think tanks, are you doing or have you done any work on globalisation and looking at the rougher edges of globalisation? As we came here, we saw the deal that the UK Government did with Google, but today there is a story that Facebook is resisting UK attempts to claw back. Regarding doing something on that, we have seen individual attempts by France and Italy. The Times is running the story of Italy trying to give money back, but would that reduce tax competitiveness in Europe and disadvantage the drive to achieve a more coherent tax policy for companies that are obviously more adept than individual countries at dealing with their own issues and tax problems? There is an issue looming there; is it something you have looked at? Guntram Wolff: I have a couple of points. The first is that I totally agree with you that we have an issue of loss of trust in elites and we need to take that absolutely seriously, because it is one of the biggest problems we are facing. Then there is the question of what is behind this and certainly there is the question of whether the labour share continues to fall as it has in some countries. It has fallen quite significantly in the United States, in the United Kingdom and also in Germany, but much less in other countries of the EU. The Chairman: What do you mean when you say “labour share”? Guntram Wolff: The labour share in national income—so the amount of income going to labour has fallen. Then the question is why that is the case and there is a very big debate on this in the United States. Roughly and simply put, there are two camps. One camp says, “It is induced by technological change, robots taking our jobs” and so on and, basically, robots are capital, right? The other camp would say, “It is basically power politics and we have a structural shift in power towards big corporations”. I do not know which view is correct, but those are the two views out there in the US. Irrespective of which view is correct, if we think that the labour share is falling structurally, where is the tax base going to come from? Taxes are now mostly collected from labour and thinking about how to tax other sources of national income, especially capital income, is therefore necessary. Then there is the question of how you do this with tax competition and so on, on which there is a huge amount of literature.

Q128 Lord Haskins: The governance of the eurozone, at the moment, as we understand it, lies predominantly with the Parliament, which raises a few questions as to how that affects the non-eurozone members of the Parliament. Should they have responsibility for it or not, or should there be an additional approach to the governance of the eurozone, which would,

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Hans Hack, Guntram Wolff and Fabian Zuleeg—Oral evidence (QQ118-128) in a sense, be quite divisive if another form of democratic supervision was created? What is your view on that? Fabian Zuleeg: I am not convinced that we should split the European Parliament into a eurozone and non-eurozone parliament, because it is extremely difficult to distinguish what issues would be discussed by which parliament. Also, someone would have to make the decision about who would allocate the different issues and that would be a political process in itself. There are also a number of issues around having a eurozone parliament, if we start going down that route. We have a differentiated integration model already. We have a number of other areas where there are particular opt-outs. We have a different configuration every time we discuss a different type of topic. If we are talking about justice and home affairs, there are certain opt-outs, but then some countries, not least the UK, have also opted back in to some of those issues. You would have to then decide on a case-by-case basis who has to leave the room and who has to come back in. That is not a very workable mechanism. What we need is a mechanism for better co-ordination within the eurozone. The euro group can fulfil that function and it could work better if we had a permanent president of the euro group who would be responsible for pulling that together, but I would not change the parliamentary system. Hans Hack: Democratic accountability is very important and I totally agree with you. I might be slightly biased because I have a Council past, but the democratic accountability of the European Parliament is something that, in itself, is not a given, in my view, with voting once in five years and they do not have a constituency. Different political systems in Europe are different, but there is not a continuous dialogue between the European Parliament and its constituents. I find the UK push, as it were, for more involvement of national parliaments in European decision-making a very healthy one. As I have heard over the many years I have been coming to Brussels, one of the things that Europe suffers from is that the good things coming from Brussels are nationally sold as being a national initiative and there is no reference to the fact that they might have originated from co-operation between member states, whereas bad things are easily shifted onto Brussels as being bad. There is a very lopsided view of what Brussels does. That is where the national parliaments do need to step up their involvement in the European decision-making process and how they co-operate with the European Parliament, because they do have a role themselves, from a European perspective and not a national perspective. I do not know how to structure that best, but with the current European Parliament and the way it is elected and functions, I would not place all my bets on them to increase the democratic accountability of decision-making. Guntram Wolff: I agree with Hans on this but will just add one thing. I would also say that we do not need a eurozone parliament at this stage but, if we think of serious fiscal integration, it is very difficult to conceive that a European Parliament with British MEPs would vote on eurozone fiscal matters. I do not think that is possible, so at that stage there would have to be at least some split on fiscal matters. Lord Butler of Brockwell: We have a parallel with English votes for English laws.

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Hans Hack, Guntram Wolff and Fabian Zuleeg—Oral evidence (QQ118-128)

The Chairman: I was just thinking that. We are having that very discussion in our own Parliament vis-à-vis the other parts of the United Kingdom. Thank you very much for that. That now concludes the public part of this meeting. Mr Zuleeg, Mr Wolff and Mr Hack, thank you very much for coming and giving us your time today. It was an invaluable session.

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Janet Henry, Sebastian Barnes, Henning Christophersen and Martin Sandbu—Oral evidence (QQ27- 44)

Janet Henry, Sebastian Barnes, Henning Christophersen and Martin Sandbu— Oral evidence (QQ27-44)

Transcript to be found under Sebastian Barnes.

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Dr. Dermot Hodson—Written evidence (EMU0002)

Dr. Dermot Hodson—Written evidence (EMU0002)

Dr Dermot Hodson10 Reader in Political Economy Birkbeck College, University of London

What are the merits of the recommendation by the European Commission to introduce a euro area system of National Competitiveness Boards?

1. The proposed euro area system of National Competitiveness Boards is a modest attempt to deal with the perennial problem of adjustment in EMU. The slow adjustment of relative prices and wages made it more difficult for some euro area members to cushion the impact of country-specific shocks during EMU’s first decade. This lack of adjustment, in turn, amplified the effects of the global financial crisis. EU policy-makers tracked this problem of competitiveness adjustment (see, for example European Commission 2006) but they struggled to find a solution through instruments such as the Broad Economic Policy Guidelines.

2. National Competitiveness Boards have the potential to increase peer pressure as an instrument of EU economic policy coordination. My research suggests that the effectiveness of the Broad Economic Policy Guidelines was blunted, in part, because the application of peer pressure through non-binding recommendations proved more costly to the sanctioner (e.g. the European Commission) than the target (i.e. the member states) (Hodson 2011: 80-84). The 2005 re-launch of the responded to this problem by appointing ‘coordinators’ within national governments but such measures did not deliver the ‘national ownership’ over EU economic policy coordination hoped for at the time. The creation of National Competitiveness Board seeks to do something similar, albeit through bodies that operate with a degree of independence from national governments.

3. National experience suggests that Competitiveness Boards have a role to play in EMU but that their potential contribution to economic policy should not be overstated. A case in point is the Netherlands, where an independent body, the Bureau for Economic Policy Analysis, has a reputation for preparing credible economic forecasts and analysis of public policies. The Dutch experience suggests that National Competitiveness Boards can play a constructive role in EU economic policy coordination by sounding the alarm when prices and wages are slow to adjust to country-specific developments. Of course, sounding the alarm is not the same as putting out the fire. Rigorous macroeconomic analysis is important but it is by no means certain that it can – whether it originates from a body located at the EU or national level – have a decisive impact on national systems of wage determination. The limitations of the UK’s National Incomes Commission provides a salutary lesson in this regard (Wood 2000: 442n).

10 This evidence is submitted in a personal capacity and does not necessarily reflect the views of Birkbeck College. 243

Dr. Dermot Hodson—Written evidence (EMU0002)

To what extent does the Stability and Growth Pact achieve a balance with respect to creating flexibility and maintaining credibility?

4. In spite of reports to the contrary, the Stability and Growth Pact retains a large measure of flexibility. My research sees the Stability and Growth Pact as an instance of soft economic policy coordination in which enforcement relies for the most part, on peer pressure and persuasion rather than pecuniary sanctions (Hodson 2004). I see limited evidence thus far to revise that assessment in spite of comprehensive reforms to the Stability and Growth Pact under the so-called six-pack reforms. Member States have been subject to no shortage of peer pressure since these reforms took effect in 2011 but none have faced financial penalties and most countries have been given a margin of flexibility to get government borrowing under control.

5. Early experience of implementing the reformed Stability and Growth Pact confirm the continued flexibility of the EU’s fiscal rules. In 2014, for example, 4 out of the 11 euro area members that found themselves with excessive deficits at the beginning of the year – Belgium, the Netherlands, Austria and Slovakia – saw disciplinary proceedings brought to a close after the Commission and ECOFIN Council agreed that government borrowing in these countries had fallen below 3 per cent of GDP. Six of the remaining states – Cyprus, Spain, Greece, Ireland, Portugal and Malta – faced no additional measures. The most difficult case was France, which was adjudged to be at risk of non-compliance with earlier recommendations. But even this country was eventually granted more time to get its budget deficit under control.

What are the advantages and challenges associated with the creation of an advisory European Fiscal Board?

6. The European Fiscal Board can help to reinforce EU fiscal surveillance. On occasion, the Commission has found itself isolated when it comes to enforcing the rules underpinning EU economic policy coordination. This occurred most visibly in February 2001 in relation to Ireland and the Broad Economic Policy Guidelines and in November 2003 over the excessive deficit procedure against France and Germany. The European Fiscal Board will help to bolster the European Commission’s position should similar situations arise in the future.

7. The European Fiscal Board can also provide an added layer of scrutiny to the Commission’s role in EU economic governance. Significant in this respect is the European Fiscal Board’s mandate to make suggestions concerning ‘the future evolution of the Union’s fiscal framework’.11 Concerns have been raised by Eurogroup President Jeroen Dijsselbloem about whether the body is sufficiently independent to play such a role. Such concerns are legitimate since members of the European Fiscal Board are appointed by the Commission. It should be noted, however, that most national fiscal boards in euro area members, including that of the Netherlands, are led by appointees of national governments or parliaments (ECB 2014: 97).

11 Commission Decision of 21.10.2015 establishing an independent advisory European Fiscal Board, C(2015) 8000 final 244

Dr. Dermot Hodson—Written evidence (EMU0002)

What is your understanding of a fiscal union? What type of fiscal union is appropriate or achievable for the euro area based on the political capacity available? Is a fiscal stabilisation function necessary and achievable?

8. Fiscal union is a concept that should be handled with care because it has no fixed meaning in EU policy debates. For some, it refers to the creation of a centralised budgetary instrument that could play a stabilisation role in response to economic shocks that have asymmetric effects on euro area members. For others, it refers to a situation in which centralised institutions, such as the European Commission, can enforce compliance by member states with the EU’s fiscal rules.

9. Neither a centralised budget nor more centralised institutions would provide a panacea for EMU. A centralised budget could help to promote macroeconomic adjustment within in the euro area but at a cost that could fall disproportionately on the geographic core of the euro area. More powerful centralised institutions could ensure a more credible commitment to fiscal discipline among euro area members but they risk damaging the EU’s legitimacy by encroaching on an area of economic policy that has traditionally been the preserve of national governments.

10. The history of EMU suggests that plans for fiscal union will face significant political obstacles. For the reasons discussed above, periodic calls for fiscal union in the MacDougall Report (1977), the European Commission’s study Stable Money – Sound Finances (1993) and the Four President’s Report (2012) all received a lukewarm reaction from member states. On this basis, the Five President’s report’s call for ‘a mechanism of fiscal stabilisation for the euro area as a whole’ should not be read as a statement of intent by euro area members (Juncker 2015: 4).

What are the implications of the euro area unifying its external representation on issues such as programmes, reviews, economic and fiscal policy, macroeconomic surveillance, exchange rate policies and financial stability in the International Monetary Fund? How would this proposal affect the UK and other non-euro area Member States?

11. The euro area’s fragmented system of external relations has been widely criticised in the scholarly literature. The Treaty on the Functioning of the European Union allows the Council of Ministers to establish a unified representation in ‘international financial institutions and conferences’ (Article 138 TFEU), but the Commission’s attempts to make use of this provision have thus far been rebuffed. Instead, member states have adopted ad hoc and informal measures to coordinate EU involvement in the International Monetary Fund (IMF), the World Bank, the Organization for Economic Cooperation and Development (OECD), the Group of 7 (G7) and the Group of 20 (G20). The fragmented manner of these arrangements have been criticised by a number of scholars (e.g. McNamara and Meunier 2002; Cohen 2008).

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12. My research suggests that euro area members are capable of speaking with one voice in multilateral institutions and fora such as the G20 and the IMF (Hodson 2011: 97- 107). In the case of the G20, it finds that EU member states were at the forefront of efforts to forge an international consensus on policy responses to the crisis and that they secured key concessions at the landmark G20 leaders’ summits in 2008 and 2009. In the case of the latter, it finds that EU member states exercised considerable collective influence within the IMF when it came to the provision of financial support for , Latvia, and Romania. The EU was more circumspect about seeking financial assistance for Greece in early 2010, but such delays were rooted in deep-seated differences between EU member states rather than a lack of coordination between European representatives at the Fund.

13. These findings point to a paradox in the external representation of EMU (Hodson 2011: 107-110). When member states agree on international economic priorities, there is little point in establishing a more unified system of external representation, but when member states fundamentally disagree about what to do on the world stage, there is little hope that a more unified system of external representation could fare any better. As regards the first of these points, the EU, it should be recalled, had a seat at the landmark G20 leaders’ summits in Washington, DC, London, and Pittsburgh in 2008/2009 but it played a supporting role alongside the collective efforts of France, Germany, and the United Kingdom. With respect to the second, there is little that a single EU chair at the IMF could have done to expedite financial support for Greece in 2010.

14. Establishing a more unified representation will not necessarily increase euro area influence on the international stage. The ability of euro area members to reach common positions on IMF business will be decisive in this regard. The Commission’s October 2015 proposal envisages coordinated positions within the IMF being prepared by the Council, the Eurogroup, the Economic and Financial Committee and/or the . Coordination across a range of institutions risks being bureaucratic and slow moving, thus raising concerns about the ability of a single euro area constituency to respond rapidly to fast changing events in the international monetary system.

15. The UK could see its influence in international financial institutions and fora diluted by closer cooperation between euro area members. Within the IMF, the UK Executive Director works closely with the representatives of euro area members through the EURIMF committee, which in turn is supported by the EU Economic and Financial Committee’s Standing Committee on the IMF (SCIMF). These institutional structures are likely to be reconfigured if reforms to euro area external representation press ahead. Opportunities for UK involvement in such structures are likely to be reduced; for example, the SCIMF has been headed in the past by an official from HM Treasury but it is difficult to see how such an appointment would materialise in the future under the reforms being considered.

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16. It is also possible that euro area influence within the IMF will be further diluted by any attempt to establish a euro area constituency. Debates about the euro area’s fragmented system of external representation often overlook the fact that European influence within the Fund is considered to be disproportionately high by many commentators outside of Europe. Such concerns reflect the rise of new global economic powers and, what I refer to in my research as, the IMF’s emergence as a de facto institution of the EU during the euro crisis see Hodson 2015). The IMF’s quota reforms in 2010 saw European countries lose influence at the expense of China and other dynamic emerging market and developing countries. Future quota and voice reforms are likely to continue this trend, which will be accompanied by a push to break the EU’s hold over the post of IMF Managing Director.

How should democratic accountability be enhanced if decision making is pooled across the euro area? Is democratic legitimacy weakened by the complexity of the crisis management framework?

17. Treaties remain the primary means through which member states consent to the transfer of new powers to the EU. Welcome though the Five President Report’s calls to integrate national parliaments into the workings of the European Semester are, the increase in interparliamentary cooperation envisaged is modest.

18. The Five President’s Report – in spite of its ambition – is coy on the subject of treaty change. Reference is made in the report to the integration ‘into the framework of EU law the Treaty on Stability, Coordination and Governance; the relevant parts of the ; and the Inter-governmental Agreement on the Single Resolution Fund’ during the proposed ‘deepening by doing’ stage (1 July 2015 – 30 June 2017) (Junker 2015: 18). But the report also emphasises the need to ‘make the best possible use of the existing Treaties’ during this stage (Juncker 2015: 5), which seems to rule out Treaty revision. No explicit mention is made of treaty change in relation to the proposed second and final stages of completing EMU. This leaves unanswered the key question of how the ‘democratic accountability and legitimacy’ of the proposed euro area treasury – and a completed EMU more generally – would be ensured (Junker 2015: 8).

References

European Commission (2006) ‘The EU economy: 2006 review: Adjustment dynamics in the euro area — Experiences and challenges’ European Economy 6. (Luxembourg: Office for the Official Publications of the EU). Cohen, B. (2008) ‘The Euro in a Global Context: Challenges and Capacities’ in K. Dyson (ed.) The Euro Area at 10: Europeanization, Power and Convergence (Oxford: Oxford University Press) 37–53. European Central Bank (2014) Monthly Bulletin, June (Frankfurt: ECB).

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Hodson, D. (2004) ‘Macroeconomic Co-ordination in the Euro Area: The Scope and Limits of the Open Method’ Journal of European Public Policy 11(2): 231-248. Hodson, D. (2011) Governing the Euro Area in Good Times and Bad (Oxford: Oxford University Press). Hodson, D. (2015) ‘The IMF as a De facto Institution of the EU: A Multiple Supervisor Approach’ Review of International Political Economy Vol. 22(3): 570–598. Juncker, J.C. (2015) ‘Five Presidents Report: Completing Europe's Economic and Monetary Union: Report by: Jean-Claude Juncker in close cooperation with Donald Tusk, Jeroen Dijsselbloem, Mario Draghi and Martin Schulz (Brussels: European Commission). McNamara, K. R., & Meunier, S. (2002) ‘Between national sovereignty and international power: what external voice for the euro?’ International Affairs 78(4), 849-868. Wood, S. (2000) ‘Why ‘Indicative Planning’ Failed: British Industry and the Formation of the National Economic Development Council (1960–64)’ Twentieth Century British History 11(4), 431-459.

20 November 2015

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Dr Dermot Hodson, Graham Bishop and Philippe Legrain—Oral evidence (QQ1-14)

Dr Dermot Hodson, Graham Bishop and Philippe Legrain—Oral evidence (QQ1-14)

Transcript to be found under Graham Bishop.

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Gunnar Hökmark MEP and Sylvie Goulard MEP—Oral evidence (QQ92-100)

Gunnar Hökmark MEP and Sylvie Goulard MEP—Oral evidence (QQ92- 100)

Transcript to be found under Sylvie Goulard MEP.

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Professor Otmar Issing—Oral evidence (QQ205-214)

Professor Otmar Issing—Oral evidence (QQ205-214)

Evidence Session No. 19 Heard in Public Questions 205 - 214

THURSDAY 3 MARCH 2016

Members present

Baroness Falkner of Margravine (Chairman) Lord Boswell Lord Butler of Brockwell Earl of Caithness Lord Davies of Stamford Lord Lawson of Blaby Lord McFall of Alcluith Lord Shutt of Greetland ______

Examination of Witness

Professor Otmar Issing, President, Center for Financial Studies

Q205 The Chairman: Good morning, Professor Issing, and welcome to the European Union sub-committee’s inquiry into Europe’s economic and monetary union. You have a list of interests that have been declared by Committee members. This is a formal evidence-taking session of the Committee and a full transcript will be taken. This will be put on the record in printed form and on the parliamentary website. You will be sent a copy of the transcript and you will be able to revise any minor errors. That is the technical information that I am obliged to give you. I should also say, Professor Issing, that it is a busy day today, and Lord Lawson of Blaby will have to leave at 11 o’clock. Other members will most probably be able to stay for the full session, but we hope to conclude at some time around 11.30 am. Thank you so much for coming here. We have been lucky to have German LSE week this week, so that many of you can come into town. We understand that you also have a full day.

Let me commence by explaining to you that we are coming to the concluding stages of our inquiry into Europe’s economic and monetary union. It was predicated on the Five Presidents’ Report, with which you are very familiar, and I see that you have written journalistic articles about it extensively. What is your assessment of it and the actions introduced in the short term as well as the longer term? First, do you believe that the proposed actions will come about? If they do come about, do you believe that they will result in the euro’s long-term stability?

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Professor Otmar Issing—Oral evidence (QQ205-214)

Professor Otmar Issing: Thank you for the invitation to come before the Committee. We had this hearing in Frankfurt some years ago, and the topic has not changed much. As I published a rather critical article on the Five Presidents’ Report, I must not withhold my remarks here, so I will say nothing different. I will probably be more open in a presentation like this one. Let me start by saying that this report has a number of good ideas, especially on economic union and competitiveness, et cetera, but unfortunately we also have a long history of wishful thinking about what countries and Governments should do. One cannot repeat that often enough, so I do not criticise that. The only thing I am critical about in relation to this part of completing economic union is the idea of creating competitive authorities in all countries. To my mind this just adds red tape, because since the Lisbon agenda back in 2000 it has been obvious what should be done. The Lisbon summit in 2000 decided to make Europe the most dynamic region in the world. If it were only to take decisions, we would be in a better situation now. It was during my term at the ECB, and I was criticised by some colleagues for interfering in politics when I said that I thought this was a very dangerous path to follow, because Europe—and your country was included in this decision; it was a European Union decision, a declaration—took responsibility for communicating to the public on things on which it has no competences, because structural reforms et cetera must be done on a national level; it is a national responsibility. We have been dealing with this problem since the start of monetary union and even since the start of the European Union, and in this respect the Five Presidents’ Report does not add anything special. It repeats what has been repeated every time. Suggesting another bureaucratic level of competitive authorities, to my mind, is not helpful. My positive assessment of the report ends here. I am most critical of the idea of creating fiscal union and moving towards political union. Q206 The Chairman: We will come to that later in the questioning. You have identified very clearly that national competitiveness boards should already have been in place in any event, but what would you identify as the most important priorities for the next phase, which hopefully will be enunciated in the White Paper in 2017? As an economist, what would you suggest they should be doing? Professor Otmar Issing: I did not expect much from that anyway, and my scepticism, if I may say so, was confirmed by recent developments. One idea in the Five Presidents’ Report is the creation of what is called a European fiscal board, and my assessment is that this deserves a trial to create an independent authority, committee or whatever you might call it to survey the public finance of national Governments. If this is to work, the precondition is that it is an independent board with independent experts, but, as I almost expected, the Commission has already taken it over. The Commission obviously has no interest in having an independent surveillance board. To personalise this, although it is not just Juncker, when Juncker came into office he said, “I will be a political President”, and in the field of fiscal policy that means that decisions on fiscal policies in the context of the Stability and Growth Pact and of two-packs and six-packs et cetera may be political decisions. Rules are pushed aside and lip service is paid to them, and this move by Juncker to bring this authority under the surveillance of the Commission totally destroys the idea in the Five Presidents’ Report of an independent authority.

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Professor Otmar Issing—Oral evidence (QQ205-214)

The Chairman: We also know from your published views that you have been critical of the proposals for debt mutualisation. Do you think it is the wrong thing to do in the current context—both political and financial—because of moral hazard, or would you rule it out for ever? Professor Otmar Issing: Will you allow me to make a personal remark? The Chairman: Indeed. That is why you are here. Professor Otmar Issing: When I went through the potential issues that you would like to discuss, in every second sentence there was the feeling that “this guy is against everything”. It was not explicit, but that was the thrust. Forgive me, but your question goes in the same direction: that I am for ever against everything involving debt mutualisation. Whether I will be for ever I do not know. I am old enough already. The Chairman: As an economist, you will know John Maynard Keynes’ comment that in the long run, we are all dead. I will not press you on that. I am just confirming that, at the moment, you do not think that this would be appropriate in terms of sovereignty. Professor Otmar Issing: The key point is that if parliaments—in my case, the German parliament—decide, with a majority vote, to participate in debt mutualisation, this is a democratic decision and members of parliament have to justify that before their voters. But nobody had this in mind, because it would fail, so talking about debt mutualisation is a back- door move that, as it has no democratic legitimacy, I am strongly against. I am not against debt mutualisation in principle, but it involves the transfer of taxpayers’ money, and I need not explain to this House that for that you need democratic legitimation. If that is the intention, okay; I can vote against the party that is in favour of it, but that is all.

Q207 Lord Butler of Brockwell: Good morning, Professor Issing. Here is a chance for you to talk about something that you are in favour of. You said that not much has changed since you met the Committee in Frankfurt, but the role of the ECB in banking governance has developed since then. Do you think those developments have been helpful? Professor Otmar Issing: I was a member of the de Larosière committee, a high-level committee that was installed by President Barroso. Jacques de Larosière was the chairman. We presented a paper containing two proposals, one of which was to establish a European macroeconomic surveillance board. That has happened, and the ECB is more or less in control of its administration, but it is a European board. We were strongly against transferring competence in banking supervision to the European Central Bank. We pointed to a conflict of interest for monetary policy, and politicising decisions at the Central Bank, because, in the end, it is taxpayers’ money that is at stake if it comes to the resolution of a bank, which puts the independence of the bank in a very awkward position. These were our arguments, and we proposed an independent European banking supervisory authority. For that, one would of course need a treaty change, and there is no way to achieve that in the present circumstances. By the way, at that time the Commission and the European Council accepted our proposal more or less unchanged; only minor changes were made. So they welcomed and supported that, but things worked out differently because treaty change is not on the cards. The Council referred to an article in the treaty that says that some, but certainly not all, banking

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Professor Otmar Issing—Oral evidence (QQ205-214) responsibilities can be transferred to the European Central Bank without changing the treaty. I am not a lawyer, but let me demonstrate the point. The Commission’s legal service said that this was enough of a legal basis to transfer the whole competence of banking supervision to the ECB. Other law committees, such as that of the Bundesbank, said that it was obvious that this was not a sound basis. There is a case before the German constitutional court on exactly this point, but it is useless to discuss this issue, because if it came before the European Court of Justice the court would say, “That’s okay”. So let us set the legal issue aside. I must confess that I would not have thought it possible for the ECB to hire more than 1,000 people and at the same time start this very complex supervision of the 123 biggest banks in the euro area. In this respect, it deserves high applause. It was easy to foresee the position which the ECB would take in respect of Greece and Italy. At the same time, the quality of collateral has been reduced, helping weak banks to get central bank liquidity. This is a monetary policy measure, but at the same time it is a banking-supporting measure, and the supervisory authority is in a very awkward position in this regard. We have to live with that now; the decision has been taken to conduct banking supervision in this way, but I expect more problems. I am very concerned about reputational problems for the European Central Bank if a bank fails, et cetera. This will be a big problem, to put it mildly, for the reputation of the ECB. Lord Butler of Brockwell: I think a British audience finds this difficult to understand, because for many years the Bank of England was both the banking supervisor and the lender of last resort. We never saw any conflict in that position. Professor Otmar Issing: I remember a past crisis during which the Bank of England did not gain by this authority. Would you agree with that? Lord Butler of Brockwell: I am not sure I would. Anyway, given that the ECB has effectively become the lender of last resort, should it extend its role to buying sovereign bonds, in the manner of the Fed or the Bank of England? Professor Otmar Issing: To me, the idea of a central bank being a lender of last resort— which came from this country, from Walter Bagehot, back in the 19th century—is a very strange one. The idea is that a central bank is a lender of last resort for banks, with punitive interest rates, on the basis of good collateral. Somehow, in the context of the crisis in the euro area, the idea of lender of last resort was transferred to lender of last resort for governments. That is totally different. This is the monetary financing of governments who are in fiscal trouble. The idea is that this is the source of the transfer of the term to governments. In the US, for example, investors would never be afraid of the US dollar collapsing, because in the end the Fed, as the central bank, could print money without limits. No such institution exists in a monetary union in which you have different governments and nations. To transfer this authority of lender of last resort to the European Central Bank is, for me, totally misguided, because this is not being the lender of last resort e.g. for California. In this sense, it is being the lender of last resort for the US. No such thing exists in the euro area.

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The Chairman: Lord Butler, I wonder whether we might allow Lord Lawson to come in now, because he has to leave. Lord Butler of Brockwell: Not at all. Thank you. I had finished my question anyway.

Q208 Lord Lawson of Blaby: I would like to move away from the detailed matters that you have just been discussing—not that they are not important, but they are matters of detail. In your recent articles and pronouncements, you have raised the most fundamental concerns about this whole process as it is now. I must say that I find myself entirely in agreement with you, but it would be helpful if you could summarise for the benefit of the Committee your most fundamental and major concerns. Professor Otmar Issing: Summarising is difficult with such a complex issue and might create misunderstandings, but I will try. I should start from my position back in the 1990s, which was the position of most politicians and economists, at least in Germany, that political union and monetary union should at least come together. It is better to have political union first and then monetary union. By the way, this was Chancellor Kohl’s thinking. Lord Lawson of Blaby: It is also the history of Germany, where political union preceded monetary union. Professor Otmar Issing: But, as we know, when monetary union started, no steps were taken in the direction of political union. Countries did not even try. When the euro started, the question was: can monetary union survive without political union? Let me make clear what my position is now. I will try to be as pragmatic as the British are thought to be. For the time being, the nations of the Union are probably further away from the idea of a political union than at any time in the past, so the idea of political union is at best a vision for the distant future. This is my major critique of the Five Presidents’ Report, because if you take this point—and it is hard to deny—if any country in the euro area dares to have a referendum on entering political union, just do this test of thinking. If you take this as a given, whether you like it or not is not my point—I am not saying that I am against political union; I am just stating the fact that the major part of the Five Presidents’ Report loses its anchor when the whole text in design goes in a direction that ends in a political union. This is the fundamental philosophy behind the whole process, and if you take that away for a relevant time, this whole proposal loses its anchor. My major concern—and here I come back to your initial question—is that those who have written this report know that. So any suggested steps in the direction of a fiscal union are steps towards a fiscal union without democratic legitimacy, because without political union all transfers et cetera will lack European democratic legitimacy. This is my major concern: that they know it—nobody can be so stupid as to assume that political union is around the corner. By the way, the scepticism of the authors is demonstrated in a way. When I read the report I was sitting in my study and I laughed, because they said, “We should start this process only after 2017”. Why 2017? Because just by chance there will be elections in France and Germany. They do not want to confront voters in these major countries with such ideas before a general election, only after it, and I think this demonstrates their fundamental lack of confidence in this idea. I am afraid that we might have a transfer of taxpayers’ money in a process without democratic legitimacy. Again, to make it clear, if this were a democratically 255

Professor Otmar Issing—Oral evidence (QQ205-214) legitimate decision of national parliaments I would not criticise it, but the thrust of all these ideas is fiscal union by the back door. The Chairman: Just on that point, one could of course argue, without I hope appearing unnecessarily naive, that there had to be some point when they produced a White Paper. The European elections will be in 2020, so a midway point was some point in 2017, and if there were going to be two significant elections there was no point in doing it until after they were over. Am I being incredibly naive? Professor Otmar Issing: If I had written this report, I would have left it open and not set the date of 2017. The Chairman: That is really helpful. Thank you. Lord Lawson of Blaby: To conclude this, I share your analysis 100%. I will, if I may, read briefly from something that you wrote only a few months ago, which is very much in the area that you have been discussing: “without true political unification”—and here I put in parenthesis that that is, of course, the object of the whole exercise, as you have pointed out—“efforts to pursue the rest of the Presidents’ plan, including the transfer of fiscal competencies to the European level, would carry serious risks”. Is the serious risk that you refer to the affront to democracy, or is there some other serious risk? What did you have in mind when you referred to “serious risks”? Professor Otmar Issing: To clarify what I mean by that—by the way, when I wrote that paragraph I wrote more sentences in this direction, but I deleted them and left this rather weak remark about serious risk—in the end I am afraid that people, voters, will in the end understand what is going on, and they will not accept being exploited in a way in which they have no say. This will foster extremist parties on the left or the right, because the major parties will be unable to resist such developments. Let me give an example. Mario Draghi and the ECB were substantially criticised by German Members of Parliament. When he attended the Bundestag for the first time—I did not attend, but I read the newspapers—it was a very friendly meeting. Just by chance, some days later I met two of his strongest critics, and I said, “I am very surprised. I read that this was a very friendly meeting. I expected some critique. Why did you not present your reservations?” Some days later, one of them finally opened up to me, and the answer was not surprising. He said, “There was a danger that a rescue package of €30 billion would come to the Bundestag to be decided by the Parliament, and in this case I thought it was better that the ECB did this”. I do not want to put too much weight on this particular event, and I am not saying that I know what all 80 million Germans are thinking, but you can imagine the unwillingness of people to accept that without having any say. That is the major risk that I see if this approach continues.

Q209 Lord Davies of Stamford: Professor Issing, listening to you today, and I have heard you before, I have the strong impression that you are a perfectionist—perhaps what you might describe as a platonic idealist: you believe that there is one solution to problems and that it should be implemented thoroughly and in every possible detail, you do not like partial solutions, you do not like indirect progress, you do not like political compromises, you do not like loose ends. You do not like what we in England sometimes call the crooked timber of

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Professor Otmar Issing—Oral evidence (QQ205-214) humanity. You have a sort of mathematical vision of how things should work. I do not know whether that is a fair description; it is not meant as a criticism.

