EU ECONOMIC AND FINANCIAL AFFAIRS SUB-COMMITTEE Genuine Economic and Monetary Union Evidence

Contents Professor Kern Alexander—Written Evidence ...... 3 Association for Financial Markets in Europe (AFME)—Written Evidence ...... 6 Professor Dr Ansgar Belke—Oral evidence (QQ 263-272) ...... 11 Professor Agnès Bénassy-Quéré—Oral evidence (QQ 222-229) ...... 24 Graham Bishop, Megan Greene, and Hugo Dixon—Oral evidence (QQ 19-38) ...... 33 Sharon Bowles MEP, Roger Helmer MEP and Syed Kamall MEP— Oral evidence (QQ 209- 221) ...... 51 British Chambers of Commerce and City of Corporation—Oral evidence (QQ 39- 54) ...... 66 Professor Claudia Buch, Professor Jan Pieter Krahnen and Professor Otmar Issing—Oral evidence (QQ 297-315)...... 82 BUSINESSEUROPE—Oral evidence (QQ 148-156) ...... 99 Professor Willem Buiter and Dr Holger Schmieding—Oral evidence (QQ 55-65) ...... 109 Centre for European Reform, John Peet and Open Europe—Oral evidence (QQ 1-18) .... 124 Professor Jagjit S. Chadha and Professor Michael Dempster—Written Evidence ...... 144 John Chown—Written Evidence ...... 146 City of London Corporation and British Chambers of Commerce—Oral evidence (QQ 39- 54) ...... 158 City of London Corporation—Supplementary Evidence ...... 159 Lorenzo Codogno—Oral evidence (QQ 197-208) ...... 160 Tim Congdon—Written Evidence ...... 173 Professor Michael Dempster and Professor Jagjit S. Chadha—Written Evidence ...... 187 Hugo Dixon, Graham Bishop and Megan Greene—Oral evidence (QQ 19-38) ...... 188 Working Group—Oral evidence (QQ170-178) ...... 189 —Oral evidence (QQ 101-108) ...... 199 European Commission—Supplementary evidence ...... 209 European Policy Centre and Professor André Sapir—Oral evidence (QQ 134-147) ...... 218 Mr Nigel Farage MEP—Written Evidence ...... 233 Elisa Ferreira MEP and Liêm Hoang Ngoc MEP—Oral evidence (QQ 157-169) ...... 249 Dr Clemens Fuest—Oral evidence (QQ 89-100) ...... 263 Professor Luis Garicano—Oral evidence (QQ189-196) ...... 274 Professor Kern Alexander—Written Evidence

Megan Greene, Graham Bishop and Hugo Dixon—Oral evidence (QQ 19-38) ...... 285 Anton La Guardia—Oral evidence (QQ 121-133) ...... 286 Professor Mark Hallerberg—Oral evidence (QQ 248-262) ...... 299 Roger Helmer MEP, Sharon Bowles MEP and Syed Kamall MEP—Oral evidence (QQ 209- 221) ...... 313 HM Treasury, Nicky Morgan, Economic Secretary and Peter Curwen, Director Europe— Oral evidence (QQ 316-331) ...... 314 Liêm Hoang Ngoc MEP and Elisa Ferreira MEP—Oral evidence (QQ 157-169) ...... 332 Professor Otmar Issing, Professor Claudia Buch and Professor Jan Pieter Krahnen—Oral evidence (QQ 297-315)...... 333 Syed Kamall MEP, Roger Helmer MEP and Sharon Bowles MEP—Oral evidence (QQ 209- 221) ...... 334 Professor Jan Pieter Krahnen, Professor Claudia Buch and Professor Otmar Issing—Oral evidence (QQ 297-315)...... 335 , MdB/MP (CDU), Detlef Seif, MdB/MP (CDU) and Manfred Zöllmer, MdB/MP (SPD)—Oral evidence (QQ 287-296) ...... 336 Professor Rosa M. Lastra—Written Evidence ...... 347 Professor Rosa M. Lastra—Supplementary Evidence ...... 352 Ruth Lea—Written Evidence ...... 355 Ulf Meyer-Rix—Oral evidence (QQ 273-286) ...... 357 Open Europe, Centre for European Reform and John Peet—Oral evidence (QQ 1-18) .... 369 Marco Pagano—Oral evidence (QQ 78-88) ...... 370 Marco Pagano—Supplementary Evidence ...... 379 John Peet, Centre for European Reform and Open Europe—Oral evidence (QQ 1-18) .... 380 Professor André Sapir and European Policy Centre—Oral evidence (QQ 134-147) ...... 381 Dr Waltraud Schelkle—Written Evidence...... 382 Dr Holger Schmieding and Professor Willem Buiter—Oral evidence (QQ 55-65) ...... 386 Dr Daniela Schwarzer— Oral evidence (Q 230-247) ...... 387 Detlef Seif, MdB/MP (CDU), Bettina Kudla, MdB/MP (CDU), and Manfred Zöllmer, MdB/MP (SPD)—Oral evidence (QQ 287-296) ...... 405 Dr Federico Steinberg—Oral evidence (Q 66 -77) ...... 406 Sir Nigel Wicks—Oral evidence (QQ 179-188) ...... 417 Guntram Wolff—Oral evidence (QQ 109-120) ...... 428 Manfred Zöllmer, MdB/MP (SPD), Bettina Kudla, MdB/MP (CDU) and Detlef Seif, MdB/MP (CDU)—Oral evidence (QQ 287-296) ...... 441

2 of 441 Professor Kern Alexander—Written Evidence

Professor Kern Alexander—Written Evidence

Professor Kern Alexander 1

An integrated financial framework (Banking Union)

3. Will the proposals for banking union decisively break the link between bank and sovereign debt? If not, what more needs to be done? Is the three-pronged model of a single supervisory mechanism, a common resolution mechanism and a common deposit insurance scheme realistically achievable, how long is likely to be needed to achieve it and what are the risks of long delays?

1. Mutual influence of banks and sovereign debt, the so-called “doom loop”

Sovereign-debt exposure in the banking system

The link – or so-called ‘doom loop’ - between bank balance sheets and sovereign debt arises mainly from EU bank capital regulation, which has traditionally set a 0% risk-weight for EEA/EU member state government bonds issued in domestic currency to regulated financial institutions. 2 In addition, government bonds have been exempted from the 25% large exposure limit that has applied to most other risk-based assets. 3 The Capital Requirements Directive IV – consisting of a Directive (CRD) and a Regulation (CRR) – continues to apply in the CRR both the 0% risk-weighting to sovereign bonds issued by EEA/EU states and the exemption from the 25% large exposure limit for sovereign bonds issued by EEA/EU states. The original Basel III proposal for a Liquidity Coverage Ratio permitted only government bonds to be used as the highest quality liquid assets (Level 1 assets) to fulfil the Basel III Liquidity Coverage Ratio. 4 The revised Basel III and EU CRR, however, widens the scope of assets that can be held to fulfil the Liquidity Coverage Ratio requirement, making such bonds merely one of many other admitted liquid assets. 5 Regarding the proposed Single Supervisory Mechanism (SSM), it has little bearing on these regulatory incentives to hold -zone government bonds, prompting some authors to suggest, in addition to the banking union proposals, the elimination of at least the risk-weighting exemptions mentioned above. 6

2. The ECB policies linked to sovereign debt transactions?

Beyond the regulatory incentives to hold sovereign bonds, the ECB’s cheap 3-year loans at 1% interest (known officially as the Long-term Refinancing Operations – LTRO) adopted in 2011 have led governments to turn to their banks as buyers-of-last-resort who – under the

1 Chair for Law and Finance, University of Zurich, and Senior Research Fellow in International Financial Regulation, Centre for Financial Analysis and Policy, University of Cambridge 2 Annex VI Part 1, Pt. 4 CRD; Art. 114 (4) CRR. 3 Art. 113(3)(a) CRD ; Art. 400 (1) (a). 4 The original Basel III Liquidity Coverage Ratio mainly included in its ‘Level 1 high-quality liquid assets’ (i.e. assets that, for LCR purposes, could be held without limits or haircuts, as opposed to Level 2 HQLA), “cash, central bank reserves, and certain marketable securities backed by sovereigns and central banks”, since such assets “are typically of the highest quality and the most liquid, and there is no limit on the extent to which a bank can hold these assets to meet the LCR.” (BIS, Summary description of the LCR, January 2013, available at http://www.bis.org/press/p130106a.pdf 5 Art. 416(1)(c)(i) CRR 6 Daniel Gros, “EZ banking union with a sovereign virus”, Vox, 14 June 2013 (available at http://www.voxeu.org/article/ez- banking-union-sovereign-virus)

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LTRO Programme – can use the ECB funding to invest in sovereign bonds (the so-called "Sarkozy Trade"). Even the ECB itself can, for the exclusive purpose of fulfilling its monetary policy mandate, purchase sovereign bonds on the secondary market. These policies together heavily reinforce the link between sovereign debt and banks (as governments then rely on banks either buying their bonds with ECB money or selling them to the ECB on the secondary market). This situation could well be exacerbated by a new ECB mandate to ensure macroeconomic stability as a bank supervisor in the SSM – thereby making the complete organisational separation between the supervisory and monetary policy arms of the ECB all the more essential as set forth in the SSM Regulation.

3. Failing banks and public finances

While the draft Recovery and Resolution Directive’s (RRD) bail-in tool can shift the burden of a failing bank away from the public finances, some argue 7 that the true debt ratio relevant to a country’s solvency is not the public debt to GDP ratio, but rather its total external debt – both public and private – to GDP, so that by bailing in the (usually) domestic creditors the shift of the debt burden away from the public sector merely moves it to the private sector, which still burdens country’s total solvency ratio in the broader sense. Another RRD fragmentation issue that leaves some sovereigns exposed to failing banks is the inherent differences in the size of resolution funds across the EU, resulting in some countries exhausting their resolution funds faster than others, something that a pooled EU- wide resolution fund could remedy. 8 One could argue that this is not a (dreaded) mutualisation of losses in itself, but rather a mutualisation of an otherwise unused buffer in other countries – leaving their public finances ceteris paribus untouched. Regarding the European Stability Mechanism (ESM), the newly developed direct bank recapitalisation programme requiring euro area national governments to contribute 10/20% of the total ESM contribution unless justified by exceptional circumstances (as well as inject capital should the bank not fulfil the 4.5% Tier 1 equity ratio requirement) has been criticised by some 9 as defeating the tool’s very purpose of breaking the link between failing banks and sovereigns. Indeed, even Olli Rehn, the EU’s economic and monetary affairs commissioner, said that the ESM would merely be “diluting” the link.

4. The European Commission’s proposed Single Resolution Mechanism

The European Commission proposed on 10 July 2013 a Single Resolution Mechanism (SRM) to serve as one of the pillars of the Banking Union that would complement the supervisory powers of the ECB in the Single Supervisory Mechanism (SSM). The SRM is designed to put banks experiencing solvency problems and which are supervised by the ECB/SSM into resolution with minimal costs to taxpayers and to the broader economy. The SRM would apply the substantive rules of the proposed RRD to banks that are supervised by the ECB/SSM. 10 The main requirements of the SRM proposal are the following: 1) the ECB would identify when a bank operating in a state subject to SSM was in serious financial

7 Wolfgang Münchau, „The EU will regret terminating a banking union”, FT of 30 June 2013 (available at http://www.ft.com/intl/cms/s/0/4d433ec6-de93-11e2-b990-00144feab7de.html) 8 Speech by Jörg Asmussen (ECB Executive Board Member) at the Atlantic Council, 9 July 2013 (available at http://www.ecb.int/press/key/date/2013/html/sp130709.en.html) 9 Peter Spiegel, „ESM’s direct recap plan: Really ‘breaking the link’?”, FT Blog of 17 June 2013 (available at http://blogs.ft.com/brusselsblog/2013/06/esms-direct-recap-plan-really-breaking-the-link/) 10 The EU Council of Finance Ministers and Committee on Economic and Monetary Affairs are negotiating details of the SRM proposal and the draft RRD and are expected to reach final agreement on both proposals in the autumn 2013.

4 of 441 Professor Kern Alexander—Written Evidence difficulties and should be resolved; 2) A Single Resolution Board consisting of representatives from the Commission, the ECB, and national authorities where the bank operates would make a recommendation on resolution; 3) the Commission would have ultimate authority in triggering a bank resolution and in approving the resolution plan; 4) national resolution authorities would implement the approved resolution plan under the supervision of the Single Resolution Board; and 5) a single Bank Resolution Fund would be established under the control of the SRB and would be funded by contributions from the banking industry, thereby replacing the national resolution funds of member states participating in the SSM. announced in July 2013 its opposition to the SRM proposal on the grounds that it concentrates too much authority to make the final decision on resolution with the Commission and that any centralisation of resolution authority with the Commission as set forth under the proposal would require EU Treaty changes. Indeed, there is significant controversy regarding whether the Commission is the appropriate institutional body to exercise such powers, as the Commission would be given full discretion as to whether and when an institution will be put into resolution or insolvency. Germany and France have proposed an alternative single resolution mechanism for countries participating in SSM which would be established on the basis of existing EU treaties and on the following principles 11: 1) a single resolution board in SSM consisting of national resolution authorities who would have powers to act expeditiously in triggering and implementing a bank resolution; 2) pre- financing by the banking industry in which there would be national funding arrangements that would evolve over time and eventually converge or join-up with the European Stability Mechanism, in which the ESM would play a broader role in providing lending facilities to member states and direct recapitalisation to SSM-regulated banks as part of the SRM mechanism. 12

Germany’s objections to the Commission’s SRM proposal has occurred in the context of EU leaders postponing their decision in late June on euro-zone economic integration (including the SSM banking union proposal) – a delay some ascribe to the upcoming German elections, predicting even more delays as the EU Parliament will in turn be up for election in May 2014. 13

In parallel with the SRM proposal, the proposed Regulation establishing the Single Supervisory Mechanism, while less controversial, has already seen its ambitious deadline for full ECB powers pushed back from 1 January 2014 to one year after the Regulation’s entry into force – an unpromising prospect at present since the EU Parliament has not yet approved it. The Parliament voted in May 2013 on the so-called ‘March compromise’ for the proposed Regulation for a Single Supervisory Mechanism. The Parliament however decided to defer its final vote on the proposed SSM Regulation until an agreement is reached with the ECB ensuring safeguards for democratic accountability of the ECB's supervisory arm.

The final vote on these additional amendments to the SSM is not expected until autumn 2013. This means that the SRM – if approved by Council and Parliament in autumn 2013 – is not expected to begin operations 2015 at the earliest.

04.09.13

11 See ‘France and Germany – Together for a stronger Europe of Stability and Growth’, (Paris, 29 May 2013) p. 4.# 12 Ibid, p. 5 13 Peter Spiegel, „German politics puts sand in cogs of EU machine“, FT of 28 June 2013 (available at http://www.ft.com/intl/cms/s/0/74d2d4a4-e007-11e2-9de6-00144feab7de.html#axzz2ZxyjaCUm)

5 of 441 Association for Financial Markets in Europe (AFME)—Written Evidence

Association for Financial Markets in Europe (AFME)—Written Evidence

Introduction and Executive Summary:

1. The Association for Financial Markets in Europe (AFME) welcomes the opportunity to respond to the call for evidence by the EU Sub-Committee on Economic and Financial Affairs (“the Committee”) regarding the inquiry into EU “Genuine Economic and Monetary Union” and its implications for the UK.

2. AFME represents a broad array of European and global participants in the wholesale financial markets: our Members comprise pan-EU and global banks as well as key regional banks, brokers, law firms, investors and other financial market participants. We advocate stable, competitive, sustainable European financial markets that support economic growth and benefit society.

3. Whilst AFME is a European trade association, given the importance of the UK markets, both to the as a whole and to the many EU and international firms that have operations in, or provide services on a cross-border basis into the UK, we consider it important to engage proactively and constructively in national debates that determine the environment in which our members undertake their business.

4. In response to the Committee’s call for evidence, AFME considers, that given the specific focus of our recent work so far and the Committee’s expressed desire for brevity, it would be most helpful to the Committee’s deliberations to provide a targeted response. We will therefore concentrate our response on Q3: “An integrated financial framework (Banking Union)”.

5. We welcome the Committee’s inquiry into this important topic, and our members agree that the building blocks for the future of the EMU are an integrated financial framework, an integrated budgetary framework and integrated economic policy framework and strengthened democracy, legitimacy and accountability and that all are essential to stabilising and strengthening EU financial markets.

6. Banking Union represents a key departure for all banks in Europe towards a new supervisory landscape. It is thus important that all parties, both inside and outside the Single Supervisory Mechanism, are engaged to ensure that the forthcoming system is appropriately coordinated and consistent, to the benefit of the Single Market for financial services as a whole.

7. AFME and its Members strongly support the banking union project, which we see as vital to stabilise the euro-area and enhance financial stability. We believe that his major advance in financial market integration will permit the better functioning of the European financial system to support the economy. The establishment of a Single Supervisory Mechanism (SSM) led by the ECB and combined with the responsibilities of the EBA for the Single Rulebook and the Single Supervisory Handbook for the whole EU Single market for financial services, represents a pivotal opportunity to embed a key set of lessons from the financial crisis and move decisively to the implementation of high quality, effective supervision across Europe.

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Detailed Response: Question 3: “Will the proposals for banking union decisively break the link between bank and sovereign debt? If not, what more needs to be done. Is the three-pronged model of a single supervisory mechanism, a common resolution mechanism and a common deposit insurance scheme realistically achievable, how long is likely to be needed to achieve it and what the risks of delays. “

8. AFME believes that a single resolution mechanism is necessary alongside the single supervisory mechanism to complete banking union and to decisively break the link between sovereign debt and banks.

Single Resolution Mechanism and resolution fund

9. AFME considers that a protracted separation of the jurisdictional scope of supervisory and resolution arrangements could give rise to significant inconsistencies and systemic weaknesses. It is thus important that a single resolution mechanism, complementing the SSM, is put in place as quickly as possible, but without this hindering progress on implementation of the SSM.

10. While we consider that a single resolution mechanism is an essential complement to the SSM, we do not think that this requires the establishment of an ex ante resolution fund. This is consistent with the views and arguments that we have put in the context of the current legislative negotiations on the Bank Recovery and Resolution Directive (BRRD) proposal.

11. Mis-pricing of risk and moral hazard were at the centre of the crisis. AFME and its Members have firmly supported, and worked intensively, to contribute to the development of proposals to ensure that shareholders and creditors bear losses in the event of bank failures. We are firmly supportive of bail-in as an important mechanism for allowing this to be achieved.

12. We believe that this work will be undermined if the perception emerges that significant funds are readily to hand to bail out banks that get into difficulties in the future. We believe that the establishment of an ex ante resolution fund would be likely to give rise to such perceptions. We believe that there is likely to be the need for the provision of liquidity for certain banks in resolution. While the immediate provision should be by relevant authorities, there should be an ultimate industry responsibility for any residual shortfall not recovered from the failed bank after the resolution process; this should be by way of ex post and not ex ante mechanisms.

The implementation timetable and dialogue with the industry

13. With regard to the appropriate timings needed to achieve the new regime, we believe that momentum needs to be maintained in order to realise the historic opportunity presented by the banking union proposals. While recognising the scale and complexity of the challenge, we believe that the overall timetable set out in the ECOFIN text represents an appropriate balance between speed and quality. It is important that this balance is well maintained over the coming period in order to maintain market confidence.

14. In this regard we consider that the close involvement of the industry will be essential to success. We welcome for example the requirement in the ECOFIN text that the

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ECB should carry out open public consultations, and we look forward to formally providing input to the forthcoming ECB consultation on the operational aspects of the SSM. Beyond this however, it is important that the perspective of the industry as supervised entities, as well as that of consumers of financial services, should be well articulated and understood by means of ongoing dialogue. In this regard AFME and its Members stand ready to contribute and assist in any way that might be useful.

Challenges of the SSM and suggestions for addressing them

15. We recognise that there are a number of important challenges to be addressed to ensure that:

- the design and implementation of the new framework while timely, is also coherent and effective;

- there are clear and robust arrangements, avoiding gaps and weaknesses, during the period of transition; and

- the establishment of a banking union strengthens the Single Market across the EU as a whole.

The SSM operating framework and Supervisory Relationships

16. As the SSM’s operating framework is still largely undefined, the industry sees an opportunity to contribute to its final design with a view to addressing issues such as the delays firms are experiencing in supervisory approval of internal models and, more generally, duplicative supervisory processes. A strong banking union will be based on high quality and effective supervision.

17. It is important that systemic risk arising from the activities of banks and financial groups, whatever their size or complexity, is clearly recognised as the responsibility of the ECB. Furthermore it is important that the ECB has the appropriate tools to supervise effectively such risks. The ECB should be taking an active supervisory role, and the industry is eager to see a detailed transition plan tabled for the SSM set-up, as regards timing and procedures. In order to avoid duplications and uncertainty as regards roles and responsibilities, a road map setting out the phasing of the transition of supervisory tasks to the ECB and its staff should be established.

18. Any transition programme must consider sources of ‘momentum risk’ – i.e. those risks that might lead to a protracted transition and to supervisory processes that undermine the quality of supervision in the EU – and must optimise the deployment of supervisory resources for model approvals and ICAAP reviews.

19. The ECB should properly and timely communicate its approach to supervision both in terms of how it looks at prudential supervision and how it intends to manage the changing relationships the SSM gives rise to.

20. There will always be a need for a close knowledge of the local environments in which a financial institution operates and in the shorter term there will be important transitional needs to maintain continuity of specific expertise, knowledge and availability of sufficient resource.

8 of 441 Association for Financial Markets in Europe (AFME)—Written Evidence

21. In the initial phase, an approach could be envisaged involving supervisory teams comprised of staff from the range of authorities within whose jurisdictions a firm is active. We believe that it is important, and in line with the legislative text, that such a cross-jurisdictional team should be clearly led by ECB personnel. Over time one could imagine such teams consisting for the most part, or wholly, of ECB-accountable staff with national authorities playing an important role in the provision of information and risk-assessment in respect of the local market environment etc.

22. We stress the importance of dealing with the ‘external dimension’ of the SSM – for example MoUs and bilateral agreements developed by EU home supervisors.

The Single Supervisory Handbook

23. The creation of a Single Supervisory Mechanism should have the effect of deepening financial integration for the European Union as a whole. Firms stress the need to ensure a degree of supervisory consistency between the SSM and the non-SSM zone within the EU single market for financial services. One important way in which this can be achieved is by taking the opportunity to advance rapidly towards a consistent approach to supervision for the whole EU. It is for this reason that AFME strongly supports the development of a Single Supervisory Handbook by the EBA, to sit alongside the Single Rulebook.

24. Such a Single Supervisory Handbook, developed on the basis of agreement between the ECB and the other prudential supervisors, would set out the general approach to, and key aspects of prudential supervision within the European Union. In this respect it is important that the forthcoming ECB supervisory manual for the SSM zone is consistent and appropriately coordinated with the EBA Single Supervisory Handbook.

Potential areas of duplication or overlap

25. We would consider as ‘failure’ a scenario where the ECB sits at the centre of the SSM, simply collecting data and thus just adding a further layer of supervision. This would simply increase the number of supervisors involved.

26. There is a need to manage potential inter-regulatory conflict and duplication that could arise where prudential supervision overlaps with non-prudential supervision.

27. AFME and its members warn of the potential problems arising from the coexistence and application of EU law and national law, for example as regards the ECB mandate in relation to the CRR/CRD IV flexibility package, that gives Member States some discretion in the implementation of key provisions.

The importance for clear rules and coordination regarding macroprudential powers

28. It is important to develop a macro-prudential framework within banking union that is clear on basic policy objectives, roles and responsibilities, specific policy instruments and methods of coordination among the relevant authorities.

29. We believe that the sharing of macroprudential oversight between the national and the European level is appropriate given the current state of economic integration

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within the and more widely. Economic circumstances continue to have significantly national, as well as European, components. This means that it remains, for the moment, justifiable to have national as well as European competences seeking to mitigate potential excesses in the credit cycle.

30. However, there are also significant risks to such a dual-responsibility approach. In particular, there is the risk that macroprudential powers become diverted at the national level towards the protection of perceived national interests other than the avoidance of undue intensifications of the credit cycle.

It is therefore essential that a clear and robust articulation of the objectives of macroprudential powers should be developed quickly and that the exercise of such powers should be firmly related to the achievement of those objectives. It is essential that there are ultimate levels of authority at both national and Eurozone/Banking Union levels in relation to the deployment of macroprudential policy.

31. Macroprudential policy tools regularly take the form of micro-prudential instruments that are used for systemic purposes, and effective mechanisms of co-ordination between macro and micro prudential supervisors will therefore be needed, together with safeguards to mitigate potential conflicts of interest.

Conclusion:

32. We would be pleased to discuss the issues covered in this submission with the Committee or to provide further information about any of the matters which our Members have raised if that would be helpful.

Peter Beales on behalf of the Association for Financial Markets in Europe (AFME)

21.06.13

10 of 441 Professor Dr Ansgar Belke—Oral evidence (QQ 263-272)

Professor Dr Ansgar Belke—Oral evidence (QQ 263-272)

Evidence Session No. 22 Heard in Public Questions 263 - 272

THURSDAY 7 NOVEMBER 2013

Members present

Lord Harrison (Chairman) Viscount Brookeborough Lord Davies of Stamford Lord Flight Baroness Maddock Lord Marlesford ______

Examination of Witness

Professor Dr Ansgar Belke, Full Professor of Macroeconomics at the University of Duisburg-Essen, Director of the Institute of Business and Economic Studies (IBES), University of Duisburg-Essen, and Research Director for International Macroeconomics, German Institute for Economic Research (DIW)

Q263 The Chairman: Colleagues, let us make a start. Professor Ansgar Belke, welcome here this morning. My name is Lyndon Harrison and I chair this Committee. As you know, we are doing research into genuine economic and monetary union, and we know that you can help us in this task. These are the final witness sessions that we are doing here in Germany before we return home to write up all about it. Perhaps you would like to say a little bit about what you do and where you come from in that respect.

I notify you that we will make a transcript of this exchange between the two parties. We will send it to you and ask you to correct it and improve upon it. When you have brilliant ideas as you go out of the room and think “I wish I’d said that”, could you add those as well? Indeed, if you have further thoughts which you think would be useful to the Committee, we would be very obliged if you could furnish us with those.

Perhaps you would say a bit about yourself. Then would you tackle what has been a core question for us, which is to reflect on the genuine economic and monetary union architecture? What elements do you think are essential and which we should drive forwards, do and complete? What elements are perhaps less necessary? Indeed, it may be that some of them are unuseful, even obstructive, in the attempt to set about and establish a genuine economic and monetary union. Professor Dr Ansgar Belke: Thank you for the invitation. Let me just say a little bit about myself. I am not very active any more at the DIW. I have been there for a couple of years as a research director. I am still affiliated to it but now I am more with the CEPS, the Centre for European Policy Studies, doing joint work with Daniel Gros on banking union. Since 2009, we have been joint members of the Monetary Experts Panel of the European

11 of 441 Professor Dr Ansgar Belke—Oral evidence (QQ 263-272)

Parliament, where we regularly prepare briefing papers on issues relating not only to monetary policy but to the euro area as a whole. Because monetary policy is doing more and more fiscal policy stuff, things become more interconnected. Our heads were asked to prepare a report on genuine economic and monetary union in December last year, and half the questions I received directly tackled the fiscal reports. I answered the questions and collected the relevant pieces. The other six questions relate more to stuff concerning banking union. At the moment, I am a professor of macroeconomics at Duisburg-Essen, and I am a member of the councils of the EIB Institut für Europäische Politik and the Arbeitskreis Europäische Integration, as well as some other associations dealing more and more with policy issues. Originally, I was an econometrician. Since 1998, we have been preparing reports for the European Parliament, jointly with Daniel Gros, on the sense or non-sense of the European Financial Stabilisation Mechanism. So I have been doing some joint work around that. The next paper that we have to prepare for the Monetary Experts Panel is on potential exit strategies from monetary policy. That is not very topical for us here, I guess. The paper which is cited here, Towards a Genuine Economic Monetary Union—Comments on a Roadmap, is essentially my report for the Monetary Experts Panel and it appeared in Politics and Governance. It deals with the seemingly important pillars of what is contained in the concept of genuine economic and monetary union. In general, what can we say about this? I think that we have four building blocks here and we are dealing with three of them. The fourth one, we do not have to deal with here. The first one is the integrated financial— The Chairman: We will have a go at all of those but, just looking at the architecture first, is there anything that is clearly missing which should be added in to those four building blocks or would you prioritise the existing building blocks? Would you see them as being more or less important? Dr Ansgar Belke: What you clearly see is that Van Rompuy and others who are propagating this concept of genuine economic and monetary union are telling you that the euro area is not perfect in terms of flexibility, markets, prices and so on. To a certain extent, they give in and argue that we have to have a common budget in order to cope with the stabilisation of asymmetric shocks and so on. This means that they are telling us that we need something like a system of fiscal equalisation, perhaps a common tax and perhaps a shock absorber to a certain extent. Lord Marlesford: A common tax? Can you define that? Professor Dr Ansgar Belke: Yes, a European tax would be a better expression. Lord Marlesford: I am sorry; do you have in mind a corporate tax or personal tax, or VAT or what? Professor Dr Ansgar Belke: I think that VAT would be a much better thing but they are also talking, implicitly at least, about corporate tax harmonisation if you look at what is going on in Cyprus and Ireland. But what is more important here is what I argued in the paper— that the congenital defects of the EU cannot be simply defined away by introducing such stuff. The important thing is to make a comparison with the US—for instance, what sense it would make to have a kind of debt mutualisation and policy co-ordination mechanism? That is a very important discussion. What we argued, jointly with Daniel Gros, in the European Journal of Political Economy, or Elsevier, is that in normal times you need a kind of competition among fiscal policies—among the tax and expenditure packages—to compete with each

12 of 441 Professor Dr Ansgar Belke—Oral evidence (QQ 263-272) other in the euro area because this serves as an insurance mechanism. If you correlate these policies very significantly, you also correlate the mistakes. In normal times, the problem is that Van Rompuy goes too far with his proposals, and one gives in too early, saying that we cannot make markets more flexible but, on the other hand, imposing something that we call a common budget, an asymmetric shock absorber and so on. This is an important issue that we could talk about for years. I argued this in the paper. The second important point of course is the role of monetary policy and debt mutualisation. We also talk about the fact that some frictions are related to this. What we clearly recognise is that, secretly, that mutualisation has already taken place via the ECB’s earlier monetary policies. The Chairman: Let us pursue those as we get into the questioning. Lord Flight, perhaps you would come in with an early question.

Q264 Lord Flight: You are saying a lot of important things in what to me is code, in that I think there is some background. If the euro is to survive, we need to have something that looks much more like the US in terms of political and economic integration, transfer payments, borrowing arrangements and so forth. In a recent article you have argued that the region needs competition-based fiscal federalism with a properly defined banking union. To me, that is what you are talking about basically. On the banking union side, where we are at present is really just a move towards better regulation, which is no bad thing. However, unless you have all three bits and a pan-European funding base to help bail out things, then you are just going to worsen the sovereign debt problem and, again, it will be left to individual countries. Germany seems either to be officially unwilling to consider any of this or it does it by the back door, as you rightly point out, vis-à-vis what the ECB has done. To me, there is a huge difference between north and south. We had very clear testimony from leading Italians along the lines of what I have just been saying, and then you come to Germany and the response is, “Oh no, we can’t possibly have debt mutualisation. We can’t possibly have transfer tax. You can only have what we have at present”. But the euro is not going to survive on that basis. Professor Dr Ansgar Belke: The main thing right now is that I present to you my main thoughts on these issues. Explicitly, this year the main idea is that you have to disconnect the fate of the banks and the fate of the states. That is clear. This is most probably done, as we learn from the Cyprus debate, by having common oversight by the ECB. We would also have to have a way of restructuring, and how to do that is still being debated, and, not necessarily but maybe, a common deposit insurance, which has to be constructed in such a way that the existing insurance mechanisms are not destroyed. German lobbying institutions like the savings banks are already getting ready for this. You can construct it, for instance, by having national insurance mechanisms paying some risk-related contribution to a common budget, in a sense. Common insurance serves for big shocks, so this may be the construction. In this way, you can trust the markets again. They can evaluate specific countries, and they can go for their own evaluation of sovereign bonds. From the econometric studies on the formation process of the interest rates on bonds and so on, I do not see anything like a common risk factor which the Banca d’Italia sees, but I see a very clear way of determining bond yields. So you can go back again to some competition, like you have in the US, between different areas of fiscal entities. You do not have all the problems which you have with the euro bonds. Also, I consider that with monetary policy conducted partly as a debt mutualisation, the moral hazard problems are defined away in such a construction.