We are in a particular, concrete situation now, at a particular conjuncture. Moves have been made—in my view, very successfully—towards fiscal union and towards improving productivity and competiveness in the less competitive countries of Europe. In my view, there has been very considerable progress. Four countries that were bailed out only four years ago are now doing rather well—indeed, at least three of them are doing outstandingly well—so I think a lot of progress has been made. What would you do? Is your solution just to do nothing at all and to say from the side-lines, “It is all hopeless. Everybody got it wrong. I was right all along”? Do you have a practical agenda of your own? If you were in a position to impose your own programmes and policies at present—taking account of the actual situation we are now in, not starting from 20 or 30 years ago—what would you actually do? Professor Otmar Issing: I was just thinking at what age that description of my thinking was appropriate—probably 30 or 40 years ago. I am no longer that person. When I write, I try to start from sound economic thinking, and if it comes to making decisions I try to separate that from the conditions under which people such as Mario Draghi and Juncker have to act. I am not a politician and I am fully aware that I sometimes still come across as a naive professor. Modesty is required. I am reminded of a hearing at the European Parliament. Some members of this country’s Labour Party attacked me, as a former Bundesbanker, describing me as very dogmatic. I tried to explain my position, and then somebody said, “Intellectual arrogance is a very dangerous thing”. My reply, which is documented, was that, “Intellectual arrogance has no place in the central bank. Humility in respect of what we can do is key”. That was a principle during my time at the Bundesbank and the European Central Bank, so I am fully aware of all the constraints. One of the reasons why we are in the mess we are in in the euro area is that at almost no point in time were politicians confronted with what would happen if they continued on this slippery road. For that, you need a clear framework. Lord Davies of Stamford: You are not answering my question, Professor Issing. My question is: what would you like to see done? In my view, Mario Draghi has been in the best tradition of pragmatic central bankers. To some extent, you have to make up your own solutions as you go along—which is in the fine tradition that was recognised by Bagehot, by the way, and which we have always recognised at the Bank of England. You cannot always predict all the instruments that you will require to deal with a particular kind of crisis. I think he has done brilliantly, but his approach has been pragmatic. Your approach is the exact opposite. It is theoretical; indeed, some people might call it dogmatic. If you were forced to take responsibility now for European economic and monetary policy, what would you do, starting from today? The Chairman: Professor, before we go further, we are of course well aware of the fact that you have been right at the coalface of public policy in your role at the European Central Bank. I wonder whether you might answer the question very briefly, because I would like to move on after that. Professor Otmar Issing: First, I should say that I have no fantasy of being a dictator, so I find it difficult to put myself in the shoes of one. Secondly, there is no way in which anybody can 257

Professor Otmar Issing—Oral evidence (QQ205-214) totally change the direction we are moving in. I am afraid that I am much closer to your thinking than you imagine. My major concern is not theory or fundamental positions but that pressing developments are taking us deeper and deeper into this mess. I am driven by concern for this European project. The same is true for Mario Draghi. The question is: how do we deal with that? I am not here to criticise the ECB and its policy, but in Europe—forgive me when I say Europe; I mean the euro area. The Chairman: We say Europe now. Professor Otmar Issing: I am not so sure what it means in this country, but that is what I mean when I talk about Europe. The ECB’s monetary policy is seen as the only game in town, and politicians rely on that. If they cannot deliver, the ECB will deliver. This is a very dangerous position for the central bank, for politics and for the euro-area project as a whole. That is my concern. Let us take the example of OMT. It was during a visit to this country that Mario Draghi said that we will do “whatever it takes”. He added, “within our mandate”, but he must have been sure that this would immediately be forgotten. What does this announcement—“whatever it takes”—imply? Yesterday, Mervyn King referred to that remark when addressing the panel at the LSE. He was Governor when Draghi, a central banker, made that remark. To clarify my position, as a central banker I always insisted on our independence. No politician of any calibre would ever have put me in danger of forgetting my principles. At the same time, I was always convinced that this is a limited responsibility. An independent central bank’s mandate must be limited, and that limit has to be observed. A central bank, which consists of appointed technocrats or whatever you choose to call them, cannot play politics with distributional consequences. This is up to parliaments—democratically elected members—not central banks. This is my basic reservation: that a central bank, with the best intentions, has no mandate for going beyond a rather limited remit. There are emergency situations, no doubt—in Germany, the republic collapsed after the First World War—but, since 2008, have we really been living in a permanent emergency situation in which the European Central Bank is the only game in town? This is the core of your question. I think we fully agree that this is the key problem. Lord Davies of Stamford: Professor, I do not agree at all. I want a central bank that will always do what it takes to maintain stability and that will use unconventional methods when necessary. The Chairman: I think the key point was “within its mandate”, as you said, which is forgotten. On the point about democratic accountability, I want to bring in Lord Shutt. Lord Shutt of Greetland: Just before we get to that, can you clarify one thing? Do you believe that the euro, as a currency, ought to succeed? Professor Otmar Issing: It depends on what you mean by “succeed”. It will stay; I am sure about that. There is too much political investment in this project to allow the idea that the euro will one day collapse. Of course, nobody knows what the future is about, but as far as one can argue I think the euro will stay as a currency. What is forgotten in all these discussions is that the euro is a stable currency. It is the second most important currency in the world, so the situation of the currency as such is not so bad.

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Q210 Lord Shutt of Greetland: That is fine. That is interesting. Lord Lawson has left us, but clearly, although he agrees with you in many ways, he does not agree with you on that, so at least we have that.

Coming to the points that I wanted to raise, you have been clear that political union might remain possible “in the distant future”. Now, while we are here, what democratic accountability arrangements do you favour at present if steps towards political integration are taken? Should something be done at this stage? Is there a distinctive German view on this? Should there be further movement on democratic accountability? Professor Otmar Issing: Let me start with the question of whether arguments are just arguments. I am a German, and as a representative of the Bundesbank I was also a representative of a German institution. When I was at the ECB, you would never hear any remark from me that you could identify as defending German interests. I continued to be a German, but I served a European institution and a European project. What is German about the idea that a central bank should take care of the stability of the currency and should not finance public deficits? Is this German? It is, rather, also the mandate of the Bank of England here. I am too old to change, and sometimes I think, “It’s too late for that”, but if I phrased my words differently and removed the German flavour from my interventions, they might have more impact. On the other hand, it is not my character, so I have to leave it at that. To clarify, I am not arguing here that it is in the interests of Germany. I think it is in the interests of all people who are interested in a stable currency and solid public finance, and for that we need a solution. For me, putting aside the question of whether political union is desirable or not, it could happen in the not so distant future if you took this position. We have to concentrate on what the euro area is. It is a group of countries, or whatever you might call it, that have transferred their sovereignty in monetary policy to the European Central Bank; one common central bank, one single currency. Of course, we have a lot of common policies. I do not need to explain that here, but this is one of the issues that I can discuss now. To a large extent, nations in the euro area have given up their independence in trade and competition policy, the European Court of Justice et cetera. These are all elements of a political union and a central bank by itself. For all the colonies that became independent in the past, the first thing to do was to establish a central bank, introduce a national currency, establish a national airline. Let us go back to the currency. These are elements of a political union, and so far the arguments that you hear almost every day are that the lessons of the past, of history, are that all monetary unions that were not combined with political union collapsed over time. This is true, but the comparison is misguided for two reasons. First, the Latin Monetary Union, for example, was a currency union at the time of the gold and silver standard. It was totally different, and it lacked all the elements, which I just mentioned, that are there. What remains is the final responsibility for taxes and public expenditure. This is key for democracy, as I said a few minutes ago. If we think about the present situation, we have to stabilise this arrangement, and in the end it must lead back to the no-bailout clause, because in such an environment Governments are in the end responsible for their own actions. This is congruent with the no-bailout clause. This clause is violated almost every day, and we would have to go back a long way to get back to that, but, as I said before, one needs a principle. Forgive me, this has just come to my mind, but it is another argument in a nutshell. There

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Professor Otmar Issing—Oral evidence (QQ205-214) was once a Minister of Cultural Affairs in Bavaria. He was a professor of law and a very erudite person. He once said, “You need principles, but you have to hang them so high that in case of need you can go under them”. Most people see only the move below, which might seem more pragmatic than you would expect, but the message is twofold, because he was aware that principles still exist, and that if you deviate from them in an emergency you have to explain why. The principle of no bailout should in the end lead fiscal policies into the future in a more stable environment. Lord Shutt of Greetland: Okay. I had better leave it there. The Chairman: Thank you, Professor Issing. I should have introduced Lord Boswell of Aynho, who is Chairman of the EU Select Committee, who has joined us today. Lord Boswell, you have some questions.

Q211 Lord Boswell of Aynho: Thank you very much, Lord Chairman. It is a great privilege to be able to come to your Committee and to hear Professor Issing. I should perhaps make it clear that I have not participated in this inquiry and have not heard all the evidence. I should also declare an interest in that I have personal shareholdings in both UK and euro-area securities.

I have two points to make. First, I want to be clear in my understanding. The argument I have heard from you is that although the ECB is capable of creating an economic and monetary union, or managing one, the issue is not so much the feasibility of that process as the democratic acceptability. Is that a proper understanding of your position? Professor Otmar Issing: The ECB was forced into politics by events, but it has not resisted that too much, to put it mildly, although I fully agree that we could not immediately stop the process for the time being. As the Five Presidents’ Report demonstrates, our concerns are the same, as I have said before. Mario Draghi is a friend of mine, so I am not criticising him personally. I met him just recently, and he was not particularly friendly about my remarks. I was not surprised about that, but we agree that we share the same concerns. Let me give you a telling example. In May 2010, there was a Eurogroup meeting in Brussels on a Friday, at which Trichet presented a dire picture of what might happen in the financial markets on the Monday—you must have been aware of that as a shareholder—if Governments did not intervene to help Greece. It was very clear that this was a matter of fiscal policy and was the responsibility of Governments. At the same time, it was clear that politicians, Finance Ministers, even if they wished to, could not intervene on Monday with billions of euros. So the ECB was in a lose-lose situation. If it had not intervened, nobody knows what would have happened on the Monday. I did not agree with this dire description, but there was uncertainty about that. If the markets had totally collapsed on Monday, the ECB would have been blamed for refusing to intervene. Intervening means that the ECB lost its innocence. A former president of the Bundesbank said that it had crossed the Rubicon, like Julius Caesar. Some journalists called me at home, and I refused to comment. I asked myself, coming back to a question I was asked earlier, “What would I have done?” From my professional, theoretical position, putting myself in the shoes of a central banker, with the associated responsibilities, I was not sure what the right move was, because it was a lose-lose situation. The ECB should have made it clear to politicians, Finance Ministers, Heads of State and 260

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Government that in such an emergency we did what we are normally not allowed to do, but that this was the first and last time. Do not expect us to continue along that line. I would not criticise the intervention on that Monday, for the reasons I have just explained, although missing was the clear signal that next time you should be prepared. If you are to make it credible, such an announcement is a hugely complicated task. To some extent, since the ESM was created, it worked. Lord Boswell of Aynho: Thank you. That is very helpful. My second question might further muddy the waters, and I would just like a brief comment on it. You will be aware—and this is of wider interest than simply economic and monetary union—that there is some interest across Europe in a greater role for national parliaments, perhaps as opposed to the European Parliament; indeed, reference was made to this in the British deal in the European Council conclusions in February. Although this House is not democratically elected, we are representative of the interests of our member states and are relatively close to our electorates—the people who pay taxes and who may, for example, become unemployed— do you see scope for national parliaments having an input into the democratic process, or do you think it would be very difficult to produce a sensible accountability structure? Professor Otmar Issing: On that, I must confess that I have no clear view. The Presidents’ report has some ideas about mixed committees involving Members of national parliaments and Members of the European Parliament. These are very complex constructions, and I have limited confidence in creating democratic legitimacy in that way.

Q212 Lord McFall of Alcluith: Professor, I am a Labour Party member. You mentioned earlier Labour Party members criticising you. When I was Chairman of the Treasury Committee during the early 2000s, we went to Frankfurt regularly and spoke to you. We always left with more intellectual curiosity than when we started, so I thank you for that. We were left with the impression that people were feeling their way in the dark as to how to go about European monetary union. You mentioned ex-Governor King. In his new book, The End of Alchemy, he states very clearly that, presently, central banks and economists do not know how the world economy works. I think that fits with what we have heard in the evidence so far, particularly on the issue of banking union. First, if we are going to get a banking union, we need to clear up Europe’s legacy issues, which in many ways have so far been ignored. I would therefore like you to comment on the legacy issues.

Secondly, what does banking union really mean? Does it need to include debt mutualisation? Does it need to include the European deposit insurance scheme? In the vein of your informing us of your opinion on a practical level, I would value it on those two points. Professor Otmar Issing: May I just come back to the issue of the hearing before I was appointed? Notwithstanding the initial attacks, in the end there was not a single no vote against me. Lord McFall of Alcluith: I was confident of that. Professor Otmar Issing: Your party colleagues finally gave up, or supported me—for what reasons I do not know. Lord McFall of Alcluith: We did.

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Professor Otmar Issing: On the one hand, banking union is a technical concept. On the other, it goes deep into the structures—I am thinking of the capital markets union and so on. One question, for example, is: would we be safer with the American system of market-based financing of industry, or a more bank-financed system? I am in favour of removing the barriers that still exist to medium-sized companies accessing the capital market. Doing so would be beneficial. Independent of the capital markets union, it should be fostered in all countries, and we are probably on the way to that. I would combine your second question with the first one on debt mutualisation or debt forgiveness. For me, it is rather obvious that we will get out of the present situation only if we clarify the legacy problem. You might be surprised to hear this from me, and I will say it only here. Take, for example, the debt of Greece. This money is lost anyway, so it would be much better to start by cancelling the debt in a process that probably accords with the German Council of Economic Experts’ proposal, which you mentioned, of a solvency rule for states. I would be immediately in favour of that if it was not an incentive to start the same bad behaviour as in the past. This is not about Greece, but I take Greece as an example. This is key for the future of a world economy with such high indebtedness. I have no answer to the moral hazard problem, but I fully agree with you that the legacy problem has to be solved. Here we come to another aspect of banking union: deposit insurance. At present, deposit insurance, to European eyes, at a time when banks in different countries are in a very different situation, is just the expropriation of taxpayers’ money in some countries. The idea of a common European deposit insurance is fine, but before we have that we have to clarify balance sheets et cetera and then have a new start on a European basis. This refers back to your question and is also tricky and complex. Even a dictator coming in tomorrow would immediately be caught in this complex situation, so there is no simple way out, just a muddling through. I am a great admirer of Karl Popper, who said that politics is piecemeal engineering, but to do that and not be misguided you need principles and concepts.

Q213 Earl of Caithness: Good morning, Professor. May I probe you a little further on fiscal union? You commented on it in answer to our Chairman and to Lord Lawson. We got evidence from an MEP that is rather telling. He said, “A lot of people are sure they know what fiscal union is until they are asked what it is, and a lot of people want it until they get it”. What is your interpretation of fiscal union, and what is politically achievable in Germany with regard to the facets of that? Professor Otmar Issing: Some years ago, I wanted to write an article on the concept of fiscal union. I looked into the literature and deleted one page after the other. I came to the conclusion that the notion of fiscal union in substance is to a large extent transferring competence for taxation and public expenditure to the European level. It also refers to bank resolution. This all implies taxpayers’ money, and if it is about taxpayers’ money, fiscal union means Europeanised competence on taxation and public expenditure, not fully but to a large extent. This, for me, is the key notion of fiscal union. There are many, many concepts and details, but in the end it all boils down to that. In this context, for me, the next logical consequence is that, in order to transfer such competences, you need democratic legitimacy. That is the connecting link with democracy. This is my basic interpretation of what fiscal union might mean.

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Earl of Caithness: But that is not going to happen, because that political step will not happen. What do you think is achievable for further fiscal union at the moment, given the political situation, or do you think there will be a hiatus for some time to come? Professor Otmar Issing: As I said before, and this is a key point for me, it is obvious that Greece, for instance, needs financial support; we see the refugee problem. National parliaments should decide on that and deliver the money. I would not call that fiscal union; this is just solidarity with a country that has problems that it has not created itself. Many aspects of fiscal union imply a transfer mechanism for mistakes of national policies. Take, for example, the idea of European unemployment insurance. This would create moral hazard. The worse the labour market policy is, the more you get subsidies from the European fund. Lord Davies of Stamford: No one is proposing that. They are proposing a reinsurance system that would be triggered only by changes in the rate of unemployment. So there is no moral hazard in the proposals that have been put forward. No one is producing a proposal as naive as the one you are suggesting. Of course, you are perfectly right that if we just had a pooling of unemployment insurance, the countries with lower unemployment would subsidise systematically those with higher unemployment. That would be very perverse. What has been suggested in the European Union is not that at all; it would capture not the structural but the cyclical changes in unemployment, so that when unemployment rose above a certain margin in a particular country there would be a reinsurance and money would be available from other funds. It is a reinsurance scheme. Professor Otmar Issing: I am not surprised that you are very familiar with quite a number of very intelligent designs for such an insurance system. I know a number of these proposals, and I have great respect for the intellectual capacity of the authors of them, but if you think about implementation, what will be left? All the complex provisions and structural aspects are excluded. In the context of the Stability and Growth Pact, to define and measure the structural deficit is a highly complex issue that, in the end, is solved politically. One can design a system that does not create moral hazard, I agree, but I am afraid that once this idea enters the political arena, a very different animal will come out of this process. Lord Davies of Stamford: Those objections have been met, of course. The Chairman: Lord Davies, did you want to pick up the theme of economic governance? Lord Davies of Stamford: We touched on fiscal union, Chairman. I do not know how long we have to discuss that. The Chairman: Professor Issing, can you stay on a little longer? You are available to do so. Lord Davies of Stamford: Professor, do you not recognise that in relation to the crisis—you have talked about 2009 and 2010—considerable progress has been made? When one reads your articles it looks as though everything is very grim indeed and that the European Union is heading over a cliff, but are you not struck by the fact that over the past five years there has not been the crisis that was expected in the euro area? There has been considerable progress towards fiscal union with the two-pack, the six-pack. After all, what is destabilising is the deficits rather than the total level of public expenditure or the structure of taxation, and there are now real constraints on the deficits that are preventing irresponsible fiscal policies by member states. Do you not feel that some progress has been made and that we

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Professor Otmar Issing—Oral evidence (QQ205-214) are in a much better position than we were a few years ago as a result of the measures that have been taken? Professor Otmar Issing: My answer to your question is on two levels. One is that there has been substantial progress on structural reforms in Spain and Portugal, and even Greece, on the budget side, has made tremendous efforts. For me, it was a mainly misguided concept. The troika played a doubtful role, because it concentrated too much on fiscal constraint and too little on structural reforms. In this respect, not much has happened in Greece so far, which is very bad for employment. What we see now in Portugal and Spain raises extreme concerns for me. Spain and Portugal came out of a deep recession, made progress, growth was coming back, unemployment was falling—too slowly, true, but substantially—and then we had the national elections. The parties in government—whether Conservative or not I do not care; for me, it is not a party problem—in taking responsibility for reforms that hurt, were only partly supported by the development of the economy. This progress was visible, but it was not enough to convince the majority of voters to support the continuation of those reforms. Take, for example, what Prime Minister Tsipras said—and here we are again at the core of the political issues. We had elections and people decided on a policy that is different from the one that is needed for monetary union. This goes to the core of democracy. Lord Davies of Stamford: I agree that they decided that, but then unfortunately they changed their mind and are now implementing the programme. Professor Otmar Issing: Yes, but reluctantly so, and so it remains. You were not among them, so I will risk saying that probably no politician understood what he signed when he signed the Maastricht treaty. Signing that treaty meant for them removing DM and transferring monetary policy to the European Central Bank, and that is it. In the treaty, there is no line on unemployment or labour markets, although there is on the fiscal side to some extent. Having a single currency, a single monetary policy, that has to fit all—there is only one—has deep consequences in many fields of politics in which, de facto, national Governments have lost competence, without transferring it legally. That is what makes this situation so complex.

Q214 The Chairman: You have mentioned Greece, Spain and Portugal. Can I take you to the asymmetries in current account surpluses and deficits among the eurozone member states? Can we hear, in concluding, whether you believe that there should be greater pressures for symmetry among the eurozone states—the surplus and deficit states? This, of course, is the big question, given the popular—in other words, democratic—deficit that it touches upon. Professor Otmar Issing: But the present situation has to do with the policy of the ECB. The spreads on government bonds, as bond holders know, have shrunk. They are not invisible, but— The Chairman: Yes, they are very low. Professor Otmar Issing: They do not represent the different risks of different national policies. This creates an illusion in countries. This includes Germany, by the way, as our balanced budget would disappear immediately if we had “normal” interest rates. Germany can borrow money over 10 years at zero interest rates—for five years in negative territory. This gives an illusion of fiscal solidity, and this is true for Germany and even more so for 264

Professor Otmar Issing—Oral evidence (QQ205-214) other countries. This is politics—if you are not under pressure from fiscal constraints, you think that you can afford many things, but the fundament is very shaky. Lord Davies of Stamford: You are implying that we are going back to inflation, but if we do not go back to inflation there will not be problem. The Chairman: Then you would have Japan. Professor Otmar Issing: When I arrived at the Bundesbank and at the ECB, it was to contain the threat of inflation. Now they struggle to have higher inflation. The Chairman: And to encourage demand. Nobody wants a Japanese-style, low-inflation economy. Thank you so much, Professor, it has been a most interesting session. We are very grateful to you for coming here and we wish you well for the rest of your busy day. We now conclude today’s public evidence session and the Committee will continue in private. Professor Otmar Issing: Thank you for your kind remarks. Please forgive my German style. I cannot promise to change. The Chairman: This Committee likes candid interlocutors.

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Professor Erik Jones, Megan Greene and John Peet—Oral evidence (QQ68-81)

Professor Erik Jones, Megan Greene and John Peet—Oral evidence (QQ68-81)

Transcript to be found under Megan Greene.

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Philippe Legrain, Graham Bishop and Dr Dermot Hodson—Oral evidence (QQ1-14)

Philippe Legrain, Graham Bishop and Dr Dermot Hodson—Oral evidence (QQ1-14)

Transcript to be found under Graham Bishop.

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Dr. Andrew Lilico—Written evidence (EMU0001)

Dr. Andrew Lilico—Written evidence (EMU0001)

The “Five Presidents’ Report”, Completing Europe's Economic and Monetary Union, contiunues the discussions in the European Union and the euro area in particular about two key topics:  How to extend the European Union’s project of building ever closer union  How to respond to the Eurozone crisis As is well-known, the Five Presidents propose developing economic, financial, fiscal and political union within the Eurozone, with a programme of measures in three stages, to be complete by 2025. There are many fascinating and important issues raised by the Five Presidents’ Report. However, I understand the House of Lord European Union Committee to be especially interested in its implications for the UK. Much discussion of the implications for the UK of the development of economic, financial, fiscal and political union in the euro area has regarded the impacts on the UK as largely indirect, arising from the interest the UK has in economic, financial, fiscal and political stability in one the main economic zones with which it trades and invests (the euro area) and with which it interacts over broader political issues within the European Union. And indeed there are important issues for the UK arising in this way. A second set of issues discussed, in this respect, concerns whether deeper political integration within the euro area might lead it to have common interests which diverge from those of the non-euro EU and to tend to vote as a bloc within the EU, affecting policymaking – with the potential implication that the euro area tends to set policy for the whole EU (because it has a collective qualified majority), meaning that the UK’s position as an EU member might increasingly resemble that of non-EU member Norway, which must abide by Single Market rules even though it has no voting influence over those rules. That is a topic about which I have written in the past at some length and regarding which several committee members are probably aware of my views. On this occasion, however, I would like to emphasize that neither of the above effects — the UK’s general interest in Eurozone stability or its concerns about being outvoted by the Eurozone in Single Market policymaking — is the main (or at least most concrete) way in which the development of much deeper integration within the euro area should be expected to affect the UK. The most concrete set of effects for the UK arise from the implications for the EU’s institutions of greater political integration within the Eurozone. The Five President’s Report anticipates the Eurozone having a treasury, with tax and debt- raising powers and powers to spend. Such a treasury function would clearly require political oversight. And indeed there is now an ongoing discussion about the establishment of democratic accountability mechanisms within the euro area. For example, it has been suggested (obviously correctly) that the Eurozone political union will need its own parliament. It will also need its own civil service functions, so as to guide its policymaking. How will these institutions work together with the institutions of the European Union? First, is it really credible that there will be both a Eurozone parliament and a European Parliament? If there were both institutions, would the European Parliament fade in significance? If there were not two separate institutions (and I believe it simply not credible

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Dr. Andrew Lilico—Written evidence (EMU0001) that there will be), and yet we maintained both functions (both European Union parliament and Eurozone parliament functions) how could the functions of both institutions work within the one European Parliament? Would there, perhaps, be a Grand Committee of the Eurozone members, akin to the Grand Committee sometimes suggested as a way to implement English votes on English measures? Would a Grand Committee of the Eurozone be any less problematic than the English version? The UK funds the EU budget, including providing funding for the European Parliament. But if the European Parliament were spending a portion of its time operating in Grand Committee as the Eurozone Parliament, would the UK be happy to fund that? If not, how would the UK contribution to the EU’s budget be affected? If there were urgent business that needed attending to at European Union parliament level but different urgent business that required Eurozone parliament attention, which would have the priority? Is there not, in practice, the strong likelihood that (especially as the number of non-euro members in the EU fell), the European Parliament’s activities would be more and more dominated by Eurozone parliament activities with European Union parliament activities becoming of only marginal or occasional interest? If that were really so, would it be worth the UK having full-scale elections for European Parliament members, or should we switch back to sending delegates for the rare occasions when the European Parliament met as a whole? A similar set of issues arises with respect to the European Commission. The Eurozone political union would require a confederal-level civil service. Is it really credible that there would be both a Eurozone civil service and also the European Commission, given that the vast majority of EU members are members of the euro and more are scheduled to join? I think it’s a little less certain in the case of the Commission than of the Parliament that two sets of institutions could not be maintained, but I still think it very unlikely the Eurozone would want a separate civil service. The European Commission is funded from the EU budget, to which the UK contributes. If more of the European Commission’s activities consisted of policy analysis relating to the Eurozone political union, would the UK be happy to fund that? If not, what are the implications for the UK’s contribution to the EU budget? Suppose that in some case there were an imperfect alignment (or even conflict) of interest between the Eurozone and the European Union (e.g. perhaps the interests of the European Union as a whole might be best served by a liberalising policy in some area but the interest of the Eurozone lay more in greater control or restriction) — how would that be managed by European Commission officials? Suppose there were time clash or resource clash — how would that be managed? These issues all appear to me to be extremely concrete and of direct impact upon the UK as a non-euro EU member. But as far as I am aware there is almost no discussion of them yet. Perhaps the House of Lords European Union Committee could help stimulate such a discussion?

19 November 2015

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Dr Andrew Lilico, David Marsh and Professor Lucia Quaglia—Oral evidence (QQ167-178)

Dr Andrew Lilico, David Marsh and Professor Lucia Quaglia—Oral evidence (QQ167-178)

Evidence Session No. 15 Heard in Public Questions 167 - 178

WEDNESDAY 3 FEBRUARY 2016

Members present

Baroness Falkner of Margravine (Chairman) Lord Borwick Lord Butler of Brockwell Lord Davies of Stamford Lord Haskins Lord Lawson of Blaby Lord McFall of Alcluith Lord Shutt of Greetland Lord Skidelsky ______

Examination of Witnesses Professor Lucia Quaglia, Department of Politics, University of York, Dr Andrew Lilico, Executive Director and Principal, Europe Economics, and David Marsh, Managing Director, Official Monetary and Financial Institutions Forum

Q167 The Chairman: Good morning, Mr David Marsh, Professor Lucia Quaglia and Dr Andrew Lilico. Welcome to the European Union Financial Affairs Sub-Committee’s inquiry on completing Europe’s economic and monetary union. You have a list of interests that have been declared by Committee members. This is a formal evidence-taking session of the Committee, and a full transcript will be taken. This will be put on the public record in printed form and on the parliamentary website. You will be sent a copy of the transcript and will be able to revise any minor errors. The session is on the record: it is being webcast live and will be subsequently accessible via the parliamentary website.

I will kick off the questions by pressing you on your overview of the Five Presidents’ Report and the actions pertained in it. Do you think that it does enough to strength the euro’s long- term stability? Would you also comment in your opening remarks on the overall implications that you think it will have for the United Kingdom? Mr Marsh, would you like to start? David Marsh: The Juncker report is a valid attempt to paper over some of the cracks in economic and monetary union, but it is very evident that the real decisions under the Juncker report, the Five Presidents’ Report, will not be made until after the French and 270

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German elections in 2017. That tells us something a little more. If I may say so, many of us have known for many years that you need more political union to make a monetary union work; Chancellor Kohl said it nearly 30 years ago. The trouble is that, as time has gone on, something that becomes more desirable becomes less feasible, because there is not much political will, particularly in France and Germany—the two most important members of monetary union—to make this thing work. This is exposed in the Five Presidents’ Report. They do not, as you said in your remarkably perspicacious questions, to which of course there is normally no answer, mention debt mutualisation. They have dropped that, above all because of German hostility, but also because France does not really know what it wants. Professor Lucia Quaglia: The report seeks to strike the right balance between what is economically desirable for the completion and good functioning of a monetary union and what is politically feasible, taking into account the different preferences of the member states and the different domestic constraints that they face. To that extent, the report is successful. Whether all the right points have been covered I am not so sure. On fiscal union, for example, much emphasis is still placed on monetary and fiscal union and less on mechanisms for macroeconomic stabilisation. Dr Andrew Lilico: It recognises the importance of increased political integrity to make the euro work and the need for democratic accountability that is associated with that. It is an advance that it abandons debt mutualisation, which was one of the greatest threats to the euro as a whole. It is a mistake that it focuses its thinking about fiscal union upon temporary measures to the exclusion of ongoing fiscal transfers, which will be absolutely required for the euro to function over the medium term. I emphasise, though, that there is quite a lot in here that will have direct implications for the UK via the institutional implications for the European Union. It will mean that the European Union institutions, as distinct from euro- area institutions, become increasingly irrelevant. It reinforces that there is unlikely to be, over the medium to longer term, any place for any non-euro member of the European Union.

Q168 The Chairman: Thank you. I will first pick up one or two things that you have said, Mr Marsh. If I understood you correctly, you said that it is an advance that they have abandoned the Four Presidents’ Report’s emphasis on debt mutualisation. Dr Andrew Lilico: I said that. David Marsh: I said that it is notable that they left it out. The Chairman: Is that a good or a bad thing? David Marsh: I think it is a good thing to recognise political reality. Mrs Merkel has said, “Over my dead body”, which might be metaphorical, of course, or she might actually die. That was a fairly strong hint from Germany that they do not find debt mutualisation acceptable, so they have exerted a veto there. One of the problems with monetary union is that everybody thinks that they are victimised by the others. There is a culture of victimisation, so the Germans think they are being hoodwinked by the French, and the French think they are being hoodwinked by the Germans. You can go on and on. The Chairman: Dr Lilico, we have seen your paper, which was very interesting. Will you elaborate a little on what you have just said?

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Dr Andrew Lilico: Sure. In my view, the only real way to make the euro work over the medium term will be associated with deeper political integration, which will also require mechanisms for democratic accountability. It is clear that the document mentions specifically the idea of an increased role for the European Parliament, with its focus on the euro area, and the development of democratic accountability mechanisms associated with the management of a treasury function. As the number of non-euro members of the EU declines—and it continues to decline; the euro continues to be an expanding project, and quite a successful one in the political sense at least—you should anticipate that the European Parliament will increasingly sit is a sort of grand committee for euro-area matters that is equivalent, perhaps, to some of the ways in which people in the UK think of English votes for English measures being dealt with by a Grand Committee of the House of Commons. I would expect that, in much the same way in which people fear that that would lead to the marginalisation of Scottish Members of Parliament, they fear that it would lead to the marginalisation of UK MEPs within the European Parliament. Similarly, I would expect that more and more Commission business to be devoted to euro-area matters to the exclusion of wider EU matters, which in due course would mean that the interests of non- euro members of the EU become increasingly marginal. So I do not see how, as things stand, there is any long-term future for any members of the European Union who are not members of the euro. Lord Lawson of Blaby: May we ask Mr Marsh whether he agrees with that? David Marsh: First, I disagree with the idea that the non-euro membership is becoming smaller. I could easily see it becoming larger, frankly—and you all know who I mean. Secondly, I feel that there will be some safeguards under— Lord Davies of Stamford: Presumably we are talking about Greece. David Marsh: Greece, and there is a strong danger that other countries might follow. It is like Chancellor Kohl’s cardigan starting to unravel. So I do not agree with Andrew on that point. Secondly, I do feel that there are very strong reasons why the rather well-performing European Union members that are not members of the euro, and are not likely to be members of the euro for some considerable time—I cite Sweden and Poland here above all—may be given some safeguards to guard against the kind of caucusing that Andrew has been speaking about. So I disagree with both of those propositions. The Chairman: Thank you. That is really interesting. I want to come back a little on what Dr Lilico said. Do you accept, nevertheless, that the presence of our MEPs in different groupings is there to provide the democratic accountability? Dr Andrew Lilico: They are there, absolutely, to provide one element of democratic accountability within the European Union framework as it stands—there is the Council of Ministers as well, of course. The issue is not whether the MEPs provide any mechanisms of democratic accountability as it stands. I do not think the intention of the European Union via the MEPs is that much to provide individual member state-level accountability; it is via the MEP. But my issue is not there; my issue is that as you move towards a greater political union, which you have to make the euro area work, the role of those that are not in the euro will become increasingly irrelevant.