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If you look at Switzerland or the US—if you go to federal states—you will see that it is possible for individual countries to become insolvent, and they have to pay market interest rates for further indebtedness. This is the kind of position which is also agreeable for the German public, because the German public would never accept this kind of debt mutualisation as long as there are elections in the participating countries. For instance, you can never be sure that expenditure decisions by the Greek Parliament will not have to be financed by the German taxpayer. This would never become acceptable if you could not rely on a Government staying in office and making efforts to go for more competitiveness. Or we could look at the Debt Redemption Fund, which is always said to be a solution. It was a proposal from the German Council of Economic Advisers. It has certain weaknesses. Its advantages put Italy at an advantage right now. Italy is a very problematic country right now in terms of political governance. You have stalled the problem that countries cannot be financed by this and other programmes, even by this kind of construction, which is a most probable compromise. So it is very clear that this kind of solution may be the way forward, but, as turned out last year in a discussion in , in transition times it may include at least temporary debt mutualisation. However, it is much lower in costs than a , which has certain other disadvantages. The problem right now is backing stress tests. In the end, Europe did not agree on the backstop. Everybody is telling you that there has to be a cascade, putting the unsecured creditors first, then the shareholders and so on. But the backstop is not defined, so the ECB is not very clear what it can risk. The Chairman: Is that a kind of layered deposit insurance system, whereby, after the supplies from the national Government have been exhausted, you would have this EU deposit insurance scheme operate? Is it modulated in that sense? Professor Dr Ansgar Belke: Yes, it is seen as the third step. I think it is related to what you are asking here in the list of questions. It is seen by some as the necessary third step because, as we have seen with Northern Rock, the markets do not work perfectly, at least with banks. I read in the documents that Willem Buiter is of a different opinion; he is saying that banking regulation is enough; you do not need this. As you ask completely accurately, what happens if the third pillar is missing? I think that what you see then is a kind of colonialisation of banks—that banks within the euro area, which enjoy a larger safety net than others, will take over the banks in the other countries. I know that you UK guys also fear that if we have a common deposit insurance in the euro area, you might yourselves be at a competitive disadvantage because you do not have this and you have to regulate your banks more. However, this is less of a danger than the colonialisation of banks within the euro area. What I observe is a very close relationship between banking and currency. The borders are quite similar.

Q265 Viscount Brookeborough: What is your view of the proposal for the single resolution mechanism? We have heard from your Finance Minister that only a timber framed rather than a steel framed SRM is likely in the short term. At what stage could this resolution mechanism come in? Is it post this current crisis, and, if it is not, who will fund it? Professor Dr Ansgar Belke: This is Question 8, I see, but let me just see what I have noted down. What we see here is clearly understandable because we have European Parliament elections. There is a kind of pressure to push something through before the elections, at least that is my impression, and this has to be rather weak. Schäuble is under great pressure from the savings banks and so on to say that we need a treaty change in order to install all this. We are close allies with the UK, as I understand, and hence Merkel—that is also

14 of 441 Professor Dr Ansgar Belke—Oral evidence (QQ 263-272) another question—is very much in favour of having the UK still in the EU to defend these kinds of issues. Viscount Brookeborough: But a treaty change cannot come that quickly. Professor Dr Ansgar Belke: That is exactly the reason why we have to soften it down and go for national institutions for the single resolution mechanisms and national resolution institutions, and we should not have it in , for instance, but elsewhere on a national level. In this sense, I think that Germany and the UK are close allies. If you look at the coalition coming up in Germany you clearly see that the Social Democrats are very close to Merkel in that respect because they do not want to have big rescue mechanisms for banks— at least they have a responsibility with respect to their voters not to introduce something like that. You clearly see the timber framed solution here and there is a watering down. Probably your call for evidence includes this. Viscount Brookeborough: So you believe that the new coalition as a whole will be allies of the ? Professor Dr Ansgar Belke: Yes, in that respect at least, but of course not with respect to competitiveness and so on. It is very much in Merkel’s interest to have the UK in the EU. At least, as far as I can see, you have a kind of transnational orientation with Merkel. She needs the UK in in order to go for more intergovernmental solutions.

Q266 Lord Flight: Do you see the irrevocability of the euro as sacrosanct or would Germany be willing to see some current members move on that? The practical aspect of that is that we are potentially heading in that direction right now unless there is a much more federal effort to underpin the euro. Professor Dr Ansgar Belke: Merkel shifts her opinion but she is offering a kind of package deal. Officially, the irrevocability of the euro is sacrosanct. This is also because, at least publicly, there is co-operation with the ECB as regards the OMTs and so on. Merkel very much pushes through this kind of solution: that is, having debt mutualisation via the ECB which is not very noticeable to the German population, but also going for a fiscal compact. This is exactly the discussion also before the German constitutional court, which has to decide whether the ECB is responsible for the composition of the euro area. Merkel’s consultants on European policy issues tell you that there are negotiations going on with the Baltics, Poland and the Czech Republic, which do not want to enter the euro area. However, there is a package deal on offer to get them in earlier in order to change voting powers in the ECB council by making it larger. However, with respect to Greece, I was in the last year on the budgetary committee and we calculated the cost of Greek exit for the German taxpayer. Surprisingly, the SPD invited me because it is more critical in that regard than Merkel, at least than she is officially. If you calculate the cost of a Greek exit and go for debt relief for 10 years or so, it is very easy to see that Germany can refinance this kind of stuff very well because interest rates are very low although they are increasing now because the markets anticipate the rescue burden for Germany. But at least refinancing goes well for Germany. The cost for Germany would not be very large if we agree with— Lord Flight: The cost of what? Professor Dr Ansgar Belke: The cost of the Greek exit for the German taxpayer if you combine it with the temporary debt relief and so on. However, the costs are much higher in terms of refinancing for countries under financial distress, of course. This might backfire in the long run because Germany is the most potent member of the rescue mechanisms and if

15 of 441 Professor Dr Ansgar Belke—Oral evidence (QQ 263-272) other countries lose their rating they may suffer, but in a sense the composition de facto is not sacrosanct.

Q267 Lord Davies of Stamford: I have been told to speak loudly because we do not have microphones in front of us as you have. First, I must make absolutely clear what you were saying on two important matters. One is on retail bank deposit insurance. If I understood you correctly, you suggested that a national system should remain in place and then there would be at the European level what I would characterise as a reinsurance scheme, which would be paid for by premiums delivered by the national retail insurance authorities. Is that correct? Professor Dr Ansgar Belke: This would be the main idea. There are some sketches around. I am more involved in monetary policy issues and the interrelationship between commercial banks and monetary policy. However, for instance, there is some proposal around *baschoenmarke*. (08:57:23). Daniel Gros and others have details on this. Perhaps Daniel Gros has told you about this kind of solution in detail. He set out in a Centre for European Policy Studies commentary how this could work in detail. This is something which the German savings banks would accept as a minimum solution. They do not really want to see anything like this but this would be the least bad compromise. Lord Davies of Stamford: I see the attractions of it. I am clear what you were saying. The other important thing you were saying, which I want to be clear about, is your view on the right structure for the sovereign bond market in the euro currency area. I think what you were saying was that the right model was the American system in which different fiscal authorities would have different ratings according to the market assessment. That implies that those bonds issued by different fiscal authorities within the euro area would no longer be regarded as risk-free, as they are artificially now, for the purpose of, for example, banks calculating their capital ratios under Basel III and for the purpose of the open market operations conducted by the ECB. So what would be the instruments that would be regarded as risk-free in your model for those two purposes? Professor Dr Ansgar Belke: You are totally right. The bank stress test model shows that you go for risk-rated assets and neglect sovereign bonds. This immediately shows you that the same methodology is used as that which the ECB uses with regard to OMTs—outright monetary transactions. If you tell the people that these things are risk free and that you agree with the bank’s assessment, investors are impressed that the ECB is the lender of last resort and at least capitalises the value of the bonds. This is essentially what they are trying to do. This is a kind of open flank of the strategy with regard to the bank stress test. This is clear in my opinion. I cannot follow why investors are not allowed to rank countries such as or Greece differently given that they expect some hazards from these countries. There must be different interest rates. Lord Davies of Stamford: I can see the point. The present situation, as we all know, is completely artificial and potentially dangerous but, if you replace it with the model that you have just described—the American style model—I repeat, what will be the supposedly risk- free instruments which can be used either for open market operations or for the calculation of bank capital funds? Lord Flight: We should not forget that the American model has federal borrowing as well. Lord Davies of Stamford: That is exactly right, Howard; that is my point. The Americans have Treasury bills and federal liabilities which are up to 10 years risk-free. We do not have that and you yourself said that you do not want Eurobonds, so I repeat my question for the

16 of 441 Professor Dr Ansgar Belke—Oral evidence (QQ 263-272) third time. If you go over to your American-style model, what is going to play the role of those central risk-free instruments for the two purposes I have outlined? Professor Dr Ansgar Belke: Maybe German bonds as well. If you want a market, they could use this kind of stuff. The other thing is if you look at the proposals for a debt redemption fund, you see a proposal on backing with gold, or some other valuable commodity, to be used as a pledge. The pledge is decisive in that respect. All proposals for the Eurobond include—if you read the EU Commission’s proposals—some important assets as pledges. This has not been emphasised very much because it is in the footnotes. What I would like to go for—we prepared some proposals for the monetary experts panel—would be to back with gold the sovereign bonds of weaker countries. Gold is down in value right now. You can abolish some of the weaknesses of the OMTs by this method.

Q268 Lord Davies of Stamford: We do not have time to go into the technical details of that but this seems to me a very important matter which will not be resolved. The instruments which you describe are mere fictions of your imagination. They do not exist currently and so we need to be quite clear, if we are serious about developing those instruments, what would be the modalities and the risks of creating them. I think that a lot of work requires to be done on that subject. I now turn to another matter which you just touched on. I was not quite clear to what extent you think that the lack of an automatic fiscal stabilisation mechanism in the eurozone is a really serious matter, is an existential matter, is something that has to be dealt with, or whether producing such a mechanism would merely be a luxury which you do not have to have essentially. In which of the two categories do you place that? Professor Dr Ansgar Belke: As I have already indicated, I am very sceptical that these kinds of measures make much sense. I wrote an article about it in a paper, which was cited here, and perhaps can be distributed. One aspect is that, already in 1998, when we were asked by the European Parliament to take a stance on the stabilisation fund, we said that shocks were regional and not national in the euro area and that you can deal with this. What we see is that in the US the budget redistributes more than it stabilises and the main target is, for instance, unemployment. If you look at an unemployment insurance system, the issue is structural unemployment and not business cycle unemployment, given that the latter is normal in market economies. You do not need to stabilise these kinds of temporary employment shocks. The main problem in the euro area is structural. When I studied Spain in the late 1980s, it was already hampered by structural unemployment. This goes to the root of the crisis. Many countries see the euro budget as an instrument of redistribution. You also need huge fiscal multipliers. These things make sense if you are in a boom cycle trough. You should have a mechanism in place which deals with these kinds of troughs. The multiplier is not very high. The IMF claims that it is very high, but if you look at the EU Commission or the ECB, as soon as you put in some control variables these multipliers break down. Many more arguments could be made in relation to these kinds of stability funds but those are my core comments. Lord Davies of Stamford: We heard an interesting proposal yesterday from Daniela Schwarzer, whom you may know, for an EU-wide unemployment insurance fund, which she presented as a good model for an automatic fiscal stabilisation mechanism. I wish to be absolutely clear that what you are saying to us is that you do not think that would be effective because it would largely not be a stabilising measure but a redistributive one, and it would really be financing structural unemployment rather than cyclical unemployment. Is that the essence of your response?

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Professor Dr Ansgar Belke: Yes, it is the essence of my response. I have many arguments listed in the article.

Q269 The Chairman: Before I bring in Baroness Maddock, who is going to explore some aspects to do with the north/south divide, let me just ask you this: the US Treasury has given the opinion that Germany has not made enough effort in encouraging domestic demand within Germany itself. It has said some quite sharp things about that. Can you respond to that? Professor Dr Ansgar Belke: Yes I can, but allow me one comment on the preceding question on unemployment insurance. Maybe one could have mentioned also the idea of the reverse stabilisation with the standard loss deposit insurance mechanism. We still stick to the national unemployment insurance systems because they are closely related to health insurance, to country-specific national regulation in terms of social security and unemployment benefit systems, and have a common component in addition to that where the national systems pay in. There are also risk contributions, so Spain would have to pay more of course, because you will see from history that for decades it has been suffering from higher structure unemployment than other countries. It is simply not true, as Paul De Grauwe argued, that one country is better off one day and another country is better off another day, which is an essential ingredient of any insurance mechanism. You have to take care, and can take care of this, if you use France’s approach and augment it maybe by this kind of deposit insurance mechanism and apply it to labour markets. Let me get more deeply into that. Maybe, ironically speaking, Germany should be grateful for these comments because some of the savings lent to other countries in the euro area for instance have now to be regathered as transfers. We do not receive anything back. So we should be grateful that in the area of competition policy the EU Commission is serving the German interest and so is the US with these claims. It is ironic of course but maybe there is a kind of truth included because, of course, this contributes to using the savings at home for investment, which has been underemphasised in the past, admittedly, in all the infrastructure, the education system and so on. Also, in the deregulation of services we could do something. On the other hand, there are many arguments which speak against it. If you ask many people in Stuttgart, where I have been for seven years teaching at the university, the entrepreneurs do not agree with you that monetary and fiscal policy—that politics even—has anything to do with their export success. This is non-price competitiveness, non-price factors and so on. This is down to a kind of specialisation game, and also innovation. That is the first point. Secondly, usually a country which exports more will lack imports as a business cycle locomotive. If you think in terms of input/output analysis, Madame Lagarde said once that we should increase our rate of unit lending costs but if you calculate it through in your input/output table, it may be the case that the value of your exports increase if you increase your wages and push through your products on the world market still. What happens is that the export surplus even increases. Of course, this points again at the nonsense of this kind of balance of payment procedure in the European semester. This is a kind of weakness we have here. America only agreed to the 6 percentage points because she knew that Germany would not have to pay for it as a large country. It is not possible to push this through politically, to punish countries with the surplus. The Chairman: Is it something that we do not understand in the United Kingdom and elsewhere: why German consumers are reluctant given that they have money in their back pockets?

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Professor Dr Ansgar Belke: They are not. If you look at it from the German Gemeinschaft angle, the common forecast of the most important German institutes, you clearly see in the forecasts for the next two years that foreign trade has a negative contribution to growth and that growth is heavily based on domestic consumption. So I do not see that. If you look at the autumn forecast, you will see a negative contribution to growth. Viscount Brookeborough: So you are saying that the German people, the market, do not have this money in their pockets to spend, or that they are just unwilling to spend it. Professor Dr Ansgar Belke: They are spending it. If you look at the data, you will see that it is not a problem that we have here right now. Baroness Maddock: It sounds as though the Americans did not look at the figures very clearly when they made this comment. Professor Dr Ansgar Belke: Of course there are the figures in the past, but the export shares and the import shares of the euro area stay constant. To a certain extent they may have looked into it, but they may have had diplomatic reasons to, just at this moment, come up with this. That is what I am trying to say. If you look at intra-European trade, you will see that the export surplus diminished dramatically. Imports have moved very close to German exports within the euro area.

Q270 Baroness Maddock: That was not my main question, but I wanted to clarify it. You have written quite a lot about the north/south divide. Do you think there is any likelihood that an initiative along the lines of the Marshall plan might be put forward for the southern part of Europe? Professor Dr Ansgar Belke: In the past, we had to comment on this on several occasions. Once, for instance, our former economic Minister Rösler had to launch an initiative on this kind of stuff. If we look at the Marshall plan, the pros are that it is part of a two-handed approach with respect to the south. I wrote in my articles about the north/south divide in the heads of the people: they do not trust Germany any more so Merkel’s proposal for co- ordination between Parliaments is quite good. This has a psychological impact. The people in the southern states not only have to deliver but also receive something so the motivation could increase. But if you look at what happened in the past with the Marshall plan—what the main idea and effect was—it was no panacea for reconstruction. I think that Greece and the UK received less Marshall plan support than Germany, for instance. There has to be some constitutional part of it, for instance, be it some ordoliberalism or some kind of institutional stuff that make this kind of Marshall plan more productive. If you look at Barry Eichengreen’s studies, there was 0.6% additional growth by the Marshall plan in the past. A classic infrastructure programme is not necessary for Greece if you look at the streets and so on—the classical infrastructure. You do not need the kind of stuff we saw after World War Two—on the contrary. I come from the University of Duisburg-Essen in the Ruhrgebiet, the coal area. Maybe you could, and this would again be compliant with the US proposal, commission more demand for infrastructure there. We have nearly full employment. We attract workers from the southern states, at least temporarily, and import more. The Marshall plan should be conducted in Germany to a certain extent. Other structural problems are, partly, that consumption is called investment in this kind of Marshall plan. Very large firms in Germany are also very much in favour of it because, as they did it in the past in East Germany, they use these kind of countries as a bridgehead, with their low wages and so on. They can use the plan for purposes for which it is not intended. So there are pros and cons to it.

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Baroness Maddock: I cannot remember which witness we heard it from, but we did hear that actually workers do not move as much as we would expect, because of language problems. That does not seem to bother them coming to England, of course, because English is a common language. The other thing I want to ask was this: in the coalition discussions, have they been discussing a Marshall plan? Has that been part of the coalition discussions? Professor Dr Ansgar Belke: To your first point, I know that the Goethe-Institut in Portugal—I often stay in Portugal for research or graduation—is very active and we expect much movement in Germany in the area of old-age servants and so on, people who are helping with healthcare. That demographic change is taking place in Germany. To your second point, I am not clear about the kind of Marshall plan that is going on. This has always been something that was part of an announced compromise. Investment is always good. We can always tell people that you should do something for infrastructure. Before the elections, I quite closely followed Mr Steinberg, the SPD candidate. I had several panel discussions with him. The Marshall plan was of course part of the proposals regularly. But at the same time, on Eurobonds, he was very sceptical about unconditional bonds and even on the redemption fund. That was a proposal mainly supported by the Greens. I think, because we have much more impact from larger firms in Germany and lobbying groups putting pressure on the politicians, the proposal would come up stemming from their interests, adding a bridgehead or work bank, like we had in the GDR, and having done much infrastructure investment in the south. But you cannot compare this kind of stuff with, for instance, the coal area. It is very interesting: the coal area stuck too long in the tradable sector and went to services. The other thing has to be done in the south: go away from services and move to the tradable sector. There should be some interest in that but because we are put under pressure by the US and the Commission, I expect more infrastructure investment going on within Germany—the Marshall plan in Germany instead of the south. The Chairman: We are running short of time. I turn now to Lord Marlesford because there are some important points to be made about the .

Q271 Lord Marlesford: I would like to ask you for your opinion of the process by which the ECB is conducting its stress tests on the asset situation of a bank. Perhaps I can put that in the context of two earlier points that I think you made. The first was that the German people would be more ready to contemplate mutualisation of debt that already exists where it can be quantified than they would the mutualisation of future debt; in other words, an open cheque for future borrowing either by banks or by sovereigns. Of course, the object is to get rid of the toxic link between the sovereigns and the banks, but we have not done so yet. Then you also made an interesting comment about the possibility of German bonds as opposed to euro bonds. My understanding is that you feel that German bonds would be more acceptable to the market than Eurobonds and would have less of an implication for German underwriting. Of course, the quality of German bonds would depend on the extent to which Germany held a liability for any sort of mutualisation of other debt. Going straight into the ECB situation, first, do you think that it has the competence in the timescale envisaged to carry out these real stress tests? Secondly, do you feel that there may be a conflict between the two remits of the ECB, one being to carry out the stress tests, that concerns one lot of people in the ECB, and the other being, as the monetary authority, to keep the show on the road and to maintain confidence—in ’s famous words— by doing what it takes? I am really trying to get your assessment not only of the competence and capability within the timescale of the ECB, but also looking at what may transpire in terms of the argument about mutualisation.

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Professor Dr Ansgar Belke: Thanks a lot for the couple of questions that I have been given. I do not share completely your view that the German population contemplates more future debt. Lord Marlesford: I think you said earlier on that the Germans would be less happy to underwrite future debt than they might be to underwrite debt which has already been incurred, although they might not be very happy about that either. Professor Dr Ansgar Belke: Yes, but the German population also sees existing debt in, for instance, the Spanish banks as a danger because the European Stability Mechanism would be approached. Lord Marlesford: So, it is clear that the Germans do not want mutualised debt. Professor Dr Ansgar Belke: In total, yes. But I agree from what has been said in our discussions that this part of the old debt had to be put somewhere, such as in a redemption fund in order to cope with it. This is precisely the area where some debt mutualisation unavoidably has to take place. However, one can think of an insurance mechanism for future debt that avoids this kind of taxpayer burden on Germany. That is the first point. The second point is on the comparison of T-bills and Eurobonds. The only argument in favour of Eurobonds from the German perspective is that they offer an alternative—a safe haven—for oil-producing countries and emerging markets. They can now put their money into American T-bills, and are financially depressed by doing that. We have a very fragmented bond market so the recycling of petrodollars is always done using T-bills. This allows the US to go for all the current account deficits. But, on the other hand and as we heard, Germany is not prepared to accept current account deficits and hence cannot be the recipient of inflowing money, at least in so far as Germany dominates the euro area. Then we come to the ECB and its role in stress tests. There are some arguments that I can try to elaborate, although that may take a few minutes because it is complicated. First, it must be seen that there are conflicts of interest. For instance, in a recent briefing paper I argued for the Monetary Experts Panel that the higher the monetary stimulus, the lower the unconventional monetary policies of the ECB, which will lower the incentive for commercial banks to repair their balance sheets and for sovereigns to try to restructure their financial sectors and introduce reforms to secure unsustainable debt burdens. There is an interaction between the current course of monetary policy which does not seem to have changed. They are thinking about new LTROs and OMTs, and once they are in place, if you think about closing a big bank which may be systematically irrelevant, you have to consider the consequences for price stability. Until now, financial stability has not really been included in the ECB’s constitution. What kind of emphasis has to be placed on these issues? There is a clear conflict of interest. They have tried to separate the bodies, of course, but still there are some people who are responsible for the decisions taken in both areas. If we look at the stress test now, are we getting things right? There are two possibilities for the ECB. Either the stress test has to be conducted very softly so that almost all the banks do not fail, but then the purpose will not be fulfilled. If it is very strict, maybe they will detect a lack of equity capital of €50 million or even €100 million euro which will have to be made up. In my personal opinion, I do not think that the risk is very large. However, if you go for a consequent assessment, the risk is quite large when it is historically expressed because in Germany you have one or two banks that are active in the shipping sector. They may reveal some risk of exposure, and that is precisely the reason the ECB conducts its stress tests. That also shows Germany that it is not always the southern countries that are the relevant ones, so there is a diplomatic aspect

21 of 441 Professor Dr Ansgar Belke—Oral evidence (QQ 263-272) to this. Partly, also, the private and commercial area of the economy will become a problem and the cheap money of the ECB has increased the problems. But if the ECB does not come up with a stress test, it would immediately become clear that the backstop has not yet been defined. There is now a chain of responsibilities, so again it is what we call in Germany— hauen und stechen—which translates roughly as cut and stab. Who will be responsible for this? Who is filling these capital gaps? Is it the bank itself by increasing its capital? That is a way only for banks that are in a healthy state. Maybe it is the taxpayer. Recently we were irritated by a box in an IMF report on taxing German savings in order to support the south. That is now being moderated by the IMF. I look forward to that because I will be a research fellow at the IMF from 23 November, dealing with current account balance issues as an econometrician. For the crisis countries, I think that the ESM is envisaged, and again that is for the German or the northern countries’ taxpayers. Or let us look at the model of Cyprus. Will there be something like what we have observed in Cyprus again? That would lead to great uproar. Until now, if you look at the EU decisions, that is not foreseen. The ECB acts inconsequently, as we discussed, because sovereign bonds are not considered to be risk- bearing, which is another problem. This implies, as you said, that in the future the ECB will be forced to make government bonds risk free. That is the immediate implication on my preliminary reading of it. Or, if you have haircuts, then banks could fear losses which are not secured by equity capital, although they have gone through the examination and have emerged as healthy banks. If you want healthy banks in the long run, the proposal by Professor Hellwig, a colleague of ours here in Germany who is an economics professor and active in the area of financial regulation, it may make sense for the equity endowment with respect to the whole balance sheet, the leverage ratio, to be larger. In the US it is at six percentage points whereas for European banks it is only something like three percentage points. The leverage ratio should be larger. So, in summary: first, the project of banking union has not been planned properly, particularly for the initial phase. It has open flanks and other problem areas. Secondly, considering sovereign bonds to be risky would be rational when you look at Portugal, Greece and so on. That is not on the agenda because those Governments are relying heavily on their ability to place them on the market and are very much bothered by the ECB. The Chairman: Professor Belke, I fear that we must draw this session to a close. However, there is one question that I hope we can squeeze in. Perhaps you could give us an answer to it if you feel capable of doing so.

Q272 Baroness Maddock: The question is about the position of the United Kingdom in all of this. We have made it quite clear that we do not want to participate in any of the GEMU proposals. Our concern has been particularly about the effect on the single market, and thus not just on ourselves but on other member states. How realistic is this position for us? Professor Dr Ansgar Belke: To go through with your own interests you mean. The most important problem for the UK, as far as I understood it, was sticking to the principle of double majority, although there is a core developing in terms of the 17 euro area member states making decisions about financial services, which is your main interest in respect of the single market. You want to avoid a two-speed Europe. The newspapers talk about you being pushed into the slow lane.

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The Chairman: Professor Belke, what is your feeling about the UK? You are here in Germany and you are an academic of great standing. What advice would you give to the UK as these matters develop? We would like your views. Baroness Maddock: The question that we have asked of the other witnesses is this: Are we an obstacle or are we irrelevant? Professor Dr Ansgar Belke: Let us look at what you have managed to do in terms of the European Banking Authority, which is to have some form of veto. But you should not be so sure that that is de facto working because the ESRB dominates, so the issue about the EBA is not so relevant. However, I think that you have a close ally in, for instance, Mrs Merkel. She is very much in favour of a transnational approach to intergovernmental issues. She wants the UK fully in because her mantra is that of moving towards more competitiveness in the long run. That is the panacea for the recovery of the euro area. She needs the UK in that respect because you are also an ally in respect of nationalisation, of banking surveillance, deposit insurance and so on. Moreover, like Schäuble, you are also very much in favour of not having the Commission in. Mrs Merkel is also not keen on the Commission and to a certain extent she wants to circumvent it. So you have close allies there. The Chairman: Professor Belke, perhaps we will finish the session now. That was a very clear answer on the UK. I thank you on behalf of the Committee. As I mentioned before, we will send you a transcript and please do correct it. I congratulate you because I know how difficult it is to speak in a foreign language when cups and glasses are rattling away around you as you try to compose your thoughts. You have done admirably for the Committee and I thank you on its behalf. Your thoughts will be examined much more closely when we get the opportunity to read the transcript. Professor Dr Ansgar Belke: Thank you very much for the invitation. The Chairman: That was very helpful. Thank you very much indeed.

23 of 441 Professor Agnès Bénassy-Quéré—Oral evidence (QQ 222-229)

Professor Agnès Bénassy-Quéré—Oral evidence (QQ 222-229)

Evidence Session No. 19 Heard in Public Questions 222 - 229

FRIDAY 25 OCTOBER 2013

Members present

Lord Harrison (The Chairman) The Earl of Caithness Lord Hamilton of Epsom Baroness Maddock Lord Marlesford ______

Lord Bowness Lord Maclennan of Roghart Baroness O’Cathain

Examination of Witness

Professor Agnès Bénassy-Quéré, University of Paris I Panthéon Sorbonne

Q222 The Chairman: Bonjour, Madame Agnès Bénassy-Quéré. Je m’appelle Lyndon Harrison. Je vous remercie très chaleureusement pour nous aider en ce qui concerne toutes les questions difficiles économiques et monétaires européennes. A very warm welcome to you. I hope you can hear me clearly. Professor Bénassy-Quéré: Thank you very much. Good morning. I am very honoured to be here to discuss these very important issues. The Chairman: Thanks very much indeed. I would like to ask you a first question, if I may, about the genuine economic and monetary union. Do you think the proposals from the four Presidents, the Commission, are actually going to work? Are the proposals introducing all the necessary elements to achieve the aims and the objectives they desire? Are some elements of them undesirable, and might they even be contradictory to what they are attempting to achieve here? Professor Bénassy-Quéré: There are four elements: the financial framework, the fiscal or budgetary framework, the economic policy framework and the democratic legitimacy that needs to be strengthened. These four objectives presented are very general, and I think that all four of them are necessary, although maybe not in the way they have been discussed so far. The first one is obviously the most urgent—the financial framework—and we are on our way to banking union, although there are many hurdles. It is the most urgent because it is not only for the future; it is not only for the new governance of the monetary union; it is also, for today, how to clean up the banking sector and how to stop the bank/sovereign nexus.

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The Chairman: Has any element been missed out that should have been part of the response from Herman Van Rompuy and the Commission? Is there any additional work that should be done? Professor Bénassy-Quéré: Apart from these four directions? The Chairman: Yes. Professor Bénassy-Quéré: It is already a big deal, so I think it may be already too much. Thinking of additional elements is difficult.

Q223 Baroness O'Cathain: I was going to ask you about the relative weakness of the French economy and whether it is going to reduce the effectiveness of the Franco-German alliance in arriving at solutions for the governance problems of the EU/euro, seeing as they have been the mainstay of them. Professor Bénassy-Quéré: This is a difficult question for me, since I am currently the chairperson of the French Council of Economic Analysis, which is supposed to give advice for French economic policy. So far we have issued ten reports and our results are relatively limited. I would say that foreign countries have tended to focus on the lack of fiscal adjustment in France, and I think this is the wrong focus. There has been a lot of fiscal adjustment in France, and it is probably not the pace of the adjustment; it is more how it was achieved and the fact that it relied mainly on tax increases. The Government seem to be decided on lowering expenditures, but so far we do not know how. This is a big weakness. Another one is the lack of structural reform. There have been structural reforms. There has been labour market reform and there has been pension reform, but these reforms are not very far-reaching. They are understood as small steps in a good direction, but further steps are needed. It is not so certain that there is the political will to go forward, and this is the main weakness of the French economy today. It is the lack of spending cuts and the lack of structural reforms. In the long term, I am not pessimistic. In the long term, the French economy has really good assets. It is at the core of the euro, the geography is very good for France, the demography is very good, and it still has good infrastructure. There should be growth in the long term, but in the short term it is true that France has some weaknesses, and these reduce the power of the Government to discuss with the Germans. Baroness O'Cathain: Are you actually saying then that the dangers facing the French economy have been exaggerated? Here in the press, we get this opinion that not enough push has been behind lowering public expenditure particularly. Just going for tax increases is not necessarily a good thing to do in the long term. Professor Bénassy-Quéré: There has been a lot of French-bashing. Part of it is correct. Part of it relies on a large image of the economy. Sometimes there are reforms that are not so well communicated and they are still a kind of game-changer. For instance, the labour market reforms can be quite far-reaching. Companies can agree with the workers to lower wages for two years in order to make the adjustment. There is more flexibility and this point has been underestimated, probably because as always in France things are very complicated and very difficult to read from outside. This is one point. The second point is that there was a strategy for fiscal adjustment. The idea was that the fiscal multiplier was lower for tax increases than for spending cuts. Secondly, to do long- lasting spending cuts you need a strategy and it takes time. The strategy was initially to increase taxation in order to adjust the fiscal deficit and then to proceed to spending cuts.

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There has been a strategy for spending cuts so far that has not delivered. It could have been a good strategy, and maybe it is still a good strategy, but we do not know. Baroness O'Cathain: Just finally, do you think that rating agencies have had difficulty reading this, as well as everybody else? Have they come to the wrong conclusion or are they more pessimistic than they ought to be? Is the downgrading just regarded in France as a non-event? Professor Bénassy-Quéré: This is not only for France, but for other countries too. When I read the reports of rating agencies justifying a change in the rating, I am always very confused. For instance, sometimes the argument for downgrading is the fact that other countries are weaker and that the country would be obliged to bail them out, or that long- term growth is lower. Long-term growth, though, is not something that changes from one week to the other. I think we should not put too much emphasis on the rating agencies, because there is a risk that it distracts us from the real problems that are there. There are real problems. Again, we can do much more in terms of reforms. You can hardly see a goods and services reform in France; there is a lot of power in existing lobbies and this is detrimental for employment, especially for the young. Secondly, on labour market reform, there have been some steps but I have the impression that we can do much more. Today, there is a very important reform under way for education of adults, which is very inefficient in France, very costly and very unfair. There should be some willingness to reform. I am awaiting the results of these negotiations because it could be a real game changer for employment and public spending.