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Lord Haskins: Following Mr Marsh’s comment that, on the one hand, Chancellor Kohl said this had to end up in political union and, on the other hand, that there was not a cat in hell’s chance of anybody agreeing to the measures that are required to make that happen, what will be the outcome? David Marsh: It is a rather messy halfway house, with elements of political union. You could mention the European Parliament, which you might say gives a fig-leaf of democratic accountability. There will clearly be greater oversight of different countries’ budgets under all the different European mechanisms that have been included in the last few years. There will also be some degree of debt mutualisation of the sort you might have in a proper federal state, simply because there are many mechanisms now by which, either through the front door or the back door, the creditor countries are mutualising some of their overall foreign claims against their liabilities: the debtor countries. What we will not have, though, is a genuine sharing of fiscal mechanisms and the kind of long-term, permanent transfers that Andrew is talking about. That will not happen, and that is a major lacuna. When monetary union was being talked about in the early 1990s, there was a thought that at least 3% of the budgets of the European Union should be there to spread around in transfer payments for the less fortuitous states. In fact, as we all know, the EU budget is 1% of GDP; in America, it is between 10% and 20%. That is the essential gap, and until you can close it there will be no properly functioning monetary union worthy of its name. The Chairman: That may be the case, but do you think the Five Presidents’ Report has created the framework for the likelihood of strengthening the financial stability, given where we were in 2011 and so on? David Marsh: The banking union has been a major step forward, and they have surprised me by going further forward, particularly on the supervisory mechanism, and even on the resolution mechanism. So there is an element of building in some additional financial stability on the strictly banking side. The problem with financial crises is that it takes 10 years to put into effect the mechanisms needed to forestall another one, and another financial crisis normally happens five years after the one before. So Europe is always a little out of kilter, I am afraid, with the realities. I am afraid to say that what might be brewing now could wash away the rather slender edifice of banking union that has been constructed so far. Professor Lucia Quaglia: If I could add to that, it seems to me that there are two elements missing from the banking union project. The first is a common European deposit guarantee scheme, which has now been proposed by the European Council. The second, which is also under discussion, is the setting up of a fiscal back-stop. The Chairman: Dr Lilico, any comments on strengthening the financial stability? Dr Andrew Lilico: As people here may know, I think that deposit insurance is a mistake all up, and that the common deposit insurance scheme is a mistake on stilts. I agree that the development of an improved resolution framework is positive, although I might add that we should not neglect the significance, both for financial and financial stability, of developments such as a common European pension and common European unemployment insurance, which are both being explored quite actively. Those kinds of things could also be significant for this.

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Q169 Lord Borwick: We have got into the second section of the question without leaving the first, which is wonderful. Your description of it, Mr Marsh, as a lacuna sounds more like a fatal flaw. You are really talking about the collapse of the euro system, are you not? The effects on the non-euro countries could be economically really rather bad news. David Marsh: It depends what you mean by “fatal”. The more literal English view of “fatal” is that you are going to die of it, whereas the more metaphorical continental view is that it is simply something that is very difficult to get out of. It may well turn out to be terminal. It is certainly a flaw. Other people might think that it is something that you can work your way out of. As I said, everybody knew that this was a flaw right from the very beginning. Kohl’s views was that there would be so much monetary union they would push political union along. That has not worked. Therefore that could be the end of it all. On the other hand, Europe has a remarkable facility for continuing to survive when all around think it is dead. It is limping on in a way that could well be thought of as terminal. Lord Borwick: So would you predict the recreation of the deutschmark and the at some stage? David Marsh: If it came to a really seminal bust-up, there would be the recreation of the ERM, such as we had it up until 1999, with a strong d-mark/Netherlands guilder link. It would probably still be called the euro, there would be six or seven countries inside it, and they would probably include countries such as Sweden, Denmark, and possibly Poland, which are not actually in the euro at the moment, so no, I do not think we will go back to the deutschmark. Lord Borwick: But you are implying the creation of a lira and a Greek currency. David Marsh: That is always a possibility. I would not like to judge that. Nor would I like to judge where the French will fit in; they are, as always, unpredictable. Dr Andrew Lilico: The Greeks and Cypriots might still leave the euro at some point, although that is now increasingly unlikely, given that they did not leave last year. I do not expect the collapse of the euro. People have predicted the collapse of the euro many times, yet it keeps on going. The members of it boast of it as a success. New people keep joining the euro area, so I do not see why you should expect it to collapse. To my mind, the threat to the euro would come only from the core countries—France and Germany—deciding that it was no longer in their interests. We should not think of it as the euro unless it has France, Germany and Italy in it, so the thought that Italy might leave and the euro might carry on is not very realistic. The threat I see would be that the countries that provide the money might decide at some point, “If the only point of the euro is that we pay for everyone else, then we’re off”. This is why I say that things like debt mutualisation are the real threat to the euro project. It is not the small countries that are the threat to it. The euro can carry without them. What it cannot carry on without is the big ones. There is already a system of fiscal transfers within the European Union: the structural and cohesion funds. It is just that they are very small and at the kind of regional policy level in the EU; only 0.8% or something of that order. I agree absolutely that they need to get to something like 3%. I think they will get there in the end; I just think that there is a bit of political difficulty in getting there. The key political difficulty is that while those who will fund these things suspect that any other scheme is a way of making them responsible for €2

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Dr Andrew Lilico, David Marsh and Professor Lucia Quaglia—Oral evidence (QQ167-178) trillion of Italian debt which the Italians took on before the euro even existed, they are going to be resistant. Once you reassure the Germans enough that the Italian debts, the existing debts, are not your problem, they will be much more open to moving forward in other ways.

Q170 Lord Butler of Brockwell: Do you think that either the election or the threat of election of populist parties might lead to the break-up of the euro, or at least to certain countries leaving it? Dr Andrew Lilico: The most obvious candidate for that is the FN in France, I guess, although there is also some possibility of AfD, and the CSU is calling for a German referendum on euro membership at some point. You could imagine such a scenario. I am not saying it is imminent, but if I were to think of two kinds of scenarios that might constitute a threat, I suppose the one other might be Five Star in Italy, which is an outside possibility. Lord Butler of Brockwell: Or Podemos. Dr Andrew Lilico: Again, I think the euro could continue without the Spaniards, although I do not think it is very likely to. On Podemos, it turns out that one of the lessons of Syriza is that you would have to be doing things pretty badly to end up getting chucked out. It really has to be catastrophic. If Syriza did not get chucked out, basically nobody is going to. It also turns out that your freedom to act in ways that are a risk to the euro ends up limited, even for these very populist parties. The one thing I would add is that I would have thought that the great likelihood is that a party such as FN, which has already tried to rehabilitate itself a long way in the public mind, would achieve power only if it rehabilitated itself to the point at which it was no longer a threat to the European project. You could imagine it getting in and having quite extreme views on lots of other things, but the movement of populist parties to reach for power would be associated at the same time with the movement of them towards being a less of a threat to the euro project. Professor Lucia Quaglia: Perhaps I could add to this. It is interesting not only that there are increasingly Eurosceptic parties—in particular, on the periphery of Europe—but that at the level of public opinion has increased to a remarkable extent in those countries which used to be very pro-European. So it is a problem at the level of political parties and at the level of public opinion. To some extent, political parties respond to public opinion, but that also happens the other way round in that public opinion is somehow carried away by the political parties which are increasingly Eurosceptic. That is an interesting trend to detect.

Q171 Lord Butler of Brockwell: Shall we go on to the external representation of the euro? One of the recommendations of the Five Presidents’ Report is for co-ordinated external representation of the euro, and I would like to ask you one or two questions about that. First, going back to the handling of the euro crisis, what effect has that had on the perception of the euro countries by the outside world? Does it regard them as more unified or less unified as a result of their handling of the euro crisis? David Marsh: If I could have a stab at that, it is all to do with the politics. We have spoken about the lack of political union. Ideally, after 17 years of monetary union there would be one euro bloc with a certain percentage of voting at the IMF, with one member of the

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Executive Board, rather like in the United States, for example. That clearly has not happened. The French and the Germans, to say nothing of the British, want their own representation because they are still all individual countries. On the second question, about how the euro is viewed, you can see that in the way the central banks hold their reserves. There was some talk, mostly among the French, who always got a little carried away by this, that the euro could become a real challenger to the dollar on the international monetary scene. You can see that most strongly in the reserve holdings. After a bit of a fillip in the early 2000s, that has not happened, and the percentage of reserves held in euros has been falling gradually over the last three or four years to the favour of the dollar but also to the favour of other currencies, such as sterling, the yen or even the renminbi. So the euro seen from abroad still looks a bit more stable and permanent than many people in this country might see it as being, but it is not anything like as attractive a currency as many thought it would be. You can see that particularly if you go to Asia. The Chinese were big buyers of euros right from the very beginning. They wanted to have the euro in the same way as an airliner might want to have an Airbus as well as a Boeing. They saw it as an alternative reserve currency. They have been deeply disappointed; they bought the currency and expected a state to come along sooner or later. They are not really interested in talking to the provincial governor of Luxembourg or Belgium; they want to see the people in charge. The problem with the euro is that nobody is in charge.

Q172 The Chairman: We are getting slightly ahead of ourselves, but perhaps I might just press those of you who have the expertise in this area. Do you think there has been a problem with the eurozone’s representation at the IMF? At the moment, as you know of course, apart from the members of the board, others are divided into constituencies. Do you think that there has been a problem with them taking a common position on issues that are relevant to them? It is certainly flagged up in the Five Presidents’ Report and was reiterated in the 21 October statement from the Commission, but our own feedback from the Minister is that the United Kingdom, sitting at the table, does not seem to think that there is an issue. Certainly a European Union pre-meeting takes place the week earlier and there is a sub- committee of the European Union members at the IMF. So there is some lack of appreciation in the United Kingdom that there is an issue. What is your assessment of that, please? Professor Lucia Quaglia: My impression concerning, for example, the handling of the euro area crisis and the IMF discussion is that even among the euro area member states there were different preferences. It was not a case of the UK against the others, so to speak; the European Union and the euro area itself was internally divided. I am not sure whether unified representation would have made a huge difference. Dr Andrew Lilico: This is not an area in which I have strong expertise, so I will probably defer to the others on it, although I am happy to put in my twopenny-worth. I guess my inclination is to think that the key issue for external people with regard to the European Union more generally—I will perhaps come to the IMF question—is that they could regard euro area states largely interchangeably. You could see this with the debt premium associated with the yields on government debt over the period of the euro up to 2007. Then it turned out that they were mistaken in that. They then tried to look around for somebody they could deal with, and I think that they have alighted upon Draghi, whom people now think of as the

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Dr Andrew Lilico, David Marsh and Professor Lucia Quaglia—Oral evidence (QQ167-178) representative rather than anyone else. I would have said that over the medium term that kind of issue would be more resolvable. If you started issuing euro area debt, a euro area treasury representative would deal with them in respect of euro area consolidated debt, and that would resolve the debt question. Once you started issuing debt, that might make a difference to the European Union’s representation of bodies such as the IMF, because then there might need to be a distinction between the sovereign euro area dealing with the IMF and the individual sovereign area dealing with the IMF. I think that they would probably continue to issue at least some debt. David Marsh: Perhaps I could add two sentences. I think the real crunch will come over Greece. Do not forget that the IMF programme for Greece runs out in March and there will be a decision by the Executive Board, on which France and Germany sit, on whether to renew it and under what terms. Do not forget that the German Finance Minister has put forward a proposition which is still on the table for Greece to leave the euro area “temporarily”—a proposition with which France definitely does not agree. Professor Lucia Quaglia: Perhaps I may add to this. It is important to consider also the implication of unified external representation of the banking euro area in other international financial regulatory fora. I have in mind in particular the Basel Committee. I did some work for the European Parliament on that. It is very interesting that now the SSM and ECB are full members of the Basel Committee. The Commission and the European Banking Authority are there as observers. Then there are representatives from the central banks and national banking supervisory authorities of certain member states. Assuming that the member states of the banking euro area have similar preferences, I guess that that will have an implication in the future in the sense that they may be more able to exert some sort of influence, or at least to project their preferences in the Basel Committee, which is a very important body. Lord Butler of Brockwell: So what do you think are the practical prospects of the formalisation of integrated representation of the euro? If I understood Mr Marsh correctly, he said that that would follow the emergence of a unified treasury function. That seems to be a long way off. If we look at this proposal in the Five Presidents’ Report, do any of you think it is likely to be achieved in the near future—that is, in stage one? David Marsh: I do not think it will be in the next five to seven years. Also, more generally, when I was in Berlin recently I saw a number of senior officials and they all distanced themselves very much—surprisingly, actually—from the recommendations, such as they were, of the Five Presidents’ Report. I was not expecting such a lukewarm response. Lord Borwick: To the whole report. David Marsh: To the whole report. The Chairman: Dr Lilico, you mentioned a eurozone treasury or head of finance Minister or something. Do you believe that that is imminent? Dr Andrew Lilico: It depends what you mean by imminent. Even at the last EU President election, Juncker tried to claim that he had been elected. People did not really buy it, so he is the only person who claims that. But I do not think it will be long before you get an EU President of some sort. Exactly whether that is a euro area President or an EU President is slightly up for grabs, but I think that the finance person would follow on from the political election of the head of the European institution as a whole, and that cannot be far away. 277

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Once people start claiming that they are elected and at least some people start buying it, you will get momentum behind that two or three elections down the line. Lord Butler of Brockwell: Would you like to define “far away”? Dr Andrew Lilico: As I said, two or three elections down the line. Professor Lucia Quaglia: I also consider that to be a sort of long-term project. More likely in the short to medium term is a formalisation of the Eurogroup. That has an implication for outsiders in that the Eurogroup is generally seen as a smaller body in which member states are better able to reach a consensus. Therefore, if there is a formalisation of this body, it will have implications for the outsiders. My impression is that increasingly important, or at least politically controversial, decisions are taken in the Eurogroup first and are then discussed in the ECOFIN council. The Chairman: Just before we leave this, would treaty change not be required? Dr Lilico, you see this as happening two or three elections down the line but you are assuming that, in this interim period, in order to create that role there will have to be treaty change. Dr Andrew Lilico: Yes, clearly.

Q173 Lord Skidelsky: I would like to turn to economic policy co-ordination and ask for your views on what seem to me to be two omissions from the Five Presidents’ Report. The first is any proposal for dealing with current account imbalances—in particular, permanent German surpluses, which tend to force deflation on deficit countries. The second is the absence in the fiscal rules of any proposal for stabilisation or countercyclical policy; there is very little scope for that. In so far as those two omissions affect the economic performance of the eurozone and the European Union as a whole, they will affect Britain, whatever the view of the present British Government might be on those questions. So not only will it affect the economic viability of the eurozone, that will have an impact on the United Kingdom as well. I would like your views on that, please. David Marsh: If I could start, you have put your finger on two really important issues, and it is not surprising that they are not dealt with in any great detail. First, on the imbalances, it has been glaringly obvious that the current account deficits and surpluses of the euro states since the start have been among the largest in the world in terms of percentages of GDP. Some of the most egregious problems with the deficits have obviously been healed but the countries that have surpluses are still piling up enormous surpluses. Germany, which you mentioned, has surpluses amounting to 8% of GDP, and that is probably growing slightly because of the weak euro. The Dutch surplus, which does not get talked about very much, is 12% of GDP. This is clearly, as you say, the cause of some kind of deflation, or at least it lowers the propensity for economic growth, because the other countries that had deficits are now being forced to have surpluses. So everybody has a surplus. That means that there is not enough domestic demand, which, in my view, is the principal problem of the euro area. When people try to put their finger on Germany and say, “You should do something about this”, or they say that there should be some fines or some sort of finger-pointing, the Germans say that it is not their fault and that they have a very competitive Europe-wide industry these days. And of course Germany is being helped very much by the weaker euro. There is absolutely no way, it seems, of dealing with this very large problem. It also creates problems for Germany. It is registering enormous increases in its foreign claims as a result of 278

Dr Andrew Lilico, David Marsh and Professor Lucia Quaglia—Oral evidence (QQ167-178) these very big build-ups of surpluses but it will never get the money back. The situation is even worse for the Netherlands. It has net foreign claims of well over 15% of GDP and that money will never be redeemed. So it is really a zero-sum came. When it comes to countercyclical policies, again, people in Europe tend to look at the budget deficits in nominal terms. They should have gone over to structural terms some time ago. In fact, the Germans insist on running a surplus even though that means that their structural surplus is very large, because they have more or less full employment these days. There is no willingness to think of the deficit in terms of what it would be if you adjusted for the cycle. Greece has had a monumental adjustment of something like 15 percentage points in its budgetary position. No credit is given for that. In fact, the Greeks are rather the whipping boys still. On the other hand, there is no criticism of Germany for running a policy that is certainly inimical to growth. So there is an enormous difference between the creditors and the debtors. It goes back to the Keynes position about asymmetrical adjustment, and it is the same thing that people were complaining about in the 1940s. You see it writ large. As you said, all this would have big implications for Britain. Whether we are in or out, Europe is still our biggest trading area. Indeed, Britain is the biggest and most important trading area of the euro bloc, both in imports and exports. We are bigger than China and the United States. So if there is a progressive dismantling of the euro area, which I think could easily be accelerated if Britain were to leave the European Union, we will be hit one way or the other by the fallout. We cannot really escape the problem of what I consider a gradual European disintegration. Lord Lawson of Blaby: I think Dr Lilico wants to add something to that. Dr Andrew Lilico: Perhaps I could briefly respond on one or two things. One element of the imbalances is that they are the counterpart to the budgetary imbalances. If the Greeks borrow a lot of money from the Germans to fund their budget deficit, there will be a balance of payments consequence of that. To the extent that you address the fiscal question, you will automatically address some of the imbalances issues as well. Secondly, on the report, I think you should understand some of the discussion about competitiveness in terms of seeking to partially address the problem of imbalances. It sees some of the imbalances as arising from differentials and differential trends in unit labour costs. If you could get everybody to improve their competitiveness, that should partially address those things as well. There are some things to say about capital spending but I do not think I need add any more.

Q174 Lord Lawson of Blaby: I would like to stick with this area, because we are now talking about the big issues. It is easy to get seduced by talking about all these technicalities, which are not totally unimportant but they are not the main thing. The main thing is that there is undoubtedly a huge problem with the eurozone. Indeed, David Marsh has addressed this in a book which he has just updated. It is well worth reading. Dr Lilico has also addressed it in his excellent written evidence to us. Tell me if I am wrong but the position seems to be that if the euro area is to be a success, and if the euro as a single currency is to be a success, there has to be an automatic transfer union. You cannot have to have a vote of the members each time there is a transfer; you have to do what the United States does, with most taxes being raised in the more successful parts of the Union and public expenditure

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Dr Andrew Lilico, David Marsh and Professor Lucia Quaglia—Oral evidence (QQ167-178) disproportionately being in the less successful parts. So the transfers have to be automatic— they should not have to be voted on—and therefore you need a transfer union which requires a political union. There seems to be a consensus that that is so, and I believe that is right. There also seems to be a consensus that that is not going to happen any time soon. Indeed, it may not happen at all. The question then is: what are the economic consequences? There is also the question of what the political consequences will be. It seems to me to suggest two things. One is frequently spoken about and the other less frequently. The one that is frequently spoken about is that the eurozone will be a continually underperforming economic area, although the euro will not necessarily collapse. The second thing is that for the European economy to really prosper—this is generally agreed—there need to be major structural reforms of one kind or another. Structural reforms—I have some experience of this—are politically extremely difficult and need huge, single-minded determination. It seems to me that in the European area—whether the eurozone or continental Europe as a whole—even if there were this determination to implement structural reforms rather than just talking about them, which varies from place to place, they are so preoccupied with the problems of the eurozone and the euro, and devote so much of their firefighting and energies to it, that the chance of their being able to implement these needed structural reforms is approximately zero, or certainly very small. Therefore, underperformance will continue. I do not welcome this. What is your view of the economic consequences of this eurozone dilemma? Dr Andrew Lilico: On the economic consequences and their thinking about the kind of thing that implies, suppose I have a bath and I want some water in it. It turns out that the plug is not in, so water drains out continuously. I might try a couple of times, if I have not worked out that the problem is that the water is draining out continuously, to chuck in a new bucket of water to keep it going. That will not solve the problem because the water will continue to go out through the plughole. I will get equilibrium only if I can switch the tap on fast enough. If I cannot put a plug in, I have to have water going in continuously at the same rate as the water is coming out. At the end of the day, unless you address the point that for many parts of the euro area to function you must have a continuous fiscal transfer equivalent to that tap going on, you will have a series of crises which people will try to resolve by chucking in a new bucket of water. Eventually they will work out that this will not solve it, so they will then have to accept that they have to provide a tap or give up and leave. I think Mr Marsh thinks that they will eventually leave—that they will collapse. I think that series of crises will eventually be embraced as meaning that you have to have a tap, but I agree that it could go either way. Lord McFall of Alcluith: But the volume of water matters. Dr Andrew Lilico: It does. Lord McFall of Alcluith: So tell us about that. Will it be ever-increasing? Dr Andrew Lilico: My estimate is that you would want something in the order of 3% of transfers. There are already structural and cohesion funds of something like €60 billion, so for, say, Italy and Portugal, you could have transfers of around 1% of GDP. Although that is

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Dr Andrew Lilico, David Marsh and Professor Lucia Quaglia—Oral evidence (QQ167-178) not a trivial amount of money—I calculated that that was €37 billion or something12; I cannot remember the exact number now, but it was one and a bit per cent of GDP, which is more than the growth that they have had in the period of the euro. So you would be able to provide, with a relatively modest contribution, more growth for these countries. I have the figures for this, but not in front of me, I am afraid. I can send them along in due course. Compare that kind of feature—a modest contribution, a few tens of billions each year, across the euro area, exposing yourself to €2 trillion-plus of debt via a mutualisation or debt risk, taking on the responsibility for other people’s debts. That should be considered a no- brainer in terms of the type of thing that people are willing to do. There are many people who say that at the end of the day they will be forced to accept debt mutualisation. That was a claim many people made in 2011-12. My point is that if you think that they might be forced to do that, how can you think it is incredible that they might accept giving much smaller sums on an ongoing basis? I do not believe that you should consider that incredible. If that is a natural extension of kind of programmes that are already in place, you could transform the situation—not provide a final solution, because you need to be getting up to 3%-plus of GDP—merely by providing something of the same order of magnitude again as the structural and cohesion funds that are already in place. Professor Lucia Quaglia: Fiscal transfer is a common feature of all the federal states and nation states, but the European Union and the euro area are not federal states, and politically it would be very, very difficult for certain countries to accept a transfer union and a permanent set of fiscal transfers; I am thinking of Germany but also the Netherlands, Finland and the other Nordic states. What might be politically a bit more feasible but still very difficult is the construction of a stabilisation mechanism in a countercyclical way, which is different from permanent fiscal transfers taking place within the euro area. Even that would be quite difficult to achieve, because there is concern in particular member states about moral hazards and about being permanent net contributors, if you want, to this sort of euro-area mechanism for stabilisation and distribution. The Chairman: How would you suggest that is done? Professor Lucia Quaglia: At the moment, certain proposals have been put forward in the Juncker report, but they have not been fleshed out. I guess that we might see more details in the White Paper after the German and French general elections. David Marsh: I would like to address a couple of points that Lord Lawson made: one on structural reforms and the other on the transfer union, which these days translates into a question not just of utilising new debt but of restructuring existing debt. First, on the structural reforms, the problem is that they always get done, as Lord Lawson says, at the wrong time, and there will be winners and losers. Germany got its retaliation in early by doing structural reforms when it actually had some very strong advantages because the rest of the euro area was growing very fast—too fast. The lack of demand in its own country, which these structural reforms caused in the early 2000s under Gerhard Schröder, was made up for by booming exports. That was extremely fortunate from a German point of view. You

12Dr Lilico subsequently provided the correct numbers as €20-€40bn, referenced from: Institute of Economic Affairs, The Euro – the Beginning, the Middle … and the End? (2013) p 119: http://www.iea.org.uk/sites/default/files/publications/files/IEA%20The%20Euro.pdf [accessed 1 March 2016]

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Dr Andrew Lilico, David Marsh and Professor Lucia Quaglia—Oral evidence (QQ167-178) are now asking countries to carry out extremely difficult and laborious reforms at a time of low world demand and low euro-area demand, for all the reasons that have been spoken about. They will not be able to do it against a backcloth of the very high levels of unemployment and big social and political opposition that we have seen in places such as Portugal, Italy, Spain and Greece, and you should not take that lightly. It takes a long time for these people to become angry about the European Union, but it is now happening. It is clearly offset by all sorts of social cohesion and young people living with families and so on, but it is building up and we ignore it at our peril. It is very difficult to do these structural reforms, even though we all know that they are needed, and there will always be some countries that seem to have done it better and earlier than others. On the debt, just to continue the bath-time metaphor, we need the people who are controlling the taps to be in favour of running more water. We probably need another set of taps. Actually, we need to combine a few bathtubs here; it is more than just a single-tap issue. I do not see that there is the political will here. As I said right at the beginning, something that we all knew was desirable right from the beginning has now become progressively infeasible, because crises, I am afraid to say, do not breed greater solidarity— at least in Europe they do not; they breed greater egotism. Also, because Germany now has these huge net foreign claims on other countries, this makes the Germans avaricious— something that was foreseen by Wolfgang Schäuble about 30 years ago: the Germans do not want to part company with these very large foreign claims. We are now talking about massive debt restructuring, which is needed. It is not just existing money that is needed for transfers to pay the present problems: the bills of Greece, Spain and Italy. We are talking about massive losses from the past that will need to be covered one way or the other by the creditor countries, and the creditor countries, not surprisingly, are digging in their heels. So I do not see that there is really an answer to that. Europe will limp on. I agree with Andrew Lilico that the big problems are likely to come more from the large creditor countries, which simply refuse to turn on the taps and may indeed decide to move house and not share that particular bath any longer. The problem is that the Germans will never want to be seen as the people who, to use another metaphor, are sticking in the dagger. They do not mind if somebody else commits suicide, and they might even supply the dagger to do the deed, but they will not be seen, in a theatrical sense, plunging in the bloody sword at the end of Act 5 of this particular tragedy. The Chairman: Those remarks will provoke quite a response. We are going to hear from Lord Skidelsky, then Lord Davies and Lord Shutt.

Q175 Lord Skidelsky: I just want to take up the point made by Andrew Lilico. As I understand it, you think that a fiscal transfer union is inevitable and might come about quite soon. However, there is an alternative, which is that countries resume control over their own currencies—in other words, they leave the single currency. Why do you think that the development of a fiscal transfer system is more likely than the break-up of the single currency area, which would lead to a smaller eurozone? Dr Andrew Lilico: It is not completely implausible that one loses a couple of euro members, but that should not be considered a significant break-up of the eurozone. I think that the euro can carry on happily without the Greeks and the Cypriots. In fact, it would probably be better without them. If the logic of the system demands fiscal transfers or break-up, it is

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Dr Andrew Lilico, David Marsh and Professor Lucia Quaglia—Oral evidence (QQ167-178) more likely that you will end up with fiscal transfers because the commitment to the political project is extremely high. They have been building this political union for 64-plus years and they are not going to stop any time soon. They would consider it a catastrophe of monumental proportions to abandon a project that they have been working at for such a long time, and going back to national currencies would be regarded as that. There is every prospect of that leading to the collapse of the EU as well at the same time. Lord Davies of Stamford: If I may say so, I thought that Mr Marsh’s reading of history was a bit quirky. He said that Helmut Kohl’s prediction that monetary union would lead to political union was wrong, which is a rather extraordinary reading. I cannot think what the Lisbon treaty was unless it was a step in the direction of political union or indeed the two-pack, six- pack, the European Semester, the banking union and all the measures that have been taken over the past few years. I think there has been a lot of confusion about the transfer union in this discussion. There has been talk about transfer union in terms of long-term structural, which means permanent, transfers from one member state to another being a necessary part of monetary union, but I do not think the case has been made at all. Such transfers are obviously irrelevant where the same cyclical pressures are faced by all the member states or all the states of the euro area—in other words, where shocks are essentially symmetric. By definition, they are irrelevant where shocks are asymmetric if they are permanent, because the whole point about transfers is that if they are to be effective in stabilising against asymmetric shocks, they need to be specific to those asymmetric shocks and not long term or so-called structural. The experience that we have had in Europe of long-term structural transfers has not been a happy one. Italy has had these long-term structural transfers since the 1950s, which has just created this climate of dependency in Calabria, Puglia and Sicily and so forth. We have had the same problem in Northern Ireland and Cornwall to some extent. The Germans have been playing the same game in subsidising Mecklenburg- Vorpommern and so forth, and I do not think that has done any good either. So that is irrelevant. We need mechanisms that deal with asymmetric shocks. There I agree with Professor Quaglia that we need to take further some of the suggestions that are already on the table about having some element of a common unemployment insurance system. You cannot possibly have a merging of national unemployment insurance funds, because that would create the most appalling perverse incentive as the more efficient, higher-employment countries would be subsidising on a structural basis the structurally higher-unemployment countries. You could have something that insures against the cyclical element of unemployment, such as a reinsurance scheme of some sort. It has been talked about. I think the Bruegel institute has developed a model of that kind, which is quite interesting. There is also a suggestion on the table that we might have an IMF within the euro area or the European Union that would be in a position of dealing with people who ran short-term gain—if we are talking about asymmetric shocks—or short-term liquidity balance of trade problems. That is also an interesting suggestion, so I think that is the way forward. As for the debt element, of course it is a worry that debt is so high in Italy and so forth. Frankly, any kind of mutualisation creates the most appalling moral hazard. The only solution is to get back to what I call a normal rate of inflation, which might be about 2%, which is what the ECB is supposed to be aiming for. I think we will get back to that. At that point, we must maintain fiscal discipline as a result of the two-pack, six-pack, European Semester and 283

Dr Andrew Lilico, David Marsh and Professor Lucia Quaglia—Oral evidence (QQ167-178) other measures in the pipeline, which I thoroughly approve of, so that people maintain relatively balanced budgets throughout the cycle so that the fiscal position tends to be neutral through the cycle. I say “through the cycle”, because there must be an element of stabilisation there. Then, if there is a reasonable rate of inflation, the real value of this debt will be seen to be falling over time in a cyclical trend, which will reassure people and be sufficient to enable us to live with these levels of debt. At current interest rates, they are not frankly a burden on the fiscal position of the countries that they might otherwise be. The Chairman: Lord Davies, did you have a question? I am not encouraging you to go any further. Lord Davies of Stamford: I made a statement that was probably provocative. If anyone wants to disagree with me, I would be very happy. David Marsh: Could I make a point about the quirkiness of my historical interpretation? Lord Davies, you made a point that would have been perfectly valid about 25 years ago, but because of the way that monetary union has developed, we have now moved on. It has become a monumental series of resentments between creditors and debtors. It is not me saying that; it is said by people who are utterly in favour of the monetary union—people such as Mr Draghi or Mr Issing, who was at the ECB when it started. They are telling me—I am not telling them—that it has become a debtor/creditor quagmire. We have to take account of that. What do you mean by political union? I think we would say political union tends to have a sovereign body that is allowed to take tax and spending decisions for the body of the people represented by that state. It has to be a body that decides on questions of peace and war, armies and navies. It needs to have a flag and a football team and all the other apparatus that goes with it. Things like the six-pack might excite people like you and me and Professor Begg, but I do not think they add up to much more than a very thin gruel on the path towards political union. Chancellor Kohl once said to one of his speechwriters, “Political union. Very good question, Mr X, and an impossible question to answer”. That was Kohl about 20 years ago. They have not actually defined what they mean, and what we have now is in no way, shape or form political union, so we will go back to fulfilling the Maastricht criteria, which were all nominal and not structural. The Germans have the phrase, “He who has the money has to have the control, and he who pays the piper plays the tune”. The Germans want to have control over these countries, and the other countries will say, “This is not why we went into monetary union—to be bossed around by the Germans”. Above all, it is France saying that. There you have the dichotomy between France and Germany. I am sorry to say it, but that is reality. The Chairman: I know that we spent quite a lot of time with central bankers both in and out of the eurozone. Are you saying that there is no common collective vision of what is needed to make the eurozone sustainable? David Marsh: I am very much saying that

Q176 Lord Shutt of Greetland: Let us go to back to the bath. It seems to me that there is no point getting into the bath unless you want to be cleansed. Of course, you have been out in the internal market getting filthy and then you get into the bath. What I cannot understand about what I am hearing is the extent to which this tub is a eurozone tub or an EU tub. The

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Dr Andrew Lilico, David Marsh and Professor Lucia Quaglia—Oral evidence (QQ167-178) discussion has all been about it being a eurozone. To what extent is it a communal tub as far as the EU as a whole is concerned? Is it debtor or creditor? The Chairman: Professor Quaglia has been very silent. Would you like to come in with your views? Professor Lucia Quaglia: It is a very difficult question. I would reframe the question about the implication of, for example, the euro area initiative for the wider European Union, and the one I have been looking at is mainly banking union. There are very clear spillovers there, some of them not very positive, for the entire European Union and potentially for the single market. In that sense, there is a connection between the two baths, so to speak. Dr Andrew Lilico: I think that most of these are euro area issues. The ways in which they mainly spill over into the non-euro area are threefold. Obviously it is in the interests of the countries that are major trading partners of the euro area that the euro area does well, so there are implications from that for the trading and capital flows of our financial partners. There is also the issue of the measures taken, which may include measures at a European Union level. They, too, may have spillover impacts on the non-euro members. A classic example of that would be the attempt by the ECB—which it will manage in the end—to move euro area clearing and settlement to within the euro area instead of it being based in London. Lord Davies of Stamford: But they have withdrawn from that. Dr Andrew Lilico: No. They have withdrawn from the explicit measure but I would expect that in due course they would look in a more friendly way on those doing their clearing and settlement within the EU. I expect soft influence to deliver that in the end, even if explicit measures are forbidden. The third way is the impact that deeper political integration, which I think will occur, will have on the functioning of the European Union institutions in the way that I described in the paper that I sent to you. David Marsh: May I comment on what Lord Shutt said? This is a crucial question. The key to all this is Poland. Until a few years ago, we would easily have thought that Poland, along with a lot of other central and eastern European states, as well as Sweden and Denmark, would be members of the euro area. That is certainly what people were predicting in, say, 2010, but that has not happened. Therefore, there is a big body of fairly well-run and populous countries—quite large players—that are outside the euro area. Therefore, the point that you have put your finger on is extremely important. I was very pleased to see in the Donald Tusk paper from yesterday that the other Europeans acknowledge, as is clearly the case, that there are other countries in the euro area and not part of the euro. I think that should be enshrined in some sort of force of law, whether it is treaty change or a watertight document which says that, if Britain remains in the European Union, we will have nothing to do with euro area bailout measures. That needs to be made absolutely watertight, either through a treaty or in a sort of Freshfields-signed document. I think all your allusions to tubs and whether we are all in it together are very important in that regard. The clearing issue is very important. London remains an important financial centre and therefore, if we are to stay in the European Union, we must have safeguards so that we can carry on doing euro trading here. If we leave, of course things may change, but that is extremely important.

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The problem is that you do not know whether individual members of the euro tub will remain. It is all very well for Andrew Lilico to say, “Oh well, some may go but if they are small it doesn’t really matter”. I think it would be incredibly important if a small country, particularly one such as Greece with so much history and so much willingness and ability to get its way, were to leave. We cannot simply say, “They’ve left. They’ve gone off to another tub. They’re going to take another bath towel from somewhere else. Let them get on in their own little tub”. That would have an enormous impact on Italy and France. Lord Davies of Stamford: I want to challenge what Mr Marsh has just been saying. I think there is a fundamental contradiction in what you have just said. If we are to be the financial capital of the EU area, banks and other institutions in the City of London will have massive amounts of assets in the eurozone. It follows that if there were a systemic threat to the stability of the eurozone, we would be exposed to that, and it might be very much in our national interests, and necessarily in the national interests, to be part of a bailout. The alternative might be worse and cost British taxpayers even more money in refinancing or recapitalising our banks because liquidity had been destroyed. So if we are to have a key role in the European Union, it makes no sense at all to say that we need some legal safeguard that makes it impossible for us ever to be a part of a bailout. David Marsh: Perhaps I may make one point on that. I did not say that we would never be part of it. We decide as a sovereign body. Britain took part in action to help Ireland. We were not part of the euro area; we did that of our own accord because it made sense for British interests.

Q177 The Chairman: Thank you. I just want to pick up on the bath analogy, and I promise that this will be the last reference to it. You talked about a bath and the water draining out. What about the plug in the bath? That takes me neatly on to the banking union. Do you see that as the backstop? Do you think that risk-sharing over the medium to long term is going to happen? What are your views on banking union taking off under the Dutch presidency in the slightly longer term in terms of its missing elements at the moment? Dr Andrew Lilico: I would say that by far the most important and positive element of the banking union is the resolution framework. The introduction of a bailing tool and things of that sort are excellent advances, although they are not complete. I think that having such a high level of insurance in the form of depositors is a mistake. I do not believe in depositor insurance. We have got on perfectly well in the UK without any depositor insurance since 1979. We seem to be happy enough with having only 2,000— The Chairman: But if we had not had it, the banking crisis would have had a rather catastrophic effect. Lord Davies of Stamford: Are you suggesting, Dr Lilico, that little old ladies with £5,000 to deposit should spend several days looking at the balance sheets of all possible banks to decide what credit rating she might to give each one and where she can safely place her deposit? Do you seriously think that? Is that reasonable from a human point of view or would it be systemically dangerous for the stability of the system? Dr Andrew Lilico: I have written about this at some length. Until the 1970s we had a set of institutions called savings banks in the UK. The Trustee Savings Bank was the last of them until its nature was changed in the mid-1970s. You put money in the bank and it was 100% 286

Dr Andrew Lilico, David Marsh and Professor Lucia Quaglia—Oral evidence (QQ167-178) backed by government bonds, gilts and things of that sort. I am saying that you should have two kinds of deposits in every bank licensed to accept retail deposits. If all you want to do is store your money in the bank, you should be able to put it into storage deposits, but if you put your money into a fractional reserve bank, there should be no deposit insurance whatever associated with that. The Chairman: I want to come back and focus on the eurozone. Dr Andrew Lilico: That is the system in New Zealand, for example. There is no deposit insurance. The idea of moving towards increased collective risk-sharing is a mistake. The sense that the right objective here is to spread risk over a larger area is a mistake. The central useful thing here is achieving a common resolution framework and some greater cross-border collaboration. We have already had some of these things. There were measures in 2008 and there were ones before that with various kinds of colleges of supervisors and so on agreeing resolutions. Those are possible developments but I would say that the risk- sharing elements are a mistake. The Chairman: Thank you. Professor Quaglia, I take it that you have a slightly different perspective. Professor Lucia Quaglia: Banking union has been quite successful in preventing the worst outcome from the euro area sovereign debt crisis. It has also been successful in breaking the vicious cycle of states supporting the banks. The single supervisory mechanism has been set up and works quite well, and there is also a single resolution fund and a single resolution mechanism. It seems to me that the missing parts in the completion of banking union are a European deposit insurance scheme and then the setting up of a common fiscal backstop. David Marsh: Very briefly, I think that the setting up of the Single Resolution Board, which has really become effective only in the last month, is a major milestone. It remains to be seen whether it will be tested in the heat of battle. The problem with the non-performing loans that we are becoming aware of around Europe is that all that will become significantly worse if Europe fails to do even as relatively badly as we thought it would. If we have a major world problem as a result of the United States not growing as much as we hoped it would, that will hit NPLs in, say, Italy. I wonder whether this international mechanism for the Single Resolution Board will work or whether we will go back to elements of banking nationalism, which we had before. I would not be prepared to swear that the sovereign banking nexus has now been ended. That has to be tested but I am not confident that that can prove to be resilient enough to face the storms that we might see in the next two or three years. Professor Lucia Quaglia: Perhaps I may add to that. The decision-making process of the single resolution mechanism seems to be quite convoluted as it involves several authorities at a national level—the Commission, the European Central Bank and the Single Resolution Board. The big question is whether it will be effective enough in taking decisions in the heat of the crisis of, say, a major bank failing. The proof of the pudding will be in the eating. The Chairman: Thank you. Shall we move on to capital markets union? Lord Davies, did you want to come in on that?

Q178 Lord Davies of Stamford: I was going to ask about the United States and that sort of thing. It would be interesting to hear your views on the extent to which the capital markets 287

Dr Andrew Lilico, David Marsh and Professor Lucia Quaglia—Oral evidence (QQ167-178) bring about stabilisation in the United States. In the case of asymmetric shocks, an awful lot of the stabilisation will inevitably be accomplished by capital markets, quite apart from what the public sector needs to do. We all know that in the United States if the price of oil goes down, it is bad for Texas but very good for New York, Massachusetts and California. That sort of system is quite healthy. To what extent could that, or should that, work, or is it working, in the euro area? World capital markets, you can help. David Marsh: It is very helpful to look at America as another role model and try to get away from undue dependence on the banks in Europe and move towards a more capital market- focused structure. I think that this capital market union idea, which has been dreamed up by the European Commission and the EIB—Lord Hill played a role in that—is very worthy. It also provides something for British banks and British asset managers, so you could say that it is quite clever politically but it also throws an olive branch to us in the UK as well. There are structural reasons why capital markets have always been much less important than the banking markets in continental Europe, and you will not be able to overcome that in just a few years. The lending for covered bonds, which in Europe go back over a couple of centuries, is an extremely important part of what you might call a banking/capital market structure. That will not change. Asset-backed securities were at the root of some of the problems that we had in 2007 and 2008. The Commission and the ECB have been trying to revitalise those but they have come up against huge regulatory and structural problems. So that it is very laudable and there are some steps forward there, but I think it will take a very long time for us to really emulate the United States in that regard. Lord Davies of Stamford: Would it provide significant protection against asymmetric shocks? David Marsh: I am not sure it would because these asymmetric shocks will be more significant than we think in certain areas—for example, Germany being affected by China or Spain or Portugal. Portugal has been immensely affected by the downturn in oil prices with regard to Angola, one of its former colonies. That is an asymmetric shock and I do not see how you can legislate for it. Lord Davies of Stamford: If there is a stabilisation mechanism, presumably it depends on the diversification of portfolios. If people hold widely diversified portfolios so that they have claims on businesses in other EU member states, whether in the form of bonds or equities or what have you, there will be a stabilisation effect. That is clearly significant in the United States, although I do not think it is very significant at the moment in the EU generally or in the euro area. David Marsh: We saw a lot of cross-border claims being built up before 2010. That was, if you like, a successful part of monetary union. Then, when problems started to occur, the creditors of the deficit countries withdrew their liquidity, leading to all this official assistance that we have seen. So we have been through that phase. Lord Davies of Stamford: But that was the banks rather than the capital markets. David Marsh: It was partly the banks. A lot of bonds were owned. A lot of German and Swiss insurance companies had subscribed to bonds issued by, say, the Greek Government, and I know for a fact that the Chinese Central Bank, too, had lots of those bonds. So it was certainly down to much more than simply the financial markets; it was down to the holding

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Dr Andrew Lilico, David Marsh and Professor Lucia Quaglia—Oral evidence (QQ167-178) of bonds. They were all withdrawn and converted, and the IMF, the ECB and the European Commission had to step in to make up for those bondholders. Lord Davies of Stamford: Are there any studies that quantify the effects? I have not seen any. David Marsh: Yes, there are, and they are immensely interesting. I am very happy to share a few footnotes with you. The Chairman: Dr Lilico, I think you want to come in on this point and then I will go to Professor Quaglia. Dr Andrew Lilico: I have three things to say. First, one should bear in mind that in the US a significant portion of shocks are dealt with by labour mobility, much more so than in Europe. That is an important factor if one would like to have more labour mobility in the EU. Lord Davies of Stamford: Some Cabinet Ministers think there is too much labour mobility in the EU. Dr Andrew Lilico: I do not, although things like the problems in the Schengen area are probably damaging. Lord Lawson of Blaby: This is an important point. Population mobility is a crucial part of life in the United States. It is accepted there; it is not controversial. Within Europe, very much the reverse is the case: it is highly controversial and not accepted. This is a major problem that you have put your finger on. Dr Andrew Lilico: The second thing I would say is that the prevalence of corporate bonds in the US relative to Europe is not mainly the result of regulatory barriers and flaws in the European framework; it is the result of traditional regulatory barriers and flaws in the US framework which limited the ability of banks to do certain kinds of corporate lending and it drove the development of the corporate bond market. The third and last thing I would say is that we did quite a lot of analysis of convergence in the capital markets associated with the single financial services market programme from the late 1990s into the mid-2000s. By 2007 there was considerable convergence in transaction costs, in equity risk premia and in debt premia across the euro area. Now, that has been reversed, partly as a consequence of the eurozone crisis, but I would view a lot of the capital market union discussion as overblowing the problems. There are not that many things to solve in that dimension. The issues, in so far as they arise, are the same in relation to the capital markets union—by and large, they are just a version of the issues that have been associated with the eurozone crisis. The Chairman: Professor Quaglia, you have the last word. Professor Lucia Quaglia: Many financial economies would argue that liquid financial markets are one of the best ways to deal with asymmetric shocks. That said, there are still very important structural differences between the European Union and the US. In the European Union, banks intermediate about 80% of the credit of the real economy; only 20% is intermediated through capital markets. In the US, it is the other way round. These are structural features that are not very easy to change, despite the capital markets union project. So it might work but it will take time.

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Lord Davies of Stamford: It is going in the right direction, is it not? Professor Lucia Quaglia: Yes. Politically, as David mentioned, I think it is also an incentive for the UK and the City to adopt a positive attitude towards the European Union. The Chairman: Thank you. Do any of you have a final, concluding thought? David Marsh: There is one thing that I would say. I wonder whether you have had any eminent French or German luminaries come to speak to you. Whether they are ex-Finance Ministers or “experts from the street”, I wonder whether that might be helpful. I know that you have Lucia here, who speaks for the euro in this body, but there are one or two eminently politically issues. For instance, all sorts of German people would be very helpful to your Committee’s deliberations. The Chairman: Thank you. We had a very interesting trip to Brussels, where we got a panoply of opinions, but it is an interesting thought. Thank you very much. I take it that the Members have no other questions. This concludes today’s public evidence session. The Committee will now continue its session in private.

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David Marsh, Dr Andrew Lilico and Professor Lucia Quaglia—Oral evidence (QQ167-178)

David Marsh, Dr Andrew Lilico and Professor Lucia Quaglia—Oral evidence (QQ167-178)

Transcript to be found under Dr. Andrew Lilico.

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Reza Moghadam and Professor Lorenzo Codogno—Oral evidence (QQ56–67)

Reza Moghadam and Professor Lorenzo Codogno—Oral evidence (QQ56–67)

Transcript to be found under Professor Lorenzo Codogno.

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Veronica Nilsson—Oral evidence (QQ129-140)

Veronica Nilsson—Oral evidence (QQ129-140)

Evidence Session No. 12 Heard in Public Questions 129 - 140

WEDNESDAY 27 JANUARY 2016

Members present

Baroness Falkner of Margravine (Chairman) Lord Butler of Brockwell Lord Davies of Stamford Lord Haskins Earl of Lindsay Lord McFall of Alcluith Lord Shutt of Greetland ______

Examination of Witness Veronica Nilsson, Confederal Secretary, ETUC

Q129 The Chairman: Ms Nilsson, thank you for agreeing to give evidence to us today for our inquiry into completing Europe’s economic and monetary union. As you know, the session is on the record and we will take a verbatim transcript of proceedings, which will be published in due course. You will of course have the opportunity to correct any minor errors or misunderstandings. Can I thank you for your patience in waiting for us to come back slightly later than expected? To commence, I wonder whether you might give us your assessment of the Five Presidents’ Report and the actions introduced in the short term and in the longer term. Do you think it does enough to strengthen the euro in its long-term sustainability and, in reflecting on that, would you also comment on what you see to be any political obstacles to achieving what is proposed in the report? Veronica Nilsson: Thank you very much. I am very pleased to be here and to meet with all of you. For us, this is a key issue. The ETUC Executive Committee adopted a position quite recently on this issue in December and we also have previous position papers on the issue of the EMU, which is of great concern to us all, I believe. There are both positive and negative elements in the Five Presidents’ Report, from our point of view. We understand the call for strengthening the current governance framework, but what if the framework is wrong from our point of view? We believe that the current framework is unbalanced. The focus is very much on fiscal stability and wage competitiveness. There is also an asymmetrical approach where deficit countries are treated 293

Veronica Nilsson—Oral evidence (QQ129-140) differently from surplus countries. We believe that there is not enough emphasis on growth and job creation. We can also see this in the instruments that are already in place: the Stability and Growth Pact and also the Fiscal Compact. First of all, we have the criteria in the Stability and Growth Pact, but then we also had the Fiscal Compact a couple of years ago, which goes even further in terms of the criteria that governments have to abide by, so it is very strict. There are also a number of proposals that we are not happy about. In particular, the proposal to set up these competitiveness boards. We do recognise that there is an evolution from the Five Presidents’ Report to the current proposal that the Commission has put on the table. In the Five Presidents’ Report, they spoke about “competitiveness authorities”. I do not remember how they put it, but it was very clear that they should influence the wage-setting process and we are very concerned, because we believe that this does not respect the autonomy of the social partners. The Chairman: These are the National Competitiveness Boards you are talking about. Veronica Nilsson: Yes, but in the Five Presidents’ Report they were called “competitiveness authorities”, so they were even stronger in terms of interfering in wage bargaining. We think that the proposal put forward by the Commission does not go as far as the proposal in the Five Presidents’ Report, but nevertheless we are very concerned about the idea of having these competitiveness boards, firstly because, as I said, it interferes with wage setting, which is an issue for the social partners. The other thing is that we do not share the view that the EU is suffering from a lack of competitiveness. Of course we want competitive companies. That is extremely important for workers as well as employers, but we do not think that that is the key concern of Europe. In order to strengthen competitiveness, I do not think that wages are a key issue, because it should never be our ambition to compete with China, emerging economies or other countries on the basis of low wages. We should compete by having strong skills, strong research and development, innovation, strong infrastructure, strong networks, public services and quality services. That is what we should compete upon, not wages, so we do not really like this focus on wages. In addition, it is not so clear what the Commission proposal will lead to, because those in favour will argue that this is not binding but is just giving advice, but we fear that these bodies will be able to exert a lot of pressure on social partners even if they are not binding. Also in the Commission proposal, the last paragraph leaves the door open for binding measures in the future, because it says that the Commission should carry out an evaluation in one year’s time. That could then lead to additional steps that are more binding, so we are very much against this proposal. We welcome that there is recognition on behalf of the Commission that they need to strengthen the social dimension of the EMU, and today we will get further information on what they have in mind for this social pillar. The question is if this social pillar will be taken as seriously as the economic rules. For us, it is also very important that the social pillar applies to all EU member states, so not only the eurozone. Ms Thyssen issued a communication a week ago where she said that this was basically for eurozone countries, although others could join if they wanted, but it is perceived as something for eurozone countries and that is not something we agree with. 294

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We believe that it is necessary to establish some kind of a common macroeconomic stabilisation function, as is proposed in the Five Presidents’ Report. There is very little information on what this should look like and what form it should take, but I do believe that EMU is not viable. First of all, we want to revise the whole structure and that is one thing. Lord Davies of Stamford: Did you say you want to revise the whole structure of the European Union? Veronica Nilsson: No, not the whole structure of the European Union; the economic governance framework. As I said before, the focus is really on fiscal stability, cutting wages and so on, this whole asymmetrical approach. The question is what it will look like, and the Five Presidents’ Report is not clear. We have our own ideas. There is, for example, one proposal by an economist, Joerg Bibow, which we find very interesting. He says that the institutions could set up a euro treasury that would issue common debt papers, but those common debt papers should be linked to investment. In exchange for this common debt, governments have to invest in their economies. This would reduce the public debt, because we would get common debt, and that would make us less vulnerable to financial speculation as the debt thresholds are very high in some countries. What is so good with it is that it links to investment, because currently we see the lack of investment as the big problem. We also welcome the report’s recognition that they need to strengthen democratic accountability, because that is missing today. Here I can only again deplore the way that the Fiscal Compact was agreed upon. First of all, according to the Lisbon treaty, any changes in the treaties should be done by calling a convention, but because the Fiscal Compact was done as an intergovernmental agreement they could avoid this. Now, though, the Fiscal Compact will be incorporated into EU law anyway, so it means that they have changed a treaty without calling for the convention. We do not think that that is really going to help strengthen democratic accountability, because it is perceived in the eyes of people as the EU just going ahead above us and that is a big problem. In the report they call for more involvement of national parliaments, more involvement of social partners and this is positive, but it is not enough. What can be done? That is a different issue and it is very difficult. I do not believe I have all the answers, but something they also mention in the report is that they are going to set up a high-level group this spring and we, as social partners, will definitely ask for a seat. I do not think we will get it, but we will nevertheless make the point that this is the future for all of us and we think that the social partners should also be able to have a seat in this high-level group. There are many things that could be said on our concerns about the democratic deficits. If I talk about these competitiveness boards again, for example, we had the Tripartite Social Summit one week before the Commission published their proposal for the competitiveness boards. We raised our concerns. President Juncker was there. We did not get much of a reaction and then, one week later, nevertheless they put something on the table that interferes with collective bargaining and without even having consulted us before. At the same time as this new Commission, President Juncker is insisting on the need to strengthen social dialogue, strengthen the role of the social partners, but as soon as the Commission proposes something that is of concern to us we are not consulted. There are many issues that need to be addressed if you talk about the democratic deficit.

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Q130 The Chairman: Thank you. You have raised quite a lot of very important and significant issues, one of them being, for example, democratic accountability and the lack of legitimacy. In your view, what would be the correct answer to how to get that? Veronica Nilsson: I do not think we have all the answers. We have started discussions within our own organisation about what can be done. We see many problems and, as I said before, it is welcome that they are involving national parliaments and social partners more. That is very important, but of course that will not be the solution and then everything will be fine. It is not enough. Also of concern is that the European Parliament does not really play much of a role in economic governance. For example, they are not asked for their opinion on the competitiveness boards. They can make their own initiative report, but it does not have that much value and that goes for the whole European Semester. The Commission published the AGS, Annual Growth Survey, package in November. There are lots of very important documents that are part of this package, but again the Parliament is not really involved. They are taking their own initiative by publishing different opinions, but it is their own initiative, so they are not really playing the role of the co-legislator in this area and this has to be changed. They need to have a more formal role in the whole European Semester and economic governance. The Chairman: You have directed us quite clearly in a certain direction. I wonder if I can ask Lord Haskins to come in more specifically.

Q131 Lord Haskins: It seems to me that people like you are struggling with two enormous problems, which I have great sympathy with. First, there is the global problem about the way labour markets are changing, through reasons mainly technological, but jobs available for unskilled workers or semi-skilled workers are being squeezed, and one can see this even in the United States now, with the resultant huge inequalities developing in those markets. Secondly, the other side of it, in the eurozone, if you look at the German labour market operating against the Greek labour market, then you know who is going to win. That is a dilemma for the eurozone: can you do anything to narrow the differences between the way the labour markets work in Scandinavia and in Germany compared with the Mediterranean? Those two problems seem sometimes to be almost irreconcilable. Veronica Nilsson: The Commission is doing quite a lot in terms of imposing structural reforms and that also comes back to the democratic deficit, what the troika did and that was criticised by the Court of Auditors the other day, which perhaps you saw. We do not necessarily agree with the reforms proposed by the troika, by the European Commission and so on. Lord Haskins: What would your answer be? Veronica Nilsson: How do you narrow the differences? We have to look more at the evidence of what kind of reforms are successful. Recently, Paul De Grauwe, who is a Belgian economist, issued a very interesting report showing that the labour market reforms that have been carried out these last years have not had the intended effect, so what kind of reforms are needed? The focus we have seen is on reducing things like employment protection legislation, making labour markets more flexible. In the UK, you have zero-hours contracts. It will not be a surprise to you that we are not very fond of those. I am not an 296

Veronica Nilsson—Oral evidence (QQ129-140) expert on Greek labour market policy, so I cannot say exactly what kind of reforms are needed in Greece and I do not want the ETUC to be perceived as being against reforms. It is all a question of what kind of reforms and that will be very different in different countries. Being Swedish, structural reform is part of the Swedish model, but I cannot give lessons on what kind of reforms other countries need. Lord Haskins: If the eurozone is to work, something has to be done about the Greek labour market and, I would say, the French labour market too, in a sense. They do not compete successfully against the Scandinavian, the German and the British models. Veronica Nilsson: We had this discussion on Monday. We had the macroeconomic dialogue and my colleague from the TUC showed that productivity is much higher in France than it is in the UK. Lord Haskins: It is, but unemployment is much higher too. Veronica Nilsson: It is. You have to look at each country separately and it is very difficult for the Commission to make general recommendations. The problem is, as I said, they go in the same direction and it is about flexibility all along, and is not so much focused on security. We see that in the AGS, maybe not in the Five Presidents’ Report, I do not remember, but the whole “flexicurity” concept is coming back on the agenda. This is a concept that tries to balance flexibility, yes, with security, which we need. We cannot just have one or the other. That does not work, but what is the right balance? Lord Haskins: Sure, but the security issue is a global issue; it is the technological thing. How do the leaders of the labour movements across the world react to the global issue? Veronica Nilsson: Digitalisation is both positive and negative. Of course it provides opportunities. It could also be an opportunity for more flexible working arrangements. It could be a way of improving the work-life balance for some people, but we are also very concerned about the social impact, because it is not just positive. Jobs will disappear and what kind of quality jobs will we have? Take crowd-working, for example. What rules apply to crowd workers? Which labour code of which country applies? That is not very clear. It is also a problem if these workers are not seen as workers. I am not sure if it was the ECJ outcomes, but there was a court decision where they claimed that the workers who were going to get the crowd workers in order to negotiate their wages were seen as a cartel, so it was not allowed. I do not remember the detail; I have not followed it closely myself. There are opportunities, but there are many problems as well and here again the Commission has a bit of a technocratic approach, focusing more on the opportunities. We have to also look at what the problems are, what the risks are and how we can avoid them.

Q132 Lord Davies of Stamford: I was disappointed to hear what you said about the lack of consultation with the Commission. I thought the Commission was rather good among bureaucratic organisations in consulting generally and particularly committed to consulting with the social partners, so I was sorry to hear what you said about that. Have you had and have you taken up opportunities for consultation with the Commission in the context of the European Semester and the discussion about appropriate economic policies? That should, presumably, open up quite a lot of the field for consultation and discussion.

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Veronica Nilsson: Yes, indeed, and I do have to say that the Commission has improved a lot, in particular when it concerns the European Semester, because that is the area where they are interested in involving the social partners. We regret that they do not take so many initiatives in the social field to invite the social partners to negotiate framework agreements. The consultations are really taking place within the European Semester and there is definitely an improvement. We are consulted much more than we used to be. Here, at the European level, we also have more informal consultations, which sometimes are more helpful because you can have more of a frank exchange and more of a dialogue. When you are in a formal meeting you are more in a situation where you give statements rather than have a dialogue. That is positive and it has improved. At the national level it is different, because that also depends on governments, of course, but here also the Commission is trying to play a positive role. When they send country teams to the different countries, they also meet with the social partners, for example. Here, our criticism would be more towards some governments. In some countries it works very well, where the social partners are consulted properly, but not all countries. Lord Davies of Stamford: Like in Sweden. Veronica Nilsson: Of course.

Q133 The Chairman: You mentioned earlier that you had just had a macroeconomic dialogue session a few days ago. Do you think that is a positive and useful tool in terms of economic governance? Veronica Nilsson: It is, but we would like to improve it further. The Chairman: What would you specifically wish to see? Veronica Nilsson: First, we would like to have more resources provided by the Commission. We used to have interpretation in at least two languages for the technical meetings, because there is both the technical and the political meeting, and it makes it very difficult for trade unionists from countries like Spain and Italy to come and participate in the discussions if they have to do it in English. Unfortunately, that is the reality of things, so we have a tendency to bring affiliates from northern Europe where the language skills are usually better. More resources is one thing, not just when it comes to interpretation, but also so that we can have a broader and bigger delegation with trade unions from different countries, because we do get into quite technical discussions. A colleague mentioned Greece; I am not an expert on Greece, but I would like to have a colleague from Greece saying, “This is what we need in Greece” or “This is what the situation is in Greece”. For example, for the technical meeting we can bring 10 people altogether. When it is the political meeting we can only bring four people, so we would like to have broader participation. We also want to have a stronger link with the European Semester. It is starting to change, but it was not there before. We want to use the macroeconomic dialogue to also talk about the macroeconomic imbalance procedure, the country reports and the country-specific recommendations. That is changing a bit, though, so it is becoming better.

Q134 Lord Shutt of Greetland: I am looking at number five and you have covered a lot of this already. We know that you are arguing for there to be more democratic accountability. 298

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You obviously want your own organisation to have more involvement, but where do you see this in the democracy of Europe as a whole and is there any difference with the governance of EMU as compared to the European Parliament? How do you see this going forward? Are there any other democratic accountability issues that need to be brought into place that you want to raise, anything specific? Veronica Nilsson: First, I believe they should abolish the troika. It has been more or less abolished already, but the way the troika was set up has done a lot of damage and does not help to create confidence among citizens. There is also the role of the ECB, which we have not discussed. The ECB is too political. They are interfering with policy-making, which goes beyond their mandate of running monetary policy in Europe. I remember a few years ago, when Jean-Claude Trichet was still the director of the ECB, he sent a letter to the Italian Government telling them to introduce reforms in the labour market—more or less a covert threat that otherwise they might not get so much support from the ECB. That is stepping outside their mandate, as well as the fact that they participated in the troika. It is not their role and I could give many examples. I am not really sure how to resolve the problem of the ECB stepping outside its mandate and going too far, but there are also other things in the ECB structure. The ECB has missed its price stability goal for four years and we think that the goal should be revised; we think it is too low. It would be more effective to have an inflation goal of maybe 2% to 3%, or something like that. They should also act as a lender of last resort. I know they are trying, but it is difficult. They should support public investment, shield member states from market speculation and also become more like the Federal Reserve, which does not only have an inflation goal but is also looking into employment and growth.

Q135 The Chairman: Can I press you a bit on the ECB and its role in the troika? I suspect that, if we were speaking to them, they would argue that they stepped up to the plate when nobody else was there to do so, potentially reluctantly, but there was a vacuum that needed to be filled in a crisis. Would you agree with that? Veronica Nilsson: Yes, I understand that argument, which is perfectly legitimate. The Chairman: Incidentally, while we are on that, do you believe that the IMF had a legitimate role? Veronica Nilsson: Well, we are not particularly fond always of the recommendations coming out of the IMF, but the problem here is that we have the ECB and the Commission being bound by the treaties and EU law. EU law does not apply to the IMF, so that is the big difference. Lord McFall of Alcluith: Is the issue you are focusing on with the ECB the lack of democratic accountability? Is that the issue at the core of it? Veronica Nilsson: The core of what? The Chairman: Or is it its mandate? Is your concern with the ECB democratic legitimacy or is it the mandate itself?

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Veronica Nilsson: It is both. They are two separate issues. One is the economic policies, when I am saying we need a little more inflation in our economies, but that does not have anything to do with democracy. That is more the role that I see the ECB taking. On the aspect of democracy, I also think there is a tendency on behalf of the Commission to rely much more on independent experts than they used to do. That is the general tendency and I do not think that all these independent experts are neutral, because we all come from different perspectives and have our own cultures and traditions that we are coloured by. For me, it makes more sense, for example, to invite social partners, because you know trade unions represent the interests of the workers; employers represent the interests of the employers. You know where they come from. All these independent experts are taking too much space. I am thinking again of the competitiveness boards, because the idea is not to involve the social partners in that. The proposal is clear: it is the competitiveness boards with independent experts. They are doing the same on the European Fiscal Board. Again, this is for independent experts. They are doing the same on Better Regulation with the Regulatory Scrutiny Board that they have set up with independent experts. For me, it permeates the whole of the EU, this idea of independent experts, and I have a feeling they are almost taking over policy-making. The Chairman: Can I come in? It is a little controversial point I am going to address. I see where you are coming from and certainly in the German system you have the workers’ representatives represented on boards, but we have seen the disaster of the VW board, where you had the interests of the company very tightly controlled by controlling shareholders and then you had the workers’ representatives, who seemed to have rather got lost in terms of strategic oversight. Would you not accept that the public may have more confidence in independent experts’ advice being heeded than perhaps a side that might have a vested interest? Veronica Nilsson: That is not a very glorious example, obviously, but the German model is very particular. There is no other country where you have that system. We have something in Sweden, but it looks very different. You are not part of the board in the same way, so there is no mix-up between different interests. That is very much a German model, which does not really fit the rest of Europe. What can I say? The Chairman: That is a difficult one. Lord Davies wanted to come in.

Q136 Lord Davies of Stamford: I am quite interested in what you were saying on characterising the present trend of the Commission to staff these bodies with independent experts or the platonic approach to governance; it is quite an interesting comment. I just wanted to note two rather striking ironies about what you have been saying in criticising the ECB. First of all, the trade union movement in the European Union is interminably criticising the futile policy pursued over the last years on the grounds that it is too demand-restrictive, but the only body at the present time that is taking action to increase demand is, of course, the ECB with their quantitative easing programme and yet you are criticising them. Secondly, you were making comments about the ECB not restricting itself to a purely monetary role, allowing itself to take an interest in politics, which sounds exactly like the criticism being made of the ECB by extreme right-wing monetarists in Germany, like Hans-Werner Sinn. I thought I would just point out those two ironies that emerged from your remarks.

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Veronica Nilsson: That is fair enough. The Chairman: The Ifo Institute is not exactly your best friend. Veronica Nilsson: No. First of all, the quantitative easing came a bit late. Although we wanted to stimulate demand growth, investment and so on, there is the danger that quantitative easing has not given the result that we wanted. It has not increased inflation. Inflation is still extremely low at 0.2% and the inflation expectations have come down, so it is a very tricky situation. Although we want to stimulate demand growth investment and so on, the problem is that quantitative easing can inflate stock values, but not really provide the investment that the economy so desperately needs. Lord Davies of Stamford: It increases stock prices, it reduces the cost of capital and so it makes a contribution, all other things being equal, to the propensity to invest. Veronica Nilsson: There is still the problem of what we see: inflation is not going up, so how effective has this programme been? Lord Davies of Stamford: It has been a move in the direction you have been urging, more demand. That was what I was pointing out. Veronica Nilsson: Yes, absolutely, I agree. On what I said before about the ECB stepping beyond its mandate, I was perhaps not very clear. To be really frank, what the ECB did in Italy is blackmail. It said, “We are going to buy your debt if you do the reforms we want you to do”. That is not acceptable. The Chairman: However, if the Commission does a country-specific report that tells Italy, “You have a problem”, is that okay? Veronica Nilsson: First of all, the ECB is not elected. The Chairman: Neither is the Commission, if I recall. Veronica Nilsson: No, and that is also the problem. My overall impression is that even the staff of the Commission, the civil servants, are much more political than any civil servants you would come across in the ministries at national level. They play a very different role. The Chairman: We often complain about that in the UK too. Lord Davies of Stamford: I do not think there is anything remotely improper about what you have just described. It is public money that the ECB has and if you are a fund manager, it is no different from saying to Siemens or BP, “I am not going to buy your bonds or I am not going to buy your shares unless you make the following improvements in your governance or in your priorities”. It is a totally reasonable dialogue to have between lenders on the one side and borrowers on the other.

Q137 Earl of Lindsay: Can I ask you two questions? One is very short and it is just really for my own clarification, so therefore I would accept a very short answer. Am I right in saying that most of the concerns you and your members have are about detail and process, but if you look at the big picture, the big vision that EMU is trying to achieve that the Five Presidents’ Report is trying to map a path to, you do not have problems with the big, glorious vision; it is just the detail of the path to get there? Is that correct?