Q224 Baroness Maddock: Do you think the proposals we have seen so far for genuine economic and monetary union will be sufficient to ensure that euro area economies are resilient enough to deal with any asymmetric shocks that we might see? Professor Bénassy-Quéré: It is very difficult to say whether something is sufficient. Today in peripheral countries credit is still decreasing. SMEs in Spain and Italy have difficulties getting credit, although there has been a huge achievement in Spain—not so much in Italy, but at least with Spain—in competitiveness adjustment. We have the impression that SMEs are more competitive than they used to be, and it is still very difficult for them to get credit from the banks. The banking union is clearly a key issue for recovery in these countries. In the longer term, better regulated banks will allow them to maintain credit even when there is a downturn or when there is a credit cycle. This is a good thing. Banking union could also be the starting point for the development of cross-border banking in the euro area. This should be stabilising. Maybe the biggest asymmetric shocks that a country can see are financial shocks coming from the banking sector. There is literature on risk-sharing showing that banks and credit are the main shock absorber. In terms of risk-sharing, credit is at the top. Even in the US, where you have quite a large federal budget, it does less than credit. It is very important when there is an asymmetric shock in one country that a pan- European banking sector would be able to provide credit. Today, when you have a downturn, when you have a negative shock in one country, on top of that there is a reduction in credit or an increase in interest rates. It is procyclical, and we want a banking sector across the euro area that stops being procyclical. The banking union is one way to try to achieve this. Baroness Maddock: Do you think that what has been proposed so far is going in that direction enough?

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Professor Bénassy-Quéré: Clearly, it is going in the right direction. So far, we do not see how the single supervision will be connected to the single resolution. This is the main debate today, because clearly the single supervision cannot be credible if no single resolution with a resolution fund is able, even in the short term, to participate in the resolution of a bank. This is a major issue, and it will be the major issue until early next year. The Chairman: Before I ask Lord Hamilton to pursue the point you made at the end, I am going to ask Lord Marlesford for a comment on earlier exchanges. Lord Marlesford: This is really just a follow-up on the situation in France. It is a very simple question. Is any consideration being given in policy circles in France to whether the 35-hour week can and should continue? Professor Bénassy-Quéré: You would be surprised that that there is no real discussion on that issue. Lord Hamilton of Epsom: I am not surprised. Professor Bénassy-Quéré: Within the labour market agreement of last January, it is possible to increase working time temporarily with an agreement in each firm. It is on a case-by-case basis. There is no discussion on the 35 hours a week. There was a pension reform, which is a way to increase working time but over the lifecycle. The focus of structural reforms is not on this.

Q225 Lord Hamilton of Epsom: I would like to follow on from Lady Maddock’s question. We are being told by some people in the eurozone that the eurozone crisis is over. I do not think we believe that, and I think I can speak for all the Committee that we are seriously concerned about many of the eurozone banks and their capacity to survive. As you know, there are agreements that there are going to be common stress tests, which I gather will be carried out by the EBA under the auspices of the ECB. What do you think those stress tests are going to reveal, and how does the ECB actually deal with them if the single supervisory mechanism has gone through but there is no resolution mechanism? They will merely be able to find out what is wrong with the banks, but they will not have the power to intervene, sort them out and recapitalise them. Professor Bénassy-Quéré: On the one hand, I think the ECB is going to be very serious for the asset quality review and then for the stress testing of the banks. It clearly has an incentive to be tough, since the banks will be under its supervision following these tests. However, you are completely right that if there is no single resolution mechanism that can actually resolve a bank at the same time, the credibility of the whole thing is gone. The discussions are going on, and I am not following it day after day. I think it is still progressing. The main flow here is the fact that we seem to think that there will no longer be a need for public money in the resolution of the banks. I am not so sure of that. At least in the short run, resolution funds, which will still be national, will obviously not have the means to resolve a bank. Then the question is extent of intervention of Governments and with which backstop. There is a contradiction between two views. The first view is that legacy assets and debts should be dealt with at a national level because it was under national supervision, and if there was a failure it was a failure of the national supervisor, so there should be no solidarity on that. There is a second view that if we leave the whole burden on the national Governments, the loop between the banks and the sovereigns is going to grow. The solution that was taken is half way, with the ESM lending to the Governments, but this is still sovereign debt, so it is not completely satisfactory. We have not really decided between these two extremes.

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There are four pillars for the banking union. The first is supervision, the second is the resolution mechanism, the third is the resolution fund, and the fourth is deposit insurance. There is a directive for deposit insurance with some provisions, but on the whole I do not think this is the most urgent thing. We have seen for Cyprus that, to a large extent, the TARGET2 system is a kind of substitute for deposit insurance. We should not be too frightened by the possibility of deposit flight in crisis countries, because we have this TARGET2 system. This single deposit insurance scheme should come last. We should focus today on the resolution mechanism, but also on the fiscal backstop to resolution, which is very important for the whole thing to be credible.

Q226 The Earl of Caithness: I would like to ask you two questions about the integrated economic framework. I will take them separately. The first question is: do we really understand and is everybody clear what an integrated economic policy framework will encompass? Professor Bénassy-Quéré: No one has a clear idea. We have piled up a number of new schemes since the start of the crisis, and no one can understand any longer what is happening. It is very difficult to explain our present economic governance to anyone. In the coming quarters or years, some of those schemes will have to be dropped. For instance, the procedure for excessive macroeconomic imbalances can really be streamlined. It relies on a scoreboard that is ill designed. For instance, in the scoreboard, you have the loss in global market shares—market shares of each member state on the global market. As we know, since we have emerging countries, the market shares should fall everywhere, even in Germany. Germany is going to be a country concerned with that, so it is absurd. In an equivalent sense, in the scoreboard, you have the real effective exchange rate not within the euro area, which would make sense, but for each country vis-à-vis the whole world. If the euro goes up or down, this will move all the countries in one side or the other side, and it does not make sense to have a scoreboard based on that. Just looking at the current account of a country would have achieved a lot before the crisis—for instance, it was evident for Spain and Ireland—to detect macroeconomic imbalances. Then you can have an in-depth analysis of whether this is good deficit or bad deficit and things like that. This, for instance, can be streamlined. Also, in the fiscal compact you have a debt reduction rule, which is one-twentieth of the excess of debt being reduced every year. This is very tricky because basically it does not depend on the Government. The Government can have a huge fiscal surplus and still, due to the evolution of interest rates or growth evolutions, the debt will not be reduced by the required amount. This is really going to make fiscal policy even more procyclical. We want to have less procyclical fiscal policy, with a focus on structural deficit rather than headline deficits. With the debt rule, it is going in the other direction. In my view, this is quite inconsistent. On the other hand, we have done very little in terms of growth. If you look at the co-ordination of economic policies over the last 20 years in the EU—not only in the monetary union—you see that everything that concerns employment and growth is non- binding. The only rules that are binding are those that concern discipline. There is a clear preference for discipline as compared to employment and growth. It is an asymmetry, and this needs to be corrected. The Earl of Caithness: That is helpful, but it is confusing if we are not all agreed as to where we are going and what is encompassed. Let me turn to the second question. The Commission has proposed, and various agreements have been reached on, for instance, the

28 of 441 Professor Agnès Bénassy-Quéré—Oral evidence (QQ 222-229) stability and growth pact, none of which have achieved the desired aims. They have now come up with convergence and competitiveness instruments. What will the French reaction be to being told what to do by the Commission? How will the national Parliament and the French public react to the budget that is being looked at by the Commission before it is looked at by the French Parliament? Professor Bénassy-Quéré: This is already under way. There is no difficulty having the French Government or the French Parliament discussing with European authorities. The problem is the announcement. It is quite difficult for the President, for instance, to say, “The Commission told us that we should liberalise the labour market. Let us do it”. Since the Government are accountable to the French people and the Commission is not directly, or even indirectly, in fact, there is a clear asymmetry. This could be changed with a change in the treaty. For instance, if the President of the Commission were elected by the European people, it would make a big change. So far, I think communication is going to be very difficult. It does not mean that this process is useless, but it may be awkward to communicate too much on that. Was your question also on the possible contracts for structural reforms? The Chairman: Yes, on the convergence and competitiveness instruments. Do you think they are realistic? The proposal that has come is what we would call carrot and stick in English parlance. Professor Bénassy-Quéré: I do not think it is a good avenue to think about buying reforms in a country. The Chairman: Is there any particular reason why you think it is an unhelpful avenue? Professor Bénassy-Quéré: Because you need ownership. This is not the way to have ownership. A better avenue, which we have proposed at the Council of Economic Analysis, would be to define minimum requirements, for instance on the labour market or goods market, and to attach blocks of European policies to that. For instance, we have proposed that a European leg to the insurance scheme be related to structural reforms in the labour market. This is different because it is not a country by country approach. You define at a Union level the minimum requirements for a labour market to function correctly. Then each country chooses to abide or not by these requirements. If it abides and it fulfils the minimum requirements through structural reforms, it can apply to the European insurance scheme. You can imagine the same thing, for instance, for protected professions in our country. We have a big problem with protected professions, which are very difficult to open up because there are very strong lobbies against that. You could imagine, for instance, that you have minimum requirements for opening up of the professions and, attached to that, a European programme for the youth. A country that fulfils requirements for some non-tradable sectors would be entitled to apply for the youth employment programme. This is a much more convincing avenue than a country by country approach where you discuss and you negotiate a contract to make structural reform that is out of reach of the people.

Q227 Lord Bowness: Bonjour, Madame le Professeur. We have a recent paper from the Conseil d’Analyse Économique in which it is proposed that there should be an independent European fiscal committee. Can you perhaps explain this proposal to us in a little more detail? Can you tell us whether you envisage it being outside the control of the Commission? Which body or European institution would it be answerable to? How would

29 of 441 Professor Agnès Bénassy-Quéré—Oral evidence (QQ 222-229) it function and, especially, how would it relate to the Commission’s role in macroeconomic surveillance? Professor Bénassy-Quéré: This is not really a new body. It would be a meeting of existing fiscal committees of the national level. The idea is to organise a co-ordination of these national fiscal committees that have been set up after the fiscal compact. These national fiscal committees would meet, co-ordinate and harmonise their methodologies for the measurement of potential output, for instance, on the accounting of off balance sheet liabilities. They would exchange information and look at aggregate fiscal policy, which no one seems to be looking at. There is a big inconsistency between the recommendation for the aggregate euro area and the recommendations for each country. This may be more controversial: they could also set debt issuance savings, which they would propose to another body because they have no decision-making power. They would have to propose that to the Commission or the Parliament. Within these debt issuance savings, on a country by country basis, countries that complied with these savings would automatically qualify for a precautionary financing line from the ESM. This is a way to activate these precautionary lines, without the stigma attached to that because it would be automatic. Germany would comply, so Germany would get this kind of insurance from the ESM, although Germany does not need it. It is like car insurance. The fact that you have car insurance does not mean that you are a bad driver because it is compulsory, so everyone has it. The Commission would remain responsible for the excessive deficit procedure or for the macroeconomic imbalance procedure. It would not change. The European committee—which is not a new body; it is just the gathering of maybe the presidents of national committees—would provide information to the Commission to help it do its job.

Q228 Lord Marlesford: Could I ask you about mutualisation of sovereign debt? What role could Eurobonds have in achieving such mutualisation? Do you feel that Eurobonds would be issued by the European Central Bank on behalf of particular countries, or would countries issue the Eurobonds themselves for them then to be underwritten by the European Central Bank? Professor Bénassy-Quéré: This is a question about Eurobonds. There are general ideas about Eurobonds and then more specific specificities. What are the advantages of mutualisation? What are the advantages of Eurobond issuance? There are maybe four of them. The first one is that, on aggregate, the evolution of the debt in the euro area is much better than in other countries like Japan or the US. The sovereign debt crisis really comes from the segmentation of this debt. This is the first argument. The second argument is that during a downturn a country normally should insure itself through issuing more debt, and during an upturn it would reimburse. The problem is that during a downturn we have seen that the countries no longer have access to foreign financing at reasonable rates, so it does not work. This has a link with what I said previously about the lack of a credit channel or the weaknesses of the credit channel for insuring countries against macroeconomic and idiosyncratic shocks. The third argument for a Eurobond is the possibility to have an aggregate fiscal policy. In principle, there is no need for an aggregate fiscal policy at the euro area level because we have the ECB, but we have seen that in some cases there would be a need for an aggregate euro area fiscal policy. For instance, when the interest rate is at zero, there is not much scope for monetary policy, and then we could argue that it would be necessary to have a euro area level fiscal policy.

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The final argument that has been floated is that if we had an equivalent to a US Treasury bond in the euro area, the ECB would be normalised as any central bank. It could buy these bonds without thinking of which country it is because it would be a federal bond. This would make the ECB much more like other countries, and it would facilitate liquidity management, because these bonds would be an instrument for liquidity for the banks that could re-finance them. There are three main objections to the Eurobonds. The first one is a political one—no taxation without representation—so we would have to change the treaty. The second one is fairness and the problem of the common pool. The virtuous countries would have no gain and would be potentially at risk, whereas the profligate countries would gain and it might reduce their incentive to adjust. The final argument is an economic argument that if you split the debt between the national debt and the Eurobonds, there is no gain because de facto or de jure the Eurobond would be senior to the national bond, and so the interest rate on the national bond will go up or the interest rate on the Eurobond would go down. For a country like Italy, there would be no gain because it would pay less on the part of the debt that is mutualised, but much more on the part of the debt that is not mutualised. On average, there is no gain, so the debt sustainability problem will not be solved. There have been a lot of different proposals and there is confusion in the debate because it mixes up different objectives of the Eurobond. I sent a graph that tries to map the different proposals. A decision needs to be made on whether you want Eurobonds to solve the present crisis about legacy assets or to complete the monetary union to make a genuine monetary union. The instruments are different in the two cases. If you are in the first approach and you want to solve the sovereign debt crisis—and I very much agree that the crisis is not over, as you said—then you have two problems. You have liquidity problems and a solvency problem. The liquidity problems so far have been fixed by the OMT. There was a proposal for Eurobills, but the OMT is a substitute for Eurobills, so I do not think Eurobills are as useful as they used to appear. You also have a solvency problem, and today the solvency problem is more important because the OMT has solved the liquidity problem. The OMT has co-ordinated the markets on lower interest rates. In a normal country, you solve a solvency problem through debt restructuring. There has been an alternative proposal by the German Council of Economic Experts for a redemption fund. The redemption fund is half way between solving the liquidity problems and solving the solvency problem. It solves liquidity, because in the short term it means that the redemption fund would buy the debt that matures, so there is no longer any problem of rollover of the debt. It tends also to fix the solvency problem because it reduces the interest rate on the debt and it offers a longer horizon to repay the debt, and because the resources to repay the debt are earmarked, so it is a kind of commitment to repay the debt. However, I think that your group is concentrating on genuine monetary union, so it is a more forward-looking perspective. Here, we can have two purposes for Eurobonds. The first is to fund public goods, in the sense of having a fiscal backstop to the banking union; if you think that financial stability is a public good, you want to fund it, so you can fund it through a Eurobond. The second possibility is with project bonds. This is one thing that has been done, although it is limited. The other purpose can be stabilisation. The stabilisation purpose can be thought of in two ways. First, for each country, we would face asymmetric shocks, and secondly, for the euro area as a whole. What I have shown you on one paper are the asymmetric shocks. We can maybe discuss later what kind of scheme you can imagine for cushioning asymmetric shocks

31 of 441 Professor Agnès Bénassy-Quéré—Oral evidence (QQ 222-229) within the monetary union. Several proposals have been made. The general idea is that with a 2% of GDP budget, you cannot do much to stabilise. You can do more if you can borrow, but then you need very strong governance and you probably need own resources for the budget.

Q229 The Chairman: Professor Bénassy-Quéré, we are running out of time and I just wanted to ask one last question. We are very grateful to you for all the information that you have sent through to us, including the tentative classification, which was very valuable to us. Just as France and the United Kingdom work well together in the defence field, on what areas do you think the United Kingdom and France might work together on genuine economic and monetary union? Are there areas where we together can give a special lift to what is being achieved and attempted within the European Union? Professor Bénassy-Quéré: This is a great question. Maybe something that the UK and France have in common is the share of the services sector in the economy, although in the UK it is much more financial services and maybe in France it is services more generally. The UK has always pushed for more opening up of service sectors, and I think the French economy can also gain from that. In the transatlantic discussions, there is a big question about services. Working on the European market for services and the competitiveness of European countries in services, and selling services to foreign countries, would be an interesting avenue for co-operation. The Chairman: Professor Bénassy-Quéré, on behalf of the Committee I would like to thank you for coming before us today and for answering the questions so well and so richly. We have found the three-quarters of an hour very useful indeed. We will send you a transcript of all that has been exchanged between the two parties. We would ask you to correct it and, indeed, if there is any additional material that you have, please send it to us. Thank you very much indeed for participating today. We conclude today by saying that if ever you are in London, come and see us in person in the House of Lords. For the moment, au revoir à la prochaine fois. Merci bien. Professor Bénassy-Quéré: Thank you very much for your very kind attention and thank you for the invitation. I will surely come one day. I hope that you will have very good discussions internally after these different hearings. I do not know whether your work is public. The Chairman: Yes, it is. Professor Bénassy-Quéré: Maybe from outside I can get part of the conclusions, because it is also useful for us to have an outside view on these questions. Thank you very much. The Chairman: We will publish just after Christmas. Thank you very much indeed.

32 of 441 Graham Bishop, Megan Greene, and Hugo Dixon—Oral evidence (QQ 19-38)

Graham Bishop, Megan Greene, and Hugo Dixon—Oral evidence (QQ 19-38)

Evidence Session No. 2 Heard in Public Questions 19 - 38

TUESDAY 4 JUNE 2013

Members present

Lord Harrison (Chairman) Earl of Caithness Lord Carter of Coles Lord Davies of Stamford Lord Flight Lord Hamilton of Epsom Lord Kerr of Kinlochard Baroness Maddock Lord Marlesford Lord Vallance of Tummel ______

Examination of Witnesses

Megan Greene, Chief Economist, Maverick Intelligence, Graham Bishop, European Affairs Specialist, and Hugo Dixon, News

Q19 The Chairman: Colleagues, we renew our interest in Genuine Economic and Monetary Union. We have three very fine witnesses, not the least two of whom have come at such late notice. We are most grateful to Graham Bishop and Hugo Dixon for that, and we warmly welcome Megan Greene. Perhaps I may ask the three of you that when you first speak to say who you are and where you come from, that would be very helpful indeed. Those of you who are familiar with the House of Lords know that we make a transcript of the exchange of views. We will send that to you at the conclusion and we would ask you not only to correct the transcript but to let us have any further ideas you think should be shared with the Committee. We would be most grateful if you could do that. I believe we are webcast.

Our last witness session produced a certain amount of interest. Perhaps I may also remind colleagues on the Committee that if they have any interests to declare, they should do so in the usual fashion when they speak. Perhaps, Megan Greene, you could help us with Genuine Economic and Monetary Union. In your view, does it correct the faults that were found in the construction of the euro? Is it something that is going to work? Is it something that can be run with? Do you have a view on that?

Megan Greene: I do. I think that it could work in theory, creating an optimal currency area in the eurozone but that requires a few different kinds of unions. It requires a banking union, which there is a lot of talk about now. It also requires a full political and a full fiscal union. In

33 of 441 Graham Bishop, Megan Greene, and Hugo Dixon—Oral evidence (QQ 19-38) theory, I think that is the direction that the euro area needs to go in, certainly in order to keep all of its current members. Realistically, however, I think there are a lot of reasons to worry that Member States might not get there. We are already seeing it in the banking union with Germany and France pulling back recently—yesterday, I think—on their conception of a banking union. Probably the best that we can hope for in some of these types of union is sort of a Soviet style, “We will pretend to work and you pretend to pay us” where Member States pretend to be interested in things like a banking union but are not really. So an ineffective, insufficient bank union, for example, is set up and the ECB pretends to believe Member States and buys up sovereign bonds in the meantime. I think that is probably what we are going to be looking at.

The Chairman: Could you give us a quick pen portrait of who you are and where you are from? Megan Greene: Sorry. Yes. Megan Greene, I am the Chief Economist at Maverick Intelligence, which provides consulting services to companies focused on Europe.

The Chairman: Thank you very much. Hugo Dixon now, please. Hugo Dixon: Yes, I am the editor-at-large at Reuters. Answering your big question, my sense is that we are not going to get much more fiscal and political union in the eurozone. I think that we have pretty much seen the high water mark. I do not think that it is necessary to solve the euro’s problems to have greater integration, so that does not bother me. It seems to me that the main need for the eurozone to survive and thrive is to become much more competitive and have much more flexible economies, not for there to be debt mutualisation and lots of centralised rules on how you run your budgets, which is what a fiscal union in a fully fledged sense would consist of. I think that through a mixture of political pressure and market and economic pressure the eurozone is finally getting its head around competitiveness as the main solution to its problems rather than mutualisation as the main solution to its problems. A couple of years ago, the whole talk was about Eurobonds, fiscal compacts and things like that. If you look at the Franco-German contribution that was published on Thursday—if you have not read it, certainly it is worth looking at, it is their nine-page contribution to the at the end of this month—it is littered with the word “competitiveness”. It is quite interesting for a document that is half French. Of course, the Germans have been pushing that message very strongly for the last few months. That would be my overall view. Just to say from the British national interest, that is quite positive because if you think that the eurozone is going to be charging down the direction to a fully fledged banking, fiscal and political union, that will inevitably mean that the UK will be further marginalised within the process. If, on the other hand, they are not going down that direction but down the direction of more competitiveness and perhaps only limited further union, the competitiveness agenda is one that has been a traditional British agenda for Europe and, rather than being marginalised, we might have an opportunity to get involved.

The Chairman: I think colleagues will be very interested to pursue your idea of competitiveness and its importance there. Before I turn to Graham Bishop, could I ask Megan Greene about the interest in the banking union? If there are no further steps as originally outlined, would that mean that we did not have the building blocks of a true genuine economic and monetary union? Would that be your worry? Megan Greene: Yes. That is precisely right. However, so much in financial services is based on confidence. The idea is they can set up enough of a banking union for there to be more

34 of 441 Graham Bishop, Megan Greene, and Hugo Dixon—Oral evidence (QQ 19-38) confidence in the banks and therefore a true banking union is not really needed. In my view, that is a very risky strategy and probably insufficient, but I think that is what we will see.

Q20 The Chairman: Graham Bishop, I wonder if you, too, could respond to those first thoughts. But also, were it to be pursued through the original tripod setup as envisaged, would we finally arrive at a more optimal currency area? Graham Bishop: First, I am an independent commentator and consultant on European financial affairs. The competitiveness aspect is absolutely critical. If there was a flaw in the operation of monetary union from the beginning, it was that the discussions at the beginning that mentioned competitiveness, or various elements of it, were not pursued. The policy operational targets were all made budgetary, but that was insufficient, as we now know. The Commission has just published its third country-specific recommendations for all the states, other than those in the programmes and this represents a big step. This is the third annual semester. This is a big step towards a much more collective oversight of the competitiveness of the Member States. We are three years down a road that is going to take us to a much closer union on both monetary and economic matters. The democratic side has to keep up. Sorry, your other point?

The Chairman: If it is pursued, will we get an optimal currency area, as was hoped for? Graham Bishop: Yes, I have always thought that the optimal currency area theory may be fine in the fullness of time. We have such a long way to go before it becomes operational that we can quite easily leave that for another generation. We are so far away from it in the sense of designing industrial structures to represent that, it will happen over the years. However, but the main thing now is to get each country more competitive so that the industry in it becomes more competitive and it is happening. This is not a pie in the sky, but looking at the improvement in the trade balance of Italy, Spain, Portugal, Ireland and so on, development and competitiveness have already shown substantial improvements, even in the past two years.

The Chairman: Before I turn to Lord Davies, Hugo and Megan, do you share the view that the optimal currency area will or may develop in time and that may be agreeable? Hugo Dixon: I do tend to share with Graham the view that we are a long way from an optimal currency area. It was premature to create a single currency. However, I do think that the eurozone is stuck with it, so they have to make the best of a bad job. The process of becoming more competitive and more flexible is one of the building blocks to create a more optimal currency area. When you look in the optimal currency area literature, a lot of it is about mobility of factors of production and flexibility of prices and wages, but also about the extent to which you have the transfers from the centre. We are not going to get many transfers from the centre. To some extent, certain structural elements in these economies are going to converge over time and there will be more mobility of labour, partly because the younger generation is all speaking English.

The Chairman: Megan, do you have something to say on the optimal currency area or are you happy with those comments? Megan Greene: I think we probably will see some transfers but through the back door or stealth transfers, so they will not be called transfers. We have already seen them to some degree with some restructuring of loans for some of the bailout countries. I think we will probably see Greece get a big write-down on its official sector loans. So the ECB, if it ends up buying bonds, that will be a form of backdoor transfers. So I think we are very far away

35 of 441 Graham Bishop, Megan Greene, and Hugo Dixon—Oral evidence (QQ 19-38) from an optimal currency area, but there are little steps that in the meantime they are trying to build up on their way there.

The Chairman: The models of Switzerland and the USA, are they relevant here? Megan Greene: They are absolutely relevant as something to work towards as a possible end game. I just think we are about a decade away from that.

Q21 Lord Davies of Stamford: There is no antithesis, is there, between having a competitive economy and having a well-regulated banking system with properly capitalised banks and so forth? Mr Dixon was speaking as if the two things are somehow in contradiction but you can and, indeed, you probably do want to have both, do you not? Hugo Dixon: Yes. I think that there are different routes to trying to keep the eurozone together is what I am saying. One could be massive mutualisation, the other could be more competitiveness. Of course, you could have a bit of both or you could have a lot of both. When you talk about the banks specifically, the question then is: what sort of banking union are we looking at? Banking union does not just mean well regulated banks, although I am very much in favour of well regulated banks. The idea is that you have supervision by the ECB. That is the first step. Then you have a resolution mechanism that would in some form or fashion be able to take failing banks and close them down or deal with them in a non- catastrophic fashion. The third is that you have some sort of deposit insurance backstop. As regards what we are getting, I think that we are definitely getting part one of that system. I would say we are almost certainly not in the short run getting part three of that system, the deposit insurance. We are getting some sort of halfway house for the second pillar of that banking union. I think that will work to some extent but, again, if you look at what the French and Germans said in their contribution last week, and if you see the reports that have been coming out of what the European Central Bank is now thinking—it will have to take on the role of the single supervisor—a lot of effort is going into making sure that the banks are cleaned up before the ECB has to take on the job of supervising them. That is because the ECB does not want to be in a situation of taking on a pile of zombie banks and discovering a few months or years later that they all start failing on it without there being a resolution mechanism that has a proper backstop to take it on. So you could see this from the ECB but also from the Franco-German contribution—at least if you read between the lines—that there is going to be a big stress test and a clean-up job. I think that what you are also seeing, and what you saw in the Cyprus situation, is that there is going to be greater emphasis on bailing in bondholders if banks get into trouble rather than bailing them out through taxpayers’ money. The way that you are going to be able to square this circle of having strong supervision without there being full mutualisation is by getting tough on the banks and by making sure that they are properly stuffed with capital, they are properly cleaned up and that if they get into trouble it is the creditors who take not all of the pain but most of the pain. Frankly, I think that is quite a credible way of proceeding, not just credible but has the right economic incentives for the eurozone. If you think of it from the British national interest, I think that the more we can encourage them down that direction of proper regulation of banks, proper capital for banks and bailing in creditors, that is good for us for two reasons. First, that is exactly what we are doing in the UK and there was a risk that if they went down the mutualisation route, we would be regulating our banks very tightly and they would be regulating their banks rather more loosely but having a big eurozone safety net. That would have meant that our banks would have been at some sort

36 of 441 Graham Bishop, Megan Greene, and Hugo Dixon—Oral evidence (QQ 19-38) of competitive disadvantage. In so far as they jack up the regulation of the banks that makes it more of a level playing field. Secondly, is that in so far as they jack up the regulation of the banks, it is going to be harder for the banks, even in the long term, even once they have gone through this zombie period, to operate as effective financial intermediaries. They will obviously be there but it will be more expensive for them to do the intermediation of capital. Sorry, I have gone on a bit.

Lord Davies of Stamford: Are you saying that they are going to be more highly capitalised in the eurozone than outside the eurozone so will be under a competitive disadvantage? Hugo Dixon: Not more highly capitalised than outside but more highly capitalised than they were going to be and perhaps about the same as British banks will be.

Q22 The Chairman: Let us get on to Graham and then go to Megan, who I think wanted to contribute, did you not? Megan Greene: No, no, that is okay. Graham Bishop: Responding to some of these points, yes, the asset quality review, the AQR, that the ECB is going to undertake before banks come under its supervision is absolutely crucial. If the ECB wants to avoid any risk of its credibility and its monetary policy credibility in the background being tainted, it has to be quite sure that the supervision is done well. Stage one is to make sure only sound assets come in. The next question is the stress testing of the banks that have come in to make sure they are well capitalised for all reasonable circumstances and expectations. I think we are all agreed here that at that stage you do not need deposit insurance at a European level for the immediate future because the chance of any of these banks failing is quite low. The problem with all this is when the banks are bought into the system and the asset quality review shows some duff assets, who is going to pay for the losses? This is going to be the bag, I suspect, of the national Governments. We have the banking recovery and resolution directive going through at the moment and that is exactly what will force ex-post, as it were, the creditors to take some of the burden. This is where shareholders, bondholders—is there a depositor preference? This is the debate that is surfacing very strongly.

Lord Davies of Stamford: What you are describing, Mr Bishop, sounds completely sensible to me, that you would try to clean up the banks before the ECB takes them over, then in future it is expected that large commercial depositors, above the 100,000 limit, and bondholders are expected to evaluate the risks that are attached to the yield that they are receiving. That seems to be very sensible.

Can we move away from the normative issues as to whether this is a good idea and move to the factual issues of what is actually happening on what sort of time scale? Are we going to see a common single supervisory system in place by the end of this year, which was the Commission’s original intention? If not, by when? Graham Bishop: The SSM directive has been approved in principle, political agreement. We are now awaiting the German Parliament defining its agreement to enable—

Lord Davies of Stamford: Just briefly, what is your assessment of the timing on all of them?

37 of 441 Graham Bishop, Megan Greene, and Hugo Dixon—Oral evidence (QQ 19-38)

Graham Bishop: The timing is that by the middle of this year we will certainly have the SSM in operation legally and it will be fully functioning by July 2014.

Lord Davies of Stamford: What about the common resolution system? Graham Bishop: We await the formal proposal from the Commission. I expect it to be more ambitious than the Franco-German proposal, if it is a proposal. That will be operational as a college system at about the same time as the SSM comes into operation. It will not be ideal—

Lord Davies of Stamford: This year? Graham Bishop: The middle of next year, yes.

The Chairman: Megan and Hugo, would you care to respond on when these things will be in place? Do you have a timetable? Megan Greene: I think it is realistic to think that we will have an SSM in place by the end of the year. It might have some teething problems in that you might just add another layer of supervision above the national supervisors initially, but I think that we will have it by the end of this year. For a single resolution mechanism, we have seen leaked documents on what the European Commission has proposed and it is a lot more ambitious than what France and Germany have proposed. But there is still the issue of potential treaty changes. If there are treaty changes, it will take years, absolutely. Graham Bishop: That is why there will not be.

Q23 Lord Davies of Stamford: That is my last question. Perhaps you could address that because the other day Mr Schäuble said he thought that treaty change was required. Surprisingly, he seemed to think it was required for a single supervisory mechanism and he also felt it was necessary for a common resolution system. Can you just address that? Are Mr Schäuble’s concerns right? Is he correct in his assessment of that? If so, is that going to have an impact on the timing? Megan Greene: I think we will get an SSM without a treaty change. In the eurozone, a lot of things are illegal until all of a sudden they are not. It is like bailing out a Member State, for example. I think these legal challenges are more political than anything else. I think Mr Schäuble is trying to avoid any further serious discussion about this, certainly before the German elections in September. Even beyond the elections though, I do not think that the Germans are particularly interested in having a fully fledged banking union, so I think they are just stalling for time. Graham Bishop: If you want to have a new community institution called the single resolution authority, if it is going to operate through union law, you will need treaty change to set up a new institution. That is not going to happen, either quickly or for a number of reasons such as some countries might decide to have a referendum about that treaty change.

Lord Davies of Stamford: There would be an ad hoc inter-governmental arrangement in place by next year? Graham Bishop: No. No. I believe that what we will see is that there is already a community institution in existence—it is called the European Commission—which will be able to operate this as the final and formal decision within the legal framework of the Meroni judgment in its power to delegate and so on. The European Commission will be the

38 of 441 Graham Bishop, Megan Greene, and Hugo Dixon—Oral evidence (QQ 19-38) authority but it will act in exactly the same way as the Member States have agreed that the SSM will. That set of regulatory authorities will provide advice to the Commission and it will then act in accordance with the existing treaty.

Q24 Lord Flight: How big do you expect the pre-ECB cleanup of the banks to be? My view is that it could be very large indeed with a slight lack of clarity of who is paying for it. Logically, it looks like Governments but I think, Mr Bishop, you made the point that you thought that could include some creditor bail-ins. Is that correct? Graham Bishop: Yes. I look at the average price of bank shares versus book value and as a round figure it is 50%. The equity market is discounting some big expected losses in the future. There is a problem with the accounting standards where the auditors and so on say, “These are the incurred losses presently reported”, but equity markets look ahead. That is what has to be cleaned up and those will be substantial. The question now is will some of that be imposed on the creditor hierarchy?

Lord Flight: Exactly. Graham Bishop: I think the answer is going to be yes because the relevant directive will be enforced. Some people will say, “That is a bit rough because I did not know that at the time”, but the fact is the equity holders are pricing at half value so they must have expected something.

The Chairman: Let us press on.

Q25 Lord Hamilton of Epsom: Binding contracts known as convergent and competitive instruments have been proposed for GEMU. This involves sticks and carrots. Do you think that this is workable and can you see this taking effect?

The Chairman: Hugo Dixon, you are very interested in the competitiveness side. Hugo Dixon: I am. I think we are going to see some of these contracts. They do appear, again, in this Franco-German paper. I do not see them as the main game in town and part of the problem is, as you say, carrots and sticks. Where is the carrot going to come from? It cannot come out of the normal EU budget. It would have to come out of some new euro area budget. Although there is some talk about creating a new euro area budget nobody has really put a figure on it or said where they are going to get the money from. One idea was to get it from this financial transactions tax, which, thankfully, looks like it is dying a slow death or at least is going to be much smaller than when it was first considered. I think that this idea will come through in some form, but I do not see it as the main game in town. I see the main game in town as pushing competitiveness through, largely through the existing system, largely just through the need to get people back into work.

The Chairman: I think this Committee is dying a slow death in dealing with the financial transaction tax! Megan, can you contribute? Megan Greene: Yes, I would agree. I think we will see some binding contracts but I would question how much they are enforced. I think a good example of that is we just had the European Semester and they had a bunch of countries that they did this macro-economic and balances test on. was one of the first countries to test it. This was all set up in December 2011 so it is not very old and already they decided not to impose what they would have had they followed the letter of the law. I think that is a good thing, it reflects

39 of 441 Graham Bishop, Megan Greene, and Hugo Dixon—Oral evidence (QQ 19-38) that policymakers are starting to look a little bit more flexibly at the crisis response, particularly during times of recession, and I think we will see more of that going forward.

The Chairman: Before I bring in the Earl of Caithness, Lord Marlesford, did you have a supplementary?

Q26 Lord Marlesford: Mr Bishop, in a sense answered it. I do have this concern about the body to do it. You talk about a new body needed and then you went on to say, “The Commission is fulfilling the role”. Is there a trigger point at which the Commission will not be able to fulfil the role and then you will need treaty change for this new body? Is there some particular trigger point? Graham Bishop: If we do not have another financial crisis in the near future, the Commission acting as an existing European institution tasked with the role through the directive of being the single resolution authority, acting on advice received in the way it does with all sorts of things at the moment. That model works perfectly well. If we felt that at some stage we were running the risk of another major crisis and we wanted to beef that up, that is when we would need a treaty change to create this new institution within the European treaty, which would be called the single resolution authority.

The Chairman: Is that your view too, Hugo? Hugo Dixon: I must say that is not my view. My view is that we probably will not get the European Commission acting as the resolution authority. I think that Germany does not want that to happen. It looks like France does not want that to happen. I think that they just do not think that the European Commission has the competence to do that.

Lord Davies of Stamford: What is their solution? Hugo Dixon: Their solution is that it is not an authority. They have talked about a board, which is something more than the network that Mr Schäuble was talking about. It is taking a lot of national resolution authorities coming together in an inter-governmental board. They have not spelt out exactly how that would work, but what they have said is that that might, at some point, be merged with the European Stability Mechanism, which is a euro area institution that is responsible for bail-outs and has €500 billion of spending authority. But it is quite interesting because the governance on the ESM, the European Stability Mechanism, is completely different from the governance on the European Commission. Basically the big states, particularly Germany, France and Italy have votes equivalent to their economic weight and that gives them a veto. Each of those three big countries has a veto over what happens. Is it only Germany? Sorry, I stand corrected. Only Germany.

The Chairman: Megan, could you use the Article 136 example to set up any such new institution? Would that be possible? Megan Greene: To set up a new institution?

The Chairman: Yes. If the Commission does not deal with it? Megan Greene: You could set up a new institution. It would need to be embedded in some kind of democratic process and that is a political union right there, which not all the Member States are interested in anyhow. So procedurally you could set it up. There would be questions about the democratic deficit and also about governance. I do think I would highlight something Hugo mentioned, which is that the German-Franco idea is eventually use

40 of 441 Graham Bishop, Megan Greene, and Hugo Dixon—Oral evidence (QQ 19-38) the ESM. But you cannot really use the ESM credibly because all of the Member States contributing to it can say, “We do not want our money to go to that”.

Q27 Earl of Caithness: I would like you to look a little bit more into the future, notwithstanding Mr Dixon’s comment that we had reached the high water mark of economic integration. Surely, particularly with the EU beginning to flirt with competitiveness, there will be increasing demands for harmonisation of taxation? Where do you see this working? Is this a possibility? What are the benefits for those within the euro and what are the disadvantages for those that are not in the euro? Graham Bishop: I think it is absolutely fascinating that suddenly the EU as a whole has started talking about the financial transactions tax. Okay. I agree entirely that is disappearing, mercifully. But now the savings tax has come back and that is where the UK Government have played a full part in bringing our dependent territories, as I understand it, into that net. Then there is the whole question of corporate taxation. The common consolidated corporate tax base—CCCTB— is coming on and I am not surprised by this in the corporate area. The Council has just come forward with proposals about addressing the aggressive tax avoidance schemes that have been going on. Again, the UK Government has been heavily involved in that. Suddenly there is an economic necessity of collecting taxes and the estimates are that there are a trillion a year of taxes lost. I do not believe that. It is so big I just cannot believe it. But, nonetheless, they are big numbers. Something must be done and there must be co-operation. In terms of corporate taxation, I have always argued that since we have had a single set of accounting standards—and we can debate the fine points— it is not going to be long before companies say, “This is how we define profit”. To have that taxed in a different way over there and there and there, there will be a drive to have that more harmonised and the CCCTB proposal is exactly a step down that road. I expect this to happen much more in the years ahead, driven by the economic necessity now of collecting all possible taxes. Megan Greene: That is probably right but I think there will be a lot of resistance to harmonising corporate tax rates, for example, from the likes of Ireland, which would rather default than give up its corporate tax rate. We are headed in a direction where we are all going to be trying to collect as many taxes as possible but there will be a lot of opposition. Graham Bishop: I did say about the base rather than the rate. That is the critical thing. The rate becomes a very sensitive aspect.

Q28 Lord Kerr of Kinlochard: Continuing with things that perhaps are not quite top of the agenda but where the Commission is making proposals, what about fiscal capacity? Clearly it envisages—

The Chairman: Can you speak up a bit, please?

Lord Kerr of Kinlochard: —an inner budget, an extra budget drawing on fiscal capacity from and for eurozone members. Do you think that is likely to come about and, if so, how will it relate to the existing budget of the European Union? Hugo Dixon: I must say I think probably something will come about but it will not be very big. I do not know where they will get the money from or how they will control it or how it will interface with the European Commission but maybe Megan or Graham have some better idea.

The Chairman: Megan, do you have a view on that?

41 of 441 Graham Bishop, Megan Greene, and Hugo Dixon—Oral evidence (QQ 19-38)

Megan Greene: Yes. The debate on this is really just starting. There are absolutely no details on what exactly the new EU budget would be used for or how it would be funded. I find it questionable that we will even get one given how unclear and murky it all is. Graham Bishop: I just see this slight possibility on the horizon that if we are going to make the banking system, particularly the big banks, much more European and we are going to have the taxable base much more European, the backstop, the supervision, the resolution, which eventually will be the SSM, are all European. Maybe some of the tax revenues of these European companies should be paid into a central European treasury. Lord Kerr of Kinlochard: Seriously? You really believe that is possible? In your answer to the last point you clearly distinguished between harmonising the tax base where, yes, there is general support although the United Kingdom and Ireland are strongly against it, and harmonising tax rates. As far as I know there is no single Member State that wants to do that because they all find tax competition a good thing. I do think this subject about tax avoidance is the one on which the greatest hypocrisy is talked in capitals and in Brussels. That is quite a high accolade because there is lot of hypocrisy about, but this is the big one. Do you seriously think that the Irish would agree that a tax on banks should be collected in Ireland or by Brussels? Graham Bishop: Once we have gone to the situation where the banks have become more and more European entities, supervised, backstopped, guaranteed, and so on, a decade ahead, that is when this is a European activity. The taxes are being levied. If these banks become Societas Europae, an actual European company, then where is their home?

Lord Kerr of Kinlochard: We know that the Commission has ambitions in that direction. As we saw on the financial transaction tax earlier on, it was suggested that the proceeds derived from the financial transaction tax might go into the EU budget. That is not the current proposal, as I understand it. I just find it unrealistic that you could get the necessary unanimity, this being tax, among Member States for any proposal along the lines you have described in the future. Graham Bishop: Ten years of European banks, I think we could find that quite an interesting change of view of it. I am not suggesting it is on the cards at the moment.

The Chairman: Do you think that might be true, Megan? Megan Greene: So I actually view this to be the other way around. You said, for example, once we have European banks, then maybe we will get some kind of pooling of assets or tax revenues. I think resistance to pooling of tax revenues will prevent us from getting European banks. The Germans, in particular the finance ministry, are pretty dead set against that kind of fiscal union upfront to help fund European banks or banking.

Q29 Lord Marlesford: We have heard a lot about fiscal union. The question really is whether the political barriers to it are insuperable and whether it is necessary anyway. If we could go back to the points that have been made about competition being the solution, to some extent it has been mentioned that competition either means competing with each other within the euro area or competing with the world as the euro area and to some extent, presumably, that must indicate more harmonisation. I do not know whether harmonisation to achieve competition is what fiscal union is really about or what are the bits of fiscal union that could be achieved?

The Chairman: Hugo, you are interested in this area.

42 of 441 Graham Bishop, Megan Greene, and Hugo Dixon—Oral evidence (QQ 19-38)

Hugo Dixon: Yes. I do not think that competitiveness requires harmonisation and I do not think that competitiveness requires union. In a market economy, the way that companies compete is often by differentiating themselves. It is not by all doing the same thing. Although people say, “You can never have the success of the eurozone while the Greeks are so much less productive than the Germans”, what I would like to point out is that often the terms “productivity” and “competitiveness” are used as if they are the same term but they are not. You cannot have a successful eurozone so long as the Greeks, the Italians, the Spanish and so on are not competitive, but there are various ways that you can get competitive. One way that you get competitive is indeed by becoming as productive as the Germans. That is not going to happen. The other way that you get competitive is by not being paid as well as the Germans and that is happening big time at the moment. It is a very nasty process but once you are through it, then you can compete. So I think that you do not need either harmonisation or transfers for this competitiveness to—

The Chairman: You were both nodding your heads and agreeing with Hugo there, is that right? Graham Bishop: Yes, the big change is going to come in wages, not productivity, in the short term. It has happened—more to go—but the Greeks in their specialist field of tourist attractions appear to be becoming more competitive again, and the tourist arrivals there are rising very quickly, so it can happen.

Q30 Lord Carter of Coles: I suspect you have partly answered this but what are your views on debt mutualisation? Do you think we are ever going to see Eurobonds introduced?

The Chairman: Megan, would you answer that or did you want to come in on the last question? Megan Greene: Sure, I will answer this quickly. I do not think we will see that mutualisation in Eurobonds. We might see Eurobills. We might see a debt redemption fund so there might be other forms of mutualisation but I do not think Eurobonds will be it, particularly for its unlimited nature and the amount of risk that the core countries would have to take on. I think that would be unacceptable for them. In terms of what we were just discussing, I agree there is a difference in how you can boost your competitiveness. The structural reforms piece of what all of these bailout countries in particular, but also some of the non-bailout countries, are trying to implement is meant to help improve productivity. So the quick and dirty way to increase your competitiveness is to cut wages and pensions. The much more sustainable way is to implement structural reforms but that takes a while to bite and start supporting growth.

The Chairman: Did you two want to add to the debt mutualisation. Graham Bishop: Yes, if I may do that. I do not believe that there will be Eurobonds. The term has become very emotive and to be very clear what we mean, all the eurozone Member States giving a joint and several guarantee of these bonds. If it applied to all public debt, what that would mean for Germany with their €3 trillion annual economy is they are going to guarantee €12 trillion of debt. The moment you say that, everyone says, “This is impossible”. That is Germany, and the same with France, Italy, and so on. So joint and several guarantees are implausible and the only place where it is done in the EU at the moment is the European Investment Bank, but then there are assets behind it.

43 of 441 Graham Bishop, Megan Greene, and Hugo Dixon—Oral evidence (QQ 19-38)

So the approach for mutualisation that is being used is the ECB, which is a pro rata guarantee, and ESM, which is exactly the same approach, and that is what I think will happen with Eurobills. Up to two years is a proposal I have put and I know that the Commission is looking at it very closely. Eurobills mean that up to two years, they say that if countries do not continue to meet the rules for competitiveness and so on, then you can just pull the plug on it and you go back to where you were, but after two years the guarantees run out. The proposal for the German redemption fund argument is interesting in theory. If you can trust your neighbours and you know that it is proven beyond all doubt for the next generation, you might want to give a joint and several guarantee for 25 years for above 60% of GDP but I think we are a long, long way from that. So, on the redemption fund, forget it.

Q31 Lord Hamilton of Epsom: The Germans claim that there are vast constitutional barriers to this. Is that absolutely definite? Graham Bishop: The Eurobill?

Lord Hamilton of Epsom: Yes. Their constitution basically bans this. Is that true or is that a barrier that could be surmounted in extremis? Graham Bishop: No. The proposal that I have put—and I have a copy here to give to the clerk—is very carefully structured to go within the constitutional courts, it has to be time- limited. Hence, two-year bills, maximum; a fund that is temporary and finishes after five years, so it is time-limited. It can be renewed of course and the volume limit must also be identified, so rules on the maximum volume. With those two safeguards, that fits absolutely within the constitutional courts’ constraints.

The Chairman: Graham, will you just distinguish between—

Lord Hamilton of Epsom: The Eurobond was completely ruled out? Graham Bishop: Yes, because it becomes an unlimited guarantee and for obvious reasons, Governments do not like to make unlimited guarantees.

The Chairman: Graham, will you just distinguish between bills and bonds just to help the Committee? Graham Bishop: Yes, if one is going to be purist, bills typically are up to a year and you pay 95 and get a 5% interest rate by it being redeemed at 100 at the end of the year. These are somewhat artificial distinctions but the reason I call this “bills” is to identify it as being short- term, because that is the key political message that this only lasts for a while and if things go wrong, you stop it and you are not on the hook for 10 and 20 years.

The Chairman: Hugo, did you want to come in on this? Hugo Dixon: I just wanted to say that I think that Eurobonds are pie in the sky; these other forms of debt mutualisation, I doubt you are going to see them. You may see the Eurobills but I somewhat doubt it and that is partly because the pressure is off. The reason the pressure is off is you have to remember a big thing happened last year. It was Draghi’s speech of “Do Whatever It Takes” and the result is that the yields of particularly Spain and Italy have come down dramatically. So the idea that you are only going to go to the northern Europeans who have bailout fatigue saying, “You have to take on liabilities for the whole of southern Europe”, they do not want to do that. The need for the southern Europeans to get such help has also receded because of Draghi’s statement and further promises of action.

44 of 441 Graham Bishop, Megan Greene, and Hugo Dixon—Oral evidence (QQ 19-38)

The Chairman: So influential has Draghi’s statement been, I fully expect to see a Euro plaque in Brussels in the near future.

Q32 Lord Flight: I declare my interests as in the register, which includes publishing a book in 1988 called All You Need to Know about Exchange Rates. It broadly foretold of what would happen if the Euro was brought in and I crudely made the point that Italy was fine if it could devalue 2% or 3% every three or four years. I think competitiveness is absolutely the centre of this. The crisis erupted because the southern states broadly had become wildly uncompetitive against Germany. I am slightly amazed—although in some sense I welcome it—that Hugo is comfortable that competitiveness is going to be restored and it will solve the problem by smashing wages. This is what I call the German gold standard austerity measure, which I think is highly likely to cause worse political upheavals down the road, the same sort of thing that led to Hitler in Germany in the 1930s.

I have not observed a currency union, which is very difficult to achieve anyway, without there having to be ongoing transfer of payments to keep the weaker bits afloat from time to time. In America, it is large. Here, it is about £70 billion a year and I just see a conflict in that I do not see a willingness in Germany to go on funding the money. The only way it can happen is backdoor transfers via the ECB. But if a currency union is going to survive, I do not think it can do so just on smashing living standards of the countries that are naturally less competitive.

The Chairman: Hugo, would you like to reply to that and perhaps bring Megan in— Hugo Dixon: They are naturally less productive, I do not believe they are naturally less competitive. The wages of the Greeks, in particular, but also the Spanish and the Portuguese, shot up dramatically. The fall in wages that they are now suffering is taking them back to roughly where they were and, of course, coming down from something you became used to is much more painful than if you have never become used to it in the first place. However, the process has not just started but has gone quite a long way. As Graham was saying, current account deficits have come largely into line. The Greek current account deficit, which is the worst one, has almost vanished. The Spanish one has moved, I think, into positive territory. It was 10% of GDP. There is an expectation that we are going to see some sort of relatively not-so-terrible unemployment figure in Spain. I think it may even be today. I do not know if it has come out but Rajoy indicated that it was going to be positive, so what does that mean? It means that it may not go up further from 27%. Is this sustainable? My sense is that we are probably reaching a point where these countries are no longer getting much worse. The problem is that you have terrible unemployment and if you have a choice between lowering wages, which gets people back into jobs, or keeping wages high and unemployment going higher and higher, I know the one I would take. I would take the, as you call it, smashing of living standards. If you have 27% unemployment, 55% youth unemployment, whether that is going to be enough to stabilise things, I do not know because that is a pretty ghastly situation. They have to get these unemployment rates coming down but it is certainly better to have them stabilising than further going up.

The Chairman: Where do you find yourself on that one, Megan, on the unemployment exchange? Megan Greene: Yes, I am a bit less sanguine, I think. You highlighted whether Germany would be willing to backdoor transfer. I question whether some of these weaker countries will be willing to do what it takes to look more like Germany. The employment issues are

45 of 441 Graham Bishop, Megan Greene, and Hugo Dixon—Oral evidence (QQ 19-38) absolutely key. The eurozone’s plan right now for alleviating unemployment is pretty lacklustre. It seems like they are pinning most of their hopes on the European Investment Bank, which will hopefully help fund SMEs. Of all the institutions I have ever looked at, the EIB is one of the most sclerotic, so I think anyone who is hoping that there is going to be a quick turnaround in unemployment in Europe is sadly mistaken.

The Chairman: Baroness Maddock, take us to a very interesting area, which I think Megan is particularly interested in.

Q33 Baroness Maddock: Yes, it was about the institutional issues, which I think you have all touched on in your comments so far. I was going to ask about what changes are needed to the EU institutions if we are going to accommodate deeper integration. Hugo, you expressed the view that you did not think there was going to be deeper integration, I think, in your comments. Megan, you talked about democratic deficit. Mr Bishop, you also talked about that—I think your phrase was, “the democratic side has to keep up”— so I would be interested to hear your comments.

The Chairman: How will the democratic side keep up, Graham? Graham Bishop: The starting point has to be the European Parliament. It now has co- decision through the Lisbon Treaty and it had a de facto role before. That is not going to be taken away. In a year’s time, we will be having a set of elections of one person, one vote. The number of seats they get is not so proportional but, nonetheless, we have a parliament that works. The only way in which the ECB can be accountable to Europe as a matter of practical mechanisms is for Mario Draghi, its President, to go to Brussels and appear before ECON. The idea that the President of the ECB can come here—I believe he has done and I am sure he will be delighted to do so—but going around 28 different countries is just not practical. So I find that the role of the national parliament—and I recognise where we are sitting—is key but the national parliament should be controlling their own executive and it is their Ministers who go to Brussels and agree the directives. That is the mechanism for involving the national parliament.

Lord Marlesford: Like the Danes? Graham Bishop: The Danes do quite a bit, I was there just last week and they find it very difficult to keep up. How to give a steer to their Ministers that is informed sufficiently, and they talk about the stack of papers when you do scrutiny—you have the stack of papers— how to really do that? So the idea that national parliaments will be directly involved, I find it very difficult to see how it can be done in practice. We have a European Parliament. It needs to work better and be seen by the citizens, the voters, as more relevant. I think the next election in a year’s time, certainly in this country, is going to be seen much more as an election about Europe rather than a series of issues about schools and domestic—

The Chairman: Our witnesses might like to know that we had Dr Constâncio as a witness to this Committee on the Banking Union Report but I do understand Graham’s point about the inability to be able to go around all 28 countries.

Q34 Lord Kerr of Kinlochard: I would just like to ask Mr Bishop about what he thinks will be the effect on the European Parliament, and on the UK’s position in the European Parliament, of what he describes. I agree with what he describes. Can ECON ever again have a British chairman? It is going to become a two-tier parliament?

46 of 441 Graham Bishop, Megan Greene, and Hugo Dixon—Oral evidence (QQ 19-38)

Graham Bishop: Yes.

Lord Kerr of Kinlochard: The answer to the West Lothian question—let us call it the Westphalian question—will be that those who are not part of the eurozone will be taking part in voting in only part of the business of the parliament? Graham Bishop: Yes, that has already been proposed. I am not quite sure how far it has gone through the system but when ECON meets to review euro matters it will be composed only of euro area MEPs voting. We are being marginalised.

Lord Kerr of Kinlochard: This can be done, can it not, without any question of treaty change because the parliament makes its own rules of procedure? It requires a super majority, as I understand it, a majority of Members of Parliament, not just those present, but it can make its own rules of procedure. Is that right? Graham Bishop: I am not too sure about some of those institutional finesses, but from my conversations I am clear that they believe that they can, with enough internal support, create sub-committees and so on, which will just be euro area committees for euro area activities. The more we go down this path, the more countries join the euro area, and remember of course that everyone except us and Denmark—I do not believe the Swedes really do have an opt-out so it is definitely us and Denmark—is committed eventually to being in. So over a period of time, and I think maybe it is a decade, that sort of flow, it will be them and just us.

Q35 The Chairman: Megan, could you respond to Baroness Maddock’s question, and Hugo as well, on the role of national parliaments? Do you see that as a counterweight or a compliment to the growing strength of the European Parliament? Megan? Megan Greene: Yes, I talked about the democratic deficit and about how a banking union, whatever kind of form it takes, will need to be embedded in a democratic institution. I have always thought the European Parliament was the most likely candidate. Whether that ends up happening or not, I think it is probably the best option for a banking union and if that is the case I think we will get a two-tiered European Parliament with eurozone countries and the others. In terms of national parliaments being a counterweight towards the European Parliament, I think as far as the eurozone is concerned, that is somewhat counterproductive in that the move is towards a political union. So I think the UK’s interests are different but as far as the eurozone is concerned, I am not sure that it would be best to have the national parliament as a counterweight.

The Chairman: Megan, are there any insights that we might get from the current US or Swiss model in terms of accountability of that kind? Megan Greene: It is a good question. Despite my accent, I am not as much of an expert on the US Government as I might sound so I do not have the authority to comment.

The Chairman: Hugo, would you like to respond to the national parliament point? Hugo Dixon: I think that although I go with Graham’s point that Draghi cannot come around every single national parliament, I think you have to remember we are the equal second largest economy in Europe. We house the City of London and there are a lot of people in continental Europe who are very interested in the British position. So I think that while it might be difficult for Slovenia to get Draghi to come and talk to them, I do not see

47 of 441 Graham Bishop, Megan Greene, and Hugo Dixon—Oral evidence (QQ 19-38) why you cannot ask all sorts of people to come and give evidence and why they would not be delighted to come and give evidence. I think if you do a good job of continuing your reports and so on and so forth, and really probing and understanding the issues, and publishing them, you can have influence in two ways. One, by directly holding Ministers to account and, more indirectly, through influencing the wider debate.

The Chairman: Before I ask Lord Vallance to conclude our set of questions, Lord Marlesford?

Q36 Lord Marlesford: I wonder if any of you could help me by suggesting in which Members of the EU or indeed the euro area the electorates would feel their vital interests can be represented by the European Parliament? Graham Bishop: The two-chamber system that now operates in Europe, first of all, their vital interests are very directly represented by their Minister and controlled by their parliament.

Lord Marlesford: Of course. Graham Bishop: But as I walk around the European Parliament—and I recognise that the Chairman would have experienced much more than I have ever done—you do find a lot of citizens there lobbying their Member of Parliament, their regional and direct representative that they voted for, or the specialists on the particular subject, and one sees that democratic process happening all the time. So if they want something done about a particular problem, the easiest way of doing something is via the parliament rather than going through their own Government, Minister, Council. The simplest way of getting something to happen, putting it on the agenda, is through the parliament.

The Chairman: I returned to the European Parliament last week after 14 years’ absence. Graham Bishop: Did you say 14?

The Chairman: Yes, 14 and I did notice the teeming activities of citizens. Graham Bishop: It is tremendous.

Q37 Lord Vallance of Tummel: You have already moved into the area I was going to explore a bit, which is the impact of all this on the UK and indeed on the single market. The assumption that you have been making on the bench is that we are in for a GEMU light rather than a GEMU substantive. That may be correct, it may not be, only time will tell. Do you think that, if it is reasonably substantive, there are any impacts of significance for the single market that we should take into account? Megan Greene: I am sorry. I did not hear the end of your question.

Lord Vallance of Tummel: If we are talking about something that is not just GEMU light, the tide has gone a bit further to run than perhaps Hugo would suggest, are there impacts potentially on the single market that we should take into account? Megan Greene: Yes, certainly, I think there will be an impact. The question is what it will be and what it will do for the City in particular. I think that is the UK’s biggest interest. The City has reinvented itself many times. Over history, I am inclined to think that if the single market is impacted and the UK is left outside of it, the City will suffer.

48 of 441 Graham Bishop, Megan Greene, and Hugo Dixon—Oral evidence (QQ 19-38)

Lord Davies of Stamford: What are the impacts? Megan Greene: For the City in particular? I think there has already been talk about trying to move financial centres away from London over to Frankfurt or Paris but—

Lord Flight: We have certainly been there before. Megan Greene: You have certainly been there before. Yes, there is evidence to suggest that it has not happened but I think that if the eurozone does morph into an optimal currency area with a full banking union and a full fiscal union, that would provide more of a threat to UK banks than what we have seen before.

Lord Davies of Stamford: Why? Megan Greene: In terms of ease of transactions. For example, I think there will be huge benefits with financial services being based in the continent than in the UK.

Q38 The Chairman: Can I ask Hugo and Graham, what do you think the right responses are for the UK in terms of the measures that are fast developing? What is our position? How do we watch these events? Do we get involved with the measures? Hugo Dixon: My sense is that we should get stuck in and work with all sorts of actual and potential allies to push our interest. I do think that there is both a threat and an opportunity from what is happening. The threat is that even if there is no further big treaty change, I would say that there will still be a progressive coming together of viewpoints within the eurozone and a risk to us, therefore, that that will be acting as a single bloc for determining rules and regulations. We have had the FTT. Maybe we have seen the end of that or most of the end of that but we have the bonus caps. We have possibly a bonus cap on fund managers that may be pushed through. These are things that are not in Britain’s interest. We had a narrow escape with the first stage of banking union where, I think, George Osborne made a huge mistake urging them on to a further banking union. Then after a few months, he thought, “Oh my god, that means that we are going to be marginalised”. So we have this double voting system but the double voting system will not necessarily last forever. It is only so long as, I think, there are four countries that are out and not in the banking union. So I think we do have threats but there are also, I would say, opportunities and this is the point I was beginning to make right at the earliest part of the session, which is that I think that the future for the whole of Europe’s financial system should be less bank-centric and it should be more capital markets-centric. If you look at the US system where roughly 80% of capital is intermediated through the capital markets, in Europe it is almost the other way around, about 80% the other way around. Banks are in a bad shape in the short run and so they cannot do the job of supporting economic growth but even in the medium term, if you buy my view that they are not going to go for mutualisation, they are going to go for tougher regulation, bailing in of creditors, and so on, it means that banks are still not going to be in the best position to do that. That is a huge opportunity for the UK because although we have big banks, the Germans have big banks, the French have big banks, and so on, where we really have a comparative advantage is not in ordinary banks but it is in capital markets business. If we could somehow encourage a shift in the capital markets so that we maybe not go to the 80% that you have in America but, say, pushed up to 50%, just think, almost all of that activity will be located in the UK.

49 of 441 Graham Bishop, Megan Greene, and Hugo Dixon—Oral evidence (QQ 19-38)

That is a huge opportunity for us and the way to get that, to answer the Chairman’s question, is to get stuck into debate. So if I give you one small example. Mario Draghi is probably the most powerful man in Europe, maybe not the most powerful person but the most powerful man in Europe. He has a flat in London. He has lived in London. He is a man of the markets. As far as I am aware, our Prime Minister has never had a one-on-one meal with him. If I was running the British Government, I would be stuck in there trying to get him on our side.

The Chairman: I will not ask you for the menu but I will just very briefly turn to Graham and Megan. Is there one final point perhaps derived from the advice Hugo has been giving to us there? I am conscious we are running out of time but perhaps each of you has something to offer us. Graham? Graham Bishop: Yes. First, the GEMU is going to be substantive and so we need to be heavily involved. I agree entirely with what Hugo is saying that the results of this banking union must be to shrink, relatively speaking, the banks of Europe. Unless we were to have a catastrophic contraction in credit, it has to go into the capital markets. That is a huge business opportunity for the City of London, which I think it is beginning to realise, but it can only get that if we are a wholehearted member of Europe. If we leave the European Union then, without a doubt, that business will go somewhere else. We do not need to discuss where it will go. It will certainly go.

The Chairman: Megan? Megan Greene: Sure, it would be more interesting if I disagree but I do not, unfortunately. I think the only way for the UK to benefit from the developments in the euro area is absolutely engagement.

The Chairman: Hugo Dixon, Megan Greene, Graham Bishop, the Committee’s thanks to you all, not only to the two of you for stepping in very late and contributing this morning but for the thoughts you have had and have conveyed to us. I would ask you to reflect on those when you look at the transcripts we send you. If there are changes to be made, if you have further thoughts, or if there is anything you have not been able to say this morning, we would be most grateful if you could commit that to paper. In the meantime, our very warm thanks to all three of you for coming in this morning and helping us on our way to finding a path through the thicket of GEMU. Many thanks indeed. We conclude.

50 of 441 Sharon Bowles MEP, Roger Helmer MEP and Syed Kamall MEP— Oral evidence (QQ 209- 221) Sharon Bowles MEP, Roger Helmer MEP and Syed Kamall MEP— Oral evidence (QQ 209-221)

Evidence Session No. 18 Heard in Public. Questions 209 - 221

FRIDAY 25 OCTOBER 2013

Members present

Lord Harrison (The Chairman) The Earl of Caithness Lord Hamilton of Epsom Baroness Maddock Lord Marlesford ______

Lord Bowness Lord Maclennan of Rogart Baroness O’Cathain

Examination of Witnesses

Sharon Bowles, Liberal Democrat MEP, Chair of the European Parliament ECON Committee, Syed Kamall, Conservative MEP, and Roger Helmer, UKIP MEP

Q209 The Chairman: Syed Kamall and Roger Helmer, a warm welcome to Sub- Committee A. I think it is your first time here. Sharon Bowles, you have been here many times before. You are departing the European Parliament next year and, just in case, may we wish you the best of luck with whatever you do in the future? Thank you over the years for coming before this Committee.

You, and I am sure your colleagues, will be familiar that we take a transcript of all that we do this morning. We send you that transcript, and we ask you to correct it, improve upon it, and when you have further ideas, which you will have when you leave the door this morning, please communicate those to us so that we get a true reflection of what you think and feel about genuine economic and monetary union. For those of you who do not know, I should explain that we have you as representatives from the European Parliament this morning. Unfortunately, Arlene McCarthy could not come because she has had to stand in for another Member, but to ensure that we did actually get the full political range when we were in Brussels two weeks ago we interviewed two members of the S&D group. I hope that is helpful to you.

Before I ask the first question of you, Sharon Bowles, I thought it would be very useful to have a little pen portrait of ECON, which I know we are meeting on Monday when you come over here en bloc to the Parliament. It would be helpful for Members just to understand the work of ECON.