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Veronica Nilsson: First, I should say that there are differences between different trade unions and, as you can imagine, our affiliates in the south are more positive and are pushing more for deeper integration than our affiliates in the north. Our position is that we have the EMU; we are not questioning the fact that we have a common currency and that we should have it, but we are seeing a number of problems. It does not work and, if it is ever going to work, we need deeper integration. That is the position of the ETUC. Earl of Lindsay: The way you have answered leads into my second question, which is, as it were, the extent to which you have differences of opinion about the plans going forward between some of your individual members. One of the concerns we have been exploring in the discussions we have been having is the extent to which we say the non-euro member countries might, in some way, be disadvantaged by monetary union. Even if one argues that the substance of what monetary union is seeking to achieve is of advantage to everyone, non-euro and euro, nonetheless the dynamics surrounding the euro membership and the way they deliver discussion and decision-making might spill into the governance and decision-making surrounding economic matters, for instance, which are of concern to all 28. Has your own Swedish trade union, has the British TUC, expressed any concerns to you about what the impact might be on non-euro member interests? Veronica Nilsson: Our affiliates are taking a bit more of a European approach. We have this European project, which all our affiliates support whether they are members of the eurozone or not. I do not think that affiliates have expressed that kind of concern, but there is concern, for example, about the social pillar and whether this would apply to non-eurozone members or not. Our position is clear: we want the social pillar to apply to all EU 28 countries and that is also the line of the TUC. I do not recall anybody expressing concern about what that could mean for non-euro countries. Earl of Lindsay: Finally, you mentioned the difference of mood between your more northern members versus your more southern members about the depth of integration. What about east/west? Is there any division there between, say, the views of your Polish and other eastern European members and affiliates and how they are looking at some of the proposals and some of the western European and longer established members? Veronica Nilsson: No, I do not see much of a division there. Their problem is that they are less involved in the European Semester. I did not pinpoint any particular countries before, but it is true that what we hear back from them is that they are not properly consulted on the European Semester. Their opinions are not really taken on board yet, when I talk to my Swedish colleagues, they will tell me, “Oh yes, we had a good discussion” and so on. For them, the problem is that they do not really get involved but, in terms of our responses, what we want to achieve, I do not see any differences there.

Q138 Lord Haskins: Coming back to what I was talking about earlier a little, we cannot get away from the fact that, in a single currency, Germany, competing against Greece and, indeed, Italy, will always apparently win, because Italy and Greece no longer have the capacity to devalue themselves out of trouble. You could argue that the German market, which has been reformed quite a lot in the last 10 years, is the example that the Greeks should be following. You could certainly argue that the Swedish model is one that should be followed. You seem to be reluctant to drive that agenda in the Mediterranean.

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Veronica Nilsson: Well, I do not think our German Trade Union Confederation (DGB), our affiliates, see the labour market reforms that took place in Germany as the model. I do not. I would rather encourage the Nordic model, as we have a bit more emphasis on security. That is also why they introduced the minimum wage in Germany, because there have been situations in Germany that we very much deplore, particularly in the meat industry, where you have had foreign workers working for a few euros an hour, which is really awful. Lord Haskins: We have that problem too. Veronica Nilsson: Yes, and for a rich country like Germany it is just not acceptable, so I would advocate the Scandinavian model more, but I also know how difficult it is to take a model from one country and try to apply it in another. It just does not work. Of course lessons can be learned. That goes back then to the “flexicurity” concept, because I believe both sides of our Danish social partners are more or less satisfied with their system of flexicurity and that is where it comes from but, when it is applied at the European level it becomes different and, in our view, more focused on flexibility than security, so you do not have the right balance. That is why it is so difficult to tell other countries what to do and what not to do. You pointed to a very important issue, which is that they cannot devalue any more and that is the whole problem: how do you manage a union where you no longer have that tool? That is why all the adjustment has been done through cutting expenses, cutting wages and so on. That is just not the future for Europe. That is not how we are going to compete with the rest of the world. Lord Davies of Stamford: Do you think devaluation is not cutting real wages? Veronica Nilsson: It does, but it does in a very different way. If you talk about the programme countries, they have cut minimum wages. They have made cuts to those who are least well off in society. If you have a general devaluation it will hit everybody in a different manner, but when you specifically cut the minimum wage, like in Greece, Portugal and other countries, it affects the most vulnerable in society.

Q139 Lord Butler of Brockwell: There are two parts of your evidence that I have found difficult to reconcile with each other. As I understood it, in your opening statement one of your criticisms of the Five Presidents’ Report was that it impinged on the independence of the social partners. Latterly, you said, and this is what a lot of people say, that if the single currency is to work it needs deeper integration. How do you square those two statements? Veronica Nilsson: What I said about the autonomy of the social partners was linked to the Commission proposal on the competitiveness boards and that is interfering with wage bargaining, which is really the role of the social partners. I do not think that deeper integration of EMU, as such, is interfering with the autonomy of the social partner so, for me, those are two separate issues. Lord Butler of Brockwell: What aspects of deeper integration do you favour? Veronica Nilsson: That is what I said before. First, many years ago when the crisis erupted, we called for eurobonds, for common debt. That would be one way of handling this problem and not just putting everything on wages. There is very little in the Five Presidents’ Report that is concrete on this issue, because that is what they leave for the future. That is why we

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Veronica Nilsson—Oral evidence (QQ129-140) are looking into, as I said before, the proposal that was made by one economist, which we find very interesting, to have a euro treasury. The whole point is to link it to investment, so you get the common debt but you link the common debt to get the investment, which we are lacking today. Public investment has continued to decrease. Even if we have a bit of a recovery and growth now, public investment continues to decrease and that is just not good for the economy. Lord Butler of Brockwell: I can understand that you might have different views from the ECB, for example, on what is done by fiscal policy and how expansive or contractionary fiscal policy should be, but would you be in favour of more co-ordination of fiscal policy? Veronica Nilsson: That is a tricky discussion within our organisation, because we have, as I said before, our southern affiliates that are more interested in going in that direction whilst our affiliates in the north are more reluctant. We do have a number of positions. We believe that the Commission and member states should do more to fight tax evasion, but the Commission has taken a number of initiatives in this area already. On fiscal co-ordination, we are also very much in favour of a common, consolidated corporate tax base. Now the Commission is relaunching this proposal. There was a public consultation, which has just finished, and we understand that this will be done in two steps, so it will be done differently. Within the ETUC, we have agreed not only that we think this is positive but we would also like to suggest—I am sure you will not like this—a common minimum rate of at least 25%. Here we have total agreement within the ETUC; this was adopted at our congress that was held last autumn. Some affiliates would like to go even further in terms of fiscal co-ordination, but we do not have a position here, because there is a lot of reluctance and many are arguing that this is a national competence. The Chairman: Can I just clarify—you would advocate a common corporate tax base of 25% across the union? Veronica Nilsson: Yes. Lord Butler of Brockwell: Your objection to competitiveness boards is that you feel that they will mean pressure for the reduction of wages. You are not against the competitiveness boards as such, are you? Suppose that what they are recommending to individual countries is the increase in investment and improvement of education, you would presumably regard that as a good thing, would you not? Veronica Nilsson: Then you have to ask the question of why you would even bother to set up the competitiveness boards, because those kinds of recommendations are already part of the European Semester, the country reports and the country-specific recommendations. There is no reason then to set up a particular body in each member country to discuss this. Lord Butler of Brockwell: Is not the purpose of the competitiveness boards indeed to try to manoeuvre governments to adopt some of the recommendations of the Semester? It is a tool of implementation. Veronica Nilsson: Yes, but if it is a voluntary tool why would it have more teeth than country-specific recommendations? The Chairman: I suspect they would argue, first of all, that it brings independent research, but also transparency into the system. When you do an assessment of labour mobility or not or inflation or competitiveness, done by an independent body, as the Dutch have and in the 304

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United Kingdom we have that to some extent, it increases transparency in terms of democratic accountability. Veronica Nilsson: Well, I am not so sure, because the country reports are rather transparent already and what can these competitiveness boards achieve, because they will be very small? This is a negotiation between member states, but that is the way it is proposed. It is not that they are going to have lots and lots of research at their disposal. I do not believe that—not in the set-up that is proposed. It is also right to point out that you have some similar bodies in different countries, but they are usually tripartite or even, like here in Belgium, bipartite, so it is a completely different structure.

Q140 The Chairman: We have a few minutes before we end. I wonder whether I might ask you about the macroeconomic imbalance procedure and how it can be strengthened when it goes into excessive imbalance. What is your reaction to the inclusion of social indicators in the alert mechanism? Veronica Nilsson: That is something we have been calling for, for quite some time, so we were very happy when the Commission took up three new indicators. Then I saw the conclusions of the finance ministers and they were not very happy at all, so we had that discussion in the macroeconomic dialogue, because I wondered what would happen next. They explained to me that this is within the decision-making power of the Commission, so the Commission had already decided that those three criteria have been added, so they will remain; it does not matter that it was criticised by finance ministers. We welcome a bit more of a social dimension to things. How can you strengthen the macroeconomic imbalance procedure? As I said before, it comes back to the fact that today it is an asymmetrical approach and the focus is on the deficit countries and not the surplus countries. What about Germany, for example? Should there be fines only to the deficit countries? What about the surplus countries? Should there not be the same balance? If you cannot have a deficit that is bigger than 3%, can you have a surplus that is bigger than 3%? Why? We believe that this is not really fair. This is not the right setup and it should change. That would be, for us, the best way of strengthening this procedure. The Chairman: Thank you. That now concludes the public part of the meeting. Thank you very much.

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Christian Odendahl—Oral evidence (QQ45-55)

Evidence Session No. 4 Heard in Public Questions 45 - 55

WEDNESDAY 16 DECEMBER 2015

Members present

Baroness Falkner of Margravine (Chairman) Lord Borwick Lord Butler of Brockwell Lord Lawson of Blaby Earl of Lindsay Lord McFall of Alcluith Lord Shutt of Greetland Lord Skidelsky ______

Examination of Witness Christian Odendahl, Chief Economist, Centre for European Reform

Q45 The Chairman: Good morning, Dr Odendahl, and welcome to the inquiry of the EU Financial Affairs Sub-Committee on completing Europe’s economic and monetary union. You have a list of interests that have been declared by Committee members. This is a formal evidence-taking session of the Committee. A full transcript will be taken. This will be put on the public record in printed form and will be on the Parliament website. You will be sent a copy of the transcript and will be able to amend any minor errors. The session is on the record. It is being webcast live and will be accessible subsequently via the Parliament website. Would you like to make any opening remarks in relation to your paper or other thoughts you have on this issue? Christian Odendahl: No, we can start with the questions.

The Chairman: In that case, let me kick off. What is your assessment of the Five Presidents’ Report and the actions introduced in the short term as well as the longer term? I recognise that the question takes us forward in terms of what is envisaged in completing the eurozone’s economic and monetary union, and that of the EU, but another question that has come up in our minds as we have gone through this inquiry is whether you think that the

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Christian Odendahl—Oral evidence (QQ45-55) economic and monetary union itself has a long-term sustainable future. Perhaps you could address that broader question first and then go into the Five Presidents’ Report. Christian Odendahl: That is a difficult question to answer, because we do not know the future path of policymaking. I do not think that the euro is unsustainable per se, but in its current form, both politically and economically, there are a couple of risks. One is that we are still in the aftermath of a crisis and still below potential in terms of growth and inflation. Economic policy changes are needed for the eurozone to return to potential. This would be a prerequisite for the long-term survival of the eurozone. Politically, if countries and constituencies believe that policies are implemented on the basis not of national democracy but of necessity to keep together a project that they were not in favour of in the first place, this threatens politically not only the eurozone but maybe even the European project as a whole. It is crucial that in the eurozone we discuss what policy changes are needed—without reservation—to make sure that it is sustainable in the long term. The Chairman: Can I just stop you there in light of what you have just said? Do you believe that the policy changes envisaged by the Presidents are inadequate? Christian Odendahl: I do not think they are enough to address the political problems. The eurozone also depends on what is happening in the world, so there is a scenario in which, if the world economy develops well, the current set-up will also be enough economically—in combination with the ECB’s monetary policy, for example—to get the eurozone back on track. But they are not adequate to address the long-term political challenges of the eurozone. The Chairman: And the Five Presidents’ Report? Christian Odendahl: There are good and bad sides to the Five Presidents’ Report. The positive side is that the Five Presidents’ Report focuses on completion of the financial union. That is very important. It has two parts to it: banking and capital markets. Banks play a very strong role in financing eurozone businesses. In the crisis they were also a prime source of instability, both for the economy and for the Governments, because local economies, local banks and the Governments were in a sort of doom loop, where the weakness of one reinforced the weaknesses of the other two. Regulation needed to be improved and the banks needed to be decoupled from their sovereigns. The banking union has been a big step forward in that respect, a larger step than I think many people believed was possible at the time, but there are lots of loose ends that still need to be tied up. One of those is implementing regulations that have already been decided, such as the BRD—the bank resolution and recovery directive—and the directive on common deposit insurance. There is also the further harmonisation of regulation and supervision, and the resolution procedures, which are still complicated and probably underfunded. So there are lots of loose ends, and the Five Presidents' Report puts a lot of emphasis, in the short and long term, on completing that. That is probably the most positive step. The other part is capital markets. Capital markets in monetary unions such as the US play a very important role in spreading regional shocks. So truly integrated capital markets and more private risk-sharing would be a big step forward. Of course, this is a much more complicated problem than banking union was. Capital markets cover a broad range of issues and they touch upon various things that are clearly under national responsibility, not European responsibility. The fact that the Five Presidents’ Report recognises the importance 307

Christian Odendahl—Oral evidence (QQ45-55) of the capital markets union and wants to make it a priority to develop it a bit further is very positive. I have two main criticisms of the Five Presidents’ Report. The first concerns fiscal policy. The governance framework for fiscal policy in the eurozone was set up as a defence mechanism against government bailouts. Clearly that has not worked, but its reforms still emphasise debt reduction, whereas fiscal policy in a monetary union is a much more complex issue. When countries give up monetary policy—their main stabilisation tool—they need to replace it with something else. Strongly countercyclical fiscal policies should have been the focus. That is not being emphasised nearly enough, in my view. The second criticism concerns the ECB. One of the most important lessons from fixed exchange rate regimes in the past, going all the way back to the gold standard more than 100 years ago, is that a deflationary period, or a period of too low demand in general, is very threatening for the entire project. The ECB has failed to keep demand on track. We still see inflation at around zero. It famously hiked rates in 2008 and 2011. We need to rethink whether the mandate for the ECB is appropriate and whether the ECB’s monetary policy is appropriate for the eurozone. The Five Presidents’ Report, for understandable political reasons, is entirely silent on this issue.

Q46 Lord Borwick: Thank you very much for your report, which I really did find fascinating. Can we talk about the differences of policy preferences among the eurozone countries, particularly where you say that each central bank will be an important player in the future? Is it not very likely that each central bank will be a national champion for its country and therefore tend to increase divergences among the eurozone countries? Christian Odendahl: That is a fair point. The difference is that national preferences are informed in part by the position in this crisis—whether you are a debtor or a creditor. Historically, there have been countries that have changed their positions based on whether they were a creditor or a debtor, so I do not want to make the argument that there is a general German view; it is also informed by the fact that Germany is the main creditor. When it comes to central banks—this was the idea in the report—they have been the guardians of macroeconomic stability in the past. The tool was monetary policy because it was the most important. When countries give up monetary policy, the tools for macroeconomic stabilisation change. The idea in the report was that central banks already have the implicit mandate of macroeconomic stability. They probably have a more macroeconomic mindset than, say, finance ministries. The tradition of central banks may well differ across the eurozone—that is for sure—but in terms of the institutions most likely to have a macroeconomic mindset and to conduct policies in the macroeconomic stability interests both of the countries and of the eurozone, I think that central banks are probably the best placed of the given institutions that already have credibility in the eyes of the public and a strong political mandate that politicians might listen to. Lord Borwick: You are saying that they are the most likely people to do this but do you think that they actually will do it. Will they be sufficient? Christian Odendahl: The idea that I put forward in the report was to facilitate the discussion about what kind of fiscal institutions we need. For instance, can fiscal rules lead to macroeconomic stability? We are seeing that fiscal rules are difficult to implement from the

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Christian Odendahl—Oral evidence (QQ45-55) outside. The idea was: is there a national institution that would be capable of that? It is hard to say. If that were implemented, would national central banks be willing to carry out that role? I would say yes. Lord Lawson of Blaby: May I add something to Lord Borwick’s question? I, too, thought that your paper was most interesting. I would like to probe one or two things arising from that, because I think it identifies most of the important issues. Specifically on this point, the idea that the independent central banks—because in addition to the European Central Bank being independent, each of the national banks is independent, so they escape the political constraints altogether—should be responsible for fiscal policy is completely unacceptable in a democracy. There has been a lot of debate in this country. In Germany, it was different. The idea of an independent central bank was accepted because of Germany’s history— because of Weimar and the inflation of the 1920s and the inflation that happened in the immediate post-war era. So there was an acceptance of an independent central bank for monetary policy. It took a long time before this was accepted in this country, because it was felt that there had to be a democratic say in monetary policy. We have accepted now that there should be an independent central bank for monetary policy, but there is no way in which this country—and, I suggest, most countries—would accept removing democratic consent from fiscal policy. It is intensely political. Christian Odendahl: Yes, absolutely. I am not proposing to put the entirety of fiscal policy in the hands of an independent institution. The idea was that in the eurozone, at least de jure, we already gave away the right to set the appropriate stance of fiscal policy for the fiscal rules that we signed up to. It is not that I am proposing— Lord Lawson of Blaby: Which are not adhered to, of course. Christian Odendahl: You might well argue that countries have agreed to fiscal rules because they knew that they would not adhere to them. That might be true, but my point is that it is only the part that determines the appropriate cyclical stance of fiscal policy that needs some checks and balances in a monetary union, where the cyclical stance of fiscal policy cannot easily be corrected when things go wrong by a tailored monetary policy in that country. I am fully aware of the political difficulties of that point, but it is crucial in the eurozone that we talk about how we set fiscal policy appropriately from a macroeconomic stability perspective. We have tended to go to fiscal rules, because that is how it was set up in the beginning, but as you rightly say, they are in part not implemented. I would argue that they are not capable of capturing the complexity of fiscal policymaking in a monetary union. I do not think that fiscal rules are necessarily appropriate, so the question is: what kind of different institution that constrains democracy in some respect is necessary for the eurozone to flourish macroeconomically? Countercyclical fiscal policy has always been difficult for democracies to implement. There are various examples across the world and across history. I always find the example of Chile the most interesting, because Chile’s fiscal revenue depends to a large extent on the copper price. Chile has given itself very predictable, very transparent fiscal rules that relate to the copper price. It is relatively easy to tie fiscal policy to copper, but even there it has been very difficult democratically, despite the experience of repeated crises, to stick to those rules when the copper price is booming. Democratically, it is very difficult to conduct strongly

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Christian Odendahl—Oral evidence (QQ45-55) countercyclical policies. Since that is what we need in the eurozone, we need to find some kind of arrangement that ensures that.

Q47 Lord Shutt of Greetland: The question was about fiscal union. Having read your paper, I wonder whether you think there should be any fiscal union. Fiscal rules are one thing but a union is something different. Would you like to expand on where you are with fiscal union? Should there just be fiscal rules and fiscal policy is to do with member states—in the eurozone or otherwise? Christian Odendahl: Fiscal union is a term that is understood differently by different people. To some extent, limited fiscal union is necessary. One thing is the function of lender of last resort for the ECB. That is one of the strongest lessons from the crisis: without a lender of last resort to Governments, the eurozone is inherently unstable. A central lender of last resort to Governments is a form of fiscal union, because it is a form of risk insurance—fiscal insurance, if you like. The other part is banking. As I said in the report and before, it is crucial that we decouple banks from sovereigns, which means that we put the resolution—back-up and bailout—capacity of banks at the European level, which is also a form of fiscal union. Some pooling of risk is necessary, but given that the democratic legitimacy at the central level is much lower than that of nation states, we need to be careful which parts we want to put under common control. That is why I would argue that the lender of last resort function, plus the banking union and whatever fiscal union that entails, is probably necessary. The other part is whether fiscal policymaking needs to be determined centrally. My argument is that nation states have all the incentives to conduct reasonable fiscal policies, because they are the ones that suffer when this goes wrong. But the problem, as I said before, is that democracies might find it hard to conduct these kinds of stabilising fiscal policies. Fiscal union in terms of risk-sharing needs to be limited to things where it is really necessary—the lender of last resort and the banking union—and fiscal union as it concerns how we want to set up fiscal institutions should probably be left to nation states. Lord Shutt of Greetland: You are talking about countercyclical policy, and I think you are suggesting that the nation states would, as it were, be trying to rev up economies. How is it going to work when overheating happens? Christian Odendahl: Countercyclical policies, of course, go in both directions. Countercyclical policy is difficult, in both the upturn and the downturn. In the upturn, during boom times, it is difficult for democratic Governments to contain that boom. There are plenty of examples in history of that. So we need a constraint on Governments during boom times that they conduct countercyclical policies to contain that boom. During a recession time, we saw a push for pro-cyclical consolidation across Europe because people disliked the deficit and they feared that they were running up too much debt. Even there, we saw pro-cyclical policies. During both periods, boom and bust, we saw pro-cyclical policies. Countercyclical policies are difficult for democracies in both periods but are equally important. The Chairman: You mentioned institutions in terms of fiscal union. I take it you would be opposed to Mr Schäuble’s vision of a super-commissioner, a eurozone Finance Minister, because you want to keep fiscal tools in the hands of national Governments. Christian Odendahl: I think Wolfgang Schäuble and I are of the same opinion on this, because his suggestion is probably a political one. He says, “We can offer a central fiscal 310

Christian Odendahl—Oral evidence (QQ45-55) institution and some kind of risk-sharing at the central level, but then we need central control”—of course knowing that no country in Europe would give up budgetary control to a European Finance Minister. My suggestion is that for political reasons we should try to keep as much as possible with the nation states, and if we can find the right institutions to implement countercyclical policy at the national level it can be left to national Governments.

Q48 The Chairman: I want to go back to a more overarching concern for our Committee, which is the implications of the Five Presidents’ Report on the eurozone outs, and whether you think that there will be implications. How do you see the nine countries outside the eurozone being impacted, particularly the United Kingdom, because it is Europe’s singular financial services capital? Christian Odendahl: The direct impact on the UK will probably be minor because the UK is not affected by most of the eurozone’s processes; it is not part of the banking union, for example. A potential upside for the United Kingdom is probably the capital markets union. If there is a larger push for a swifter process on the capital markets union, one of the countries that stand to benefit is the United Kingdom, as the centre of the financial system. The indirect impact of a more stable monetary union will of course be positive but, as I said before, most of the macroeconomic stabilisation policies are not tackled in the Five Presidents’ Report, so there will not be that much of a positive impact. The most positive impact would be if the eurozone started to generate self-sustaining growth and not depend on the outside world, including the United Kingdom, to drive its growth, as is currently the case. Eurozone growth depends to too large an extent on the outside world, and the result is a weak economy, low interest rates, a low currency and a strong pound—arguably too strong for rebalancing the UK economy. But I do not think that the suggestions made in the Five Presidents’ Report will go a long way to addressing that. The Chairman: Since you are talking about the eurozone’s reliance on a few countries only, do you think the report will have a significant direct impact on Germany? Christian Odendahl: Economically the direct impact will be minor. The limited amount of risk-pooling which the report suggests—in terms of the banking union, for example—is something that Germany dislikes but which Germany could actually benefit from. A more stable banking system—including Germany’s, by the way—is clearly in Germany’s and the eurozone’s interest. But on economic policy, I do not see how the Five Presidents’ Report on the eurozone will affect Germany much. The biggest issue is the German current account surplus. The policies for reducing that current account surplus are almost entirely national. The thresholds in the macroeconomic imbalance procedure were set at a relatively high 6%. Even now that Germany is above that level, the Commission is merely warning Germany that this is potentially endangering the balance. The measures that Germany has decided on to address that imbalance are so tiny that they will not make a difference, and there is no way the Commission can force Germany to address this. Lord Skidelsky: There are no sanctions on countries that run what the Commission considers to be an excessive current account surplus? Christian Odendahl: There are two things. First, we need the Commission to decide that it is actually excessive. Then we need a political decision on sanctions, but I do not see that happening.

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The Chairman: That takes us to Lord Butler.

Q49 Lord Butler of Brockwell: Coming on to banking union, I think I heard you say that you regarded the steps towards a banking union that had resulted from the reaction to the crisis as one of the successes of the policy. Given that Germany has expressed its opposition to the further steps proposed by the Commission, do you think that is going to be carried forward? Christian Odendahl: Germany has not expressed reservations on all the points that the European Commission proposed. If you read the Five Presidents’ Report and the action plan, some of those issues are actually exactly what Germany wants: namely, that countries implement the existing regulations first. That is one of the points that Germany insists on before any steps towards further mutualisation of risk can be taken. I think in the end there will be an agreement, because Germany cannot credibly deny the eurozone some form of common deposit insurance once most policies that affect banking are at the European level. That was always Germany’s point: wherever there is decision-making, there should also be the responsibility for risk-sharing. Once banking policies are to a large extent at the European level, I do not think Germany can resist, entirely at least, a common deposit insurance. There will be a compromise that takes some of the German concerns into account; for instance, the German small savings and regional banks probably will have to be excluded, because otherwise the political resistance within Germany will be too strong. I am not entirely sure that at this juncture, in the short term, deposit insurance is the most promising policy step in the banking union. We already have changes in regulation. We have a new set of regulations called TLAC—the total loss-absorbing capacity—which means that bailing in depositors would be a last-resort measure. We have the ECB’s established role as a lender of last resort to banks, which took the crisis to develop. We also have the implicit political protection of depositors. If you remember the Greek crisis over the summer, rather than hitting depositors, European policymakers, even in that political heat, decided to protect Greek depositors. That is also politically a strong signal that they have learnt from the Cyprus disaster and have agreed politically that depositors should not be hit, and the ECB is a strong defender of depositors, both internally and externally. I am not sure it is a necessary step. I would much rather have the resolution procedure reopened and for there to be a proper backstop for the resolution fund, which the European Commission also proposes in its action plan. There are lots of loose ends in this banking union. Germany wants some of them; the other countries want others. I hope that there is some kind of compromise. At least for the deposit insurance, I expect there to be a compromise because that is such a prestigious project. Lord Butler of Brockwell: I think you said that a prior condition was that individual countries should introduce regulations in their banking systems. Do you think that that prior condition is likely to be fulfilled? Christian Odendahl: I think Germany will insist on it. I do not think Germany will agree to any sort of meaningful deposit insurance before that, or it will build in the requirements that only countries that have fully implemented all these regulations can take part. I think that will be made a condition, absolutely. Lord Butler of Brockwell: We have a bit of a chicken and egg situation, do we not?

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Christian Odendahl: Possibly, but I think Germany has proved again that it is quite good at this game.

Q50 Earl of Lindsay: In your opening remarks you welcomed the capital markets union as being one of the more positive parts of the Five Presidents’ Report. You then went on to say that you saw complications in its delivery. Would you like to expand on what those complications are? Do you think they will be overcome? What will be the consequences for economic and monetary union if the capital markets union ambition fails? Christian Odendahl: The first complication for implementing the capital markets union is that it came about quite differently from the banking union. The banking union was decided at an emergency summit when the crisis was almost at its peak. Countries decided to put regulation and supervision under their common control, which of course gave a central institution the power to implement quite a few policies that countries would probably not have agreed to outside the time of crisis. The capital markets union came about as a project that kind of made sense, but now we need to agree on lots of little steps towards that goal. The second complication is that a lot of policies that would affect the capital markets union positively, or that are necessary for a full capital markets union, are under national control. So at every step of the way there will be a process of harmonising, say, insolvency regimes. I am not an expert on insolvency regimes, I am not a lawyer, but experts tell me that it is a task for a decade, not for a couple of years. A lot of the issues that need harmonisation in order for a proper capital markets union to emerge will be quite complex politically to implement. As to the level of ambition that we need in the capital markets union, Commissioner Hill is using a very empirical approach—which is a good idea, given the constraints—looking at the most binding, insurmountable obstacles to more integration; a review of the prospects directive; a review of regulation of risk for securitisation; an investigation into obstacles to European venture capital markets, and so on. It is a step-by-step, empirical approach. I am not entirely sure whether that is a fast enough approach for the eurozone. Given the importance of the capital markets union for the resilience of the economic and monetary union, the eurozone would do well with a faster process, but I do not think that is politically possible. Earl of Lindsay: You do not sound very optimistic that the capital markets union is going to be achieved in a desirable timescale. Christian Odendahl: Capital markets union is a broad term for a lot of things. There is a grand capital markets union where we have full integration of all policies, including accountancy rules, taxation of investment and insolvency regimes. That will take a long, long time, if it is ever achieved at all. The slightly lower aim is to constantly move towards more integration of capital markets along the lines of what Commissioner Hill has proposed. That can be reasonably expected to be fulfilled. But that is a much lower ambition than the ambition we had for the banking union before we implemented that. The Chairman: So in the early stages, risk-spreading is the most important thing? Christian Odendahl: The most important thing for the resilience of the eurozone is diversified private portfolios across the entire eurozone, to spread shocks. Equity markets are most important. So far, my main criticism of the capital markets union is that it is not 313

Christian Odendahl—Oral evidence (QQ45-55) focusing strongly enough on the integration of equity markets across the eurozone. In terms of the additional resilience the capital markets union will deliver for the economic and monetary union, in the short term there is probably not much. Over the medium term it depends on how fast we progress on integration of equity markets, private placement, and so forth.

The Chairman: Lord Skidelsky, did you want to pick up on the ECB?

Q51 Lord Skidelsky: I was interested in your paper. You favour the idea of the ECB’s mandate being revised to secure a higher inflation target of 3%. I am not against that. You say, “The European Central Bank … has failed to maintain the necessary level of demand and inflation during the course of the eurozone crisis, and needs a stronger mandate to prevent this from happening in the future”. That presupposes that monetary policy is quite potent and that setting a 3% inflation target will ensure that nominal income grows by a required amount. What is the empirical evidence that that is the case? What is the relationship between monetary and fiscal policy in the countercyclical measures? Christian Odendahl: The empirical evidence on the effectiveness of monetary policy, particularly in a crisis, is reasonably strong that overly restrictive monetary policies are not helping. That is something we can agree on. Whether monetary policy alone will be enough is a more open question, both theoretically and empirically. There are two ways in which central banks can impact overall demand. One is the more direct channel, via asset prices, interest rates and currencies. The other is via the expectation channel: shaping the expectations of investors and consumers. The ECB has mostly focused on the first, trying to lower interest rates, buy assets and support banks with liquidity. I do not think it has been aggressive enough from the start. There was no necessity, for instance, to hike interest rates in 2011, and that was a strong signal to markets that the ECB is a comparatively hawkish central bank. The ECB has not made as much use of forward guidance, commitments and expectation management as other central banks have. The ECB might want to implement a regime change away from being a hawkish central bank that hikes when inflation is slightly above target, on the basis of international commodity prices, towards a central bank that looks through these and wants inflation not only to reach its target again—as it is currently communicating—but actually is willing to let inflation overshoot, because it knows that inflation is undershooting. The ECB could implement this kind of expectation management much more strongly. If fiscal policy pulls in the other direction, every central bank in the midst of such a crisis will have a difficult time stimulating the economy sufficiently. In a deep crisis, as we have experienced, fiscal policy needs to play its part as well. But I do not think that the ECB’s monetary policy was optimal, let us say, from 2008 onwards. Lord Skidelsky: But your position is that the announcement of a 3% target and the creation of the required expectations will enable it to hit that target. Christian Odendahl: Not by itself. If the ECB had had a 3% inflation target throughout the crisis, that would have given it more room to cut interest rates conventionally and it could have let inflation run higher post-crisis. It would have given it political cover to start buying government bonds earlier or to extend this programme for longer. Higher inflation targets, strong expectation management and a more explicit backing for the central bank to buy both public and private assets would give the ECB a stronger role in managing demand. I am

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Christian Odendahl—Oral evidence (QQ45-55) not entirely sure whether any of those points alone will be enough, particularly in such a deep crisis as we have experienced. Lord Skidelsky: So you are not a complete follower of Milton Friedman. Christian Odendahl: Not a complete follower, no—of no one. The Chairman: On that happy note, let us move on to governance reform and the macroeconomic imbalance procedure. Did you want to come in on that, Lord Skidelsky?

Q52 Lord Skidelsky: Yes. I mentioned this earlier, but I find very little explicit attention to the role of current account imbalances in perpetuating the weak performance of the eurozone as a whole. In Draghi’s speech in Helsinki, he said that we know from economic theory that it is crucial in a monetary union to ensure adjustment through prices. Well, economic theory also tells us that however flexible wages and prices are, they are not going to restore full employment if you have these big imbalances between trading partners. There is almost nothing in the Five Presidents’ Report to address that question, which is actually to require Germany, through some sanction, to reduce its current account surplus. Christian Odendahl: I think you are absolutely right. The Five Presidents’ Report, in my view, is in part aiming at intellectual convergence on what is needed and the analysis of the problems, but it is also aiming for balance, which is not the same thing. I think that is a nod to Germany not to make too big a fuss of the current account surpluses, even though I fully agree with you that it is macroeconomically crucial that we have symmetric adjustment. I disagree with Mario Draghi on the importance of flexible wages and prices. In the early stages of optimal currency union research, starting with Mundell, flexible prices and flexible labour markets were seen as crucial. But over time economists have become a bit more sceptical about how much that really helps. Surely it helps those people migrating, for instance, but flexible wages in an economy also take away demand at a time when there is no other mechanism to address the weakness of demand. Migration takes away purchasing power as well. So the flexibility of labour markets, wages and prices is not necessarily a crucial ingredient for the stability of a monetary union, but I do think that a symmetric adjustment is necessary. That basically means that those regions that are doing well economically need to overheat a little. Policies to reduce the German current account surplus would almost necessarily overheat Germany a bit. I do not think that Germany is willing to implement that, and that is a deep political problem in the eurozone. Coming back to the ECB, if I may, this is one of the issues where stronger monetary policy would be a welcome development. A stronger monetary policy stimulus would almost certainly have helped Germany to grow faster and overheat a little. Monetary policy, fiscal policy and all the other policies that Germany would need to implement all come together. There is not just one policy that Germany can implement for reducing— Lord Skidelsky: And it resists them all. Christian Odendahl: I have to say yes. The Chairman: Does that not tell us something about the sustainability of the eurozone, when you have one dominant player concerned with its own interests? Christian Odendahl: Germany is not unique in Europe in following its own interests. Of course, the problem is that the changes that would need to be made to make the eurozone 315

Christian Odendahl—Oral evidence (QQ45-55) economically more sustainable in part come from Germany. There are a couple of factors not under Germany’s control that I hope will address its imbalance in the future. The first is demographic change: older generations start dissaving. The second is that the German budget revenues seem to be above target year after year, which gives the Government more wiggle room to invest. The third is that Germany has not invested all that much in its public sector over the past decade. Now, with low financing costs and a declining debt burden, the realisation that Germany needs to invest more in its future is growing in the internal discussion in Germany. Maybe I am being too optimistic, but there are a couple of developments that will reduce the current account surplus over time, although Germany should support that.