51 of 441 Sharon Bowles MEP, Roger Helmer MEP and Syed Kamall MEP— Oral evidence (QQ 209- 221) Sharon Bowles: Thank you very much. The Committee is quite large. We have 50 Members and 50 substitute Members, so we could have 100 in the room. Many of the substitute Members are equally active to full Members and some of the full Members prefer to be active on some other Committee that they are substitutes on. It means we have a range of people from many different countries and backgrounds. We have four main areas of responsibility. We have what it says on the tin: economic and monetary affairs, which are to do with oversight of the European Central Bank, issues relating to economic governance and statistics, because they are obviously very relevant both for the central bank and for economic governance. As you surely know, we have financial services, where we have had full co-decision for quite some time. We also have tax, although there is no co-decision on tax. Tax issues come to us and our reports are taken notice of. Sometimes this is a good thing. Sometimes this is not such a good thing, if one thinks about the Financial Transaction Tax. We are also responsible for oversight of competition policy, another area where we do not have co-decision as such, but the Commission reports to us on what they are doing in that area. We do have one very small bit of co-decision now relating to introduction of damages action. It is the only place where all four of those issues are seen together by the same set of eyes because it is four different Commissioners. Of course, in the follow on from the financial crisis, all four areas have been working on overtime and there is a lot of interaction. There is a lot of interaction between economic stability, the financial crisis, governance, raising money through taxes and state aid when you are rescuing banks. Those interactions are something that we are well placed to look at. Lord Hamilton of Epsom: Does that mean that my Lord Chairman should like to bring 50 members on Monday? Lord Marlesford: Since Sharon Bowles has such experience, and given the importance of the European Parliament in all this area, does she feel that the structure she has outlined is satisfactory or does she have any modifications she would like to see? Sharon Bowles: We have a workload that has been extraordinarily punishing in the last four and a half years, but we have looked at whether there are any ways in which we can split some of it off, put bits in a sub-committee and so forth. Whatever we do, we seem to diminish the benefit of having it as a whole to look at the interactions. We get calls for doing more oversight and other things, but we are stuck with the fact that all Committees are considered to be equal, yet we are running at many times the level of work of other Committees, many times the level of the trilogue negotiations. I think I have chaired over 300 now and you can probably add together the next three Committees before you get to that kind of number of our work. The Chairman: We will come on to the parliamentary aspects of GEMU as it affects the European Parliament and I shall ask Lord Maclennan to begin the questioning in that area. I will just say to your two colleagues, Sharon, that if you wanted to comment on Lord Marlesford’s questions about the construct of ECON, please do feel free to do so.

Q210 Lord Maclennan of Rogart: How would you view the anticipated governance reforms impacting upon the European Parliament? In particular, there have been mentions by the Commission and the Four Presidents report about the possibility of involving national parliaments in decision-making. Is there any way in which this might have a real impact? Roger Helmer: Thank you very much indeed for the question. The answer is that I do not see any real serious possibility for the participation of 28 national parliaments in this process.

52 of 441 Sharon Bowles MEP, Roger Helmer MEP and Syed Kamall MEP— Oral evidence (QQ 209- 221) There is a custom in the European institutions of developing ideas that are meant to reassure either national parliaments or citizens of member states that powers are not being unduly taken away by remote institutions and therefore that they are still involved in the process. The classic example would be subsidiarity. Subsidiarity is there to be talked about and discussed, but nothing ever happens. This is exactly in the same category. It is a device to give some comfort and reassurance to national parliaments that their voice will be heard and that they will be involved. I suspect that little or nothing will come of it and, seriously, if you try to imagine how 28 separate national parliaments could involve themselves alongside the European Parliament, the European Council and the European Commission in a decision- making process, I find it very difficult to imagine how it could be done at all. I would dismiss it merely as a cosmetic twist. Syed Kamall: I would say that if you look at what we have done over the last five years since 2009, you can definitely see Parliament, partly through co-decision, having a real say and at times wanting to flex its muscles, holding up certain negotiations. That is sometimes because there is a genuine disagreement with Council, but other times just to flex its muscles and say, “Do not run all over us. We are an equally valid institution”. I think you will continue to see that because we are politicians; it is a political institution, as opposed to the Council, which is at times national technocrats and then switches to politicians at a certain stage, and the Commission, which is supposed to be more technocratic. The other point about that is the role of national parliaments. If I speak to other British MEPs—and I am not trying to flatter you here—we would say that you do great work when it comes to your reports, and a number of us read them, but what more can you produce than a report? How do you make sure at the national level that you are doing more than simply presenting a report? How do you make sure that the Government of the day, of whichever party, takes your work and actually inputs that into the decision-making process? That will be a very difficult balance here and that will be replicated in 28 member states. The Chairman: We are particularly vulnerable to flattery. Sharon Bowles: We have tried in legislation on economic governance to keep national parliaments involved as far as possible. We have done the same in aspects of banking union. The very sensitive subject of course is the European semester, where the budgets are looked at and co-ordinated, and the Commission seems to be able to look at those before they have gone to many national parliaments. Some parliaments have been able to modify their timetable so that they can do it, but there seems to be a fear of disempowerment on the part of national parliaments there. We hold two meetings jointly with the chairs of the finance Committees, which of course you attend, during the course of the European semester. We try to be able to talk about it among ourselves. It is a forum that very much still has a long way to go to learn what to do. There is of course another programme of meetings of Chairs that goes on alongside with each presidency. The powers are very different in different parliaments. In the European Parliament, we have a little oversight over the multilateral surveillance, and when we have had these meetings we sometimes hear from some colleagues in other parliaments that we have more powers than they do, whereas others have great power. We are trying to find ways to make sure that, where national parliaments feel that their voices are not heard, we do what we can to give them a forum. It is very sensitive because so many of these issues are dealt with only through the Council and the Commission. There is no co-decision and there has not been a role either for the European Parliament or for national parliaments.

53 of 441 Sharon Bowles MEP, Roger Helmer MEP and Syed Kamall MEP— Oral evidence (QQ 209- 221)

Q211 Baroness O'Cathain: I just want to make the observation that here in the Lords we do just the scrutiny, so we do not think that we have that much influence on anybody. However, there are occasions when we say, “No, this we cannot do”, and then we do have a lot of influence on being able to strengthen the backbone of Ministers, which in turn relates back to the relationship with the Commission. In fact, I have a case. I am sorry I was a bit late, but I was doing an interview with somebody from who was chasing me about a letter we sent to one of our Ministers saying that the response we had was not good enough and we wanted to bring it further. Unfortunately, it is in the public domain so there is going to be a bit of a row about it, but they cannot say that they did not know. Although we are at a very low level by comparison with what you are doing, we can through this scrutiny process home in on something that is very important and not let go of it until we get some positive response from the Commission. The Chairman: Is there any response to that comment? Syed Kamall, you were nodding your head. Syed Kamall: Yes, I would say that there are parallels here. In the same way in which the European Parliament tries to flex its muscles and say, “Do not forget about us”, if you see that replicated at the member state level, that is how you get the national parliaments more involved. What we are doing is what you are doing and should be doing. Roger Helmer: If I can just add a comment, I am delighted to hear what you are saying, and anything you can do to stiffen the spine of the Government would be extremely welcome.

Q212 Baroness Maddock: I wanted to talk about the problems of the two groups going forward when we are looking at genuine economic and monetary union: those that are in the eurozone and those that are not. Do you have any views on the rather vague proposals that have been put forward about reconfiguring the Parliament along those lines? Also, more generally, how do you see the differences between the euro area and the non-euro members? Is this a great source of difficulty? Do you think it has been a bit ignored in the discussions that have gone on about genuine economic and monetary union? Sharon Bowles: Initially, it has hit our Committee most in terms of people asking why we have oversight of the ECB and even saying, “Why do we have a Brit having oversight of the ECB?”. That has changed to them in general being much nicer about it and saying, “We are jolly glad it is you”. It is not that easy to disconnect because things interact. In the project on the banking union, you cannot even deal with just the eurozone there because our banks go cross-border. Whatever you try to do, it is very difficult to isolate eurozone-only things. If you did say, “Okay, let us have a separate Committee for economic and monetary affairs”, there are things within that in the stability and growth pact that apply to the outs; it is just that we cannot be fined in the same way. You cannot draw the dividing lines very easily at all. If you came down to just what the European Central Bank is doing, that would be a possibility, but there is expertise that comes from the outs. And what about those we tend to call the pre-ins that are about to join? It is very important that they participate in any decisions that are about to affect them. Maybe you can say that the UK is in a slightly different position, but most of the others are pre-ins, not outs. You have to take that into account as well. We cannot find any way within our Committee as yet that satisfies that. If you move further afield to the question of whether there should be a separate budget for some things that the eurozone wants to do together, whatever they might be, you could probably devise that if you have a pot of money that is meant to be spent in certain countries on certain pre-defined things. You could have

54 of 441 Sharon Bowles MEP, Roger Helmer MEP and Syed Kamall MEP— Oral evidence (QQ 209- 221) a Committee that just did that, but that is on the budgetary side, not the economic governance side, because too much of the economic governance just spreads over us all. The Chairman: Roger Helmer, do you share those views? Roger Helmer: Broadly speaking, yes. If I can just add a comment, the question goes right to the heart of Britain’s relationship with the European Union. Of course, in my party we believe that we should leave the European Union, but the Prime Minister believes that we should renegotiate. He has not made clear the extent of that renegotiation, but we are seeing a fracturing of the European Union into the eurozone and the non-eurozone. As Sharon rightly points out, the non-eurozone consists of some pre-ins, and we can have a long discussion about whether they really ever will be in. We could conceive of a situation where we end up with merely two outs. There is certainly a degree of resentment in the European Union institutions against what they see as the Anglo-Saxon model and the City of London. There are some, not all, who would like to see much of our financial services market migrating to other parts of Europe. If I can just add one caveat, though, that I am very concerned about, it is that there is a tendency to think, “We are not in the eurozone so they can get into their bailouts, they can organise fund transfers and they can do whatever they like. It is nothing to do with us”. Of course it is something to do with us. There is a series of what they call instruments and what the rest of us might call financial mechanisms or funds that go right across and can be subverted to the issue of shoring up the problems of the euro. I mention cohesion funds, regional funds and solidarity funds. With all those things, Britain and the British taxpayer could be in the hole for what amounts to bailing out the eurozone. The Chairman: Before we pursue this question about the United Kingdom, Syed Kamall, did you want to add any comments to the last two? Syed Kamall: Seeing as I am throwing around flattery, I will throw some to of me, to Sharon. I think Sharon did a fantastic job when there was an attempt to create a sub- committee of ECON for eurozone members only, but that will continue. I can see some attempt at that coming back in the next Parliament, and that sets a precedent because what else do you exclude other Members from? What happens to landlocked countries when it comes to maritime issues? What happens to countries with very small armies when it comes to military matters or foreign affairs? You start to create a precedent. Those who believe in the European project and want a one-size-fits-all Europe will oppose it as much as we will, so that is a very interesting point. The second very quick point—I am sorry; I know you are against time—is that there is increasingly a tendency to confuse or conflate the single currency and the single market. “You cannot have a single market without a single currency” is the way the argument goes, as if harmonisation or one-size-fits-all is the only way to achieve a market rather than competitive currencies or mutual recognition. The Chairman: Before we pursue that very interesting line, the Earl of Caithness will ask an awkward question.

Q213 The Earl of Caithness: Do you think there is any chance of a person from a non- euro member state becoming Chairman of ECON again, and does it matter? Sharon Bowles: We never thought it was possible before because of the ECB monetary dialogue, which was a big issue when I first became Chair. The impossible has already happened, so maybe it could happen again. As I said, I think a lot of people have learnt the benefit of having even-handed outside eyes on some of the problems of the euro. I would

55 of 441 Sharon Bowles MEP, Roger Helmer MEP and Syed Kamall MEP— Oral evidence (QQ 209- 221) say, “Never say never”, but I guess it helped that the political persuasion I was from was seen as more euro-friendly. It could happen again. Roger Helmer: I have nothing to add except that, as nobody has been flattering about Syed yet, I ought to say that I think he does a pretty marvellous job defending the City of London, so far as is possible given the very limited influence of any one member state. Syed Kamall: I waited half an hour for that. Baroness O'Cathain: There is a big love-in going on here. As the Government have made it very clear that they will not participate in the majority of the measures but that these proposals must take account of all the interests of all the member states, how realistic is the UK’s position? Syed Kamall: This is where the politics really starts, as opposed to the technical details of what we are discussing in Committee. It is wholly tenable because the Government have made their points clear and therefore the others will have to deal with the reality. The problem with politics is when people say, “If you do this, that will definitely happen”, or, “We will not speak to you”, or whatever. We know what the reality is. After Cameron’s speech, it was said that the Germans would ignore it, and then you see Merkel, Cameron and others doing a deal to cut the EU budget next time round. Politicians also have to be pragmatic. We may come with our ideologies and our beliefs in certain projects, but we have to deal with the situation in front of us. If you have a strong position, the other politicians from other member states will have to deal with the reality as it is. Sharon Bowles: I think that over time, in the first instance, there has perhaps been a reluctance to take notice of things that are said by the UK as a Government or by British Members. Time has proved that some of what we have said is right, and there is a lot of support from other member states in what one might call the interface areas relating to the single market. If I may say so, the next big one that we have to look at quite a lot is state aid rules. What we have not really done from the governmental side is get involved in how the eurozone plans what it is actually going to do with the euro, because it is perceived as rather difficult to go poking around in something by declaring that you are not going to be part of it, so we are on the sidelines there. Various British individuals and some of our banks have quite a lot of constructive thoughts to offer here, if you go around the think tanks and other places where they are inputting. I wish we could somehow use that expertise to greater effect to get in on the thought process at an earlier stage because that might have short- circuited, but I have to accept that it is very difficult. On single market protection, I think everybody agrees with it, although not everybody sees the single market in the same way. We are more outward looking; others are more inward looking. As I said, the state aid issue is potentially quite important now.

Q214 The Chairman: Roger Helmer, the same question, but can you furnish examples of where the UK has clearly been persuasive or shown others that perhaps the UK line is right? Roger Helmer: Whilst it is true to say that the European Parliament voted-down the proposed cap on fund managers bonuses, it nevertheless voted for a cap on bankers bonuses and voted heavily in favour of a tax on financial transaction that will be very expensive for the City and drain money from the UK exchequer by reducing economic activity and taxable profits. I do not think we have been terribly good at that. My concern is that clearly if you have a “eurozone” and a “rest of the EU”, that is a division. Whether you like it or not, however you regard it, it is a division. There will be a tendency among eurozone countries,

56 of 441 Sharon Bowles MEP, Roger Helmer MEP and Syed Kamall MEP— Oral evidence (QQ 209- 221) who will be a majority, and among the institutions that are committed to the euro as a project, to see the eurozone as the top level of membership and to see non-euro membership as being a lower level, second-class membership. I believe that the British Government will do what I think successive British Governments of various stripes have done over time, which is to start out by setting out red lines and issues where they will insist on having their way, but we always see this euro-creep element coming in where eventually we start giving way and Brussels gets what it wants. I will stress this point—I have made it already, but please let me make it again—about Britain and the British taxpayer getting sucked into funding the euro. I have a note here of something Commissioner Günther Oettinger said over the summer. He actually said that EU budget funds could be used for the next bailout of Greece, and you notice how I mentioned the next bailout as if it is something that we all expect and that is inevitably going to happen. He is only one Commissioner and it was his view, but he did say that. Baroness O'Cathain: I just want to point out that our particular scrutiny responsibility is the single market. I can actually say that we are treated no better and no worse in our single market negotiations with the Commission than any other member state. It is really important for people to realise that somehow the power the Commission has in the economic side is much more visible, but in other areas, when you consider that some 300 reasoned opinions have been sent to the Commission and not one of them has been acted on since Lisbon, that really is a problem. We find in our particular sub-committee that in dealing with other member states that are members of the euro, we have no problems in getting a united view about how on a technical level things should be done by the Commission. The Chairman: Baroness O’Cathain is the distinguished Chair of our Sub-Committee B, which deals with single market issues.

Q215 Lord Marlesford: The Commission has produced its proposals for a single resolution mechanism. What is your view on what they have produced? In what form and when do you think it will eventually emerge? The Chairman: Sharon Bowles, you have told me that you can speak for many hours on the single resolution mechanism. Sharon Bowles: I am afraid so—oh dear. There are quite a lot of problems within it, some of which are from the Parliament side, and I can speak a little collectively and a little personally here. We see problems in the role that is being undertaken by both the Commission and the single resolution board. We see that the bank recovery and resolution directive, which covers the whole of the EU, is the basic set of rules on bank resolution that everybody should have to follow. Then we are concerned that within the single resolution mechanism there seem to be some changes. For example, the resolution plans could reference the fund that is being set up. I have put in amendments to take that out and I do not think it will stay very long, but the notion that banks should be looking at any fund in their resolution plan is clearly nonsense and a complete antithesis to everything that we are doing. The fund itself is a problem in that although it says it will be treated in a way that is analogous to state aid—there have been things in the papers this week both by Mario Draghi and me from different sides on this—they seem to think that maybe things can be done that do not trigger state aid. DG Comp is quite firm on this, but there are problems as to whether such a fund is properly captured—well, it is not captured—by the relevant part of the treaty on state aid without possibly going for some interpretation.

57 of 441 Sharon Bowles MEP, Roger Helmer MEP and Syed Kamall MEP— Oral evidence (QQ 209- 221) The role of the Commission is not liked by the Parliament because we think that the body that actually knows what is going on in the bank and is in a better position to call resolution is in fact the European Central Bank. We just do not see that a board that is composed of representatives from state resolution authorities—in some instances these are only just being set up and in other instances they are just losing supervision of their large banks because it is going into the ECB process—is going to have the information, let alone the expertise. Whether the ECB likes it or not, we envisage that it has to be involved. Then we come to an issue that I have detected with the European Central Bank: that not only is it very shy of oversight, although we have worked very hard to achieve that on the supervisory side, but it is very shy of litigation and the fact that something that it does might be challenged. One can see this in its responses on the asset quality review. I think I have put in about 180 amendments to the text and some of these are quite substantial. We have a lot of problems to iron out, but I think that these problems are recognised everywhere on all sides. It is not that the Commission did not see them; it is not that the ECB did not see them; it is not that the member states have not seen them. It is just that the treaties hem us in in such a way that we do not appear to be able to get the perfect arrangements.

Q216 The Chairman: Syed Kamall, would you add to that? Could you also let the Committee know whether you think there is a realistic prospect of a conclusion being reached by the time you rise for the European parliamentary elections? Syed Kamall: There are two issues here. I know it is far more complicated than that, but I am trying to break it into two simple issues; as politicians we have to try and simplify the issues for our electorate. One is actually the resolution issue. More than six years after Northern Rock and five years after Lehman Brothers, we still have a situation where banks are failing and being bailed out in the EU. My big criticism of all the EU legislation and the supervisory architecture and everything we have done since then is that we have not solved that fundamental problem. What is interesting about that politically is that there is consensus on the left and the right: why is taxpayers’ money being used to bail out failing banks? We have not resolved that problem. There is a difference in view as to whether you should actually save failing banks, and a view about whether banks should be any different from any other industry. As long as payments continue, direct debits continue and people can continue to get their money out of cash machines so that you do not have civil unrest, we should make sure that failing banks can fail, and then other competitors come in. I am sure you are familiar with all the arguments. The other side of it is confusing it or conflating it once again with the political movement towards further integration, the eurozone and all those issues. The difficulty is that it is very difficult to convince German taxpayers that they are going to have to bail out a failing Greek, Cypriot or Spanish bank. I do not expect a resolution of the resolution issue soon. The Chairman: Before I bring in the Earl of Caithness, Roger Helmer, do you have something to add? Roger Helmer: Yes, indeed. The proposals for a banking union and a single resolution mechanism are of course at the heart of Herman Van Rompuy’s plan to shore up and indeed solve the problems of the euro currency area. I believe he proposed his plan about a year ago. Initially, Germany rather grudgingly said that it would support the plan, but it is clear that Germany, which is fundamental to any such plan because it is the only country with any money, is backing off as fast as it can. An obvious example is that they have put in the caveat, “Yes, but we cannot take responsibility for pre-existing debts”, which blows an

58 of 441 Sharon Bowles MEP, Roger Helmer MEP and Syed Kamall MEP— Oral evidence (QQ 209- 221) enormous hole in the thing. Indeed, the impression I am getting from the recent summit and the news coverage out of it suggests that the whole process really is running out of steam and possibly running into the sand. I am interested by this phrase “genuine economic and monetary union”. Frankly, it is not something we hear very often in Brussels. Let us say that we get this thing that we are now calling genuine economic and monetary union. The plan as it stands does not address the fundamental problems of the euro. The fundamental problems are first of all the competitiveness of those southern European countries, and I do not see how that is going to be resolved by this plan. The second problem is the need for massive fiscal transfers, which, as Syed has already pointed out, is politically impossible. The German taxpayer will not stand for it. My answer here is: one, I do not think this is going to work in its own terms; two, even if it worked in its own terms, it would not ensure a successful future for the single currency.

Q217 Lord Marlesford: Can I ask a supplementary question to that? In a sense, this relates to the whole question of Eurobonds. The question of liability for bank debt is whether it is a liability directly of the ECB for the banks or whether it is national Governments who had responsibility previously. Up until fairly recently, the Commission, the troika, has been very inclined to encourage national Governments to take responsibility for the banks. If in fact we were to ever see Eurobonds, presumably there are lots of different models, but two possibilities would be: one, these are issued by the ECB on behalf of “deserving” Governments, and they are of course by definition underwritten by the ECB; or, taking your earlier point about the existing debt, they are issued by national Governments and underwritten by the ECB. I would like to ask particularly of our expert from the City of London which the markets would prefer, if either, of those? If one thinks of the Fed, QE and all that, the simple fact is that the Americans have an unlimited printing machine for dollars that everyone accepts. They have had no problem with $85 billion a month because it has been oversubscribed each time. How do you see the interface with this particular problem of the stability? The Chairman: Syed Kamall, you have been flattered. Syed Kamall: I am not sure whether I have been flattered or picked out. First of all, let me correct Roger. It is nice to be flattered by him saying that I have done great work for the City of London, but I do not see myself as speaking for them in any particular way. I know that was not what you were getting at. The problem with trying to represent the City, or to talk to the City and ask it for its views, is that they have different views. In reality, it comes down to the fact that they will deal with whatever is put before them and they will find a business case for dealing with what is put before them. If these Eurobonds come out and we resolve all these issues, they will find a way of dealing with them, make money out of them and work with them. I am not quite sure, and in fact I have never asked, which solution it would prefer. The one thing that I find a lot of the guys in the City ignore is the politics of the situation. They underestimate the politics. For the last couple of years, in my usual morning or lunchtime meetings somewhere in the City or somewhere in London with financial institutions, when I explain how the EU works and how they should get more involved, I am asked, “When is the euro going to blow apart?”. You have a position where you have people in the markets who underestimate the political will to keep the euro together, and you have politicians in Brussels and elsewhere who underestimate the determination in the market and think that they can buck the market. That is one of the reasons why we have

59 of 441 Sharon Bowles MEP, Roger Helmer MEP and Syed Kamall MEP— Oral evidence (QQ 209- 221) this tension with the euro continuing as an injured patient with a massive sticking plaster in the form of bailouts. The guys in the City will deal with whatever is put before them, but actually they underestimate the whole political will behind the project. The Chairman: I am going to pass on, but can I just very strongly endorse that? It has certainly been the experience of this Committee that from time to time we try to take the temperature of the City and that it is sometimes less than athletic in giving it to us.

Q218 The Earl of Caithness: When the Commission proposed the banking union, it was a pretty firm three-legged stool. At the moment, it seems to be quite a wobbly one- and-a-half-legged stool. What are the implications for this? Is it going to work? If it is not going to work, when is the next banking crisis going to come along? Roger Helmer: I would say this, would I not? It is an excellent question. There will in my view probably be another banking crisis. First, I do not think that the banking union proposals as currently on the table will be carried through. Secondly, if they were carried through, I am not convinced that they would work successfully. I do not know whether this will be the subject of a later question, but we have for example the current stress tests or whatever they are going to be called being conducted by the ECB on European banks. We need to understand that the objective of that is not to get to the truth. The objective of that is to reassure the markets. They are saying to themselves, “How can we present a picture that is extremely positive but also just about credible?”, rather than, “How can we really get to the truth of this matter?”. I would be interested to see, because I am not clear, what sort of valuation they are going to put on sovereign bonds, for example, which they have previously valued at 100%. That is now open to question. The other point I would make of course is that there are significant questions over the ECB itself, because many of the assets on the balance sheet it relies on are open to question. Sharon Bowles: You are quite right; we kind of have one and a half legs. In fact, I am not even sure that it is not just one. We are going to get the supervision by the European Central Bank, which we think will be stricter and an improvement. The asset quality review followed by the stress tests this time will be done in a much stronger way. The ECB is better placed to be able to resist the fact that member states will fiddle around and not provide the information. Although, as it is not yet the supervisor, there are still problems, there are going to be significantly greater amounts of transparency and involvement of the private sector in looking through the books right down to the bottom, from what I have been told. Then there will be recapitalisation. We might be squabbling about whether it counts as state aid or not and how it is all done, but there will be some form of recapitalisation, so that the legacy issues—and the fact that they have not dealt with it, and we fear there are still some dodgy European banks around—will be dealt with. It is not so much a euro issue; it is just a fact of what has happened in the banking system that has not been faced up to. That will be put to bed. I think leg one will be doing okay. Leg two, which was going to be a common deposit guarantee scheme, seems to have disappeared out the window for a long time. Leg three, which is the common resolution mechanism, we are going to get part of in good strong rules that apply across the EU. It will of course also fit with what we are negotiating with the United States and the rest of the world on how you resolve banks without taxpayers being in the front line and bailing in and all that. Part of that leg is there. The part that then says that by having something that matches up to the ECB and is euro-wide we cut the link between the sovereigns and banks is not going to work. You cannot have that

60 of 441 Sharon Bowles MEP, Roger Helmer MEP and Syed Kamall MEP— Oral evidence (QQ 209- 221) without mutualisation. It does not matter where you mutualise, you cannot have a genuine economic and monetary union without deep mutualisation. That is a long way away. We might have some partial mutualisation, but in no way is any fund that is being proposed big enough to deal with a systemic bank crisis. It is only going to be able to deal with a few idiosyncratic banking crises. That separation does not exist. In a sense, banking union is a cheap or backdoor way to get fiscal union, which will not work and was never going to. One might have limited additions—Eurobonds, bills and those kinds of things—to help us on our way, but we have a lot more steps to take. The Chairman: Syed Kamall, there is a lot to get your teeth into there, but hold your horses. I am going to ask the Earl of Caithness for a comment and then ask Lord Hamilton to ask his question. The Earl of Caithness: I have a quick comment for Mr Helmer, who did not think there was going to be any progress on the banking union before the elections next year. Given what Ms Bowles said, surely there is going to be huge political pressure on Germany and the others to cobble together some sort of agreement on the banking union to put before the people in the votes next year. Why are you so confident that will not happen?

Q219 Lord Hamilton of Epsom: Most of my questions have been covered, but can we tease this out? As I understand it, the stress tests are now going to be on a template that will be common to the whole of the eurozone. Do you all agree with Mr Helmer that they will not be very stringent with this template and that we will have a rather similar situation to the Spanish banks, where some accountants went in and said everything was absolutely fine, there was no problem at all and liquidity was all there? What is the view of all of you on the valuation of sovereign bonds? Are they still going to be in at over 100%, even though they are Greek and we know they are going to be written down? Where do we stand on all this? If we only have the leg of the supervisory mechanism and we do not actually have the resolution part of it, what is to stop a major banking crisis happening? Although we are constantly being told by the eurozone that all the problems have been hacked, I think I can speak for this Committee that we do not buy that. We think there is still a serious outstanding problem on the banks within the eurozone. The Chairman: Syed Kamall, I have one more question to add to that barrel load you have received already. Where do you think that stress tests will and should be done? I thought we had the European Banking Authority here in London to accomplish that task, but it now seems to have fled to the ECB. Please, do feel free to answer. Syed Kamall: I will try to answer some of those questions. Let us separate the issue of banks being solvent from the wider eurozone problem, because as Sharon and others have said we still have a problem with our banks; we still have banks failing. Will we have another crisis? Yes. One of the best books I have read on this subject is probably Reinhart and Rogoff’s This Time is Different. People always say, “This will not happen again”, but actually it goes through exactly the same pattern. There are a couple of really very interesting observations in Reinhart and Rogoff that I will point out. One is that since 1800, France has defaulted eight times, Spain has defaulted 14 times and Greece has been in default for more than 50% of the time. That is an interesting lesson. Secondly, even though we have resolved sovereign debt crisis, we have not resolved the issue of banking crisis and banking default. When I have looked in an academic way at how we tackle, or when I will be confident that we have tackled, the lessons from the crisis, there are three things. One, as we have all said as explicitly as possible, is no more taxpayer bailout. The problem is politicians; if a bank fails in your constituency or in one of your heartlands, whichever party is in power it will be

61 of 441 Sharon Bowles MEP, Roger Helmer MEP and Syed Kamall MEP— Oral evidence (QQ 209- 221) very difficult to resist that temptation to bail out. You need to have the mechanism in place, which we are working towards, to make sure that that process is there in advance. The second thing is director liability or some form of liability so that you make pretty sure you know what is on your balance sheet. If not, you take the responsibility. We have not seen that yet in any way. There are different forms. One is going back to a partnership model. That is probably a bit unrealistic for everyone. What about being paid in bonds or something so that you pay the price for failure? The third one is IFRS accounting standards, and that is a real problem when it comes to valuation for banks. You still have a situation where instruments are booking profits up front but actually not making sufficient provision for losses or impairment. The IFRS Foundation, when I discussed this with them, said that they are dealing with that, but across the political spectrum in the European Parliament we have very real concerns. I do not trust the valuations of most banks. The Chairman: Sharon Bowles and Roger Helmer, do you have anything to add to that set of comments? Roger Helmer: I have just one quick point. I have been looking right through this meeting for something I can disagree with Syed about. It is extremely difficult, but I think he said that we have solved the sovereign debt crisis. Syed Kamall: No, I did not. Roger Helmer: Sorry, in that case I misunderstood you. I would just draw attention to Jeremy Warner’s article in yesterday’s Daily Telegraph where he looked at the sovereign debt position of several southern European countries. His view was that if you get a sustained economic recovery in Europe it might just be all right, but that if you do not they are in terrible trouble and liable to default. He makes a very good case; I do not think we have solved the sovereign debt crisis. The Chairman: Before I turn to Sharon, I am going to ask Lord Bowness and then Lord Maclennan to ask their questions. I will give you a big chunk at the end to answer.

Q220 Lord Bowness: Looking at the integrated economic policy framework, the Commission’s proposed plans for GEMU include these binding contracts, “convergence and competitiveness instruments”, which are said to encourage structural reforms through rewards or sanctions. Are these credible proposals, are they likely to be effective, and how they would be enforced? Perhaps as an addendum to that question, how does the Europe 2020 strategy now fit with GEMU? Has it been overshadowed by the European semester? Has it disappeared from view? What is the position? The Chairman: Sharon Bowles, do feel free if you want to answer some of the earlier comments as well. Sharon Bowles: I will deal with the last one because I think that is the shortest. We did not think much of the convergence and competitiveness instrument in the European Parliament. We have had a resolution to that effect. We thought that we had a six-pack and a two-pack and we were muscular enough; we did not really need a 10-pack. We liked the idea that maybe it was time for a bit of carrot, but we thought there had been a bit too much stick already. That is where we are on that, and they are not in the Commission Work Programme at the moment. The notion that there should be inducements for doing reforms, as long as they are not foolish inducements, is inherently there in some of the governance that we have already

62 of 441 Sharon Bowles MEP, Roger Helmer MEP and Syed Kamall MEP— Oral evidence (QQ 209- 221) enacted. That was another reason why we were questioning it. If it goes down that track, fine, but we just thought that this was a step too far, and we really did not like the language about contracts and all that kind of thing. A very similar response also came out of the Constitutional Affairs Committee, but the resolution in my name in the Parliament was pretty tough on these issues. With regard to 2020, Europe 2020 is the policy in a way, and the European semester is one of the tools through which policies like that can be enacted. The idea is that when the Commission comes out with its country-specific recommendations and all these things, it should be taking account of Europe 2020. One part is policy and the other part is the tools to help implement it. It has not been superseded; it is still there, although there have again been complaints from the Parliament that from time to time we think that the Commission might not have taken enough of the parts that we like best into account. If I could go back to this whole business about balance sheet analysis and so forth, there are three things going on. There is a balance sheet analysis and an asset quality review that is done by the European Central Bank. Then, in conjunction with the European Banking Authority, it will do stress tests, so the EBA is still there. These stress tests of course should be EU-wide, but obviously they may have some extra things that they want to do within the eurozone. On the issue of sovereign bonds, we have challenged repeatedly all around on this. This has been a pet subject of mine now for about nine years. It has been a major disaster for the euro that zero sovereign risk weighting has meant that there has not been discipline through sovereign debt that could have held in check some of the worst excesses of spending in Greece and other countries. In all the financial services legislation now, Parliament keeps trying to do something about zero risk weight and none of the member states will contemplate it. They will not allow a recital to go into a piece of legislation that even hints that there might be a change to the zero risk weight of sovereign debt, even though it is at last now a live issue under consideration by the Basel Committee. What they may well be doing on the balance sheet analysis, instead of writing down the bonds, is revealing what the holdings are and letting the markets operate from a position of knowledge. That would be a pretty good thing because you would probably get a response there. I do not know that anybody is prepared to actually grasp that nettle of writing down, so we are still in a very bad place for that and the only weapon we appear to have is transparency. Lord Hamilton of Epsom: Am I right in saying that the sovereign bond holdings have actually been rising? Sharon Bowles: They have also been repatriated. Whereas once upon a time there were reasonable cross-holdings between countries and there was a kind of tacit understanding that for eurozone stability they would not be divested, that has happened so that they are all repatriated. It is the Greeks with the Greek bonds, not the Germans any longer. In this time when we have been creating banking union, it has been going slowly enough for member states to be looking to their own laurels rather than to the euro area collectively. The Chairman: Gentlemen, before I ask Lord Marlesford to ask the last question, I think you were broadly agreeing with Sharon Bowles. Would you like to add to or subtract from what she said? Syed Kamall: I will try to keep this brief. If you look at it in terms of enforcement and contracts, I think you just have to look at the experience of the stability and growth pact.