Q53 Lord Lawson of Blaby: May I go back to the fundamentals, and then move on from there? What, in your understanding, is the point of monetary union? Christian Odendahl: That is a good question. At a time when there was no common currency, a paper called One Market, One Money implied that a single market needs a common currency to function properly. The experience of the eurozone’s first decades and now the eurozone crisis is empirical proof that that was not the case, and whether the risks at least of having a common currency— Lord Lawson of Blaby: Sorry to interrupt you, but I did not say what you might think or what some economists might think—as you say, they have been proved wrong if they did think that—but it was European politicians who decided that there should be economic union; it was not a group of economists. I repeat my question: what, in your understanding, was the purpose of it? Christian Odendahl: The purpose was mostly political. European countries wanted to find further steps of integration after the common exchange rate mechanism broke down in the early 1990s, to foster integration among the core countries of Europe that wanted to participate in this. Even at the time, economists warned that that was a very risky path. As we see now, there is more divergence, both economically and politically, in the eurozone rather than convergence and closer ties between countries. The economic fundamentals were against a common currency, and the politics of managing a common currency were also speaking against it, but at the time politicians did not see it that way. So the attempt was to bind European countries closer together, both economically and politically, and I think that has failed. Lord Lawson of Blaby: I accept what you say: that it was designed entirely to bring about a move towards a political union. You could say that politicians at the time were not altogether stupid. Incidentally, although I do not agree with the idea of a European political union, I accept that there is nothing discreditable or disreputable about it; it is a perfectly legitimate objective. The cleverer ones, such as Jacques Delors, realised that it was bound to be inadequate without a fiscal union. You cannot have a fiscal union in a democratic construct without a political union. These all hang together. In a sense, that was meant to be the first step along the road. I cannot think—maybe you can tell me—of a functioning monetary union of any size at all which is not accompanied by fiscal and political union. If there is one, let me know.

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Christian Odendahl—Oral evidence (QQ45-55)

Furthermore, if I may say so, it is rather curious that you seem to define fiscal union in terms of countercyclical policy. That is not how fiscal policy is interpreted in the two major countries of the European Union—not in Germany, never has been; and not now in the United Kingdom, although it once was. We pursue fiscal policy in terms of the right size of the deficit, if any, over the medium term and, to a lesser extent, the correct balance between public expenditure and taxation. It is not a question of countercyclical policy. Furthermore, it is really what I believe is known in Germany as a transfer union. That is what is important. Of course, Germans do not like that. It is necessary that in a fiscal union, in a true sense, you have to a very large extent—of course, there will be local taxes and local spending decisions as well, particularly in a federal country such as Germany—national levels of taxation and expenditure. Inevitably, the more successful parts of the union raise more money, which goes automatically, without any discretionary decisions, to the less successful part. That is true of the United Kingdom, the United States, Germany—everywhere. That is necessary to make it work. What is your take on all that?

Q54 The Chairman: There are quite a lot of questions there. Perhaps you could start with the question Lord Lawson asked about whether you could think of any other monetary unions that were not fiscal and political unions. Christian Odendahl: It is of course right that those fiscal— Lord Skidelsky: The Latin Monetary Union worked. Lord Lawson of Blaby: That did not work. It conspicuously failed. Lord Skidelsky: It worked for some time. The Chairman: Let us hear what Dr Odendahl thinks. Christian Odendahl: There are monetary unions that were successful over at least a period of time. Lord Lawson of Blaby: Which? Christian Odendahl: The gold standard, for instance, is one of those. There is Latin America. There is one in west Africa. In east Africa they have just agreed to one. Lord Lawson of Blaby: The gold standard is quite different, if I may say so. Christian Odendahl: Of course, but it was a fixed exchange rate regime. There are not that many monetary unions as such, as we see now in the eurozone. Lord Lawson of Blaby: I am sorry, I cannot let you get away with that. With the gold standard, every single country maintained its own currency. It was not a currency union. Christian Odendahl: The mechanisms, though, of a fixed exchange regime and a currency union— Lord Lawson of Blaby: That is different. They are quite different. The Chairman: Lord Lawson, let us allow Dr Odendahl to complete his thoughts. Christian Odendahl: They are at least similar enough for economists to draw economic lessons from the parallels between them. Of course there are differences; for example,

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Christian Odendahl—Oral evidence (QQ45-55) breaking up a gold standard is much easier than breaking up an entire common currency such as the eurozone. On the fiscal policy point, I appreciate the opportunity to clarify this, because I see fiscal union as some form of risk-pooling or transfer. The lender of last resort and the banking union are two cases where I think that is necessary. Countercyclical fiscal policies are part of fiscal policymaking in every country, including this one. I disagree that this is not part of fiscal policymaking. You are right that countercyclical fiscal policy is most important for countries that do not have any other adjustment mechanisms, such as countries of a monetary union, whereas the United Kingdom has its own monetary policy and its own currency. There is a bit of a difference. When it comes to a transfer union, you are right that politically that is what Germany finds unacceptable, even though it is doing the same thing inside its borders. But I do not think that a transfer union is necessary for making a monetary union work—there I disagree with you. To some extent, a transfer union is a way of conducting countercyclical policies, because the more well-off parts will subsidise or transfer so that there is more fiscal spending in weaker regions over the business cycle. Permanent transfers are a political decision within countries to have common living standards, but not a necessity for making a monetary union work. The Chairman: Do any other Members—before I come to you, Lord Lawson—have any follow-up questions they would like to pursue with Dr Odendahl? Lord Skidelsky: That is an interesting argument. The Chairman: Lord Lawson, you had a further point to make?

Q55 Lord Lawson of Blaby: I would like to press Dr Odendahl a bit more. You say that there is not much difference between a fixed exchange rate system and a monetary union. I would say that there is all the difference in the world. This is why, although the European Union had a fixed exchange rate policy for many years, it decided to move away from that into a monetary union. If those two things were the same, it would not have done that. Germany, as you have conceded, is a transfer union because it is a political, monetary and fiscal union. The United Kingdom is a transfer union. The United States is a transfer union. We have established that a single currency and a fixed exchange rate system are quite different. Can you tell me where there is a single currency without a transfer union? Christian Odendahl: That is a good question. You are absolutely right that there are differences between a fixed exchange rate regime and a monetary union. But as I said before, the economic dynamics underlying the instabilities of fixed exchange rate regimes, including the European ones, are the same drivers of instabilities in a monetary union. The difference is that they have different mechanisms to deal with those. A fixed exchange rate regime will more likely break up because it is possible to break it up, whereas the instabilities in a monetary union will show up in bank failures, debt build-up, Governments running up debt and so forth. The manifestation of those imbalances will be different between the two, but the drivers are the same. But on the transfer union question, I would have to think about that. Lord Skidelsky: It is a new form of life, the monetary union.

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Christian Odendahl—Oral evidence (QQ45-55)

The Chairman: Sui generis. Lord Skidelsky: It is not a political union; it is not a state. The question is: can you run a monetary union without all the functions that a state— Lord Lawson of Blaby: That is right. It is incoherent without— Lord Skidelsky: That is the question. Christian Odendahl: It may not have existed in the past, but it is a question that we need to answer with regard to whether the eurozone will be sustainable in the long term. The Chairman: Thank you very much. That is a very good thought to focus our minds on as we go through this inquiry. Dr Odendahl, it has been really useful to have you here today. Thank you so much for giving your time to come and give us evidence. Christian Odendahl: Thank you very much. The Chairman: That concludes today’s public evidence session. The Committee will now continue its meeting in private. Thank you again. If you think of anything to add to what has been said, feel free to write in. This is a very interesting debate. Christian Odendahl: I look forward to seeing the transcript.

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John Peet, Megan Greene and Professor Erik Jones—Oral evidence (QQ68-81)

John Peet, Megan Greene and Professor Erik Jones—Oral evidence (QQ68-81)

Transcript to be found under Megan Greene.

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Professor Lucia Quaglia, Dr Andrew Lilico and David Marsh—Oral evidence (QQ167-178)

Professor Lucia Quaglia, Dr Andrew Lilico and David Marsh—Oral evidence (QQ167-178)

Transcript to be found under Dr. Andrew Lilico.

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Raoul Ruparel and Baroness Bowles of Berkhamsted—Oral evidence (QQ15-26)

Raoul Ruparel and Baroness Bowles of Berkhamsted—Oral evidence (QQ15- 26)

Transcript to be found under Baroness Bowles of Berkhamsted.

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Professor John Ryan—Written evidence (EMU0007)

Professor John Ryan—Written evidence (EMU0007)

What is the ECB’s role in the future of the EMU governance framework?

1. The European Central Bank (ECB) needs to be looked at in the context of its past record. It has strayed from its mandate into economic and fiscal policy, and there has been an element of mission creep.

2. The ECB is far more independent than the US central bank, the Federal Reserve, whose legal status is far weaker and which is directly accountable to Congress and the government. The ECB was supposed to be like the Bundesbank. The ECB, however, has failed to emulate the distinctive attributes that made the Bundesbank successful, such as accountability and interdependence with other democratic institutions. The ECB, in fact, is the least accountable central bank among advanced nations.

3. The ECB can justly claim to have held together a poorly-designed system in difficult circumstances. But the mission creep is its own responsibility. There is no democratic accountability when the ECB strong-arms governments into policy actions which go well beyond any reasonable interpretation of its mandate. The process calls into question the efficacy of the only form of democratic accountability the ECB submits to. If the European Union ever gets around to amending the ECB statute, the mission creep needs to be brought under control.

4. In November 2010, in a letter to the Irish Finance Minister, the ECB threatened to cut off liquidity support for Irish banks unless the government agreed to a financial assistance programme with the EU and IMF. The letter also made demands in the areas of fiscal austerity and structural reform that were not only beyond the ECB's remit but were also wrong for Ireland's circumstances.

5. The ECB threatened to cut off emergency liquidity assistance (ELA) in Ireland and Cyprus, but in Greece it actually did so. The discretion exercised by the ECB in the provision of ELA has made it more of a political actor instead of an independent technocratic institution.

6. The ECB threatened to decline its responsibility in seeking to force the Irish Government into the Troika programme in November 2010, and threatened again (this time under Draghi's leadership) in the case of Cyprus in 2013.

7. On June 28 2015, the threat was actually implemented in the case of Greece: the ECB capped the availability of liquidity support to Greek banks deemed solvent by its supervisory arm as they faced a depositor run. They had to close, and the Greek government had to impose exchange controls.

8. There is a perception that the Eurozone has become an instrument for creditor 323

Professor John Ryan—Written evidence (EMU0007) nations to impose their will on debtors. Wolfgang Schäuble and Mario Draghi, president of the European Central Bank (ECB) have been seen as threatening and bullying Greece. On 4 February 2015, the ECB unexpectedly and suddenly cancelled acceptance of Greek bonds as collateral for liquidity funding unless Greece obeyed the Troika agreement. The ECB’s irresponsible actions call into question their respect for the Greek government’s attempts to resolve its debt crisis in a sustainable way. The ECB may or may not have had good reasons to cut off Greece – depending on your point of view – but it is clear that such a move is political.

9. If the global economy is indeed about to enter another downturn, then we can expect the Eurozone crisis to resume quite quickly in some shape or form. In order to survive, the Eurozone desperately needs a recovering world economy. It is not at all clear that it is going to get one.

10. The Greek crisis shows that as long as the ECB’s role of lender of last resort remains as confused as it currently is, questions about whether the ECB is acting beyond its legal mandate and becoming overly involved in political developments will continue to be discussed. The ECB should explain why it was necessary for it to be a formal member of the Troika with the European Union (European Commission) and the International Monetary Fund.

11. The ECB has shown a willingness to shut down a Eurozone banking system. There is a question mark about the role of the ECB in d e s i g n i n g and m o n it o r in g programme conditionality relating to fiscal policy and structural reforms is consistent with its legal mandate. The European Monetary Union’s flawed and divisive political and economic mechanisms appear likely to lead a vulnerable Eurozone to ongoing ad hoc crisis management. The most probable outcome is that only the next crisis will accelerate the much-needed Eurozone integration process.

12. The future improvement of the EMU governance framework in which the ECB would operate will only start after the 2016 Brexit referendum and the 2017 elections in France and Germany.

25 November 2015

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Martin Sandbu, Sebastian Barnes, Henning Christophersen and Janet Henry—Oral evidence (QQ27- 44)

Martin Sandbu, Sebastian Barnes, Henning Christophersen and Janet Henry— Oral evidence (QQ27-44)

Transcript to be found under Sebastian Barnes.

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Dr. Waltraud Schelkle—Written evidence (EMU0004)

Dr. Waltraud Schelkle—Written evidence (EMU0004)

Qu.1: Is economic and fiscal policy coordination and surveillance working effectively in the European Union, both for euro area Member States and non-euro Member States? Is greater ‘structural convergence ‘necessary to build a resilient and smooth-functioning EMU? 1. The Five Presidents report acknowledges that non-state money, issued by a central bank without fiscal backing, needs risk sharing mechanisms between member states. Otherwise, financial markets will shift the risks of financial instability onto the weakest members, those least able to bear them. The Report proposes (p.4) an immediate strengthening of private risk sharing through a banking and a capital markets union, which would give time for “economic structures [to] converge towards the best standards in Europe”. This should prepare the ground for fiscal union. The Four and Five Presidents reports constitute a paradigm shift in how the monetary union should be governed. While the old paradigm was based on a strict separation of monetary and fiscal policies, the paradigm outlined in these reports on a Genuine EMU envisages a “union of unions”. For non-euro members, this must look like a project that leaves them behind. 2. Fiscal surveillance and the coordination of reform policies so far do not have any tangible benefits in terms of risk sharing. Surveillance under the Six Pack as well as economic policy coordination under the European Semester are still underpinned by a disciplinarian logic that takes the risk pool merely as the sum of its parts. For instance, there is no effective way of bringing the aggregate policy mix with monetary policy to bear on member states’ budgetary stance. It is all about national deficit and debt indicators, or national reforms to increase the growth potential. The Macroeconomic Imbalances Procedure is in my view the only new policy process that is useful in getting the interdependencies of EU member states in focus. But there are no incentives attached to compliance apart from those that governments have in any case to contribute to a balanced economy. Why should member states provide a public good for the euro area as a whole, such as taking the overall cyclical stance into account when planning their own primary deficit, if all they get in return is avoiding blame and shame and the threat of a fine? The coordination and surveillance framework of the EU worked only as long as there was the prize of entering the common currency area but it is now ineffective and politically counterproductive. Non-euro members have even less incentives to comply with rules that emphasize discipline rather than risk pooling. 3. The new paradigm is progress. But the stipulation that countries have first to converge in their economic structures before fiscal risk-sharing should be contemplated makes no sense. Convergence would actually reduce the potential for risk sharing since common shocks cannot be insured, except through more public debt that ropes future generations into the risk pool. The convergence postulate is a legacy of the old paradigm that if only every member state exercises fiscal discipline and had equally flexible labour markets, all macroeconomic stabilization could be left to the independent central bank. Diversity of economic structures is here to stay. This is not a handicap but can be a source of economic robustness. It requires finding ways of spreading the risks to income and employment from (asynchronous) business cycles and different vulnerabilities. Notably the risks of member states with high growth potential but stability problems can be pooled to mutual benefit 326

Dr. Waltraud Schelkle—Written evidence (EMU0004) with risks of mature member states that are stable but stagnating. Convergence on some imaginary best standard is not even desirable from an economic perspective. Moreover, the “union of unions” paradigm, rather than practical steps towards “unity in diversity”, is politically divisive 4. Public risk sharing must be strengthened before private risk sharing can be relied on. Some progress has been made in this regard, with the banking union and emergency funds. Before financial integration can lead to private risk sharing, more robust prudential supervision has to be in place. The Single Rule Book based on the Basel III framework, coordinated by a Single Supervisory Mechanism and the beginnings of effective resolution mechanisms are a good start. Emergency funds, like the European Stability Mechanism (ESM) and the Commission’s European Financial Stabilisation Mechanism (EFSM), are also quite effective in providing the discipline that is required to make member states internalise the effects of their fiscal and financial sector policies on other members. I expect the conditionality attached to these adjustment programmes to have a deterrence effect that the pro-cyclical sanctions foreseen in fiscal surveillance did not have and do not muster now, even after surveillance was supposedly fortified by the Fiscal Compact. The ESM-IMF programmes have bailed out five countries so far, each with rather different vulnerabilities. They protected euro area members and non-members alike and this was necessary: the UK banking system was also heavily exposed to at least four of the five crisis countries (Portugal possibly excluded). Pooling and diversification of risks will inevitably include non-euro members where required for the euro area’s own stability. 5. In sum, my view is that no convergence of economic structures is required, on the contrary, diversity of member states allows for risk diversification. Stronger risk sharing in the euro area would not have to come at the cost of non-euro members. On the contrary, it could benefit them directly and indirectly, the latter through preventing the euro area from becoming a source of destabilization in bond and other financial markets. But it does not happen automatically. Policy coordination and surveillance so far are not geared towards making risk sharing happen and are therefore beset with severe incentive problems of compliance.

Qu.6: In what ways can the EU’s financial framework be strengthened to reduce the negative sovereign-feedback loop? 6. The Five Presidents report rightly stresses that this feedback loop has to be interrupted. The ESM’s direct recapitalisation (DRI) instrument has been designed with this negative externality in mind: “A more easily accessible mechanism for direct bank recapitalisation would boost depositor confidence by keeping distressed sovereigns at arm’s length in the governance of restructured banks, and it would break the sovereign-bank nexus at national level.” (p.11) In contrast to the financial sector adjustment programme that Spain received, the DRI allows the ESM to acquire common shares in a financial institution that needs recapitalisation without adding to the liabilities of the sovereign. But quite a few strings are attached to using this instrument, such as exhausting all bail-in clauses as well as co- payments of shareholders and the government. It is meant to be recapitalisation of last resort. The most important handicap is that the earmarked sum amounts to €60 b only. This is such a small amount that it can actually be destabilising in a situation where it is really needed. It is a well-known feature of pre-committed rescue funds tailored to “fundamental”

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Dr. Waltraud Schelkle—Written evidence (EMU0004) needs that they invite speculation to pre-empt their running out. Instead, they should assure everybody that “it will be enough”, to paraphrase Mario Draghi. 7. In principle, the solution to the negative bank-sovereign feedback loop is joint fiscal liability of euro area member states (qu.12 of the call for evidence). But anything like a “Euro bond” is not in the offing for now. Taking seriously the political constraints imposed by integration fatigue requires thinking of public risk management short of joint fiscal liability. If governments are not ready to underwrite the risks of financial integration, then it seems logical to limit and possibly even reverse financial integration. Macroprudential instruments actually point in this direction since they are sensible capital controls that dare not speak their name. They are sensible because they do not create costly and hard to maintain borders with regressive distributive effects but organise collective action of supervisory authorities against the herding behaviour of lenders and investors. One should probably contemplate also other forms of segmenting (dis-integrating) financial markets, as the Dodd- Frank Act in the United States and the Vickers rule in the UK have done. 8. Reversing the order of private and public risk-sharing expressed in the report should be considered as well. Public risk sharing can be improved without a central budget and a common debt instrument, even though the latter would be a desirable stabilizing feature (and presumably improve compliance with norms of fiscal prudence). Re-insurance mechanisms that draw on the deep pockets of central banks are an alternative. For instance, the re-insurance capacity of the resolution mechanism could be enhanced if it were given a banking license and could thus get access to the ECB as a lender of last resort. It would no longer confine it to a finite amount of firing power, in line with what the financial industry is able to pay or beleaguered governments are able to stump up. In contrast to direct lending of last resort by the ECB, the resolution mechanism could attach strings to its rescue operations for banks, such as a strict cap on executive compensation. 9. Prudential regulation of capital requirements for sovereign bonds is another way of reducing the potential for negative feedback loops. In my view, one should resist risk classification of euro-denominated bonds according to nationality of the sovereign. Risk pooling of euro-denominated bonds irrespective of nationality of the issuer, for instance ensured through the collateral policy of the ECB, is essential for the promise which a currency union entailed for its participants. But prudential regulators could raise capital requirements steeply with the concentration of bond holdings from any particular sovereign issuer. One might even contemplate a “capital surcharge” for resident banks (headquarters and subsidiaries) holding bonds of the domestic government. This would obviously have to be phased in and thought through as, for instance, it would come as quite a shock to Italian financial institutions. But the principle is that financial institutions that are invested in the risks of the domestic economy must be given incentives to diversify away from the risks of the domestic fiscal authority. 10. Another risk sharing mechanism, operating at the interface of public and private finance, would be an insolvency law for sovereign debtors that economists at the IMF and more recently the think tank Bruegel advocated. It is a long over-due international public good. Financial investors must get back the sense that they have to share the pain and that returns are earned for taking not only the upside but also the downside risk. Obviously, banks and funds would try to pass on the losses to their shareholders and clients. But this would be preferable to the present situation in which the public institutions that rescued them have to do this unpopular business for the bank and fund managers, passing losses onto taxpayers.

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Before a union of unions can be proposed to these taxpayers, the monetary union will have to show that it can do better than the regressive risk sharing authorities were forced to practice over recent years.

24 November 2015

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Kay Swinburne MEP and Markus Ferber MEP—Oral evidence (QQ82-91)

Kay Swinburne MEP and Markus Ferber MEP—Oral evidence (QQ82-91)

Transcript to be found under Markus Ferber MEP.

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Mike Vercnocke—Oral evidence (QQ141-157)

Mike Vercnocke—Oral evidence (QQ141-157)

Evidence Session No. 13 Heard in Public Questions 141 - 157

WEDNESDAY 27 JANUARY 2016

Members present

Baroness Falkner of Margravine (Chairman) Lord Butler of Brockwell Lord Davies of Stamford Lord Haskins Earl of Lindsay Lord McFall of Alcluith Lord Shutt of Greetland ______

Examination of Witness Mike Vercnocke, Head of European Affairs, City of London

Q141 The Chairman: Mr Vercnocke, thank you for agreeing to give evidence to us today for our inquiry into completing Europe’s economic and monetary union. As you know, this session is on the record and we will take a verbatim transcript of proceedings, which will be published in due course. You will have the opportunity to correct any minor errors or misunderstandings. I will kick off by asking you for your general overview of the Five Presidents’ Report and indeed the Commission’s follow-up proposals on 21 October. Do you think the report does enough to strengthen the euro and secure its long-term sustainability? Are there any omissions you think ought to be corrected? How do you see the priorities for the next phase of the process? Mike Vercnocke: That is quite a big question. One thing I should say at the start is that the City of London’s view, and of course I work for the City of London Corporation, is that we want the economic and monetary union to work and not be dysfunctional. It is to the benefit of everybody, not just the eurozone countries. Obviously it is a great benefit for them, but also for us and indeed for the City of London, if the eurozone works effectively. In that sense, we are quite supportive in principle of the Five Presidents’ Report and the need to ensure that the monetary union works.

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Mike Vercnocke—Oral evidence (QQ141-157)

It was quite clear from the start that, for various political reasons, it was an imperfect monetary union. There is no way of getting around that. That was probably exacerbated by allowing too many countries in that were not really ready to join, but that is the past. I guess now they have to look at how to make it better. We are not overly sure the initial actions up to 2017 in the Five Presidents’ Report will be able to make that much difference, partially because of the constraints of the treaty. The treaty has already been stretched to the limit by what they have done. As I am sure you are aware, there is considerable political opposition from some member states to certain aspects of the proposals for the next stage, for example creating a euro treasury or joint representation at the IMF. These are things that the Commission has thought up but, as far as we are aware, a lot of member states do not really support those proposals at this stage. We are looking, up to 2017, at some gradual attempts to make things work a little better. The trouble with that now is that, when the Five Presidents’ Report came out, it looked possibly achievable. Events have made it much more difficult now, with all the problems with immigration, for example. I was in Paris last week talking to some of our French colleagues. The French Government are no longer really viewing austerity and the stability of the eurozone as a prime concern; they are now viewing defence and security as their prime concern. A lot of these actions are going to be blown out of the water by other things. In the short term, I do not really see huge changes. We will probably get on to the deposit insurance scheme and things of that sort a bit later. In the longer term, after 2017, it seems to me the only realistic option is for some quite significant treaty changes to be proposed. The obvious areas are certainly on the governance of the eurozone and creating more legally binding mechanisms for imposing fiscal rules on the members of the eurozone. At the moment, although we have the six-pack and so forth, it is not really that effective. Certainly the proof of the pudding so far is that it has not been very effective. They will have to look at treaty change of that sort so, at the very top level, you are looking at some sort of fiscal union. That does not necessarily mean a complete union, but some sort of mutualisation of some of the risks and possibly some joint issuance of debt, for example, which the Commission has certainly been talking about since I have been in Brussels, which is a long time. Possibly lower down you might look at things like insolvency law and possibly even some form of taxation. I would emphasise that these are all big issues that probably do need to be tackled if the eurozone is to be fully efficient but, politically, they are very difficult not just for the UK but for a lot of members of the eurozone. Lord Davies of Stamford: You could do insolvency law without a treaty change, could you not? Mike Vercnocke: You possibly could. It depends how detailed it is. The ECB certainly looked into whether you could do securities law, for example, so some sort of limited insolvency harmonisation for the financial sector or certain asset types, but it is still quite difficult and sensitive. Obviously in some countries insolvency law is enshrined in their common codes; therefore, a pretty big treaty change would be needed. Lord Davies of Stamford: It may be extremely difficult, but it is possible within the treaty. That is my point; you do not need treaty change for it. Mike Vercnocke: You probably do not. 332

Mike Vercnocke—Oral evidence (QQ141-157)

Lord Davies of Stamford: If the political will is there, you can get it through in national legislation. Mike Vercnocke: Yes, that is probably true. Of course, it probably would be easier if you had some sort of treaty change because, without it, it would be much more difficult for the Commission to convince everybody to make the changes. The Chairman: Post 2017, particularly with two major countries’ elections, do you see a dramatic change in gear? Mike Vercnocke: That is very hard to judge. You are quite right. Obviously we have the federal elections coming up in Germany and then the presidential election in France, which is already a major topic of debate in Paris. A lot could change on the outcome of those elections. I would say yes. With the caveat that we get over all the current problems, if they are determined to make a real change to the eurozone from 2017, you would have to see some really major steps. Lord Haskins: We face the issue of referenda in certain countries. Mike Vercnocke: There are about nine countries, we reckon, so it could be quite difficult. This is exactly the thing: a lot of the things that the eurozone needs to do—and a lot of people know they need to do them—are nevertheless very difficult politically.

Q142 Earl of Lindsay: You have described the positive impact that should be enjoyed by the City of London, or its perception, from the completion of the monetary union. In terms of how it is completed, are there any negative or potentially negative impacts that you are aware of and we should be aware of? You might argue that, whilst there has not perhaps been reason in the past to develop a treaty decision-making or oversight process that leaves non-euro member states out in the cold, that could develop, in terms of how decisions surrounding the euro and euro member states are developed. Is this a concern and is it something that therefore should be safeguarded against? Mike Vercnocke: The short answer is yes, absolutely. I would still say that getting the eurozone working efficiently is of benefit to us, but indeed there are potentially negative consequences that we would have to guard against. The obvious one is that, if you have a more cohesive eurozone, it is more likely that those members will vote together. We may already see that a little. We may come on to this later, but for EDIS, the European deposit insurance scheme, there is also a parallel work track looking at the reduction of risk in the financial sector, which applies to all 28. Of course, it is particularly important to the eurozone, because of the single supervisory mechanism. There is already, possibly, a certain momentum to be more coherent, which in the past they have not really been. You are right: there is a risk to all “out” member states that the eurozone might start to behave more as an entity and might take decisions that were of benefit to the eurozone but have negative consequences for the outs. For example, things like the ECB’s location policy have been avoided so far, but you could see that the eurozone might argue, for prudential reasons, that euro-dominated transactions should be cleared in the eurozone. That could potentially have a negative impact on the City of London. Earl of Lindsay: In order to address that potential threat, do you see that the role of the United Kingdom in the governance process surrounding eurozone matters should be

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Mike Vercnocke—Oral evidence (QQ141-157) inclusive rather than exclusive? For instance, do you see us continuing to have a role on the Council in terms of the eurozone agenda? Mike Vercnocke: I believe we need, or the outs need—and this is why we probably need a treaty change ultimately—a clear mechanism to regulate the relationship between those member states that are not in the eurozone and those that are. Obviously, as you know, at the moment the view of the Commission and the legal view is that, apart from us and the Danes, ultimately everybody is on a trajectory to be part of the eurozone eventually. We are now looking for a change to that, so that the euro is an option rather than a mandatory requirement of being a member of the European Union. That would then crystallise the situation where you have a single market, with some members not being in the eurozone on a potentially permanent basis. In that case, you need a mechanism to say how that relationship works. It is going to be quite difficult. Any single market legislation will be for the 28 at any rate, but of course we have this problem of the eurozone potentially ganging up. You need some legally binding mechanism so that the non-participating member states have the ability to be in the process and possibly block actions taken by the eurozone, at least temporarily. That would need a treaty change. Earl of Lindsay: Can I have just one last question? In that sense, is the Five Presidents’ Report, to your mind, more about the eurozone than it is about economic union and the single market? Mike Vercnocke: Yes. Earl of Lindsay: Is that a regret or was that inevitable? Mike Vercnocke: It was probably inevitable. It is very clear when you are based in Brussels that the Commission’s view is the single market and the euro are one and the same thing. We tend to look at them as different buckets. They see very much that the euro is the currency of the single market, the future of the single market is the euro and the two are inextricably linked. That needs to be challenged a little, because that may not be the future. The Chairman: To pick up on that point, do you see any evidence of caucusing against the UK in eurozone circles and meetings? Mike Vercnocke: No. We sometimes see caucusing against the financial sector. The Chairman: We might even see some of that in the UK. Mike Vercnocke: It is possibly justified. Sometimes we feel we are being “got at”, but when you look at it, it is not the UK part being got at; it is the financial sector as a whole. The point is that a large part of it is in London. It is still aimed at Deutsche Bank, BNP Paribas and Société Générale; it is just that those operations happen to be in London.

Q143 Lord Haskins: I know it is irrelevant, but where do we stand on the financial transactions tax? Mike Vercnocke: The Belgians, with their newish Government, are getting increasingly cold feet about it. The Belgian finance minister, who is a Flemish nationalist, has made words to the effect that he is not so sure it is a good idea. They are coming very close to the minimum number of member states. You have to have nine member states for the enhanced co- 334

Mike Vercnocke—Oral evidence (QQ141-157) operation process to continue, so it is looking very unlikely that anything will happen in the short term. The general view here is that it is very hard to kill it because so many people have put so much political capital into it, but equally there is no real will to make it happen. Lord Haskins: Is that mainly from the Parliament? Mike Vercnocke: Yes, the Parliament is certainly very much in favour of it, and some member states are. The Italians and Belgians were, but no longer. Belgium used to be a very strong supporter. In Germany, it is a very mixed view. As you know, the CDU and CSU really do not like the idea, but the SPD do. The coalition agreement was to continue with it. The other thing we have repeatedly made plain to everybody who listens is that, if you are looking for capital markets union and development of the capital markets and equity finance, the last thing you want is— The Chairman: A variable financial transactions tax. Mike Vercnocke: Yes. Earl of Lindsay: If you say that the Five Presidents’ Report is principally about the eurozone agenda, rather than the single market or economic agenda, does that introduce a fundamental incompatibility between what one agenda is trying to achieve and what the second agenda should be wanting to achieve? Mike Vercnocke: It is a possibility, but I would not say it necessarily has to be the case. From an economic point of view, what is good for the eurozone should be good for the single market as a whole. These political and governance issues are more difficult. The clear example is the creation of the single supervisory mechanism, which now supervises 129 major banks in the eurozone. From our discussions with firms, they think it is working rather well and has improved the overall prudential supervision across the European Union. Now you have the Bank of England doing a good job at one end and you have the ECB dealing with all the others, rather than having 28 supervisors all with different views. On the one hand, it creates a more powerful ECB. On the other hand, it seems to have made the market work more efficiently. We have to be on our guard, but it is not necessarily always the case that something done for the benefit of the eurozone is necessarily detrimental to the UK, but it could be, so we have to watch it.

Q144 Lord Davies of Stamford: Just on that one, if in fact it is the case, as you have just suggested, that having bank supervision organised on a 19-country basis has improved the situation, made it clearer, reduced costs and what have you, why would it not be better still if everybody joined banking union? What is in the British national interest that precludes our joining the banking union? Mike Vercnocke: From the banks’ point of view, a lot of major banks probably would agree that it would be better if they were all in the banking union. The issue at the moment, of course, is that the banking union is not purely about supervision. It potentially has some fiscal implications as well. Certainly if the European deposit insurance scheme flies, and that is coming under a lot of opposition from Germany and others, in effect you would have mutualisation of the risk. If a bank fails, the bail-out would be by all the participating members. For a country like the UK, which is not in the eurozone, that would have unacceptable fiscal implications.