63 of 441 Sharon Bowles MEP, Roger Helmer MEP and Syed Kamall MEP— Oral evidence (QQ 209- 221) When two large countries break it, how can you actually enforce it? If you want to look at Europe 2020, do not forget the Lisbon agenda, which by 2010 was supposed to make Europe the most competitive digital market. Some people thought that meant counting on your fingers. Roger Helmer: A knowledge-based economy. Syed Kamall: Actually, if you want to look at the experience of these 10-year plans, just look at the experience of the Soviet five-year plans.

Q221 Lord Marlesford: We have been talking about mutualisation of debt. Can I come on to mutualisation of spending—in other words, the euro budget? Is it ever going to happen, how can it be based, and is it essential to have it? The Chairman: Would you like to answer those and couple that with any final remarks you would like to make? Syed Kamall: Will you ever get a European budget? You have to look at the experience of other currency unions. The key to those are fiscal transfers from the richer parts to poorer parts. In Britain, we might grumble about our currency union when bits are going from the south-east to other parts of the country, but actually on the whole we accept that politically. That is the price of being in the United Kingdom. The problem is that if you speak to your German, Finnish or Dutch friends, they do not see why they have to pay for others in less productive areas. I will try not to name the countries, but I think it is fairly obvious. That is the real problem. I talk to my German politician friends and they say, “We know we have to pay”. The problem is how we implement this. One way is via a back door and the ESM and all that sort of stuff—but how sustainable is that?—so that it is not seen to be the Germans paying for the Greeks, the Spaniards or the others; it is simply seen to be Europe paying, when in reality it is the Germans, the Dutch and the Finnish paying. That is why I think we are a long way from it. Roger Helmer: If I have understood Lord Marlesford’s question correctly, he is asking whether there could ever be a unified economic policy for the whole of Europe. That is about as likely as Turkey joining the EU. It is not going to happen. I do not know what the future trajectory of the European Union is, but I would be absolutely astonished if that occurred. I must agree with my colleague, Syed. He is exactly right to point to previous experiences of attempts to impose economic policy on member states from the centre. The Maastricht criteria, the stability and growth pact and all those things just do not work. When you have something that is supposed to be a democracy and you have a national Government who are looking at their voters on the one hand and looking at edicts from Brussels on the other hand, given that they want to be re-elected they will probably bend the rules. They can break the rules in two ways: by fiddling the numbers, which we have seen and I will not go into the examples, or by just actually declaring numbers that break the rules and saying, “What are you going to do about it?”. In conclusion, My Lord Chairman, my position would be very clearly that the proposals that the European Union has before it at the moment look unlikely to be delivered, and if they were delivered—and forgive me for repeating myself—they will not solve the fundamental problems of the eurozone. Again, I agree with Syed. It could be made to work with transfers, but it will not be because the Germans will not pay. It could be made to work with grinding deflation in the southern European countries, but politically that is not deliverable. It could be made to work, or made to resolve the problem at least, by breaking

64 of 441 Sharon Bowles MEP, Roger Helmer MEP and Syed Kamall MEP— Oral evidence (QQ 209- 221) it up, which I think it will come to eventually, but there we are at least held up by the hubris of the European political class, who have so much political capital tied up in this project that they are doing everything they can to kick the can down the road and to avoid facing some ugly realities. Sharon Bowles: I suppose, like my colleagues, I remain pessimistic in the short term. I still think that there is this enormous political will to make things work in the longer term, but things are not going to be worked out within single-digit numbers of years. We are still looking at an ongoing, very long drawn out project to get to something that properly resembles a real currency union, which then would have mutualisation. If you can mutualise lots of things, you can then mutualise the spending. It may be that on that path there are a few token mutualised spending arrangements. The latest idea on this relates to unemployment benefits at the moment within the eurozone. Again, though, you can obviously see that there could be transfers there. If they did do any such kind of mechanism, they would probably have to use GDP as the way to put it in. I cannot see them wanting to levy taxes. Of course, there was this idea that they could use the Financial Transaction Tax once upon a time, but now they are finding out that it is not going to produce as much money as they had hoped. That is a problem. The euro is going to continue. There are steps that have been made to stabilise, even if it is only one and a half legs of banking union, but we have quite a lot of other things to sort out as well. Just as a final thing, it is probably better for the UK in one sense. It gives us a lot more time to see these adjustments and to progressively understand better how to be able to help and to be able to find where our balance and our equilibrium are within these changes that are going on. The Chairman: Sharon Bowles, Roger Helmer and Syed Kamall, the Committee has enjoyed this spirited exchange with you over the past hour. I warn you again that we will send the transcript. Please correct it, please add to it, please embellish it and please send us your further thoughts. Can I say on behalf of the Committee that we have enjoyed this? We have learnt a lot from you, but as long as we have as spirited Members as the three of you are—and I know that Arlene McCarthy would have fulfilled that role as well had she been here this morning—the UK voice in Brussels and Strasbourg will be well heard. It was well heard this morning here in the House of Lords. Thank you.

65 of 441 British Chambers of Commerce and City of London Corporation—Oral evidence (QQ 39- 54) British Chambers of Commerce and City of London Corporation— Oral evidence (QQ 39-54)

Evidence Session No. 3 Heard in Public Questions 39 - 54

TUESDAY 11 JUNE 2013

Members present

Lord Harrison (Chairman) Viscount Brookeborough Earl of Caithness Lord Davies of Stamford Lord Dear Lord Flight Baroness Maddock Lord Marlesford Lord Vallance of Tummel ______

Examination of Witnesses

Mark Boleat, Chairman of Policy and Resources Committee, City of London Corporation, and Dr Adam Marshall, Director of Policy and External Affairs, British Chambers of Commerce

Q39 The Chairman: Mark Boleat and Adam Marshall, as summer draws to a close today, with the weather turning, as a Committee we are most grateful for you coming in to help us to try to understand better Genuine Economic and Monetary Union, with the particular areas of expertise that you have. You know that this will be webcast, as it always is, that we will present to you a transcript of what is said in exchange between us, and you know when you go out of the room and you suddenly think, “I wish I had said that”, please do say it. Reply to us, first correcting anything that is wrong, and if you have further thoughts that you think the Committee would find useful, we would indeed find it useful, or indeed anything you can supplement, in terms of written papers or whatever. I also encourage my colleagues to declare their financial interests when they speak if they have any that ought to be known and made public, so that we have a clear opportunity to display that in the final report that we will make on this subject. I wonder whether, Mark Boleat and Adam Marshall, in your first replies you might say who you are and where you come from. That would be very helpful. Just to get matters off to a general start, there is this beast—Genuine Economic and Monetary Union—that is now sizing up and preparing itself. Do you see, perceive, understand that there are threats to the City of London and the financial services industry or do you see that there are some real opportunities? Mr Boleat.

Mark Boleat: Thank you very much; let me briefly introduce myself. I am currently the chairman of the City of London Policy and Resources Committee. In previous lives I have been Director-General of the Association of British Insurers and the Building Societies

66 of 441 British Chambers of Commerce and City of London Corporation—Oral evidence (QQ 39- 54) Association, and I wrote my Master of Arts thesis on a single currency for Europe in 1971. I said it would not happen this century, which I think was not bad under the circumstances.

A direct answer to your question is: we in the City would not see this as a major direct threat. At any one time the City of London, and indeed the UK, faces a number of challenges, and this is one of them, but in European terms I would put this as rather less of a threat than the ongoing eurozone crisis and, indeed, the uncertainty caused by British membership of the European Union. London could happily survive not being within a Genuine Economic and Monetary Union. There would be some adverse consequences at the margin. For some businesses, London would be less attractive but I think that would be at the margin.

The Chairman: Any pluses? Mark Boleat: London always looks for business, whatever it is. At the moment we are doing a lot of work to develop renminbi trading in London. That is something we would not have thought about some time ago. London is the leading centre for trading in the euro and, if we had a Genuine Economic and Monetary Union, I think we would see more trading in the euro. What we have seen over the past five years is financial markets and institutions tending to retreat to nation states, and indeed today there are figures on bank lending, where we seem to be back where we were 10 years ago, notwithstanding the development of the single market.

Q40 The Chairman: Dr Marshall, do you agree with most of that? Dr Marshall: I do agree with a lot of what Mark says. I am here representing a wider business community around the UK. Chambers of Commerce have about 100,000 members, with between 4.5 and 5 million employees around the country, and a great diversity of interests from some financial services companies and professional services companies through to manufacturing interests through to a wide range of smaller companies. We work with the EU institutions, other business groups and the City to understand the impact of these issues on business. But there are three initial things on my mind. First, this is truly a moving target. Any discussion that we have here today about Genuine Economic and Monetary Union is a hypothetical discussion because it is very, very difficult to concretise what those proposals will be ultimately. It is not a hard-and-fast agenda, so there is some element of uncertainty in all of this. That said, the thing that probably most concerns us is the potential for this agenda, and for the banking union element in particular, to have an impact on access to finance, particularly for small and medium-sized businesses. Mark has just mentioned the retreat of many lenders back into their nation state environment. There is a question about whether we might get financial institutions from the eurozone back into the SME finance market here, under banking union conditions or not. We just do not know. The third thing that is important to mention, just by way of introduction, is this. We as a business community want to see out of the eurozone’s integration process three outcomes: structural reform, stability and economic growth, because if the eurozone can achieve all those three outcomes, that is good for British business, given that about 45% of our exports—and many of my members are exporters—have as their principal trading partner the eurozone. So a stable and functioning eurozone is very much in our interests. If GEMU is one of the mechanisms that can help the eurozone to get there, that is a good thing.

67 of 441 British Chambers of Commerce and City of London Corporation—Oral evidence (QQ 39- 54)

Q41 The Chairman: There will be changes, will there not, if this is advanced and gets to a mature stage? I want to try to test and understand better how the City can respond. Hugo Dixon, who gave evidence to us last week, said there may well be a rise in development in the capital markets. Dr Marshall, you just mentioned small and medium-sized enterprises that have often lacked funding through the traditional form of banking. Might that be a distinct development, Mr Boleat, that you get a rise in the capital markets offering to engender and help small businesses? Mark Boleat: I think that is very likely. At the moment we have very tough regulation being imposed on banks, which inevitably affects their ability to lend. It is not surprising that in those circumstances alternative sources of finance develop. I think Britain has been very strong in respect of private equity, which for many small businesses is vital. It is not generally much help to a start-up business—private equity comes in rather later. But we will see a diversification of sources of finance, and on the whole I think that is probably a good thing.

The Chairman: Dr Marshall, would you see it as a wedge that is pushed between the United Kingdom and the eurozone if, on the one hand, the eurozone gets closer together but the United Kingdom, for perhaps political reasons, begins to drift away? Does that circumstance still nevertheless offer opportunities? Dr Marshall: I believe it does. I do not think, when we poll our business community, they see eurozone integration as a threat or a risk as long as it delivers the three outcomes that we were talking about before: namely, eurozone stability, eurozone structural reform and eurozone growth. I think our members would see closer integration of the eurozone as a positive even if the UK is not part of it. On the finance point, I do not think diversification of business finance in this country is in any way predicated on our participation in a banking union. We are seeing diversification happen already, quite apart from those structures, and you are seeing the emergence of a lot of new forms of equity and mezzanine funding. You are seeing new lenders in the debt area emerging, and all of that activity is quite apart from what is going on in terms of the institutional mechanics of the eurozone. I think we have the opportunity both to support eurozone integration, if it serves our interests, but to stay apart from the eurozone and continue to develop our sources of finance.

Q42 Lord Flight: Could I ask you your views about the impact of greater integration on the single market? First of all, the euro crisis has obviously been negative and, as you pointed out, has cut across country lending, but do you see it as all positive or do you see threats that could be damaging to this economy? Also, do you think the single market is headed in the right direction? To me, it is not really about free trade, in the main it is an anti- competitive movement that reserves the position of larger entities, and—like Lord Lawson—I think it would be better if it had less intrusive common rules. Mark Boleat: I think everybody supports the single market but they have different views of what the single market should be. We are very clear in the City that we would expect a single market to be a liberal market, an outward-looking market and not a fortress Europe market. There are clearly some people in Europe who are more inclined to the fortress Europe notion, and there are some people in the Commission who inevitably see regulation as being an objective in its own right. I have to say, having been a civil servant in Britain for one year a few years ago, there are civil servants in Britain who see the objective as being legislation. In Britain we are addicted to criminal justice Bills every year, are we not, imposing tougher sentences than the criminal justice Bill imposed last year. So we are not immune from that in this country.

68 of 441 British Chambers of Commerce and City of London Corporation—Oral evidence (QQ 39- 54) I think what we are seeing in Europe is that the Commission ceased to be a collective body some time ago; individual commissioners bring forward proposals that at first sight, when they see the light of day, like olive oil, look like nonsense. I am interested to know what role the British Government played in trying to stop that earlier, and I suspect not a lot. We want a liberal market, and there are things we see from Europe in the financial services sector that we do not like because they are extra-territorial but of course we see the same in America.

The Chairman: Dr Marshall, have you superb skills in olive oil? Dr Marshall: I wish I did. I am married to a Spaniard, so I will have to ask when I go home. I think in response to Lord Flight’s question, about the sort of single market that our businesses say they want, we are the only business organisation that is actively polling its members nationally about this very question. We have asked the question and we get two sets of responses back. One is of frustration about the incompleteness of the single market. We think of all the things that Britain is good at: services, digital and e-commerce, liberal energy markets, and so on. These are the kinds of things that we would like to see as part of a functioning single market, whereas in reality what we seem to have is a single market in goods, which largely functions in the interest of one large Member State more than any other, and some agricultural subsidies that serve the interests of another Member State. So there is a desire to see a single market that functions more in our interests. Mark said something that I think is very important, which is active participation in shaping the terms of that single market at an earlier stage. We seem to have retreated somewhat from defending our interests at an early stage when barmy proposals on olive oil, or whatever else it might be, come to the fore. We need to be in early, even if ultimately we do not participate in some of the resulting institutions that are for the eurozone countries, for example. However the biggest thing that our businesses are upset about, in terms of the definition of the single market, is the social chapter-employment law and various other elements of the social chapter. They see that as being not necessary to a liberal single market focused around free trade. I am not going to make a value judgment on that. That is simply the view that we get back, and I am reflecting it without fear or favour. There is a notion that you could have a leaner, meaner single market in more areas that is more in Britain’s interest.

Q43 Viscount Brookeborough: Dr Marshall, you mentioned access to finance and a single market in financial terms. From your point of view, could you tell us something especially about SMEs? Very large businesses can obviously access finance worldwide. Because we are outside the eurozone, are our SMEs at a big disadvantage compared with those in Europe who may be able to shop around in other countries but within the eurozone? Dr Marshall: I do not get that sense because you do not see large numbers of small and medium-sized companies on the continent, and within the eurozone, actively shopping for finance from country to country. Indeed, it is more about the culture of the financial institution in question that attracts the business to go in and ask than anything else. There is a Swedish institution, Handelsbanken, opening huge numbers of branches in this country. It is still regulated under the single market by the Swedish regulator but is doing great business in this country because businesses are attracted to its business model. That has nothing to do with the fact that the UK and Sweden are two non-eurozone countries, and nothing to do with membership of a common currency zone. It has everything to do with whether

69 of 441 British Chambers of Commerce and City of London Corporation—Oral evidence (QQ 39- 54) businesses feel confident that they can go to this financial institution and get a good conversation going.

Q44 Lord Vallance of Tummel: Chairman, I should declare my interest as a member of the International Advisory Board of Allianz SE, a German financial services company, and Siemens AG, which is also a financial services company among other things. The UK Government have made it quite clear that they do not want to be part of at least the majority of these measures for Genuine Economic and Monetary Union. Do you think that is the right response, or do you think there are elements of the proposals that it would be useful for the UK to take part in? Mark Boleat: I would echo what Dr Marshall has said on the need for engagement. In Britain we are inclined to complain that we lack influence in the European Union but then who is to blame for that? There are not nearly enough Britons in the European Commission. I know that all eurocrats act in the interests of Europe not in their national interest, but we still need more Brits to do what the other countries do on that. We do not have much influence in the European Parliament, and at Government level, while there has been a very welcome increase in engagement by Ministers over the last few years, we have neglected that in the past. We need to be fully engaged in all the work that is being done on banking union because, assuming it happens—and it is still a bit of an assumption; it is not a certainty—there will be two major financial regulators in Europe: the Bank of England and the European Central Bank. They will need to work closely together, and we need to play our part and bring our expertise in Britain to the way that that regulation develops. On the whole I think that is welcomed by the other countries. Dr Marshall: Do not be out of the room when the negotiations happen—I would echo what Mark has said there—even if we do not participate in the resulting measures. I think the point about engagement is absolutely clear. I was in Brussels a week and a half ago, spending a lot of time in the high offices of the Commission and elsewhere. The very distinct sense that I got is that eurocrats are quite sick of us. They are sick of our non-engagement early in the process but they are also sick of the demands we come with late in the day. Perhaps we need to learn how to play the game a little bit better in order to protect our interests, even if we are going to stay out of some of the measures.

Lord Vallance of Tummel: One tends to concentrate on the integrated financial framework, but of course there are more legs to Genuine Economic and Monetary Union than that. There is the integrated budgetary framework and the integrated economic policy framework. Do you think there are areas there where the UK Government might become rather more involved? Presumably, we do have some form of integration in our economics as between the UK and the rest of Europe. Dr Marshall: I gave evidence to the Commission when it was doing its country-by-country economic assessments fairly recently. That is a perfectly good process. If we have the Commission, alongside the IMF, the OECD and others, regularly doing a health check for us, I see no problem in that. That is not particularly invidious. In terms of participation more deeply in some of these other measures, we see no clamour among businesses in particular for participation in them. What we see from businesses is much greater concern about domestic political risk and short-termism, rather than participation in this particular European agenda. The Chairman: Mr Boleat. Mark Boleat: No, I would simply agree with that entirely.

70 of 441 British Chambers of Commerce and City of London Corporation—Oral evidence (QQ 39- 54) The Chairman: On Dr Marshall’s point about beginning to sense a real antagonism, I must say I had not picked that up in respect of the UK. It was more that they just feel we are on our way out. I do not know whether you had picked that up? Mark Boleat: I think there are varying views. We had an excellent talk in the City recently from Mr Van Rompuy, and he did make the point it is no good expressing friendship while your hand is on the door. There are some assumptions on the part of some people that Britain might be on the way out. I recently did three Chinese TV interviews in one week on this subject. That is not the prevailing view in Britain. I think most people one speaks to involved in this do not expect Britain to be on the way out. But clearly, if you think somebody is on the way out, you are rather less inclined to engage with them. It is not unknown in British politics that, if the Civil Service perceive that a Government is on the way out, there will be slightly less engagement and willingness to do long-term things in the final year of the Parliament. That is to be expected. In my previous life when I ran trade associations—since then I have done consultancy work on trade associations including in Europe—the art of running a good trade body is to influence the consultation document, not to get column inches for commenting on it and seeking to reverse a policy afterwards. Certainly, when I was involved in the insurance industry, we were in at a very, very early stage and if we simply whinge when the Commission publishes something, the proper response is, “So what were you doing early on?” A lot of British business has not been good enough in getting involved at an early stage and that would also apply to bits of government.

Q45 Baroness Maddock: I wonder if we could think more about the indirect impacts for the UK of not participating in greater union, monetary and otherwise. I am particularly thinking about attracting inward investment, which both of you touched on in your comments earlier on, particularly the position of the financial sector. We will be meeting with them later on today. You made a comment about people not getting involved early enough in the day, and on this Committee we are surprised that the City seems not to be always right up there at the beginning of proposals. Mark Boleat: Certainly, from our part in the City—and we have a rather odd role, we are not a trade body—

Baroness Maddock: I meant the people who work in the City, not specifically your committee. Sorry, I should have made that clear. Mark Boleat: In terms of long-term investment decisions, I think that is a critical issue. One sometimes gets the impression that some politicians—clearly not you—get the impression it is all or nothing, i.e. “JP Morgan has not closed down in Britain, what is the problem?” That is not the way it ever is. I spend a lot of my time talking with major institutions in the City and abroad, talking with people who might be investing in the City, or indeed the country as a whole. I use the City but, frankly, whether it is the Square Mile or somewhere else in the UK is not material to us, we want them in Britain. It is about increasing or reducing or doing a start-up. Now there is an element of uncertainty called British membership of the European Union. That is far more of a risk than the economic and monetary union. If I was an institution, whether it is a car manufacturer in Korea or a Chinese bank, whether or not Britain is in the single market is absolutely critical. Whether Britain is in a single currency is much less critical. Dr Marshall: I have a slight disagreement with Mark. The most critical things are domestic factors that we control, when it comes to inward investment. I was with a major American multinational this morning, 20% of whose business is here in the UK. I took the opportunity

71 of 441 British Chambers of Commerce and City of London Corporation—Oral evidence (QQ 39- 54) to ask them whether the European debate in Britain at the moment fundamentally impacted on their interests in this country and their desire to be involved in this country. The answer was a rotund “No”. What came back to me is what I hear over and over again: it is visa policy; it is aviation capacity; it is planning decisions; it is energy security; it is the overall business environment. European intergration is not the defining issue that some of us who operate in and around Westminster sometimes consider it to be. Many of these businesses that I speak to about this want to remain part of the single market. They think it is important, and so on. But the prominence that we give this European debate—while we ignore some of the major enablers in the business environment—I think is at our peril. Mark Boleat: Can I largely agree with Adam because I was speaking probably to the same American multinational about an hour ago? They said the same—that for them the single market was not vital. For others, it would be more important. It depends what business it is but I entirely agree on the bits about airport capacity, visa policy and so on. These are points we emphasise a great deal.

Q46 Lord Davies of Stamford: You say that there is a consensus among your members who wish to be part of the single market. Both of you have expressed yourselves strongly that, so far as GEMU and banking union are concerned, we should remain in the room—to use your phrase—even if we do not become part of the measures or the regime that emerges. But is there perhaps a case for our becoming part of the regime? Is there a case for our becoming part of the banking union, for example? Mark Boleat: There is a case, yes. I think at the moment people would say it is a weak case, particularly as whether the banking union will succeed is still open to question.

Lord Davies of Stamford: Leaving that aside, assuming it happens, can you just set out the factors, negative and positive: what are the factors that argue for our membership and those that argue against our membership? Mark Boleat: Looking at the present you would say that the single currency has been a failure so far. We still have a eurozone crisis. We are not through that. If we had a Genuine Economic and Monetary Union, with all of the fiscal and political integration that that necessarily implies, and if it was seen to be highly successful, benefiting all of the Member States—and even now we have countries like Latvia wishing to join, and a number of European countries think that for them the single currency is a success. I have heard this from them at first hand. It has helped make things happen that otherwise would not have happened. If it becomes a success and it is accepted then, clearly, the downside of Britain joining it is sharply reduced. We have a view in this country about sovereignty and so on, which I think is a bit old- fashioned—the notion that you can be a very successful economy and take whatever steps you like in any field. You cannot, as Switzerland is finding to its cost at present. I do not think we should ever say “never” but I cannot see any prospect of Britain joining a banking union in the foreseeable future, looking forward five, 10, 15, 20 years.

Lord Davies of Stamford: Just a moment, you were talking really about GEMU, first of all, and then you switched to the banking union. The banking union is a separate thing. We could be part of a banking union, presumably. Mark Boleat: I would take the banking union as being essential to secure monetary union. Yes, one could join a banking union in many respects without being part of the monetary

72 of 441 British Chambers of Commerce and City of London Corporation—Oral evidence (QQ 39- 54) union, but I do not think that is on people’s agendas at present. Again, there is still a lot of uncertainty as to how banking union is going to work. I know—

Lord Davies of Stamford: But just a moment, Mr Boleat, you say it should not be on our agendas at present. But should we not be thinking about it, because you are saying we should always be in the room, we should always be in at the beginning? You have said that several times this morning. Mark Boleat: Yes. I would hope, absolutely, that people are thinking about all possibilities in that respect. If the banking union succeeds then a lot of the banks operating in Britain will be part of it. Indeed, the British banks operating in Europe will equally be part of the banking union in some respects.

The Chairman: Dr Marshall, would you like to reply to Lord Davies’s question? Dr Marshall: I can only report the instincts of the business community that I represent, 85% of whom are against any further integration in European institutions.

Lord Davies of Stamford: On what grounds? Dr Marshall: Effectively, this is the question that was asked of them: are you in favour of further integration, yes or no? Do you think it will be positive for your business or negative for your business? Most of them view it negatively. When you ask them about things like the banking union, you get a blank stare because they do not know what the internal wiring actually means for them. But when you start to talk to them about currency union, when you start to talk to them about the more political aspects, they start to engage more. You have to realise that for most businesses in this country this is an arcane debate and one that elicits a very emotional reaction, so I do not think you are going to get from rank and file businesses around the country a clear view on banking union specifically.

Viscount Brookeborough: Just very quickly, that 85% is that the numerical number of businesses or is that value of turnover? Dr Marshall: It is numerical.

Viscount Brookeborough: So it is more SMEs than others.

Lord Davies of Stamford: Very briefly, if banking union does take place and if we are not part of it, are you satisfied by the safeguards that are being negotiated to enable those non- participating members of the banking union to ensure that their interests are not negatively impacted? Mark Boleat: I think that the safeguards that were negotiated in December were as good as could possibly be achieved, and they are an example of what can be done by quiet, behind- the-scenes, hard-work diplomacy over many months. They are the best that could be achieved but, remember, most of the outs want to be ins. Clearly, when the outs become the ins the arithmetic looks rather different. Lord Davies of Stamford: The safeguards disappear. Yes, thank you. Dr Marshall: The double majority is a very important precedent to have been set. However, it has now only been set for an agency. I think you have to look at expanding that concept so that those countries that are outside the eurozone have wider safeguards around a range of these issues. So if there is a wider programme towards Genuine Economic and Monetary Union, the double majority concept comes into play.

73 of 441 British Chambers of Commerce and City of London Corporation—Oral evidence (QQ 39- 54)

Q47 Lord Vallance of Tummel: Again, coming back to your 85% for clarification. Of your membership, of the people that you represent, what proportion of them do a significant amount of their business in the rest of Europe? Dr Marshall: Quite a significant proportion. Among exporters in our membership, which is four out of every 10 businesses, 88% of them are exporting in Europe. I represent a business community that is very, very much engaged in trade with Europe. Mark Boleat: Could I just add a point briefly? In the ward I represent in the City—which admittedly is small—most of my constituents are small businesses, for example, coffee shops, pubs and restaurants. A lot of them would not know how dependent they are on the single market. The people who are having coffee in some cases are only there because of Britain’s position as an international financial centre. We need to look through the entire supply chain to know just how important some things are.

Q48 Lord Dear: I have a couple of questions about banking union. You have covered the ground on at least one of them when you were talking about the stringency or otherwise of the results of negotiations that came up in December. Could I ask you to apply your mind to how banking union might impact the problems between bank debt and sovereign debt? Do you think that problem will be addressed by the proposals or are we still going to have the difficulties we have experienced to date? Mark Boleat: It is a clear intention to break the link between banking debt and sovereign debt, and everybody more or less agrees with that. What they do not agree with is the consequences that one country’s problems will be picked up by another. I was in Berlin for two days last week talking with policymakers, politicians and officials about this. The German position is pretty clear that, before they are prepared to agree to any mutualisation of debt, they want everything cleaned up first. Hence the European Central Bank has been charged with doing a balance sheet review of all—I think 120-something—banks that will come within its remit. One thing that has already become clear over the last few months is that countries have applied the risk rating analysis in a very different way. The criteria used in one country and another country would get different results. I still think there are some real problems in the banking sector. The Germans, in particular, will want to see those cleared before they are prepared to look at anything going forward. They are not willing to pick up past debts of countries—

Lord Dear: That has come as something of a surprise, has it not, because six or nine months ago there was a school of thought that probably Germany, but certainly everybody else, would clear all the debt, “Here you are. It is plain sailing, off you go”. It is not the case, of course, and Germany has made its position very clear on that. Mark Boleat: Indeed, Germany has a very big election coming up, as we all know. It is getting almost as much publicity as British elections, in terms of its importance for Europe going forward. But all of the German politicians know very well that there are not many votes in seeking to support Greek banks. Dr Marshall: Indeed, the decision of the German Constitutional Court—which is pending at the moment while we speak—will be influential in that. One thing that is interesting, in speaking with our contacts and the people we work with in Brussels, is that the banking union concept is being bandied around as a phrase but, in fact, some of its components have been significantly watered down in recent months. So, yes, there is a single supervisory mechanism on the table but both the deposit scheme and the single resolution mechanism are going backwards rather than forwards. In that event, you do not have all of the

74 of 441 British Chambers of Commerce and City of London Corporation—Oral evidence (QQ 39- 54) components of a banking union so it is very difficult to say that we will have a decisive break in the link between bank and sovereign debt without all of the components required.

Q49 Lord Flight: Could I make the point that we focus on banking union, but we already have EU majority diktat with regard to regulation in areas such as the investment management industry? By and large the problems of that have been that common size does not always fit, so the definitions and various other things that come from Europe are ill- fitting with the UK industry. For example, I would argue that AIFMD is going to be a disaster for the UK investment management industry. In focusing on the pluses and minuses of joining in common regulation, there is quite a powerful case that if it is the majority of EU it will not fit the UK practice.

The Chairman: Let us take that a bit further with the Earl of Caithness, who has a particular point there.

Earl of Caithness: Yes, I want you to look a bit more into the future. The impression that many people have is that the City is reactive. It is always going to be all right in London. London will survive and it does not really matter what is produced in Brussels. But if there is going to be deeper integration on taxation and employment policy, which is highly likely, what are the City and the Chamber of Commerce going to do to influence how that is drafted so that there are not adverse effects? Mark Boleat: Taking both points together, the general view of the AIFMD—and I am not an expert on this—is that it is not as bad as it could have been. But going back to the beginning of it, it came from the European Parliament, so what influence does Britain have in the European Parliament? Not a great deal. The British industry was very slow in getting on top of AIFMD. Indeed, it was the City of London people in fact who were doing some of the early work. When I was running a trade body, I would regard it as a sacking offence to let something get that far without having a big involvement in it. I was more fortunate—when I was involved in trade bodies we had Brits in the top positions in the European Commission. We were fully engaged and we would not have let something like that happen. So there is a question, not “Who are these people who did it?” but “Why were we not involved in it”? But I think the view of the industry—and we had a very big seminar in the City two weeks ago on this—is that the implementation is not as bad as it could have been. On employment, I agree with Adam. You do not need all this employment integration for a single market, but I suspect that the working time directive is something that causes huge excitement in Britain and is generally regarded as completely irrelevant everywhere else. Indeed, I think it is widely ignored in Britain as well. On taxes, of course every country is against tax competition while at the same time every country—Britain included—is saying, “Our corporation tax regime is the most competitive in the world. We roll out the red carpet to welcome businesses from other countries because it is so competitive”. We now have a very odd position on tax—businesses are not only supposed to obey an incredibly complex array of tax laws in a variety of countries, but also to decide what is fair and to pay that as well. There clearly has to be some work done on tax at the European and global level. Again, tax integration is not essential to make a single market work. America does not have tax integration. There are different rates of income tax, of corporate tax and of excise duties between the American states. It is important that the single market concentrates on what the single market needs not on what is attractive to somebody or is easy.

75 of 441 British Chambers of Commerce and City of London Corporation—Oral evidence (QQ 39- 54) Dr Marshall: That also applies to wage rates. If you look at American minimum wages, they also vary from state to state and that does not undermine their single market. Meanwhile, a colleague of mine sent me a poster from Brussels about the potential for a eurozone-wide minimum wage. You can think of the labour market distortions that such a thing would cause. Mark has made extremely clear the importance of being in the room. It is very easy to say to ourselves in the Chambers, or to our colleagues in the City of London, “We need to be there and we will be”. But I think the light has to be shone early on, on our Civil Service and on those who represent our national interest in some of those technical councils and negotiations because, generally speaking, while we go hammer and tongs at the UK Government on many domestic issues, we often work very closely together around major European decisions because we have a similar view on issues in Europe. But we need to strengthen the capacity at the heart of the Civil Service to defend our interests, because I do not think we are necessarily as good as we should be at doing that.

Q50 Earl of Caithness: Mr Boleat, you gave the standard British response in that we do not need any of these things to make a single market work. It is going to happen. So, whether we like it or not, what should people in the City be doing to try to put a brake on what is going to happen? Mark Boleat: I fear a lot of it will happen because there is an inevitable trend from people in Europe to do European things. I have also done a lot of work on regulation in this country, and I have observed that every Government is going to roll back the regulatory burden and, at the same time, every Government increases the regulatory burden. In my view, this Government is no exception, because there are very strong forces that require more regulation. When anything goes wrong people want more regulation, and it needs to be fought against. What is the City doing? We are doing our bit of engagement at a top level in Europe. The Lord Mayor and I are committed to visiting each of the EU countries or doing a significant event with them. As I said, I was in Germany last week and also in Sweden. I detect a lot of support for the views that we have in Britain. I think we need to be careful at saying we have persuaded our friends to agree with us. Actually they have very common views on what needs to happen in Europe as well. There is a lot of disquiet at the way the Commission has worked. It has ceased to be a collective body—it used to be more of a collective body. Now you get individual commissioners doing their own things. For example, we have a proposal for European contract law, which is a solution to a problem that does not exist in any way and is taking a huge amount of time to make sure it does not happen. There is a question of why that is being done. The financial transaction tax will not happen in remotely the form that is currently being proposed. You have a daft proposal and then you have people saying, “This is daft”. What we should be doing is having those discussions before the proposal is published, not afterwards. There is a lot of politics in the financial transaction tax. It is very popular in every country in the world, because it is assumed somebody else will pay it, but there needs to be a more sophisticated analysis. We in Britain need to be far more engaged, in there early, and build alliances with other countries. We have not done that sufficiently well. There has been a huge improvement in the last year or so and I can see an engagement, certainly with Germany. But before then it was just not good enough.

76 of 441 British Chambers of Commerce and City of London Corporation—Oral evidence (QQ 39- 54) The Chairman: Dr Marshall, do you agree with the line of thinking that Mark Boleat has outlined, that very well put phrase, “In Europe they do the European things”? Is there a failure of understanding in this country that there is the will and desire to do that? If you take the example that Mark Boleat gave of the financial transaction tax, this thought that it is dead is wrong, is it not? It is actually going to come in some kind of form because there is a political will behind it. Do you agree with that? Dr Marshall: I think what I see is the worst of all possible worlds emerging: a bad proposal that gets worse before it is implemented. The Government’s position on this, that an FTT is only a runner and a rider if it is a global and a universal thing, is probably the right one to take. We do not want to create competitive disadvantage for the European Union, as a whole, or for Britain in particular. If the eurozone countries decide they want to have common taxation, employment and other policies, that is their right as a group of countries. My suspicion is it will make them less competitive with respect to us, which would be to our benefit. However, the one other thing that we would want them to have is a functioning economic policy, overall, because they are our biggest trading partner. So there is a fine line that we have to walk here, and we have to be very careful. We would have to say to our friends across the Channel, “On the one hand, do not price yourselves out of being competitive here in the developed world but, on the other hand, price yourselves a little bit higher than us so we get more of the business”.

The Chairman: Let us go to our last two questions.

Q51 Viscount Brookeborough: The proposal of a eurozone budget, is that just another European thing that either will not happen or that we will ignore until it is too late? Would it have any advantages and would it be even feasible under the current situation?

The Chairman: Dr Marshall, do you want to try that? Dr Marshall: Yes. I have one very, very clear point here, which is that unless such a budget is linked to structural reform within the eurozone Member States, it has no purpose. If all it is is about setting ceilings but not dealing with the fundamental problems of competitiveness within those countries, it will be of no benefit to us or to them.

Viscount Brookeborough: But do you see it as being realistic and how might it be funded? Dr Marshall: Realism in that particular area is up to the politicians, to the German courts and to the German electoral system at this moment in time. Mark Boleat: Again coming back to the financial transaction tax, there will be a financial transaction tax. It might not be a tax on financial transactions but there will be something called “a financial transaction tax” because the politicians have said there will be one. In terms of a eurozone budget, I agree entirely with what Dr Marshall has said. Clearly, the people in Brussels want their own budget. Who does not? But it is up to national Governments to agree. What really struck me from my visit to Germany is how critical that election is in September. The result is not a foregone conclusion at all, because of their proportional voting system. The politicians are keenly aware of the views of the German people, which are probably less enthusiastic about the European venture than the views of the German politicians. That election is critical, and I hope that after the election we can get on and address some of the problems in a rather more effective way.

77 of 441 British Chambers of Commerce and City of London Corporation—Oral evidence (QQ 39- 54) Viscount Brookeborough: Can you see a change in German policy after the elections, or do all the parties realise that the electorate would not stand for any big change as far as European policy goes, in particular, funding other nations? Mark Boleat: On funding other nations they have done a fair bit of that already. Frankly, through the ECB, there has been a fair bit of de facto debt mutualisation already. But, no, the Germans are not prepared to pick up the bills for what they see as other countries’ profligacy.

Q52 Lord Davies of Stamford: We can all see why, in theory, a financial transaction tax would reduce the competitiveness of the countries that propose it. It is quite logical. But why would this FTT have such disastrous consequences—as you are both assuming—when stamp duty of 0.5%, a much higher level, on securities transactions in this country does not seem to have deflected significant business from this country? Mark Boleat: Stamp duty is a long established tax. It was established by your good selves in Parliament to fight the French, I believe, in 1690. That was the origin of it. I am sure we would not wish to do that again.

Lord Davies of Stamford: Nevertheless, it is there. It is 0.5%. If you buy the same shares through the ADR system in New York, or through a contract for differences arrangements or something, you do not pay the 0.5%. There has not been that deflection of business. Why not? Mark Boleat: I think that is partly because it is very long established and it is limited to taxation on shares and, as you say, it can be avoided in various ways. The proposed financial transaction tax is far more wide ranging. On our own analysis it would cost the British Government a great deal, because it would have to offer a higher yield to compensate for the tax that would be paid by the many European institutions that would hold British Government debt. That is why the British Government has challenged it legally. We have also had the European Central Bank saying, as proposed, it would not enable it to do its repo operations that are absolutely vital. Two weeks ago, we had Siemens and Bayer saying this was a direct attack on the German exporters—something along those lines. We had six German banking associations jointly sending a letter to the German Government on the harmful effects of the tax. It is something that superficially is attractive to some politicians because it sounds as though it is paid for by bankers. Indeed, that is one of the justifications: the bank has caused the crisis; this is a tax on bankers. It is not a tax on bankers. At the end of the day, taxes are paid by people. They are not paid by institutions or markets. This tax would be paid by people, and that has been realised the more research has been done on it.

Lord Davies of Stamford: I do not know whether we have seen the work you have done for the Corporation on this, but if we have not seen it I wonder if you would be kind enough to let us see that? Mark Boleat: We will do that.

Lord Davies of Stamford: Thank you very much. My final question is that some degree of bank mutualisation may be introduced into GEMU and the banking union, whether through eurobonds or not. What is your view about that? Would that contribute to stability in the Government debt markets? Would it create moral hazards for the future? Is that a good or a bad thing from the strictly pragmatic British financial services’ point of view?

78 of 441 British Chambers of Commerce and City of London Corporation—Oral evidence (QQ 39- 54) The Chairman: Dr Marshall, do you want to try that one? Dr Marshall: I think it is a dead discussion, quite frankly. As long as the Germans are not interested in it, and they seem to me to be very uninterested in it at the moment, it is—

Lord Davies of Stamford: We do not know what is going to happen after the German elections. What I want to hear from you is, in your view, what would be the consequences if moves were made along those lines? Dr Marshall: Going back to an answer that Mark gave a few moments ago, I think that the level of popular backlash, among the countries that would be taking on some of those obligations, would be rather severe. I do not expect that we will see this happening in the future.

Lord Davies of Stamford: That is not my question, whether it is going to happen or not. My question is: if it did happen, would it be good or bad from the British business point of view? Do you understand the question? Dr Marshall: It is a very good question and I do not have a good answer for you. Mark Boleat: I think we are going to require the stability before we see that sort of development happening, because it will not happen until Germany and, indeed, other countries are satisfied that it would not be—

Lord Davies of Stamford: You also do not want to answer my question. Dr Marshall: It is like trying to hit a moving target in some respects, is it not? Mark Boleat: If we are in a position to do that, it would be a symptom that Genuine Economic and Monetary Union is arriving. We really want—and I think we are both very much agreed on this—the eurozone to succeed. It is really important. It is adversely affecting the global economy at present, with the uncertainty and what is happening in Europe. We want to see the eurozone area thrive and that is going to benefit British business.

Q53 The Chairman: Let me ask the two of you one final question. Early on, Mr Boleat, you mentioned our seeming inability to communicate, with and through our MEPs, in such a way that we arrive early to intervening on what might be thought as the UK view on a whole number and raft of these issues, much in the way that you did 20 years ago when you and I shared an interest in the then forming European legislation. What more can we do in that area and in terms of the Commission and in other important significant areas, or people that we might speak to, to ensure that, even if these massive creations come into being, we—the United Kingdom—are still protecting that which we hold valuable, namely, the single market? Mark Boleat: MEPs. If one gives any Parliament of any sort more legitimacy, it tends to become more powerful and, dare I say it, the Lords would be a good example of that. The Labour Government having given it more legitimacy in some ways, the Lords feel more inclined to use the power. They can say, “Look we exist because there is legislation”. We had MEPs, we had Sylvie Goulard, who is a very impressive French MEP. We gave her a very good breakfast—as we do in the City for discussion—and she said, “But we are the elected representatives of the people. We are Europe’s democratic legitimacy”. Now I think we in Britain would not recognise that, and that is a real problem because the European Parliament has massive powers. We have some excellent MEPs, really good MEPs who have done a great job: Sharon Bowles, Malcolm Harbour, Vicky Ford, Kay Swinburne. There are many others who have done a great job, but you can only do so much in a small group. In terms of

79 of 441 British Chambers of Commerce and City of London Corporation—Oral evidence (QQ 39- 54) the Commission, I think something like 3% of Commission staff are Brits and it should be 8% or 10% on nationality. We have failed to get enough people into the Commission. It is seen in Britain as, “You have not done a good job. We are going to post you to Brussels”. It needs to be part of the career path which I think it is in many other countries. It is no good whingeing that we do not have influence while not doing enough to get influence. I think there is more we need to do with the Parliament. I think the British Government has done a lot more with the MEPs than before. It was put to me in a discussion that we had last week that we need to up what we are doing by 10 times in Europe. It really is a problem. The resources—I know Adam would say the same—that they could put into Europe if they had them, you could easily put 10 times as many resources and still have more to do.

The Chairman: Dr Marshall, do you share that view? Dr Marshall: I share large parts of that view What I would add is that I think the treatment of European elections, and the European election cycle, in this country needs to change if we, as a public, are to take our Members of the European Parliament more seriously. Given their expanded powers under the , and the expansion of the co-decision procedure, what they do matters a great deal more. A lot of the work that people like Mark and myself have to do, at soft pencil stage, to fight off invidious elements of regulation or legislation, could be so much more assisted if we had more visibility for the role of MEPs, and equally, more influence via the committee structure and everything else. In so far as the Commission is concerned, just two points: one is that at the renovation of the Commission next year—because obviously the mandate is up—it would be very good indeed to see a British commissioner in one of the key economic portfolios once again, as a way of trying to defend some of our interests. However, I have one minor discrepancy with Mark, which is saying that we are the only country that seems to whinge quite this much about European decision making and not get people in to key Brussels posts. I do remember an episode of the Danish television series, Borgen, which was entitled, “In Brussels no one can hear you scream” because that was the place where they too would put people off and shunt them off to one side. So perhaps we are not the only ones in that particular boat, but if we upped our language skills we would be able to do more.

Q54 The Chairman: One final question. Is there any danger that next year’s European elections will be anything about Europe in this country? Dr Marshall: We will certainly brief the business community in such a way that we will hope they will be about Europe. Baroness Maddock: Your members around the country are in a very good position to talk to their MEPs. I know Fiona Hall, our MEP in the north-east, very well. She spends quite a lot of time dealing with business—in fact, a huge amount of time. You are in a better position sometimes than we are to actually talk to MEPs, because one of the things I find quite frustrating about the way the British system works is that we rarely talk to our MEPs.

Lord Flight: Sorry, could I add my declaration of interest as on the register, for the record?

The Chairman: I thought we were going to get an astounding confession there!

Mark Boleat and Dr Adam Marshall, we are extremely grateful for that hour, which was both interesting and very insightful. We are grateful to you for coming today and offering that to

80 of 441 British Chambers of Commerce and City of London Corporation—Oral evidence (QQ 39- 54) us. As I mentioned before, we will send you the transcript and ask you to correct it. You may have further thoughts and, I wonder if I can turn to my colleagues; there may be some questions that we were not able to deal with, supplementary to the ones we gave you, that we would be most grateful if you might answer if you were able to do that. That really was very illuminating, and shades in some of the practicalities of the side of Genuine Economic and Monetary Union that we feel we needed in asking you two here today. You fulfilled that. Many thanks indeed. Dr Marshall: Thank you.

The Chairman: Colleagues, I should tell Mr Boleat, we are going to Germany in November to see our colleagues in the German Parliament, the ECB and everyone else. We think it is that important that we should do it. Mark Boleat: You will be very jealous of their new building. I should add that, when I was in Berlin last week, I saw a splendid example of how far European integration has gone, in that French farmers were protesting outside the Bundestag, and will be for some time. The Chairman: We will be sure to record that.

81 of 441 Professor Claudia Buch, Professor Jan Pieter Krahnen and Professor Otmar Issing—Oral evidence (QQ 297-315) Professor Claudia Buch, Professor Jan Pieter Krahnen and Professor Otmar Issing—Oral evidence (QQ 297-315)

Evidence Session No. 25 Heard in Public Questions 297 - 315

FRIDAY 8 NOVEMBER 2013

Members present

Lord Harrison (The Chairman) Viscount Brookeborough Lord Davies of Stamford Lord Flight Baroness Maddock Lord Marlesford ______

Examination of Witnesses

Professor Claudia Buch, President, Halle Institute for Economic Research, Professor Jan Pieter Krahnen and Professor Otmar Issing, Centre for Financial Studies, Goethe University

Q297 The Chairman: Professor Claudia Buch, Professor Otmar Issing and Professor Jan Pieter Krahnen, many thanks indeed for coming before Sub-Committee A on this inquiry that we are pursuing on genuine economic and monetary union. I think “echt” in German sounds better than “genuine” in English, which is clouded over with ambiguity, but that is a matter we will explore. Thanks for coming to help us. We are on the last leg of a very long inquiry. After the visit here to Frankfurt, we will be returning to London and writing a report. We will publish that in the new year. As you may not be familiar with House of Lords practice, we are making of record of this exchange and will send you the transcript afterwards. We ask you first of all to correct it, but we also ask you, unusually, to improve it. If you have further ideas, as is often the case when you come in to answer questions, please write them down and send them to us. As I say, we will not be writing up until the new year. We want to try and contribute something that will not only be useful around Europe on the question of how we establish the genuine economic and monetary union but naturally has an element to it that reflects on the United Kingdom’s interest and role. Please feel free in the questioning to elaborate on those points that you think might be helpful to us. Perhaps I could invite each of you just to say a few words about who you are for the record. Then I will put a first question. Claudia Buch, would you like to say a little bit about yourself? Professor Claudia Buch: Thank you very much. It is an honour to be here. I am very pleased that we could fit our time schedules together. I am here in two capacities: on the programme, it says that I am the president of the Halle Institute for Economic Research and a professor of economics at the University of Magdeburg. The institute is a large research institute in eastern Germany. I am also a member of the German Council of Economic

82 of 441 Professor Claudia Buch, Professor Jan Pieter Krahnen and Professor Otmar Issing—Oral evidence (QQ 297-315) Experts. As a matter of fact, we finished our annual report for the Government just yesterday. It will be published next Wednesday. From the report, we could add to the transcript that you mentioned because we have a couple of things to say on these issues. It is not public yet but in a few days it will be. Thank you. Professor Jan Pieter Krahnen: My name is Jan Krahnen; I am a professor of finance at the Goethe University here in Frankfurt. I am a director of the Center for Financial Studies, which has been involved in a lot of, let us say, build-up in research and policy advisory capacity in Frankfurt at the university. I have been involved in the Liikanen commission in 2012. In that capacity, I am also involved in some discussions going on in Frankfurt and Berlin on banking union issues in the broad range. The Chairman: I assume that the wonderful Goethe Haus is still in Frankfurt and open to the public? I enjoyed going there some 20 years ago. Professor Otmar Issing, you are a name so well known to many of us. There will be some very interesting questions coming from my colleagues. Perhaps if you just nametag yourself. Professor Otmar Issing: I hope that I am known for good reasons. I was a professor of economics before I joined the Deutsche Bundesbank in October 1990, becoming a member of the executive board and the governing council. In June 1998, I came to this building as member of the first executive board of the European Central Bank. My term ended in 2006, after eight years. I am now president of the Center for Financial Studies, working with Jan Krahnen. Perhaps I should mention in this context that I was a member of the de Larosière group. We made a proposal on macroprudential supervision and also on banking supervision. It was a report for the EU Members of our committee teams also from Sweden and the UK. This report was EU-wide.

Q298 The Chairman: Thanks very much indeed. Perhaps, Claudia Buch, you could start us off by analysing for the committee the proposed architecture of the genuine economic and monetary union, telling us those elements that you think are necessary and with which we should press ahead, and those which may be less necessary and possibly even unhelpful. Professor Claudia Buch: There are actually three elements to the proposed structure. I should say that as we think about this whole process, it is really the long-term institutional structures: what Europe should look like once the short-term problems have been dealt with. I shall talk about the long run and maybe we will have time to talk about how we get there, because I think that is to some extent a separate issue. The long-run structure, as it has been proposed, comprises a banking union, fiscal union or enhanced fiscal co-ordination, and economic union, so the co-ordination of certain policies such as labour market policies and tax policies—which is also of course part of fiscal union. To a degree, it is all about how much control should be at the European level and to what extent we should give up sovereignty at the national level. That is what this is all about. We have taken a very clear stance on this and we suggest an institutional architecture consisting of three pillars. As regards the first pillar, we think that fiscal union—sometimes the need for a “fiscal capacity” is being discussed—it is not feasible to implement fiscal union and we do not see the potential for countries to give up sovereignty on fiscal matters. I would argue that our way forward would be going back to Maastricht and the no-bailout principle, having fiscal responsibility at the national level, simply because we think that countries are not willing to give up control to the European level. We acknowledge that there might also be an equilibrium where control is given to the European level and where Eurobonds are introduced, but we think that is a very unrealistic scenario. Then people say that the old Maastricht concept has failed, so why would we think that the no-bail-out principle could be

83 of 441 Professor Claudia Buch, Professor Jan Pieter Krahnen and Professor Otmar Issing—Oral evidence (QQ 297-315) the way forward? There I would argue that with the fiscal compact and the national debt breaks, we have implemented elements that, I hope, make the non-bail-out principle more credible and sustainable in future. This would be our first pillar for a long-run institutional structure for fiscal policy, with economic policy, such as labour market policy, being under the control and sovereignty of the national level. The second pillar would be a crisis mechanism. Even if we do everything right and have all good intentions, there might be crises in future. For that you need a crisis mechanism such a well-designed ESM. For the banking union, the third pillar, we would argue also that, as a concept, we need control at the European level. There, we would depart from the principle of having liability and control at the national level. Because we have the ECB and some implicit risk-sharing mechanisms, we also need control at the European level. This, in a nutshell, is where I would hope this whole institutional structure is going.

Q299 The Chairman: That is really helpful. We will explore elements of that in a minute. Professor Issing, do you disagree with anything from Professor Buch? Professor Otmar Issing: I do not disagree with anything that Claudia Buch said. I agree with her that there are other things in this package that are useful. I find it especially useful as far as it strengthens national responsibility like in the fiscal pact, so that the debt limit included in the national legislature relieves the European task of surveillance and makes it a national task to provide solid public finance, which is a national interest. I always deplored that the stability concept was seen as something imposed on nations: the rules are in the interests of individual countries. This I welcome. I cannot hide that I am critical of the term genuine or “echt” monetary union. The term is misleading in two ways. First, it gives the implicit message that without these four packages—economic, fiscal, banking and political union—a monetary union is not viable. When the euro started, the big question was: can a monetary union survive without political union? In the 1990s, I thought not, and that political union should come first. When we started with the euro it was a fact that political union was not around the corner, so the question was: can this arrangement survive? The term genuine economic and monetary union implies that it cannot survive—we need political union—and I think that this is wrong. We need the right framework of surveillance and control of financial markets. For a long time to come, and I do not speculate about the very distant future, monetary union can survive without political union. My second concern why the term is misleading is that it suggests that political union could happen, realistically, in the distant future. I think that that is not the case. If you talk to responsible people like high-ranking politicians, and so on, in any country, it is a vision, yes, but almost nobody believes that we will have real political union in the foreseeable future. If you accept this premise it will have dramatic consequences because any intermediate steps might land in a transfer union without decent political or democratic legitimacy. This implies that the principle “no taxation without representation”, which for me is key in any democracy, is violated.

Q300 The Chairman: That is really helpful. Professor Krahnen, perhaps you could add to or subtract from what we have heard. Professor Jan Pieter Krahnen: Yes. I also agree completely with what has been said. If we put it all together we will see that the basic issue that we have to deal with concisely and correctly is how to set up a banking union. That is the basic part that we want to achieve. How can we deliver some aspect of fiscal co-ordination that is the backstop for the banking union without going a step too far, so to speak? There is a certain borderline that is not easy to identify and even more difficult to implement. I think that this is probably what many of your further questions are about, so I do not want to say too much now. If we have these

84 of 441 Professor Claudia Buch, Professor Jan Pieter Krahnen and Professor Otmar Issing—Oral evidence (QQ 297-315) layers: the banking union, the fiscal union, the political or economic union at the top, we are all agreed that there will not be this third level. We will get to the second one, to some extent, maybe to the extent needed to make the banking industry again market-oriented, where the market forces prevail and market discipline can be observed. As Otmar Issing said, control by financial markets should function again, which does not happen right now. For that, we need some sort of co-ordination that has some aspects of fiscal union, although it is not there entirely. The Chairman: You are absolutely right. That will be the focus of our interest. Lord Marlesford has a testing question that, given that we are in Germany, we would like to ask.

Q301 Lord Marlesford: It is really about the fact that already the ECB is taking a quasi- fiscal role in the activities with sovereign debt. Oh, I am so sorry, that is Question 2. Well, the US Treasury has said that the Germans should use their surpluses to generate growth in favour of other countries and that other countries with surpluses should do the same. This is quite a strange idea when you do not have a union. What do you feel about that? The Chairman: Professor Issing? Professor Otmar Issing: Oh, I would love to comment. It is a totally misguided concept. It is an old issue. The IMF and the Americans have made this case many times in the past, so every economist in Germany is well prepared for this question. For me, it is a long issue, which I shall cut short. To have a current account balance as a policy target is fundamentally wrong. There is one case in which international arguments are valid. This is the case when the exchange rate is manipulated. When the Chinese, for example, suppressed the appreciation of their currency, their surplus was artificially created. This manipulation of the exchange rate does not happen in Germany. Inside monetary union is different, but the argument is about the international situation, and a country should do its best to have a macroeconomic successful policy. In Germany, we do not have an output gap; we have an extremely lax expansionary monetary policy. We have a more or less balanced fiscal policy. We are close to what might be called full employment. We have a debt ratio of 80%. Why the hell should a country in such a situation stimulate demand by increasing public debt? This is against any reasonable economics. I could continue, but I will stop.

Q302 The Chairman: Professor Buch, do you agree with that? Professor Claudia Buch: Yes, absolutely. Let us look at the components of demand in Germany. Government spending has already been mentioned. We have a long-term problem in dealing with the public debt situation in terms of our looming pension problem. I do not see why the Government should now spend more or increase taxes to finance such spending. For the public sector, there is little room for manoeuvre. In the private sector, private investment has been fairly low recently, but there are good reasons for that. We have seen a high degree of uncertainty about how the European situation would develop. There was also uncertainty about the outcome of the election. I think that investment is going to increase because the German export sector has been doing fairly well. On private consumption, I do not see active government policies because these are individual decisions: how much to save and how much to consume. I do not see any of the demand components where we should have more expansionary policies. Moreover, I find this whole discussion about targeting a specific current account surplus or deficit extremely difficult, just as Otmar Issing has mentioned, let alone designing policies that can be used to implement a certain target. That would be even more difficult. I should mention a simulation study which has looked at the causes of the German surplus. It found that factors such as

85 of 441 Professor Claudia Buch, Professor Jan Pieter Krahnen and Professor Otmar Issing—Oral evidence (QQ 297-315) labor market reforms and the demand for German products are behind the surplus, while the growth effects of that surplus for other countries are actually positive. I can forward that study to you if you would be interested in seeing it. The Chairman: I think that we are aware of it, but in case we are not, we would be very grateful for that. Professor Krahnen, I do not want to go over the same ground again if you agree with your colleagues.

Q303 Lord Marlesford: I should like to ask a brief supplementary question. We heard during our discussions in Berlin that in the process of forming the coalition the SPD is rather anxious to get some form of government action to change private sector investment from overseas into domestic. That is not dissimilar to what the Americans are suggesting. Would you like to comment on that? The Chairman: You are nodding your head, Professor Buch, but perhaps Professor Krahnen would like to come in on the question of a possible coalition agreement. Professor Jan Pieter Krahnen: I do not understand the economic logic of it, so it is going to be difficult for me to comment. However, I would like to say one thing. We should not forget that Germany is part of a larger internal market in the European Union and the eurozone. For that reason, if I were to apply the same argument to the US, I would say that we should look at California, Massachusetts or even New York City, for that matter, to see whether they have imbalances in their current accounts and, based on that, come to a conclusion on whether they should invest less or more. That would be a bit strange. That is actually what we are doing in this case. One could make an argument, although perhaps it would be a little far-fetched. There is the targets question; I think another question of yours relates to it. Obviously there are many claims that you can build up other parts of the continent of Europe. That could be interpreted in the economic sense as remote spending, so to speak. It would be lax lending in a different part of Europe that would be in line with what the US Treasury would like to see. Perhaps it is happening to a much larger extent than can be seen by simply looking at the current account. The Chairman: Before I invite Lord Davies to pursue that one, we have a supplementary question from Lord Flight.

Q304 Lord Flight: If we accept the logic of Professor Issing’s argument, which I do, what seems to follow is that if Germany naturally has a surplus but the deficit countries are forced into surplus as a result of economic measures, the overall effect will be to put upward pressure on the euro. That is rather inconvenient for an economy like Italy which is struggling to get out of its debt trajectory. We have to look at the effect on the whole picture. Again, the logic of Professor Issing is to say, “So be it. They will have to tighten their belts even more.” However, that begins to risk becoming politically unpleasant, as one saw in the effect of the Gold Standard in the 1930s. Professor Otmar Issing: I agree that the dimension of this problem is twofold. The first is the international one. Germany’s surplus is rising against trade partners outside the monetary union. Inside the monetary union, the balance is shrinking. This process is going in the right direction; it is a balancing process. What is also wrong about what can be called the American argument is that within Europe—let us take Spain as an example—exports are now strongly increasing. What we need is not just expansion in Germany. Many studies have been published to show that the multiplier for neighbouring countries is very low. Even if Germany were to have a high deficit in its public spending, the impact on Spain and Italy would be almost invisible. It would be stronger in the Czech Republic, Poland et cetera.

86 of 441 Professor Claudia Buch, Professor Jan Pieter Krahnen and Professor Otmar Issing—Oral evidence (QQ 297-315) Finally, what is needed in countries like Spain, Portugal, Italy and so on is a change to the internal structure of production and economic activity from non-tradables to tradables. This is not a basic argument about macroeconomic demand, it is about competitiveness, unit labour costs and so on. This is now happening in Spain. Progress is slow and it should be faster, but it is happening, and that demonstrates once again that this is not just an issue of macroeconomic demand: it is about the composition of activity. These countries need to change from non-tradable services and home-based industries to export-oriented business. This process is under way. The Chairman: Professor Buch, you are nodding your head vigorously. Professor Claudia Buch: Yes, although I have nothing to add to that point. Perhaps I may come back to domestic investment issues. Some of the calculations that you see seem exaggerated to me. It is not clear how we should estimate the shortfall of investment over and above optimum rates. Also there seems to be a political intention behind some of the calculations we see, but I do not want to make a judgment on that. The second point is that while we have issues in some areas such as street maintenance and universities—we could argue about those—I do not see that government revenues are the problem here. It is more an issue of where we want to set priorities in terms of government spending. Some of the German states have increased spending on consumption items, so I see the potential for an adjustment of the structure of spending. I think that these investment needs could then be financed through regular tax receipts at unchanged tax rates.

Q305 Lord Davies of Stamford: I totally agree with Professor Issing—I think your comments are very persuasive. I have been very struck and pleasantly surprised by the extent to which wages in these countries are not sticking, whether in real terms or nominal terms, in the way that many of us had feared. Professor Issing, when the euro project was being conceived and implemented, you had the reputation of being very sceptical, if not hostile, towards it. Can I ask you now, in the light of that experience, how you assess that particular project? What have been the failures and the successes? Had we not had the euro, and retained national currencies, is it your view that a banking crisis such as the one triggered by Lehman and so forth would have produced worse or better outcomes in the real economy? Would output and employment and so forth be higher or lower than in a situation in which we had separate national currencies? Or, to put the same question the other way round, would a foreign currency crisis, added to a banking crisis, have made the outcomes for the real economy worse? Professor Otmar Issing: Can you stay over the weekend? Lord Davies of Stamford: With great pleasure, if I could listen to you. Professor Otmar Issing: This is a long story. First, I should say that I was never hostile— that goes too far. Lord Davies of Stamford: I said sceptical, if not hostile. Professor Otmar Issing: I was sceptical. Even when I was at the European Parliament, testifying during the appointment process, I said that it was an experiment but that if I passed the process and was appointed I would try to do everything I could to make the experiment a success. Just on monetary policy issues, the euro is a success: it is a stable currency, the exchange rate is strong and it is the second most important international currency—some distance from the US dollar but undisputed in its place. However, what comes first is price stability. My critical position was unfortunately confirmed very early on when the euro started. I stress that evidence, otherwise it looks like an argument from hindsight. In the

87 of 441 Professor Claudia Buch, Professor Jan Pieter Krahnen and Professor Otmar Issing—Oral evidence (QQ 297-315) early years, I gave speeches when I came back and my colleagues in the ECB asked me, “Otmar, are you still against the euro?” I said that I was never against it, and was not against it now, but that I saw the weaknesses and the problems that will come. Those people who see problems and try to solve them are the most helpful. This development led to a crisis which was foreseeable. It was a result of a failure of national policies relating to labour costs, divergence in competitiveness, manipulation of the stability and growth pact, and the boom in housing markets in some countries. This combination of causes led to the depths of the crisis. My good friend Martin Feldstein, the famous Harvard economist, was always a strong opponent of the euro. He wrote an article a year ago, saying that Europeans—by that he meant the members of the monetary union—have problems now with the euro that they would not have had without it. To some extent that is true, but the question is what problems we would have had if we did not have the euro. In his latest article, he has said that leaving the euro or dissolving it now would create more problems than staying in. With or without, it is very difficult to prove. My thinking is still deeply formed by what is known as —or White Wednesday—in September 1992. I am not talking so much about the UK exit from the exchange rate mechanism but about the . The lira was devalued against the DM in a short period of time by over 30%. For me, the key issue of European economic integration is the single market. I am convinced that the single market would not have survived another September 1992. At that time, many companies went bankrupt or asked for import restrictions or export subsidies et cetera. I think it is hard to argue that countries living so closely together and so connected in trade and finance et cetera should have flexible exchange rates. Theory and empirics argue the opposite. As soon as you go in the direction of fixing exchange rates, you end up in the situation that leads more or less to monetary union. Who would believe in the irreversibility of fixed exchange rates that are fixed only on paper? On balance, the problems would have been greater. Dissolving the euro would create a political and economic mess. I would say that the experiment will continue. Lord Davies of Stamford: Permanently fixed national exchange rates are a contradiction in terms, are they not? You either have the one or the other: a crisis or a single exchange rate. Do our two other distinguished guests want to add anything to that answer? Professor Jan Pieter Krahnen: I fully agree with what Otmar Issing said. This is a learning exercise. One aspect that I find most interesting is that we spent many years interpreting the convergence of interest rates in Europe. I remember being in conferences here in this building, with people from all around the world, discussing what the reason was for the convergence of interest rates across Europe. There was a belief on the part of many people that it showed that we had somehow equalised competitiveness across Europe. That is why prices fell for debt and become so similar. That was a misunderstanding and we now know much better. Much of the therapy that we are trying to achieve through banking union, which we will discuss later, is really anchored in that experience. We have to get rid of the mistake that an implicit government guarantee produces in markets: namely, uniform prices for debt. They are only uniform because of the guarantee, not because of the risks. For me, that is the main lesson that we have to take from the first years of monetary union. We have to be very careful to get rid of implicit government guarantees for funding in markets.