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Lord Davies of Stamford: If that went on in the eurozone, it does not increase the risk? Mike Vercnocke: No, but it increases whether you pay or not. Lord Davies of Stamford: The risk would be that a country in the system defaulted on its retail bank insurance obligations. That eventuality can arise whether we are part of the euro or whether we are not. It does not make it more likely if we are not in the euro. That does not make any sense. If we join that mutualisation arrangement, we are equally exposed to every other country that is in the mutuality arrangement. Mike Vercnocke: Yes, but I presume we are not going to join that. If you are in the banking union, you will have to join the mutualisation of deposit protection. Lord Davies of Stamford: That is the factor holding us back. Mike Vercnocke: I am not the Government, but I would imagine so, yes. Lord Davies of Stamford: Would you agree there are some quite important considerations on the other side of the balance sheet? One is compliance with this reform if there was just one set of supervision. Secondly, there would be no temptation or opportunities for regulatory arbitrage. Thirdly, the distinction between capital markets union and banking union is not a rigorous one. What about money market funds? What about shadow banking? What about securitisation of bank loans or the secondary market in CDOs? Is that banking or is it capital markets union? Do you agree with my points? Mike Vercnocke: That I agree with, yes. You are absolutely right. There is no easy dividing line, but the advantage of the banking union at the moment is that the way the UK supervises its banks is very strong, but that has not always been the case across the rest of the European Union. Lord Davies of Stamford: It is now with the ECB. Mike Vercnocke: Exactly, so there has been a definite increase in the standard across the EU. Also, the assessment of the risks that banks are running is now much more comparable across countries whereas, in the past, clearly what the Banque de France thought was a risk and what the Belgian banking commission thought was a risk were not exactly the same. Lord Davies of Stamford: We now have the same rules, which the EBA lays down for us all. Would you agree that most of the objections to our joining the banking union disappear? The one that remains is the mutualisation of risk. Mike Vercnocke: That probably is the main one, but I do not speak for the Government, so I do not know.

Q145 The Chairman: On that point, leaving aside whether you agree that is the only thing holding us back, do you think the culture of the City of London would tolerate supervision from Frankfurt? Mike Vercnocke: It depends on which part. Certainly at the moment, if you are looking at conduct-of-business rules, no. We are basically the only real wholesale international capital market in Europe, so that would not work. In terms of the prudential supervision of the banks, there are probably fewer obstacles, because the rules are pretty much the same and the banks are pretty much the same as well. From my point of view, there would be fewer

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Mike Vercnocke—Oral evidence (QQ141-157) difficulties in that. In terms of the capital markets, there would be much bigger difficulties, because there simply is not the expertise in any of the other member states to do that. The Chairman: From your perspective, do you think the UK would be better off in a banking union? Mike Vercnocke: There are pluses and minuses. The caveat would be: as long as the whole banking union is completed, because that is not yet the case. If it were, one advantage from the UK’s point of view is this issue of too big to fail. While a bank may be too big for an individual member state to cover, it would not be too big for the whole of the European Union to cover. There is some advantage. The Chairman: Bank resolution would become easier. Mike Vercnocke: It would potentially become easier, yes. On the other hand, you would have less control over it, so it is swings and roundabouts. The Chairman: Is the City of London thinking along these lines, as to whether the UK may be better off in banking union? Mike Vercnocke: The City of London Corporation is not working on that, but I know that some of the companies have been, particularly those that are already partially supervised by the ECB. There are possibly concerns, though, that part of the work of the review for the EDIS is the reduction in risks in the banking sector. One of the areas that the Council working group is going to be looking at is a reduction in national derogations in the directives. That, in the current situation, could have difficulties, because that would reduce the flexibility that national supervisors could use. That might be something worth watching.

Q146 Lord Butler of Brockwell: May I ask you about capital markets union and what the City’s view of that is? First of all, I imagine you welcome it. Is it making good progress? Mike Vercnocke: Yes and more or less. Yes, we very much welcome Lord Hill’s work on this. The way that President Juncker reconstructed the Commission is also very good. The capital markets union is not just Lord Hill’s project but belongs to the team, including Vice-President Katainen, which gives a lot of political cover, which we can sometimes be accused of. It is not just a UK agenda; it is supported by a large part of the EU. It is probably less ambitious than we would have hoped, but that is understandable, in that the Commission’s view is that it is going to have to be taken a step at a time, because otherwise there will be considerable opposition emerging, which might scupper the whole thing before it gets off the ground. On the other hand, we cannot delay for too long. Already, we do not think that the proposal on securitisation really goes far enough. It will not revitalise the securitisation market in Europe. Lord Butler of Brockwell: What are the deficiencies with that? Mike Vercnocke: There are a number. One issue we have is that the Council has decided to remove the third-country provision, limiting the originating securitisations to EU-based countries, which we think is a mistake. The more practical point is that the capital requirements are still far too high and will not make securitisation particularly appealing. The amendments to the Solvency II rules also do not really go far enough, because the new asset class for long-term investments is limited to the standardised approach, rather than

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Mike Vercnocke—Oral evidence (QQ141-157) the advanced or internal modelling approach for insurance companies. All the big insurance companies, like Legal & General and Prudential, will not benefit from it. It is only very small insurance companies that would, which we do not really think is going to make a huge difference. Lord Davies of Stamford: I did not quite understand that. Can you just explain the Solvency II derogation? Mike Vercnocke: To try to get the securitisation market working, one thing is to have a new asset class for long-term finance, which will accrue a lower capital charge under Solvency II. It will mean that insurance companies are more attracted to holding securitised assets, but the way the Commission has framed it this new asset class only applies if you are a relatively unsophisticated insurance company using a standardised approach, where all your parameters are set by your regulator. All the big insurance companies use an internal model approach on Solvency II, and this new asset class is not available to them under that. Lord Davies of Stamford: That sounds at first sight—and to me it is at first sight—like it is a big mistake to distinguish between exactly the same asset class in different insurance companies. Are you making progress in resolving that? Mike Vercnocke: We are trying to. It has happened that way because the standardised approach basically requires much higher capital charges than the internal model approach, because it is obviously much cruder. They felt that that would help—and it will help, but it will only help small insurance companies. The ABI and other people are lobbying the Commission on that one. Lord Davies of Stamford: Are there any case studies as to how much influence we have in regulation in the financial services area, bearing in mind that we are not part of the euro area? Do you feel we are getting the influence we ought to have in this field? Lord McFall of Alcluith: The information on Solvency II I have had over the years is that quite a bit of progress has been made and a lot of people are happy with it. Could you put that into context? Mike Vercnocke: It has improved. The potential delay to Solvency II now is necessary— because of the slowness of ESMA to do its work, which is understandable given their lack of resources—but also a problem. Yes, you are right. However, we have recently been informed by a few big insurance companies that the Commission has basically accepted the equivalence of US and Canadian insurance rules. Some domestic companies now feel they have a competitive advantage, because they are not applying Solvency II and therefore have lower charges in certain areas. It is a bit of a mixed picture, to be honest.

Q147 Lord Butler of Brockwell: Are there other aspects that are causing friction to the City that are being debated? Mike Vercnocke: Perhaps I will just come back to the point about influence. Our experience is that, certainly within the Council and within the Commission, the UK’s influence on financial services—I do not know about other areas—is still very strong, partially because we have the main market but generally because we have the expertise and are therefore able to provide the Commission and Council with valuable input. The area where we are weaker, I would say, is the European Parliament, where our influence is certainly somewhat

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Mike Vercnocke—Oral evidence (QQ141-157) diminished, but so is that of other member states. The way the Parliament went in the last election means it is much more fractured. There is no natural majority on the left or right, so it has become very much more personal. Therefore, it is quite hard to get influence in the Parliament sometimes, though we do our best. Q148 The Chairman: Which committee do you interact with the most? Mike Vercnocke: The Committee on Economic and Monetary Affairs. The Chairman: As an aside, we had a committee from the European Parliament, the Committee on Constitutional Affairs, in a round-table. In the context of the United Kingdom leaving—a Brexit debate—one of the MEPs said, with the acquiescence of the others, that they could not see the merits of the United Kingdom staying in, because the United Kingdom did not provide any value added. I reminded them of Europe’s financial centre being in London, but could your efforts in terms of influencing be more widely spread in the Parliament? Mike Vercnocke: We do try, but even within the Committee on Economic and Monetary Affairs, probably only about 20 or 30 MEPs are really interested in financial services. Of those, probably a third of them do not like financial services, so it is a bit of an uphill struggle. You are right. We try; it is the same with Jeremy, who could not be here today, I am afraid. We are undertaking a whole series of meetings with MEPs, and I took Jeremy down to Strasbourg back in October. We are reaching out to non-Brit MEPs in a big way, but it is difficult. Lord Butler of Brockwell: I think you were going to go back to the question of whether anything is causing friction. Mike Vercnocke: Not on a day-to-day basis, but the whole Brexit debate is seen certainly by some member states as an unwanted development or hindrance to business. I suppose there is a certain amount of friction in that. We feel that sometimes people say, “You may not be with us in two years’ time, so why should we worry about what you have to say?” I do not think there is that much. In a lot of areas the UK has a lot of supporters.

Q149 Lord Butler of Brockwell: I gather MiFID II is coming up before the Council, possibly in the next couple of weeks. Are you satisfied with the way that is going? In asking this question, I ought to declare an interest, because I am an adviser to an investment house. Mike Vercnocke: We feel that MiFID II has come out quite well. Lord Davies of Stamford: Is there partially a British influence? Mike Vercnocke: There very much is, yes. The initial proposals from the Commission were not all that good. To be frank, the Corporation has really been focusing on the third-country access issue. We knew that the original proposals would be detrimental to international business in the City, basically, and we successfully lobbied through the International Regulatory Strategy Group and Rachel Lomax on that issue. We ultimately came out with quite a good solution on that, which basically says that third-country firms can operate until such time as their country is deemed to be equivalent. You are in until you are in. That was a success.

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In terms of the other more granular areas, there are mixed views, depending on whether you are on the buy or sell side, but our take from the companies is that it has been quite a well-balanced piece. Obviously, it has taken a long time and we are only looking for implementation on 3 or 4 January 2017. Lord Butler of Brockwell: I gather there has been a delay and there is now some anxiety that, if it were implemented on 3 January 2017, there would not be enough time for consultation. We are likely to be pressing for a postponement of the implementation date. Mike Vercnocke: ESMA has as well, because there are considerable problems, particularly on the data side.

Q150 Lord Haskins: From the discussions we have had in the last couple of days, there appears to be much common ground between the UK and the five Presidents. Everybody seems pretty relaxed, on both sides, about the way that it might impact. That surprises us quite a lot. Moving on to regulation and governance, is there a need for a co-ordinated approach where the UK is involved alongside other members through the European Parliament or wherever in establishing high standards of governance within economic and monetary union? As you have said, the British Government are very keen to make this work as well. Is this on the cards? The other point that struck me very strongly was that somebody said there had hardly been an occasion at all when the UK had been outvoted on major regulatory proposals. That was something that frankly amazed me. The impression one gets from the British press is that we are constantly being outvoted, but never on financial proposals. Mike Vercnocke: Not really, no. From the industry’s point of view, we do not always get exactly what we want. In that sense, sometimes the vote on the final proposal is not exactly what we want, but it generally is much better than the starting point and we can live with it. The only exception is probably AIFMD, the alternative investment fund managers directive for doing hedge funds and alternative investments. Even at the end, that was not particularly good, although I think people have worked their way around it, to be honest with you. Lord Davies of Stamford: Do you mean the hedge funds financing the Brexit movement? Mike Vercnocke: Exactly, yes. The only area we lost out would be on the bankers’ bonuses. The Chairman: I was just going to say that. What is your view about that? Mike Vercnocke: In actual fact, most of the UK MEPs voted in favour of it, and I imagine it was probably one of the most popular things for the populace in the UK anyway. You are right; in general terms, I cannot really think of any clear examples of where we have lost everything, as it were. All the countries find that they do not quite like something, because that is the way it works; it is always on a compromise. Lord McFall of Alcluith: Have you lost out on bankers’ bonuses, in the sense that there is still plenty of latitude for interpretation? Mike Vercnocke: There was, although the EBA has come out with some stricter rules. We reckon the bankers’ bonuses had a very limited impact, but it did potentially have a negative impact on some of the global heads of business lines in London. These people were running the global business, basically, or all the business outside the US, for example. The issue there

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Mike Vercnocke—Oral evidence (QQ141-157) was that, if they could no longer be paid competitively and moved from London, the supervisor might also say, “Actually, the team they run should also move, because they should be in the same place”. To be honest, we have not seen much of that. The only downside, and we do have some data on this, is that the fixed costs of doing business in London have gone up compared with those in New York. The Chairman: From where you sit, and recalling where that conversation started, would you agree that what we got at the end was a lot more in line with Anglo-Saxon concerns than continental southern European concerns? Mike Vercnocke: Certainly the capital requirements directive and regulation in general came out better. The Chairman: I was talking about the bankers’ bonuses. Mike Vercnocke: It was more of a populist proposal. Even Michel Barnier did not propose it and had his doubts about it. It just came out from the European Parliament, particularly from the left, but it had quite a lot of support in the European Parliament, across the spectrum in fact.

Q151 Lord Haskins: Going back to the regulation of the euro, it has been raised with us that a lot of attention is given to countries running big deficits and not very much attention is given to countries running big surpluses. Mike Vercnocke: Such as Germany. Lord Haskins: On the face of it, this should be nothing to do with the UK but, on the other hand, this is not an issue that just relates to the euro. It is a single market issue too. Do you expect the British Government to take a strong position on something like this? Mike Vercnocke: Certainly the alert mechanism report, which the Commission puts together, identified Germany as running too high a current account surplus and that is part of the problem facing the eurozone. Yes, it comes back to this point that, although we have these mechanisms in place and the European semester, I am not sure that is going to be that well enforced, particularly in the present climate. The general feeling is that there is not really much solidarity, even across the eurozone. Lord Haskins: The impression I have from you is that, as many people have told us, somehow the euro will muddle through for the next few years. Mike Vercnocke: Absolutely, yes. I should point out that I have a slight history here, because I was seconded from the Bank of England to the European Commission in 1995 and worked on the introduction of the euro for three years, so I am guilty.

Q152 The Chairman: It is all your fault. Before we bring in governance, what can we learn from the US—witnesses have mentioned the US—and other mature federations in terms of financial and budgetary integration policies? From your perspective, what would a fully integrated financial union look like, in terms of reducing the need for a fiscal union? Mike Vercnocke: The fundamental difference between most of the European Union and the US, of course, is the social model. One of the reasons the US has such a developed capital market is because of private pension funds and private provision of wealth. Therefore, unless you were to see a wholesale change in how most of continental Europe structures its 341

Mike Vercnocke—Oral evidence (QQ141-157) social structure, it is hard to see that sort of development of capital markets. On the other hand, if you are looking at the demographic problems in Europe, in terms of the ageing population and the difficulty for Governments in finding funding for state pensions, even the Commission’s view is that there ultimately has to be a move towards private pension provision in Europe. If that were to happen, we would potentially be much closer to a US-style model but, without that, I do not think we would ever get there, because you do not have the funds going into it. Lord Davies of Stamford: Things are moving in that direction quite significantly. Mike Vercnocke: They are, but quite slowly and in some countries more than others. Holland obviously has a big pension fund. We do. In France, it was illegal to create a private pension fund until about 10 years ago and the only private pension fund was for civil servants. Lord Davies of Stamford: There are now quite a number of supplementary funds.

Q153 The Chairman: If we had enhanced financial integration, through all the different areas that we have discussed, would that reduce the need for a fiscal union at that overarching transfer level? Mike Vercnocke: A lot of these things, fiscal union and political union, are bandied around in Brussels, but no one is ever quite sure what they really mean. In terms of fiscal union, I do not think anyone is really looking at a complete single budget and basically one government, in effect. You are possibly looking at the means for some fiscal transfers. It is just to what degree you do those. Obviously the deposit protection scheme is a start in that direction. It is very limited obviously, but that would be mutualisation. The idea in the Five Presidents’ Report, as I said earlier, of creating a eurozone treasury would be another move. You are right that how far along that line you go in terms of fiscal union depends on what other things you do. If in fact you solve recovery and resolution in the financial sector, and therefore you cut the link between the sovereign and the financial sector, some of the fiscal issues probably go away. However, you still come back to the problem of some countries running large current account surpluses and others running permanent current account deficits, which obviously is not sustainable. Lord Haskins: One distinguished witness told us that his idea of fiscal union was to increase the size of the EU budget from 1% to 2%. Mike Vercnocke: Radical stuff. Of course, the Commission’s view is one option is to reduce the contributions by member states and have some sort of direct taxation going to the Commission.

Q154 Lord Shutt of Greetland: Moving to the effective governance of the eurozone, do you think there is any need for further institutional strengthening or reform? Mike Vercnocke: From the point of view of making the eurozone work efficiently, yes, there is. Lord Shutt of Greetland: What would it be then? Mike Vercnocke: It comes back to the fiscal issue a little. How should I put it? There has to be some mechanism for ensuring a more consistent economic programme in eurozone member states—i.e. they ultimately all have to be far more convergent in their economic 342

Mike Vercnocke—Oral evidence (QQ141-157) policies. You need some mechanism to enforce that. I am not saying it is a good idea but, if you really want the eurozone to work, you cannot have some countries increasing their debt massively and others not. You need some mechanism to ensure some discipline in how they set their budgets, but then it comes to political union. How can you do that and still have democratic oversight? If the central body is setting the budget, what is the national government doing? Lord Shutt of Greetland: If we had that, would it be a different outfit in which the UK is not involved? Mike Vercnocke: I would imagine so, unless we are in the euro. The other area where we may see developments in the ECB is probably on the capital markets side, where the ECB has at various meetings said ultimately it sees a role for itself as the supervisor in other sectors, not just banking. Lord Shutt of Greetland: Is there anything else on the democratic accountability front? Mike Vercnocke: It is a very difficult area. The most democratically accountable bit of the European institutions is the European Parliament, and yet no one in the populace, not just in the UK but in most countries, takes it very seriously, yet it is the one area where you have direct elections. It is quite difficult. The press in the UK is not entirely fair when it says that it is very undemocratic, because clearly the Commissioners were appointed by the democratically elected Governments of the member states; the Council is a democratically elected Government. The Commission is less so, obviously, and I suppose that is the area where there are issues, because obviously the Commission is both legislator and Executive at the same time.

Q155 Earl of Lindsay: If you look at the whole agenda that is currently up and running, and is going to run for the best part of 10 years, is there good, effective communication between the City of London and the UK Government, in terms of identifying optimum policy positions, negotiating positions and so forth? Would you also share with us perhaps any issues where there are differences of opinion between the City of London’s preferred position and the UK Government’s position? Mike Vercnocke: As you would imagine, we have quite a close relationship. Certainly at a political level, my chairman, Mark Boleat, sees this on quite a regular basis. At a working level, we have a lot of interactions with the Treasury and fewer with the Foreign Office, although we do sometimes because of our foreign travel. Operationally with UKRep we have very regular contact just generally to share information. It is not that we are exactly the same. You are right; we do not always entirely agree. In broad terms, I would say that the City of London is very much in line with most policies of the UK Government. There are areas where we disagree. Immigration is one. The City of London is very much a supporter of immigration. For obvious personal reasons, the City needs immigration to function. Earl of Lindsay: In terms of the EMU and the Five Presidents’ Report, are there any sharp differences of opinion between the City and the Government? Mike Vercnocke: Not particularly. One where we did have a difference of opinion and we lost was on the capital requirements directive, where the firms in the City were very much in favour of a maximum harmonisation approach, so that the rules applied were the maximum and you could not do anything in addition, whereas the Government wanted the Bank of 343

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England to have more flexibility and be able to apply tougher rules than those in the directive. We lost that battle, but it is usually only on the margin; it is not usually about the big thing. For example on MiFID, we did not have a disagreement, but we certainly had quite lengthy discussions with the Treasury on the third-country access issue. The Chairman: If you take, for example, the inclusion of these additional criteria in the alert mechanism scorecard, are you comfortable with that? Mike Vercnocke: Yes, I think so. The Chairman: The City was comfortable with that. Mike Vercnocke: Yes, it was. To be frank, I do not think it was a very big issue. I can always check on that point.

Q156 Lord Davies of Stamford: I would like to come back on capital markets union, which I am sure you spend a lot of your time on. There is obviously tremendous fragmentation in the single market at present. The French and Germans are better at private placements and venture capital than we are, and various things in that direction. There is obviously, in theory, a lot of good things to go for, both the microeconomic and macroeconomic, with benefits to the financial services industry, cost of capital issues and stabilisation issues—big things potentially. It could be very important. How much of the problem is really a traditional institutional problem and how much of it is really regulatory or legislative obstacles to integration? If it is the former, it is a question of harmonising or integrating attitudes or behaviour, which may be a difficult agenda. I do not know how you achieve it; perhaps you could tell us. If it is the latter, we need to know very precisely what the legislative and regulatory impedimenta are, so that we can encourage Commissioner Hill to focus in on them and get a directive very soon and remove any contrary directives. How are you addressing the habits-of-mind issue and traditional ways of doing things in different financial markets? Secondly, what are the key obstacles in terms of legislation and regulation that need to be removed? Mike Vercnocke: You are absolutely right that one of the biggest obstacles to the development of capital markets is a cultural one. In some member states, Italy for example, the capital market is really just government debt and some company debt. There is very little else. In many of the newer member states, like Romania or Bulgaria, they have a capital market, but it was simply set up to fund the Government when they privatised what had been state-owned companies. There is no actual capital-raising on them for new companies. That is partially a cultural thing—people just do not think of going to the capital markets. In some countries it is more structural. In Germany, there is considerable opposition to the capital markets union, apart from the Bundesbank, which is very much in favour, but everybody else seems to be pretty much against it. That really stems from their three-pillar banking system. The savings banks are very concerned. At the moment, they monopolise a large part of the financing of small companies, at any rate, and if those companies entered the capital market they would lose their business potentially. We are not sure if that is a real risk. There is a lot of opposition. Lord Davies of Stamford: Are there any legal obstacles there at the present time to be removed or not?

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Mike Vercnocke: In actual fact, Lord Hill is absolutely right in saying that he is trying to look at a bottom-up approach and what minor things need changing, rather than coming with a grandiose, huge European grand strategy of lots of directives, because there are probably not that many regulatory barriers. Lord Davies of Stamford: That is my feeling. I cannot get anybody to quote me any specifically. Mike Vercnocke: We have some, which we have known for years, because Alberto Giovannini in the famous Giovannini Group 10 years ago looked at barriers in the financial markets, particularly in the material settlement area. Those barriers are known and the market ones have generally been dealt with. Most of them are national laws; they are national protectionist rules. Lord Davies of Stamford: Those can and, we hope, will be dealt with. Mike Vercnocke: We are slightly concerned that, when we have talked to quite senior people in the Commission on this point, they say their approach to this, which we approve of in a sense, is not to regulate and come up with new rules but to point out to member state governments where they have national barriers to the capital markets. They say those countries will then remove those barriers. We are a little sceptical about that. Lord Davies of Stamford: A lot of Jonathan Hill’s activity is going to be exhortation rather than actual law-making. Mike Vercnocke: Absolutely, yes. There will not necessarily have to be new regulatory directives but some amendments to current ones. Lord Davies of Stamford: Have you, in the City of London Corporation, got a list or a couple of pages of what needs to be done, in your view? Mike Vercnocke: Yes, we do have papers. Lord Davies of Stamford: I would love to see some, and I am sure colleagues would too. Mike Vercnocke: Yes. You are right that, in a sense, one barrier to some of this work is of course taxation and the different treatment of equity in different countries, and generally the disadvantage of equity over debt, in terms of fiscal treatment in most countries. Lord Davies of Stamford: That is universal. Every jurisdiction in the world that I know of has that. Mike Vercnocke: Exactly, so there are areas that may need some amendments, but there are not as many barriers as you think. It also comes back to the point I made about pensions: in some countries there is no natural system or effective mechanism for making good choices for investing savings, basically. You either put it with your local bank at 0.5% if you are lucky or you put it under the mattress. You do not go out and buy equity; it is not a natural thing to do. Indeed, in some countries, entrepreneurs who open a little company do not actually want to sell the company. They want to keep the company as it is and pass it on to their children. That is probably a bigger barrier than some of the other things. The Chairman: If you have any publicly available documentation, we would be delighted to receive it. I think that brings our session to a conclusion.

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Q157 Lord Haskins: May I just ask a question outside of this debate? Is the City of London going to take a position on the Brexit debate? Mike Vercnocke: Our chairman was in the press last night, in the Evening Standard. Lord Davies of Stamford: We have not seen that. Mike Vercnocke: Frankly, the City of London Corporation does not have an official position on Brexit. We are trying to facilitate a debate, so we have been holding various events. It is clear that certainly the vast majority of companies operating in the City are in favour of staying in the European Union, purely for their own gains. We reflect that to a degree, but we fully support the Government’s approach to renegotiate, and I guess we will be waiting to see what the package is. Lord McFall of Alcluith: I was at a breakfast with Mark Boleat just a few weeks ago, and there was the intention of coming out and articulating your position very strongly, engaging business in it as well. Mike Vercnocke: We are certainly encouraging business. From both sides, business needs to speak up. There is no doubt about it. Lord McFall of Alcluith: That was one of the comments that I was discussing with him. I was giving my views on the Scottish referendum. Business largely flew under the radar, other than a few exceptions, until a few weeks beforehand. That led to a climate of fear and negativity. Mike Vercnocke: The issue for some of the big companies in London is that, whilst they would find the UK leaving the European Union a nuisance, it would not destroy them, because they would just restructure. Therefore, in a sense, they probably are a bit more concerned about coming out. Certainly the companies that have big retail bases are quite concerned about being pigeon-holed as in or out, for obvious reasons. Lord Davies of Stamford: You exist to be the focus for City opinion. You do owe it to the City and the country, if I may say so, to make clear what the consensus is. Mike Vercnocke: Certainly once agreement has been reached, we will do that. The Chairman: In concluding, are there any demands from your perspective on the City that we have not heard? Mike Vercnocke: No, not really. You have covered everything. The Chairman: We covered the ground fairly comprehensively. Thank you very much indeed, Mr Vercnocke. This brings to an end the public part of the meeting. We are very grateful to you for having come and given up your time so generously. Mike Vercnocke: Thank you very much.

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Alex White and Professor Paul De Grauwe—Oral evidence (QQ179-185)

Alex White and Professor Paul De Grauwe—Oral evidence (QQ179-185)

Transcript to be found under Professor Paul De Grauwe.

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Professor Michael Wickens—Written evidence (EMU0003)

Professor Michael Wickens—Written evidence (EMU0003)

Some Background 1. In evaluating the consequences for the United Kingdom of the Five President’s Report and the EC Commission’s recent communications concerning the report it is important to understanding the reasons why the report was written. The main reason is in order to shore up European Monetary Union. Without the proposed reforms EMU is almost certain to fail. This has been clear for at least ten years and, arguably, since its inception. It is not at all certain that EMU will survive even if the reforms are carried out. Implementing them will entail, possibly considerable, costs both to the eurozone and to other EU countries. Given the commitment to EMU, and in the continued absence of market discipline, there is probably little choice but to attempt reforms of the sort proposed. 2. The fundamental problem for the eurozone countries is that they are unable to restore a loss of competitiveness through an exchange rate depreciation. Instead they have to undertake an internal devaluation of wages and prices which are much more costly in terms of lost output, consumption and employment as wages and prices are nowhere nearly as flexible as exchange rates. For example, over the period 2000-2008 the price level in Ireland increased by about 40 per cent and that in Spain by 44 per cent whereas that of Germany increased by about 9 percent, implying a 31 per cent fall in Irish and a 35 per cent fall in Spanish competitiveness compared to Germany. 3. These consequences for competitiveness of being in the eurozone may be compared with the UK’s experience of the Bretton Woods period, which was also aimed at being fixed exchange rate system. As sterling was tied to the US dollar, the UK had a series of balance of payments crises through a loss of competitiveness that resulted in stop-go policies. It was only when sterling was floated that this state of affairs was ended as it enabled the UK to restore competitiveness through sterling depreciation. This solution to a loss of a country’s competitiveness is not available in the eurozone. 4. The problem of maintaining and restoring competitiveness in the eurozone is a fundamental issue for long-term economic performance but it was not the cause of the eurozone crisis. This was excessive public and private sector borrowing which was also a consequence of EMU. As a result of their higher inflation rates, and being able to borrow at German nominal rates which were, in effect, set by the ECB, Greece, Ireland, Italy, Portugal and Spain - subsequently the crisis countries - were able to borrow at negative real interest rates. This stimulated their economies (Ireland’s GDP grew by about 47 per cent over this period compared to 13 per cent in Germany). The problem was that negative real interest rates also led to excessive borrowing by the private sector (in the case of Ireland and Spain) and the public sector (in Italy and Greece). There was little that the ECB could do about this given its mandate throughout this period to target average eurozone inflation at or below 2 per cent in which it was very successful. 5. The reasons for the new proposals are now clear. As monetary policy is unable to control inflation and economic growth in individual eurozone countries or excessive borrowing by their public and private sectors, it is necessary to seek additional tools. The Fiscal

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Union is designed to control excessive public sector borrowing and hence prevent a sovereign debt crisis and eurozone-funded bailouts. The Banking Union is designed to transfer risk and the cost of bailouts from the public to the private sector. The Capital Markets Union helps financial markets to spread this risk and their greater regulation is designed to avoid the insolvency of the private sector banks and financial intermediaries that bear this risk. Greater convergence is required as it implies the removal of significant differences in competitiveness. The convergence of productivity levels would cause the convergence of real wages and, together with an improvement in employment prospects, would lessen internal EU migration. The Issues of Interest to the Sub-Committee 6. In terms of its stated objectives, the principal short-term focus of eurozone reform should be on fiscal and banking policy; achieving economic convergence can only be a long-term goal. It is not self evident, however, that even these reforms are strictly necessary; a market solution would be preferable as it would not involve a loss of national independence. Clearly, economic and fiscal policy is not working satisfactorily in the eurozone. If it were there would be no need for the proposed reforms. Introducing EMU in what was, and still is, not an optimal currency area is the main problem. As a result, monetary policy does not “fit all”. Any reforms should be designed so that the limited capabilities of a single monetary policy are appropriate for all eurozone countries. 7. The proposed fiscal rules go considerably beyond the fiscal rules on deficits and debt contained in the Maastricht Treaty. Moreover, member countries are expected to stick to the rules. The fact that the Maastricht conditions were not met – most notably by Germany and France – does not make one optimistic that more far-reaching rules would be met either. The aim of the new rules is said to be to better prevent budgetary imbalances and hence the need to resort to excessive debt finance. Although they would better harmonise new debt issuance, they will not bring about similar debt levels or debt servicing costs for some time. This implies that to compensate for higher debt servicing costs, countries would need to reduce other fiscal expenditures. 8. Ideally, externally imposed fiscal rules should not be required. Countries should be able to make their own choices about expenditures, taxation and debt and only be constrained by the discipline of the market, especially the rate at which a country can borrow. This rate should reflect the riskiness of lending to a government. High debt countries should therefore expect to pay more to borrow which would deter building up debt. A notable feature of the recent financial crisis is that until it arrived all eurozone countries were able to borrow at the same low rate as Germany. Borrowing rates did not reflect country risk and sovereign credit ratings proved to be over-optimistic, especially for the crisis countries. Arguably, if capital markets had priced risk correctly, excessive public and private sector borrowing would have been discouraged. Although the ECB can control the risk-free rate of borrowing in the eurozone and can bailout countries at this rate if it chooses, it cannot control market imposed risk premia. In this sense the financial crisis was also due to market failure. 9. A general problem with the proposed reforms is that they entail a large number of new rules and regulations. They would constitute a further erosion of national competences and independence. This may well not be acceptable to countries that are not used to top-

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down Napoleonic-style dirigiste government such as the Scandinavian countries and, of course, the UK. The price of propping up EMU is clearly high. 10. The determination of the fiscal rules depends on whether the aim is to impose them on countries or to use them as guidelines to help countries achieve a sustainable fiscal stance on their own. For example, a balanced budget rule if followed would clearly remove the threat of debt build up and the need for cross country bailouts and debt resolution schemes. But it would entail an economic cost as countries would then not be able to smooth temporary shocks using debt finance.( Already asymmetric shocks cannot be dealt with by monetary policy due to EMU.) Countries would have either to change their expenditures or their taxes. Both are blunt instruments that impact on the economy, and hence public finances, only after a sizeable delay. This would make it difficult to balance the budget. The same is true of the Maastricht conditions which are probably why they were not adhered to. 11. The optimal rules for fiscal policy are rather different from those envisaged by the Commission and can be implemented independently by countries without the need for external rules. These require that current expenditures and debt interest are financed by taxation; capital expenditures may be financed by debt - and hence future tax payers - in proportion to the benefits gained by current and future tax payers. Health, education and welfare should be treated as current expenditures. Temporary shocks to expenditures and tax revenues can be debt financed. 12. In the long run all expenditures must be paid for by taxation. This may create a problem that is rarely considered but which lies at the heart of the problem of fiscal and debt sustainability. It may be that governments do not have the ability to raise sufficient tax revenues to pay for their desired level of expenditures. A consequence of this is that, looking forward, future expected fiscal surpluses may be too small to pay off existing debt. This is the key issue that determines whether a government is solvent or not. It should also be the basis for determining credit risk and credit ratings. Clearly this has not been the case to date. This was why the financial markets failed to price sovereign credit risk correctly. Greece for example failed this test even before it joined the single currency. I would recommend that the Commission include such a calculation as part of their fiscal monitoring process.13 13. The successful implementation of these fiscal procedures would remove the threat of government insolvency, bailouts and inter-country fiscal transfers, the need for a banking union and ever closer political union. This is because countries would be successfully managing their own public finances and markets would be willing to lend at the right price. It would also remove the need for the citizens of eurozone countries to have a say in the fiscal policies of other countries in order to control their liabilities arising from bailouts. 14. If the threat of government insolvency were removed then it would be not be necessary for the eurozone to seek full economic convergence in order to maintain EMU. In any event, it should be considered as a long-term goal as it cannot be achieved quickly and would not provide a short term remedy for the travails of EMU. Productivity differences and hence real wage dispersion will continue for a long time. This would impair the effectiveness of National Competitiveness Boards. In reality neither economic

13 A description of how this might be achieved may be found in V.Polito and M.R.Wickens, “Sovereign credit ratings in the European Union: a model-based fiscal analysis”, European Economic Review, 2015, 78, 220-247. 350

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convergence nor competitiveness are something that can be achieved through legislation; they are the outcome of market forces: competition and capitalism. Legislation (red tape) and policy coordination are unlikely to help. Bank Union 15. The main purpose of the proposed banking union is to facilitate a market solution to insolvency and to avoid tax payers’ money or monetising debt. If risk were priced correctly a banking union would not be required. 16. It is clear that central banks have limited tools with which to deal with imminent sovereign default. Ultimately, they have to transfer the risk to themselves by buying a country’s debt at an inflated price and issuing money through QE to pay for this – at least in the short term. Alternatively, governments can, of course, take the debt on to their own books as the Irish government did. Bailing out another country such as Greece involves similar choices. 17. The Report states that “in a monetary union the financial system must be truly single or else the impulses from monetary policy (e.g. changes in policy interest rates) will not be transmitted across its Member states”. It is not clear exactly what this means. If it means that interest rates should be the same in all eurozone countries, or that the response to changes in the policy rate should be the same in each country, then a single financial system would not be desirable. One of the problems of eurozone monetary policy has been that the ECB has sought to create a uniform interest rate across member countries irrespective of their different financial risks. For the reasons explained above, it would be far better if borrowing rates reflected country risk rather than be uniform. Financial markets should be fully integrated – i.e. capital movements should be free – but monetary and financial policy should not aim set a single interest rate.

Fiscal Union 18. I have little to add to what I have said above. In my view a fiscal union is very much a second best solution to that of governments adopting the type of sustainable fiscal policies described earlier. Governments should inform the Commission about the sustainability of their fiscal stances and the Commission should advise governments on what they need to do for their stances to be sustainable. Democratic accountability etc and the UK 19. It is clear that these proposals on economic policy in the EU and the regulations on banking and capital markets are designed to sustain EMU. The principal benefit for non- EMU countries would be if these proposals did improve the economic performance of the eurozone. But they have little relevance for non-EMU countries otherwise. 20. The concern for non-EMU countries is that in time there will be pressure for the rules to be imposed on all EU countries. Clearly, these reforms would create an increasingly centralised EU. It is inevitable that the EU will seek to impose its rules on all EU countries in an attempt to achieve ever closer union. 21. If the UK stays in the EU the main threat to the City of London would be self-inflicted due to mispricing the riskiness of eurozone assets and liabilities. I would include banking regulations as part of the process of pricing risk. Regulations can be both a cost due to reducing the profits from making risky loans, and a benefit due to avoiding the write- downs on failing loans. One might ask why banks don’t make these assessments for themselves without the need for regulations as they are in their own self interest. The

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answer is that the regulations are designed to lower the risk of the tax payer having to bailout the banking system as a result of the “too big to fail” problem. In other words, the presumption behind banking regulations is that the tax payer has a lower appetite for risk than the banking system. Being able to transfer risk to the tax payer in extremis partly accounts for this. Conclusions 22. The proposed reforms are designed to save EMU and may not be directly relevant for non-EMU countries. The commitment to EMU is causing the EU to adopt ever more top- down rules and is driving the EU towards ever more political integration in order that countries can better control each other’s fiscal policies and thereby avoid taking on the fiscal liabilities of other countries. The reforms themselves are in principle unnecessary if sustainable fiscal policies are followed by each country and markets price risk correctly. The rules proposed are not the correct ones to follow. The proposed rules on banks and capital markets and further political integration would be unnecessary if fiscal policies were sustainable. A better functioning eurozone would be a benefit to all EU countries but these reforms are a second best way to achieve this.

25 November 2015

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Thomas Wieser—Oral evidence (QQ108-117)

Evidence Session No. 10 Heard in Public Questions 108 - 117

WEDNESDAY 27 JANUARY 2016

Members present

Baroness Falkner of Margravine (Chairman) Lord Butler of Brockwell Lord Davies of Stamford Lord Haskins Earl of Lindsay Lord McFall of Alcluith Lord Shutt of Greetland ______

Examination of Witness Thomas Wieser, Chair of the Economic and Financial Committee, European Council

Q108 The Chairman: Thank you, Mr Wieser, for agreeing to give evidence to us today for our inquiry into completing Europe’s economic and monetary union. This session is on the record and we will take a verbatim recording of the proceedings, which will be published in due course. You will have the opportunity to correct any minor errors or misunderstandings. If it is acceptable, I will start by taking you straight to an overview of the Five Presidents’ Report and whether you think that its elements are politically and economically achievable in the short term, but then of course in the longer term as well, and what your views are on it as related to the four Presidents’ report, which some of our witnesses have also raised. Finally, in your opening remarks, could you touch on what you hope to find in the White Paper in 2017? Thomas Wieser: That is for starters? The Chairman: We have an hour, but there are other questions as well. Thomas Wieser: The offer that only minor errors can be corrected but general incompetence or stupidity cannot is a threat. The Chairman: We are not expecting any of that today. Thomas Wieser: Still, I shall try to be brief because that minimises gross error. Thank you very much for coming; it is always a pleasure and surprise. You are the only parliamentary 353

Thomas Wieser—Oral evidence (QQ108-117) group, Europe-wide, that is genuinely interested in European questions, it appears. Almost everybody else appears interested only in national questions rather than European questions, so thank you for being here. In my view, the Five Presidents’ Report shows very clearly that, in terms of economic policy co-ordination, the euro area but also the European Union has by and large used up all the constitutional space offered by the present treaty. If you look at the short-term measures that are proposed there, they are not exactly very far- reaching, even though many people would dispute that. Better co-ordination in the International Monetary Fund, setting up a European Fiscal Board and so on may be important contributions but they are not sea changes in how one conducts business. Possibly the only exception to that is the completion of banking union, where a proposal for a European deposit insurance scheme is on the table, and I am sure that this was touched on yesterday. The Chairman: We will come to that in our conversation. Thomas Wieser: Very good. This shows economic policy co-ordination as we now know it— fiscal policy co-ordination or co-operation, whichever way you want to define it—and all other issues are more or less as developed as can be. For some people this is more than enough, whereas others consider that more would need to be done, especially if you want to further develop and deepen economic and monetary union. In my view, that implies, as the Five Presidents’ Report shows, sometimes explicitly but mostly implicitly, that in order to have deeper co-operation, which is deemed necessary for stable and durable monetary union, you need changes in the constitutional balance between member states, national parliaments and national Governments and Brussels, whatever “Brussels” may be. The clearest case is that of fiscal union, as it is called. If you want more oversight over national budgets, or if you want better co-ordination between national budgets, or if you want a meaningful euro area budget, you will need treaty change. These three examples show that there is a wide diversity of views on why one would want something called fiscal union. It is not a debate that is carried out in a very transparent manner. There is some very nice literature, incidentally, on Catholic versus Protestant attitudes towards the euro—it mainly stems from Germans and it is very interesting—as well as on Catholic versus Protestant attitudes towards fiscal discipline. I shall let you discover for yourself what the two confessions say. North of the Alps, the issue of how to increase fiscal discipline is dominant whereas the conjunctural stabilising function is more to be found south of the Alps. Whichever side one is on, if you want a greater, binding say on national budgets or if you want to transfer budgetary competences to Brussels, you need to do something constitutionally. In my view, this would be a constitutionally larger step than actually joining the European Union. You would have to have treaty change, you would definitely need referenda in the vast majority of member states, and then you would have to settle on what the democratically accountable body in “Brussels” would be. If you talk to Martin Schulz, there is no question what he considers to be the democratically accountable forum. You could have other set-ups, such as the budgetary assembly or budgetary committees of national legislatures—you know all this anyway—but all this is for my successors to start debating. For me, that is the big thing about step 2 in the Five Presidents’ Report: it is a possible gateway to such constitutional changes. As there is absolutely no appetite for these issues among member states at present, it would probably be a good idea to produce something further down the road. The only problem, of course, is 354

Thomas Wieser—Oral evidence (QQ108-117) that as time goes by, you come to the magic date of mid-2017, and we will see what the wise men and women put together in the mean time. The big difference between the Four Presidents’ Report and the Five Presidents’ Report is possibly that the Four Presidents’ Report was maybe the bigger picture. It was more courageous, in a way; it was holistic; it was written at a time of crisis; and we managed to implement large parts of the banking union part of it. The Five Presidents’ Report, however, possibly already reflects the political realities coming out of the euro area crisis.

Q109 The Chairman: One of our witnesses suggested to us yesterday that they expected quite significant legislative change after the French and German elections are out of the way and the White Paper is produced in 2017. Do you expect that? It does not sound like you do. Thomas Wieser: No. On the completion of banking union: we will come to EDIS afterwards, and that is already a very complex project. An even more complex and constitutionally challenging project, such as deepening monetary union or completing it through a fiscal union and something that is democratically accountable, requires many years, I would say, and a long period of national joint analysis, soul-searching and political debate, and I sincerely doubt that there would be any legislative consequences this decade. The Chairman: And do you think we have enough in the armoury now for the euro to be considered sustainable? Do you think that the risks of a future euro crisis could be averted through the mechanisms that we currently have? Thomas Wieser: The euro area has gotten better and more stable. Actually, the euro crisis was such a perfect storm, in a way, because it brought together the problems stemming from convergence euphoria and of high-interest-rate member states joining a low-interest- rate monetary union and, let us say, the credit bubbles that came with it. At the same time we had all the problems of maladjustment to globalisation, which are more prevalent in some member states than in others. We had all the problems of malsupervision in the banking and financial services industry, and so on. That all came together, boom, with a match thrown on to the bonfire called Greece. But Greece was just a symbol, in a way. Are any of us, either inside or outside the euro area, perfectly insulated from the next storm? Definitely not. Are we better equipped? Definitely yes. At the risk of being slightly unorthodox, and getting ahead of myself, deposit insurance is not one of the major constituent pillars of making banking and monetary union significantly more resilient. It would be good to have but one does not desperately need it. However, in order to minimise future risks: first, progress on more enforceable fiscal discipline; secondly, an economically sensible set of rules for fiscal policy; and, thirdly, an EU budget that had countercyclical properties would definitely be highly desirable in the medium to long term.

Q110 Lord Haskins: I accept your point about stability, and clearly there is much greater stability than there was, but is that possibly at the expense of economic dynamism? Have the economies of Europe lost their momentum as a result of the measures that have been taken? How does one recreate that dynamism, which was a part of the EU for so many years?

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Thomas Wieser: I think it comes down to the question of whether one agrees on what the causes of the crisis were. You could say that there are two schools of thought. One is that the European economies went to sleep at the steering wheel, given increased global competition, and procrastinated with their adjustment processes. They covered up the problems stemming from competition, Latin America, Asia and so on—early retirement schemes, for example; Greece increasing transfers to keep people out of the labour market; or shifting government expenditures from investment to government consumption, and so on—which made them less dynamic and less adjustable. The other, not incompatible, school of thought would be that had you left the Greeks with the drachma, the Portuguese with the escudo and the Italians with the lira, exchange rate adjustment would have been a necessary and sufficient condition for their remaining competitive globally. Obviously there are elements of truth in many competing theories, but my main theory is that many of the European economies just felt too safe and secure in their old achievements and most of them did not adjust to global competition. This is one of the main reasons for a certain lack of dynamism. There are two or three adjustment models. One is the US: we just let global competition happen, and the effects on income distribution are as they are. Or you can do as the Swedes do: invest heavily in education, research and development and innovation, and move more people up the value-added chain so that the number of those who feel the negative effects of globalisation is minimised while the number who profit from it is maximised. Or you can do it like unnamed countries on the continent where you just shovel money on to the problem, and in the short term people appear not to feel the effects of globalisation because they do not become obviously unemployed, (through unemployment insurance, employment in the state-owned sector and so on). Getting many of the European economies out of this trap would probably do the trick and reinvigorate both Europe as a whole and individual economies. There are individual problems stemming from joining monetary union, of course. You could say that Portugal, for example, felt that it had no need to work on its productivity because it felt safe in the safety net of Europe. That proved to be a short-term and medium-term answer but not a long-term one. Lord Davies of Stamford: I just wanted to disagree, with great respect, with something you just said about the importance of retail banking insurance issues in the future of the euro. It seems to me that there are two problems with allowing a retail banking system to rely on the creditworthiness of an individual member state. One is that in normal times that leads to people having an incentive to hold their deposits outside their member state in a safer member state, as they see it, so you will probably have a move of liquidity from the local, less productive economies—which is exactly the opposite of what you want, and there will be a higher cost of capital in those economies because those banks will have to pay more for their deposits and will therefore have to charge more for a loan. I think that that is a long- term structural problem. The amounts of money involved may not be very great in normal circumstances but it is a problem in the wrong direction, if you see what I mean. Secondly, but most importantly, the absence of mutual responsibility for retail deposit insurance is a terrible trigger for a crisis, because it means that if there is a systematic shock affecting one member state and the finances from that state appear to be deteriorating— the local bond market falls and so forth—immediately there are questions about the solidity 356

Thomas Wieser—Oral evidence (QQ108-117) and reliability of the retail banking deposit system, so people rush to put their deposits elsewhere. A small problem with the local member state’s finances becomes a major problem, with a run on the banks. Those risks are very major and it is very important—not, as you were suggesting, rather a secondary issue—to achieve some solution with the retail deposit insurance scheme. Thomas Wieser: I would not completely disagree with you. If you take the single elements of banking union, for me the most important one was having the single supervisor to get rid of, let us say, the industrial policy type of banking supervision that we witnessed. Incidentally, something that is normally taboo in this town is that, if you run a single competition policy in an internal market, there are good reasons to believe that unified oversight - single supervision - is more part of the internal market than it is of monetary union—but that is a different issue. Lord Davies of Stamford: In any case, you could not possibly have—or even suggest having—mutualisation of retail banking deposits unless you had common supervision because, first of all, you need to be sure that all the banks are subject to the same levels of supervision and control. Thomas Wieser: We have moved on to deposit insurance now. I was not trying to suggest that deposit insurance is irrelevant. Firstly, all the measures that would make all member states agree to joint deposit insurance are just as important as deposit insurance itself. I refer to anything that produces significant convergence to a level playing field, on the one hand, and what we are also talking about—the code word nowadays is “de-risking”— on the other hand. For example, what is the regulatory treatment of sovereign exposures, does one have a sovereign debt restructuring mechanism, et cetera? Deposit insurance without a joint fiscal backstop is also something different, psychologically and legally, from a deposit insurance with one. I would agree that without joint deposit insurance you would probably have some capital movement or deposit movement in the time of sovereign stress, but I still maintain that it is not one of the main constituents of banking union. Also, once you have completely unified conditions of competition, there is the question of what a euro area or banking union-wide banking sector will look like. If the main conditions of competition have been completely harmonised or have strongly converged, do we then still have a German bank, an Italian bank, a Spanish bank, a Portuguese bank or do we have a system where possibly the bank is domiciled in the country that offers the best tax treatment? It is not totally inconceivable that in 15 or 20 years’ time the vast majority of European banks could be situated in, let us say, Luxembourg because of favourable tax conditions. In the US, we have similar effects without anybody doubting that they are American banks. For some peculiar reason, not all of them but some of them are domiciled in Delaware and some in California. That would, of course, presuppose that you have a completely unified system of deposit insurances and then it does not matter in which bank and where deposits are located. It is more a question of how credit is given to firms on the periphery. Can the system support growth and jobs in peripheral countries just as well as it does now where you have nationally owned banks? Lord Davies of Stamford: Did you say that the Americans have been through all this? Thomas Wieser: Yes.

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Q111 Lord Shutt of Greetland: You mentioned an alpine divide earlier but, as far as the report is concerned, what has been the response from member states? Are there distinct groups of member states that coalesce around particular facets of completing EMU and who are they? Thomas Wieser: The overall debate of the Five Presidents’ Report at the Council and at the European Council has not been extremely vigorous and the calendar in the report is obviously a result of such discussions. That is to get on with the short-term business and then we will sit down and discuss it again. Everybody is well aware of the significance of the 2017 calendar. There has, however, been a spirited debate about the separate elements of the report and— I apologise—we come back again to deposit insurance, where there is a very clear divide between what you could call the “mutualisers” (in favour of instant mutualisation) versus the risk reducers. This is a debate that we had not only with regard to deposit insurance; we had more or less the same debate when we were constructing the Single Resolution Fund, the Single Resolution Board and the whole question of bank resolution. What is the backstop for national resolution funds or, in the case of banking union, what is the short-run and long-run backstop of the Single Resolution Fund, which over the next years will be progressively mutualised? That is a debate where I have also been under significant pressure from many colleagues to move this forward and start working instantaneously on making the European Stability Mechanism the backstop for the Single Resolution Fund. Others have pointed to past political agreements where, only at the end of the transition period in 2023, will such a question be resolved. Whenever we come to the question of mutualising backstops or fiscal responsibility now, later or never, there has been a very clear debate at the level of finance Ministers and their deputies. This is a debate that goes across banking union, fiscal union and the like. There is less of a debate amongst my colleagues on the issue of democratic accountability. This is more exogenous, as it were. Lord Shutt of Greetland: Are there any elements where you would say it is just not going to go anywhere? Thomas Wieser: One thing I have learnt over the last years of this crisis is that at times of stress, and sometimes even at times of less stress, the unexpected happens. Linear interpolations will probably not produce good forecasts, but you would have to have some unexpected turns of political will and consciousness to jump over the next constitutional steps.

Q112 Earl of Lindsay: If you look at all the proposals and developments that are planned for the completion of economic and monetary union, what do you think the direct and indirect impacts would be on the non-euro member states, in particular from the United Kingdom’s point of view? Thomas Wieser: Always assuming we are talking about EU members, I would presume that the effects are second-order or third-order effects only. A higher degree of stability in times of great economic stress is obviously most important for those directly concerned, but also for those only indirectly concerned. A higher degree of fiscal co-ordination and co-operation is eminently relevant for those who do it, but irrelevant for those outside monetary union.

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The sea change for non-euro area members in banking union was the setting up of the single supervisor. Having a unified deposit insurance scheme, if it ever comes about, does not make any additional difference, I would say. If you had a complete and perfect banking union, it would probably be that much easier for British financial service providers to do business within monetary union. You have, much more clearly, one single regulatory regime right across the whole spectrum of issues. I do not see any additional problem of co-ordination between ins and outs that is not covered currently by the rules of the EBA in London. Try as I may, I cannot think of anything negative, but I will get back to you if I do. Earl of Lindsay: Do you not think that there might be some unintended consequences? One scenario might be where the euro member states, in the decision-making, governance and oversight that they will be exercising as a euro group, might drift into making decisions, albeit informally, which are then implemented across the entire EU group. Thomas Wieser: You sound like George Osborne. There is that concern. I have been debating this with my British colleagues for the last 10 years or so. I have been in every single euro group meeting since the setting up of the thing and I cannot think of a single instance where there was this sort of, “How will we vote? What will we discuss tomorrow in ECOFIN?” It has never happened, but one has to realise that there is a concern and you have to deal with it. Earl of Lindsay: How? Thomas Wieser: This is part of the four and a half points of Mr Cameron’s initiative, so the answer will be forthcoming. You will see the European proposals to this question within a week—actually not “European proposals” but Brussels’ proposals. The Chairman: Are they not eurozone proposals? Thomas Wieser: Mr Tusk is very much the President of the European Council and not of the . Earl of Lindsay: Can I just check one other angle? Is the landscape around this question, this concern, principally one between the euro members and all the non-euro members or is it principally one between the UK and the rest of the member states? Are the other non-euro member states also sharing those concerns? Thomas Wieser: I was just thinking of the minuting of the meeting; I was not reflecting on your question. Traditionally, the UK and Sweden have had a very good spirit of co-operation and, therefore, the Swedish colleagues tend to echo the concerns of the UK representatives. None of the others do. That does not mean that they do not have concerns, but I would say that there is one and only one area where you could argue that there is a grey zone between monetary union, banking union and the internal market, and that is financial services. The vast majority of outs have very little active interest in the policy-shaping of financial services. They are regulation-takers whereas the UK is more of a regulation-shaper and, therefore, the concern is legitimate. Even under internal market rules I can remember only one limited instance, which is at least 10 or 15 years ago, of when the UK was outvoted in any financial service dossier. The Chairman: Is that the financial transactions tax? Thomas Wieser: No. Firstly, it does not exist; secondly, it is under closer co-operation; thirdly, it is not there yet; fourthly, it was something to do with investment firms or

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Thomas Wieser—Oral evidence (QQ108-117) something like that. It was a fairly trivial piece of legislation some time between 2000 and 2005, I cannot remember. Other than that, in 20 years the UK has never been outvoted, but things may change. Some of the models that have been discussed—and we will know more in a month or two—are that you have very specific modalities of voting arrangements or delaying arrangements or reflection arrangements in such areas of concern, where there might be a presumption that the members of the euro group have joint interests that they would try to impose on outs. By the time the minutes are written we will probably know exactly what the proposal is—and possibly even the result. There is, of course, a legitimate concern of the ins that the UK, if it does not like a legislative proposal, might simply claim that this is related to monetary policy or banking union even if it is a very clear internal market dossier. The concerns go both ways and that is why one has to realise that there is no way of, ex ante, totally meticulously and precisely defining where the thin dividing line between monetary policy-related dossiers and internal market dossiers is. There will always be a grey zone. What one can do is try to keep the grey zone as small as possible and find a decent arrangement for solving what is in the grey zone. The Chairman: Thank you. That is very helpful. Lord McFall.

Q113 Lord McFall of Alcluith: I know that the European Semester is something that you have been very much involved in. You mentioned the issue of democratic accountability earlier on in answer to one of the questions and I believe you mentioned that the European Semester, in your view, was more of a non-political process. If you accept that economic and fiscal policy co-ordination in Europe is essential, do we not need political buy-in if we are to achieve that streamlined economic and fiscal policy co-ordination? As far as creditor countries go, what means do you have, other than that, of ensuring that they reform? Thomas Wieser: That is a very good question and, unfortunately, one to which there is no brilliant answer. If one spends most of one’s professional life within the Brussels bubble, one tends to think that the European Semester is Europe’s answer to sliced bread or whatever— everything. It is the instrument of European policy co-ordination. Then you take a train out of the Brussels bubble and you go to a capital and you say, “What do you think of the European Semester?” and the people say, “European what?” On paper, the European Semester is an answer to the collective responsibility that all 28 member states have under the Treaty for co-ordinating or closely co-operating on economic policies in general and in the fiscal area very specifically under the Stability and Growth Pact. Much of that is then enshrined in country-specific recommendations. The degree to which member states follow or take seriously the country-specific recommendations differs enormously. That is already quite optimistic. “It leaves something to be desired” is probably the correct wording. Why is that? There are two ways to look at deficiencies in economic policy co-operation, if you think that ever-closer co-operation is desirable. One is the more coercive way, by threatening fines, withdrawal of structural funds, stepping up of procedures and the like, and my personal opinion is that all attempts at doing that have not been successful. The second way would be by increasing political accountability, political buy-in. What has happened so far is that all measures of economic policy co-operation have increasingly bypassed national parliaments, which implies that the national buy-in, the know-how of

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Thomas Wieser—Oral evidence (QQ108-117) what is being suggested, more or less stops at Brussels airport. Ministers come in; they attend ECOFIN and other Council formations; they read what is suggested for their country; they take the piece of paper back home. It is not discussed in the national media; it is not discussed by social partners; it is not discussed in national parliaments. How should it then enter national policy-making? What is contained in these country-specific recommendations is 100% the policy responsibility of the individual member state. It ranges from fiscal sustainability, labour market reform, and in the case of Germany, setting up early learning centres and kindergartens. All of this is national policy, but you are addressing it into a vacuum above the heads of national policymakers. That is why I believe that the involvement of social partners and national parliaments is the only way of bringing about any improvement. It may not produce any improvement, but at least it gives the chance for improvements.

Q114 Earl of Lindsay: Within the existing regimes, such as the Stability and Growth Pact, there is already the means of imposing fines. Can you ever envisage the situation where fines are actually imposed and levied? Thomas Wieser: Again, we come to the question of linear interpolation. If we take past experience, one would probably say that the motto of the Commission is, “Fines are fine, but no fines are finer”. Having witnessed the anguish of member states, especially finance Ministers and Prime Ministers, when the procedure is considerably stepped up but still a long way from imposing fines, I would think that the threat, ultimately, of fairly significant fines being implemented is not taken very seriously by member states. Lord Davies of Stamford: What about the withdrawal of structural funds? Thomas Wieser: There was one attempt eight years ago, I believe, in the case of Hungary. It was a very divisive debate. It hurt more member states than just the Hungarians. It resulted in not very much. Obviously, the threat was never acted upon and the result was not that Hungary changed its fiscal policy stance but simply that there was a political division between the European People’s Party and the social democrats in the Council. It was not a very edifying experience.

Q115 Lord Haskins: I wanted to ask a question about National Competitiveness Boards. Some of us are somewhat sceptical about their merits and value, in that they should be there already. If competitiveness is an issue, national governments should be looking at it and dealing with it themselves. What are the five Presidents going to add by establishing National Competitiveness Boards, which would be ducking the issue of structural reform? Thomas Wieser: This is a concern that I have heard from a number of member states. In normal or good circumstances, the issue of macroeconomic productivity increases, competitiveness or whatever you want to call it should be not totally but quite central to national policy-making anyway. In some countries, this is indeed the case. You have sometimes formal and sometimes informal institutions that provide advice or guidance to policymakers. These range from institutions such as Social Partnership in Austria to the Centraal Planbureau in Holland, but there are member states where such issues are not publicly discussed and those are the member states which, arguably, have the larger productivity problems.

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Those member states that, I would argue, have no or less of a problem are those that already have such formal or informal institutions and, as a rule, they would say, “We do not really need the Commission telling us to set up an institution of our own, we already have something. There is no need to change it, produce a new hat or something”. For those that do not have such institutions, there are usually clear but bad reasons why they do not discuss such issues. It could be that there are national oligopolies that would prefer to remain fairly un-transparent, or organised labour relations, which are run in a manner that is detrimental to competitiveness or productivity, or simply that the political system does not know how to handle such an informal advisory group, which would be at its best if it simply increases transparency on the policy consequences of policy proposals. I am sure that I do not know all 28 set-ups but, for me, the stellar example is the Centraal Planbureau in Holland, which goes as far as quantifying the electoral proposals of political parties. You have to be pretty careful of what you are promising the electorate, because the Centraal Planbureau will come out before the election and say, “This would increase the deficit to 10% of GDP” or, “This is utter nonsense, because it does such and such to the economy”. That is brilliant, but it is only in a Calvinist society like the Dutch that the political system can stand having such a thing. The Chairman: We have independent think thanks to do the same for us, and the figures are always contested. Thomas Wieser: Yes, but that is actually a government-run institution, which makes it singular. The state is its own watchdog, in a way, and it works. I know many countries where you could set it up like that but it would never work.

Q116 Lord Butler of Brockwell: We have talked about banking union. We have not really said anything about capital markets union. Do you think that that is both an important contribution to carrying forward co-ordination and also a more practicable one in the short term? Thomas Wieser: Capital markets union was not something that was devised top-down as was, you could argue, banking union. It was more a bottom-up procedure that collected a wide variety of already existing proposals, had a look at them to see if they were complete enough, added a few, took existing analyses about the structure of financing of the European economy, tied a nice ribbon around it and called it “capital markets union”. That is very important, because it improves the quality of the debate, it makes it politically more visible and it increases the probability of rapid passing of legislative acts, because people know why they are doing it. It creates a big picture into which you can fit the individual measure, such as securitisation, and it shows the wider audience how things hang together. It is a good complement to banking union, in a way, even though banking union was much more about the supervisory regime, whereas capital markets union, as far as I can see, has no supervisory elements, only legislative elements. There is, of course, the hope that the structure of financing of the European economy will change towards more equity, capital market-based financing and less credit-based financing, but there are very few people who would expect a sea change there within two or three years. I hope that will be a gradual process. I am quite optimistic that it will bring about

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Thomas Wieser—Oral evidence (QQ108-117) change, but one should not believe that in 2020 we will have a structure of financing the economy similar to the US economy. Lord Butler of Brockwell: It is perhaps more a matter for the 28 than the members of the euro, but do you also consider it relevant to reinforcing the euro as a currency? Thomas Wieser: Frankly, I have never considered it as being of central importance to monetary union. To the extent that it is good for the 28, it is obviously good for the 19, but that is all there is to it.

Q117 Lord Davies of Stamford: I want to ask about fiscal union. Views on fiscal union seem to fall into three categories, as I see it. One is what I think of as the prescriptive disciplinarians, people like Schäuble and Trichet, who think that the solution is to have very strict rules on fiscal deficits, to enforce them fiercely, as you have mentioned, to have everybody adopt plans for productivity improvement, competitiveness improvement and so forth, and to make sure that those are all enforced and that will be the end of the problem. The second category is people who say that fiscal union should require the structuring of permanent transfers in the union, analogous to what happens within member states. The third category—I think of them as the Aristotelians, which shows where I am coming from— would take the view that it was a disastrous idea to have permanent structural transfers, because that just creates a phenomenon of dependency and creates the problem that you are trying to resolve.

What is inescapably necessary, though, for effective monetary union is some mechanism for absorbing asymmetric shocks and you cannot rely entirely on the capital markets to do that, for reasons I will not go into. What you really need is to have, of course, rules on fiscal deficits and improvements in competitiveness, but the third element needs to be measures providing some absorption of asymmetric shocks.

There have been two suggestions that seem to me to have some promise in that context. One is the idea of having an unemployment fund, which would be a reinsurance fund covering the cyclical, not the structural, elements of unemployment and that could be structured in various ways. The second is to have a kind of EU-based IMF working as the IMF does, which has always worked on the basis of conditionality and providing liquidity to countries with short-term deficit problems of a fiscal or current account nature. Is that a fair analysis? If so, do you think that those proposals for contributing to automatic stabilisation are constitutionally, legally and practically feasible? Do you have any other suggestions in the same direction? Thomas Wieser: I will send you my book once I have written it. I touched upon the three elements of how you could possibly look at fiscal union in one of my previous interventions. They are three reasons which are not mutually exclusive and, if you go back and read One Market, One Money from 1992—Michael Emerson was one of the main authors—you will find many of these issues mentioned there. I once asked Jean-Claude Trichet why the Maastricht Treaty was so incomplete and he said, “Young man, it was all there in the first draft but the politicians took everything out”—so you cannot fault the drafters of the Maastricht Treaty for intellectual mistakes. It was politics, of course; the time was not yet right.

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Everybody who agrees with the concept of fiscal union would agree on the need for setting up a central budget that has a stabilisation function, with the presumption that asymmetric shocks, over time, will be more or less evenly distributed around the euro area, possibly not quite so. If you look back at the history of monetary union, the incidence of exogenous asymmetric shocks has not been very high. Lord Davies of Stamford: Exogenous shocks are mostly symmetric. Thomas Wieser: Exactly. That is why there would be less of a distributional problem across monetary union. You will be talking to colleagues from think tanks. Bruegel has been working on the issue of a joint unemployment insurance scheme. It presented such a paper to finance Ministers around a year and a half ago, which was fairly well received. It was under the Italian presidency exactly one and a half years ago. Prima facie there are quite a lot of possible negative incentive effects if you have such a joint unemployment insurance scheme. Lord Davies of Stamford: It must apply to structural unemployment. That is the important point. Thomas Wieser: Exactly. You can deal with it, indeed, but you need to take care that you have a grip on national policies that would push people from pension schemes into unemployment schemes, because for the national pension scheme you alone are paying, whereas for the unemployment scheme you have co-financing. There is a huge amount of second-round and third-round effects that you have to think through, but that can be dealt with. There is nobody who thinks you should have fiscal union who would say that you do not need joint fiscal discipline. You will not find anybody who would say that you do not need a joint stabilisation function, but you will find people who would say that you should not have a permanent transfer mechanism. My response is that you do have a permanent transfer mechanism; it is called the structural funds and actually, in the case of Greece, the present co-financing rate is 0%. What you have is already that. It is not explicitly or even implicitly linked to monetary union, but Greece is getting 4% or 5% of GDP per annum in what, in balance of payment terminology, is called “unrequited transfers”. Opinions may differ, but the reality is already partially there. The European Monetary Fund, in the form of the ESM, is more about fixing a problem once it has surfaced. Fiscal union is more about preventing such problems from popping up. The Chairman: Mr Wieser, we have to bring the session to an end because we are in danger of running into our second session, but if you have any other thoughts we would be delighted to hear them. Perhaps you could send them in writing to the office. We are hugely grateful to you for giving us your time. It has been invaluable to the Committee and we will send a transcript for you to look at. Thomas Wieser: However, I am only allowed to rectify the minor mistakes and not the larger ones. The Chairman: As you know, everyone hangs on to everything you always say, so thank you very much indeed. Thomas Wieser: Thank you very much for your interest.

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Guntram Wolff, Hans Hack and Fabian Zuleeg—Oral evidence (QQ118-128)

Guntram Wolff, Hans Hack and Fabian Zuleeg—Oral evidence (QQ118-128)

Transcript to be found under Hans Hack.

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Fabian Zuleeg, Hans Hack and Guntram Wolff—Oral evidence (QQ118-128)

Fabian Zuleeg, Hans Hack and Guntram Wolff—Oral evidence (QQ118-128)

Transcript to be found under Hans Hack.

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