Q306 Lord Davies of Stamford: The irony of course is that there was no guarantee, implicit or otherwise. Bankers were so stupid that they did not read the Maastricht treaty. Professor Issing, can I take you forward to something which you could not have anticipated,

88 of 441 Professor Claudia Buch, Professor Jan Pieter Krahnen and Professor Otmar Issing—Oral evidence (QQ 297-315) any more than I or anybody could, at the time when monetary union was set up? That is the development of outright monetary transactions. I wonder whether you feel that that is an acceptable and sensible development or whether you think that it is dangerous and takes monetary authority into fiscal policy. Professor Otmar Issing: You put me in a very difficult situation because when I left this institution, I swore to myself that I would never comment on the monetary policy of the ECB. For example, yesterday some journalists asked me to comment on the decision to reduce the interest rate. I declined, of course. But I have commented on the OMT. I comment because I do not think it is monetary policy. It goes back to May 2010 and the famous weekend when it was obvious that Governments should have supported those countries under pressure with fiscal measures but were unable and/or unwilling to do so. So the ECB came in as the last resort, which demonstrated that it was a substitute for fiscal actions. I hope that the OMT will never be implemented. If it is implemented, it is so obvious to me that it is a substitute for fiscal policies because it cannot be compared with the Bank of England buying UK government bonds or the Fed buying the US Treasury’s. It is a selective buying of the bonds of some countries and not of others. This is not monetary policy; this is something for which, in the end, you need a political decision, political support and, finally, democratic legitimacy. That is not happening. Lord Davies of Stamford: That is a very interesting and clear answer, but it opens up and begs a very important question. The trouble is that the ECB, as we know, does not have the obvious instruments with which to conduct monetary policy that classic central banks such as the Fed and the Bank of England have. It cannot use, for example, an EU liability because there are no issued EU liabilities. Should the EU issue either longer-term bonds or shorter- term Treasury bills, which the ECB could use in normal circumstances as the instrument for open-market operations in exactly that classic way? Would that not be a help in present circumstances, when interest rates are extremely low? It would surely be useful to have other arms or instruments available. For example, in America and the UK we are using quantitative easing, which again requires such an objective instrument. The Chairman: Shall we have Professor Buch on that, then Professor Krahnen and then come back to Professor Issing? Professor Claudia Buch: Thank you. Before answering that question, I want to add one point to what Otmar Issing said. The OMT has had an impact on the Euro Area countries and financial markets even without being activated. We can observe a narrowing of interest rate spreads that Jan Pieter Krahnen talked about, and I think that the markets have well understood that the ECB is now implicitly taking over some risks. I see this as an alternative to fiscal solutions when getting to the long-run institutional framework from the situation we are in, with the excessive debt of the private and public sectors. The OMT has really been a game-changer. That is also why one tool which we have proposed, the debt redemption pact, is not a complement to the OMT—the monetary solution. With regard to your specific question, because we are not willing to give up sovereignty over fiscal policy and other economic policies to the European level, as I said earlier, I do not think that we in Europe should jointly issue debt because I see that instrument happening only if we are also willing to concede sovereignty to the European level. You asked whether we do not need that to be able to conduct monetary policy for the euro area. Do we not need some kind of jointly issued debt instrument? The answer I would give is that, before the crisis, we could conduct monetary policy well without having such an instrument, so there are other ways of conducting monetary policy. The task now is to find a fiscal solution to the debt overhang, however large it may be. Nobody really has the numbers on that. If a

89 of 441 Professor Claudia Buch, Professor Jan Pieter Krahnen and Professor Otmar Issing—Oral evidence (QQ 297-315) fiscal solution to the debt overhang problem can be found, this would help the ECB to return to its normal monetary policy operations. The ECB has so far been very successful in containing inflation and performing monetary policy.

Q307 Lord Davies of Stamford: Professor Issing and you are saying that the ECB should remain a purely monetary agency but I am saying, and you are not denying, that the ECB is handicapped in its monetary function by not having an instrument available to it which all other central banks have. You are answering as a politician and saying, “There should be no taxation without representation” and so forth, and that we should not have a common liability. My technical question to you is: would it not help the ECB to concentrate on its monetary function, and do that more effectively, if it had that additional instrument available, particularly at the low levels that interest rates have now reached, when classic interest rate policy is not so effective? That is a technical question, not a political question. The Chairman: Let us take Professor Issing, then Professor Buch. Professor Krahnen, we have not heard you on the whole range of questions yet. Professor Otmar Issing: Just to be very short, if it is about fighting the risk of deflation—is this the issue you are talking about? Lord Davies of Stamford: Well, combating monetary policy. At the moment that happens to be the risk. Sometimes the risk is inflation. Professor Otmar Issing: No, I agree. If this threat exists; I do not think that this threat exists now, but let us call it a technical question. In case of deflationary threats, the ECB would be without an effective instrument—that is your argument. In this case, what the ECB could do to make it comparable to a policy of the Bank of England or the Fed is to buy proportionally bonds of all member countries according to their GDP weight. Then it would be comparable and not discriminatory; it would be purely a monetary policy instrument. However, I agree with Claudia Buch: to create EU bonds—or whatever you call them—to help the ECB would be a wrong instrument. We do not need it for technical reasons and it would open the door to all requests to mutualise debt. Professor Jan Pieter Krahnen: On this, I fully agree. The whole idea that we need a special instrument to conduct monetary policy in the way that it should be conducted bypasses the very obvious solution, which is the one that Otmar Issing just outlined. The Chairman: If Professor Buch does not have a supplementary answer, I will pass on to Baroness Maddock.

Q308 Baroness Maddock: I will continue on the role of the European Central Bank. The role of the troika has led to the bank taking on both the crisis management and surveillance role. Do you think that this is a task that the ECB is suited to, and is it comfortable with that? Professor Claudia Buch: It is difficult for me to judge whether it is comfortable. I think an answer to that question has two parts. First, it is important to have the ECB, with all its initiatives and its surveillance, on board—it is also involved in the more generous surveillance on the European Systemic Risk Board and the troika missions—because, as we have just heard, it is a very important player in this area. It is very important to have its expertise and access to information. Second, with all these initiatives—the troika missions, the ESRB and now even more so with the supervision through the ECB—we very quickly step over the lines of conflicts of interest. That is of course the case when it comes to debt restructuring in the crisis countries and when it comes to macroprudential supervision. My

90 of 441 Professor Claudia Buch, Professor Jan Pieter Krahnen and Professor Otmar Issing—Oral evidence (QQ 297-315) view would be to have these things as separate as possible, to have the information role and have the ECB in as an important stakeholder, but to be very aware of the conflicts of interest that are inherent in this process. Professor Jan Pieter Krahnen: It is important that the ECB is involved in this process. I sense that the direction of your question is that it is suited for carrying out that role in the troika setting given the institutional limitations that we face at the moment. We do not have any other agency that could basically be mandated with the role of overseeing the fiscal discipline and structural reforms needed in other countries to become competitive again. The Chairman: Professor Issing, do you have a view on that? Professor Otmar Issing: Like Claudia Buch mentioned, this has two sides. On the one hand, the ECB has a very strong position insofar as it is most suited to insist on commitments, etc. The Commission is more or less under political pressure and the IMF changes its views from time to time, so in this respect it is highly welcome that the ECB is participating. However, you need to weigh it against arguments which speak strongly against; that in the end, the ECB will be involved in national politics, etc. If you see that now the European Parliament has established, I think, a committee to do a survey on what has happened, the ECB will be drawn into politics. On balance, that is detrimental for the reputation of the ECB, but it was probably unavoidable. On the one hand I know that politicians tell you, “You are always criticising, but if we ask you to participate, then you say, ‘We are independent—it is not our business’”. So it is a very difficult situation for the ECB, this strange, unique institution that is a central bank for 17 countries. The device should be to stay out of politics as far as possible. The Chairman: Lord Flight: “stay out of politics as far as possible”.

Q309 Lord Flight: There has been a ducking of a fundamental issue, which is the model of, say, currency union: let internal devaluation deal with things, you cannot have any cross subsidies, and so forth. What Italy in particular has demonstrated is that the social costs are incredibly high. Can internal devaluations work adequately? Italy has not grown for 10 years and has something like 50% youth unemployment. It is fine to talk the theory of it, but the social cost to a generation is very high. Moreover, ultimately there is the risk of serious political instability, which was in essence caused in Europe in the 1930s by the gold standard. The other side of the coin of the model that we are all talking about needs to be focused on this and we need to ask whether that is sustainable. I am supposed to ask different things so I will try to sum them up. Within the whole model of banking union, on the issue of supervision the only issue is that if the monetary authority is also the body doing the stress testing, they happen to cock up the testing and a bank collapses or gets into trouble, is there a risk that they have damaged their reputation and damaged confidence in the market? However, having raised that, I cannot see who else can do the stress testing. Secondly, and more importantly, in the whole area of the single resolution mechanism, I am still slightly unclear on what is intended. Part of the desired effect is to separate bank debt problems and sovereign debt problems. However, if you say that most of the resolutions have to be done by the country in question, like Ireland and Spain you are pushing it straight back onto the state and worsening the state bank problems. I think we are saying that the ESM pot is there only to be used in a crisis, and the decision is that it has to be the Governments, and if it worsens their debt problem, hard luck, although whether people will want to buy their debt as a result is slightly another matter. However, it is not resolved. The idea that it is just left to the countries in question is not a very good

91 of 441 Professor Claudia Buch, Professor Jan Pieter Krahnen and Professor Otmar Issing—Oral evidence (QQ 297-315) answer, because it risks worsening the whole country debt problem with countries that are in trouble. Finally, the common deposit insurance scheme seems to me to be about stopping everyone rushing to take their deposits out of an Italian bank and putting them into a German bank, because they have suddenly woken up to the fact that Italian euros might be rather less reliable than German euros. Unless there is a common deposit arrangement, you still have that vulnerability when things start to go sour, which we saw a couple of years ago and will probably see again later next year as the Italian economy really hits the rocks. The Chairman: Professor Krahnen, would you like to find a couple of questions from all that that you can possibly answer? Professor Jan Pieter Krahnen: Yes, with pleasure. I shall start on the general point and then go on to the instruments. Do I support the general idea of the banking union? That has several parts. I fully support this concept. I think that it has several elements; you mentioned some of them. There is the single supervisor and the single resolution, deposit insurance and the single resolution fund. The whole funding part is a major issue; without it, the whole thing will not work. So in a way it is a very subtle construction, like a building in architecture, but it will be stable and solid if it has all the angles in place. The Chairman: Is it steel-framed or wooden-framed? Professor Jan Pieter Krahnen: That is true—but the issue of wood versus steel is more in terms of endurance than inherent stability. It is not stable the way it is right now, but we are moving, almost as in a strategic game, between different players, one player being the ECB— and then there is the European Commission, as the second player. The nation states are the third player; they have tried to push the problem into each other’s corner, saying, “You should solve this”. The ECB has been moving forward with the whole OMT discussion; it took over responsibility, although it may have been better not to have done so. It did so because it felt big pressure from the markets that, if it did not act, the alternative would be for national authorities to do so. But it has put itself in such a position that it cannot act, so it is like a hold-up situation in which you cannot act differently. Now that we have set up the new banking union, this is a bit different, because we are still putting the figures on the table and we are not completely done. Therefore, the whole sequence of moves and the completeness of the move once we have done it is of very great importance. Let me say a few words on these elements. On the single supervisory mechanism, it is very important to get rid of national interests; we have a lot of national special interests that are lived through the supervisory system of their countries. Moving it to a European place will get rid of much of the national protective energy, which is very much true of Germany and France—for the big countries—and also true of the UK, of course. You have a lot of common interest that is represented by the national supervisor in protecting their home industry; moving it to Europe could relieve some of that pressure. The single resolution mechanism is an important issue in itself; it has to be functional, strong enough to do the job, and have its own data access and its own staffing. Those are all issues on which it is a bit uncertain whether it will go in that direction. A very important issue that I mentioned at the beginning is the resolution fund, which needs to be set up. This is not simply an issue of national versus European; I think that we will come up with a more intelligent way in which to deal with the issue. We may start with national funds and we may have European funds in an intermediate range before it goes back to the national budget. So we have private national and European reinsurance, as you could call it; we have public national as a third layer and, as a fourth layer only, the ESM, which backs up the nation state

92 of 441 Professor Claudia Buch, Professor Jan Pieter Krahnen and Professor Otmar Issing—Oral evidence (QQ 297-315) if there is some interlinking between bank failure and state failure, so to speak. I think that these are the main issues. We did not talk about the resolution and recovery directive, the basic legal framework under which all this is functioning. Lord Flight: Deposit insurance you have not talked about. Professor Jan Pieter Krahnen: Right. For deposit insurance, it is a parallel thing, as with the resolution funding; it should follow the same idea of a layered system. We have national practice so we should use it and equalise it across Europe so that there are equal standards. Then you have the European reinsurance system. On the third layer, it falls back on the national fiscal authorities to some extent—before they get back-up, basically. Then only a European back-up would stand behind that.

Q310 The Chairman: Professor Issing, I wonder whether you could cover the same ground, perhaps starting where Professor Krahnen talked about national supervisory bodies needing to be reformed into the ECB’s role of supervising. Would that be a necessary step? Professor Otmar Issing: There is probably no country in which national supervision has not failed. So it is a huge challenge for the ECB to be neutral objective. And supervision will not be easy. There will be political pressure and, despite having a large staff, it is not so big in relation to the task. It will always depend on national information. This is a critical point. I mentioned the de Larosière commission, which warned strongly against mandating the ECB with banking supervision because of potential conflicts with monetary policy, and being involved in politics. When it comes to rescues and so on, you have to deal with national politicians. So it is a huge challenge. If you compare the experience of the past, the ECB has the chance to do much better. But the proof of the pudding is in the eating, so we have to wait. The ECB is aware of that, and has insisted on having the value judgment before, which is a strong sign that the ECB recognises this as a challenge to its reputation. The Chairman: Do you want to go any further on the other elements raised? If not, I shall ask Professor Buch to reply. Professor Claudia Buch: I want to stress one point concerning the asset quality review, the single resolution mechanism and what backstops and financing mechanisms we need. I see a big issue about the short run versus the long run. We can talk about the long-run resolution mechanism and how it will be funded at the European level; we need a bank restructuring fund that is financed through bank levies and so on, and we need a defined role for deposit insurance systems. Financing of bank resolution has, at the same time, an important short- term component. Addressing this is very urgent, because if the ECB starts the asset quality review and we do not have proper fiscal backstops in place, it is highly unlikely that we will learn what is on banks’ balance sheets. So we need the fiscal backstops before the start of the asset quality review, and those fiscal backstops cannot rely on the single resolution fund that we may have at some point in the future. There, I fully see your point that it is a big conflict. If we say that all the burdens of the past have evolved under the weak supervisory systems, as we have just heard, to me the only logical answer to that statement is that we also have to have responsibility for those bad debts and that legacy at a national level. Of course, that might overburden national Governments. As Jan Pieter Krahnen said, in the end we need a backstop to the fiscal backstops through the ESM. But before the ESM comes in, national funds should be used, and national governments should remain liable for ESM funds. In this process, we also need to discuss to what extent we want to use bail-ins, as has been done in the case of Spain and Cyprus, with all the problems that evolved. Of course, the more debt that we can bail in, given the

93 of 441 Professor Claudia Buch, Professor Jan Pieter Krahnen and Professor Otmar Issing—Oral evidence (QQ 297-315) shortfall of capital, the smaller will be losses that Governments have to take up. So we need to discuss those issues—and that is urgent, because markets are expecting the asset quality review to start. We need a solution to that, so we need an agreement pretty soon. The Chairman: Let us pass on to that with Lord Marlesford, but I shall come back to you later, Professor Krahnen.

Q311 Lord Marlesford: You have absolutely confirmed many of the points which we have learnt from our previous evidence. I was struck by Professor Issing saying that that there is no central bank that has not failed to supervise. The challenge of supervision is of course huge, but the need to assess the situation before you take on the supervision is itself huge. Half the time, the banks themselves do not really know what their liabilities are, let alone the quality of their liabilities. How on earth will that be worked out in time? The point is that when the ECB announces the result of the stress tests, there will be a risk that the markets will ask what is the total sum that will be needed and where will it come from. It has been suggested that there should be something more sophisticated than the single fund. The maximum figure for the single fund sum mentioned so far in Brussels has been €500 billion, but we have no idea what the fund will be, so how is this going to be handled, how will the ECB keep confidence and keep the show on the road? The Chairman: Professor Buch, I think, was shaking her head at one stage. Perhaps we should hear from Professor Buch and then Professor Krahnen. Professor Claudia Buch: I think that I have said everything that is needed at this point. Professor Jan Pieter Krahnen: I said earlier that this is a strategic play between different parties. I think that the ECB has moved cleverly, because it has said, “Let us fix the date of the test first. Let us talk about the seriousness of our conditions first”, and put them in place. It is like saying, “Check”. Now the move is on the other side. The speed has a lot to do with the speed of markets. My expectation is that markets will pretty soon come up with estimates of what type of correction is needed on the capital side for the European banking system. It is the nation states who have to move now, not the European Commission. In particular, I think that the German and the French Governments have to get their act together and make a decision on how such a back-up could be funded, not leaving it entirely to the nation states to come up with a back-up which of course, in the eyes of the market, will not be credible. I am actually optimistic that this backstop will come up.

Q312 The Chairman: Professor Issing, are you optimistic? Professor Otmar Issing: I think that it is a complex process. The starting point for genuine monetary union is that, if national authorities had not failed, nobody today would talk about the need for banking union. Open financial markets could have worked perfectly in a well supervised and regulated system, so it is about correcting failures. I would be a bit more hesitant about bringing in the resolution fund and deposit insurance too early as European solutions. If you think for a moment that Germany would ask Italian and Spanish taxpayers to pay for terrible mistakes that the German bank, HRE, has made, all would say that you are crazy. If you put it the other way round, they say that this is a sign of solidarity. That says something about the quality of the argument. If we leave it to the European level to deal with legacy problems, the ESM will very soon be exhausted. It was created for different purposes. Professor Claudia Buch: I am afraid that I am less optimistic than Pieter Krahnen on the fiscal backstops coming forward. The issue is that, in some countries such as in Germany and France, but I am not sure about all the other countries, we have the financial stabilisation

94 of 441 Professor Claudia Buch, Professor Jan Pieter Krahnen and Professor Otmar Issing—Oral evidence (QQ 297-315) funds—SoFFin / FMSA in Germany—so there are some funds left that can be used for bank recapitalisation. So I do not think we would need a big public policy debate in Germany about whether to use extra funds for banks; we could deal with it. If you concur with the statement that these issues must first be dealt with at the national level, we do not have those funds in all the other countries, so these countries would have to go through a political debate about whether they want to put those funds aside given the fiscal problems that the countries have anyhow. I am not so optimistic that Governments can agree on that fiscal burden-sharing agreement very quickly. But it is needed because we are talking about banks that are active Europe-wide or internationally. Professor Jan Pieter Krahnen: I would distinguish between what I would call the steady state that we all aim for once the whole new structure is in place and the legacy issue. How do we get to the steady state? I am not talking about the steady state when I say that I am optimistic that we will get this European backup; I was talking about the legacy issue. I think that this will be a burden mostly borne by Germany and some other countries. If they do not shoulder it, we will not get there. This situation will become more prominent in the relatively near future as the test gets closer and closer. The Chairman: Colleagues, I am conscious that Professor Buch has to leave us fairly soon. I have Viscount Brookeborough, Lord Davies and Baroness Maddock to call, so perhaps we will begin with Viscount Brookeborough and then begin to draw to a close.

Q313 Viscount Brookeborough: How far do you think that deeper economic integration should go within the current aims of GEMU? Looking at the budgetary framework, we have been told that Germany is implacably opposed to debt mutualisation, especially Eurobonds. We also understand that you have ideas of a debt redemption pact, as advocated by the German Council of Economic Experts, of which you are one. Professor Claudia Buch: First, a few remarks on the general willingness of the German public, which I observe as an economist; I am not a political scientist. It will be very difficult for Germany to concede to major debt mutualisation, as we have seen in the outcome of the recent elections. The new party, the , did not make it into Parliament but I see a risk—it is not a forecast in the true sense of the word—that if we start talking about debt mutualisation on a larger scale with the next European elections coming up, those voices will become even stronger. I do not see big support in Germany for that. The debt redemption pact was proposed as an instrument, as Jan Pieter Krahnen said, to get from the short-run to the long-run steady state. In the long run steady-state, Governments should be responsible for their own debt—the no-bailout principle should apply—but we start from a situation in which Governments are heavily indebted. The question is how do we get there: how do we make the fiscal compact and the implementation of national debt breaks credible? The problem of Italy was mentioned. With the high interest rates that we had before the OMT, the primary surpluses that Italy would have had to have to fulfil the requirements of the fiscal compact would have been very high—perhaps politically unfeasible to implement. The Council’s idea was that the debt redemption pact would have involved a substantial subsidy, transfer, or whatever you want to call it, from Germany to Italy; Germany benefiting from very low interest rates and Italy suffering most from very high interest rates. Now, with the OMT in place and interest rates having narrowed, the rationale for the debt redemption pact is much less urgent. We think that the advantage of the debt redemption pact would have been that you could have imposed some conditionality on those countries.

95 of 441 Professor Claudia Buch, Professor Jan Pieter Krahnen and Professor Otmar Issing—Oral evidence (QQ 297-315) You could have said, “We are willing to enter this agreement only if you post collateral and have a whole range of mechanisms to contain moral hazard”. As I said earlier, this was never designed for the majority of countries; it was never designed as a long-term debt mutualisation tool. People have criticised the Debt Redemption Pact and said that it is not time-consistent. All those criticisms are well taken, but in the new world, with the OMT and the ECB playing the role of contributing through its announcements to the narrowing of interest rates, we do not think that the debt redemption pact should be used as a complement to OMT. We have a debt mutualisation tool that we did not wish for then but it is there now. It would be very difficult for the ECB to take it back; it cannot sit down at some point and say that the OMT is over. So I do not see an economic rationale at this point for the debt redemption pact. Viscount Brookeborough: You said earlier that the ECB would inevitably become more political. Therefore, do you see deeper economic policy integration within the ECB? Professor Claudia Buch: We need new mechanisms and we have established these mechanisms. Now the question is: are we willing not to make the same mistake that we made earlier? We had rules, but we broke them because there is always a good reason to break the rules. Now we have to use all these fiscal surveillance mechanisms and the strengthened growth and stability pact to ensure that they are really lived. I think that it will also be a relief for the ECB in the end in conducting its regular monetary policy operations. Viscount Brookeborough: It is always said that Germans do not break rules. Professor Otmar Issing: The problem of debt mutualisation is, in short, based on the idea of issuing Eurobonds. Here I would say that, even for countries taking advantage of declining interest rates because others take guarantees for their bonds, it is a mixed blessing because it creates moral hazard. It gives the impression that you can enjoy low long-term interest rates without your own efforts. But for countries such as Germany, because of higher guarantees, immediately their position in financial markets will decline. Not only the rating agencies would say that this is implicit indebtedness for Germany, and so long-term interest rates would rise. One might say, okay, this is the price Germany has to pay. One can discuss it, but what for me is key, is that this would imply a transfer of taxpayers’ money without any democratic legitimisation. I have mentioned before that this is taxation without representation. I do not predict war, it will not go so far, but it would create deep difficulties for people to identify with this kind of Europe. I have nothing to say about such extreme fiscal issues. I think this is a violation of a fundamental part of our democracies. The Chairman: Professor Krahnen, do you broadly agree with that? Professor Jan Pieter Krahnen: Broadly, yes, in the sense that the whole concept of this bank redemption pact is basically building on, as Claudia Buch mentioned, ideas of “pacta sunt servanda” that we have lived through and do not believe in any longer. If we really want a solid, credible system that embraces no bailout, we have to think very hard how to implement building concepts, both on the banking and on the sovereign levels. To get bail-in to be a credible instrument, a lot more has to be done. We are not yet there. Even if you take the recovery and resolution directive that addresses bail-in, it only goes half way. The commission I was working in, the Liikanen commission, made concrete proposals about how you can make bail-in truly credible and workable. The main conclusion of that report in this respect was that you have to make sure that there are some holders of bank debt that are not banks themselves and will not basically produce that feedback loop, which we always see on the eve of a critical banking crisis weekend, which forces authorities to bail out. We have to get rid of that. We can do it at the banking level with a relatively easy regulatory idea; and

96 of 441 Professor Claudia Buch, Professor Jan Pieter Krahnen and Professor Otmar Issing—Oral evidence (QQ 297-315) we can do it on the sovereign level as well by specifying that there must be some noted or recorded sovereign debt that is not held by banks, so if there is any write-down, it will not produce a banking crisis the next day. These are the two steps which I find much more credible than any pact about repayment. Professor Claudia Buch: Just to clarify, the original idea was to get to a regime where the bail-in is feasible. Then we could disagree on whether in the current situation a bail-in would be feasible given the high levels of bank exposure to sovereigns and given the high levels of debt over GDP by Governments. The idea was to get to a regime where we could credibly also implement bail-in clauses. So in that sense it is not inconsistent. Lord Marlesford: Is the haircut part of the bail-in? Professor Jan Pieter Krahnen: Haircut is one way to do it. Another way would be conversion, which is, in a way, economically also a haircut.

Q314 Lord Davies of Stamford: I have greatly benefited from this discussion and I am sure my colleagues have as well. I am most grateful. I have been thinking, Professor Issing, about your proposal that the ECB could perfectly well use a weighted portfolio of member state liabilities for open-market operations, including QE if they want to do it, and that there is no need, for this purpose at least, for eurobills. I have not had a chance to put that to the ECB. I am sure that it has thought it through, but I have no idea what its response would be. However, I suspect that its response might be that it is technically not feasible because some member states have not issued a sufficient amount of debt. Some states may not have issued any short-term debt and there may be very few longer-term bonds close to maturity. It would be a terrible conflict of interest if the central bank bought interest rate-sensitive debt. That would not be a sensible idea at all. I am sure you agree with me. There may be technical problems of that kind. Romania, I know, has a debt ratio of 30%, so you might not be able to put together a weighted portfolio with sufficient amounts to be able to conduct those open-market operations. How would you react to that possible difficulty? Professor Otmar Issing: In short, I think that this is a minor technical problem. If a country like Latvia has not issued any debt at all, we ignore it. Lord Davies of Stamford: But then immediately people like you will say that this is the ECB moving into fiscal policy and that it is making political choices and selections. Professor Otmar Issing: No, the country does not provide something you can buy, so you can leave it out without any major conflict with the basic idea.

Q315 Baroness Maddock: We are almost at the end of our inquiry and your contributions this morning have been incredibly helpful in getting our heads round a difficult subject. I wanted to talk particularly about the position of the United Kingdom, because we are not going to take part in much of this. One of our main concerns has been how this affects the single market. If I quote correctly, I think Professor Issing said that the single market would not have survived without the euro. I found that very interesting. Do you think that the position that the United Kingdom is taking is realistic? How else should we try and engage with this whole agenda? The Chairman: I am going to save Professor Issing for last. Professor Krahnen, perhaps you would start us. Professor Jan Pieter Krahnen: My basic premise is that, given the current crisis, the most important issue we are facing in Europe is systemic risk in the banking industry that brings us

97 of 441 Professor Claudia Buch, Professor Jan Pieter Krahnen and Professor Otmar Issing—Oral evidence (QQ 297-315) to the brink of collapse. This applies also at state level, but it was caused by the banking crisis. My point of departure is how we get there. The big challenge for the time after the financial crisis is to avoid any reappearance of that constant systemic risk being part of our decision-making. I do not think that that can be achieved without some co-ordination among the big European countries, in particular the UK and others. In that sense, I cannot imagine that, even if one tries to move apart and distance oneself, the issue will go away. Financial markets and banking markets in particular are so highly integrated that the power of politicians to cook their own meal basically is much more limited than many people still remember from history. It was different. Now we are in a flow of financial market dependency that will make us behave better, in a co-ordinated way, to protect and preserve a minimum of manoeuvrability for our national boat. This cannot go on independently any longer. The Chairman: Professor Buch, do you more or less agree with the problem of the boats moving around if we do not do something about it? Professor Claudia Buch: Yes. With regard to the UK, I think that the problems that we see now are not only problems for the single currency but these problems are about excess capacity in banking and about the right regulations of banking. That is why the banking union should encompass the EU-27 concept in principle. The solution that I see to that right now is that the ECB governing council is formally in charge of supervision, but the decisions are prepared by the supervisory body and a mediation panel. To some extent, this solution is a way around two issues. One is that that EU treaty at the moment does not allow for a different structure. It is also a way of dealing with non-euro area members of the EU. That has to be addressed because, with the possibility of opting in and out, particularly in the case of the UK, it is very hard for me to see how that can be a stable structure. It would be useful to have the banking union as a stable construction without this opt-in/opt-out possibility, which would mean that we would need a treaty change. Professor Otmar Issing: Very briefly, I agree with Claudia Buch. The contribution of the UK within EU concepts is so important that we should make regulation as light as possible. Its strength is needed. It is in your interests and it is in the interests of Europe. To conclude, as you referred to my remark on the euro and the single market, I shall be a bit teasing here, if you will forgive me. The people across the Channel are very critical of what is happening in what you call Europe, and with most of the criticism I agree. However, if the situation in the UK over time became so strong and much better than on the Continent, I would expect, if it was based on something fundamental, that the pound sterling would appreciate like the Swiss franc. If it is not happening, it is not a sign of strength. But if it did happen, I think that businesses and people in the UK would think twice about having an extremely strong pound, with all the problems that you have avoided so far. There we come back to the currency and the single market. The Chairman: Otmar Issing, Claudia Buch and Jan Krahnen, I do indeed call this the Continent. I live in the United Kingdom, and that is part of Europe. I know that my colleagues this morning, Baroness Maddock and Lord Davies, have already taken the opportunity to thank the three of you for coming this morning. We are most grateful to you. Please look at the transcripts we send you. As I said, please correct them, update them and add to them. Claudia Buch, you mentioned a paper that I hope you will be able to send us. You are all three very welcome in London—which is part of Europe—at any time to pursue these further discussions. In the mean time, our very sincere thanks. Professor Otmar Issing: We will be sure to come on the Eurostar.

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Evidence Session No. 12 Heard in Public Questions 148 – 156

WEDNESDAY 2 OCTOBER 2013

Members present

Lord Harrison (Chairman) Earl of Caithness Lord Hamilton of Epsom Lord Kerr of Kinlochard Lord Vallance of Tummel ______

Examination of Witness

James Watson, Director, Economics Department, BUSINESSEUROPE

Q148 The Chairman: James, do come in and sit yourself down. I have welcomed you outside. I am very pleased to see you here. You may know that we spent yesterday, and are completing today, deliberations on genuine economic and monetary union. We would like to learn a little bit about BUSINESSEUROPE and your role in it; perhaps you could say a few words at the beginning. We have also been taking evidence this morning on the financial transaction tax. I know that Lord Vallance would like to ask you a bit about that, if you feel able. James Watson: I like talking about the FTT, yes. The Chairman: We like our witnesses raring to go. We will make a transcript of all that passes here and send that on to you. We would be grateful if you could look at it and correct it, but also if you have fresh ideas, please feel free to communicate them. Colleagues will introduce themselves as we go round. Would you like to start and tell us a bit about yourself? James Watson: Thank you. What is most important about BUSINESSEUROPE is that we represent the 41 major business federations in 35 countries across Europe. I sometimes say that we are bigger than the EU but smaller than Eurovision. For example, in the UK, the CBI are our members, in France it is MEDEF and in Germany it is BDI and BDA. That is our membership essentially, so we are representing European business through those members. I am director of the economics department of BUSINESSEUROPE, which means I am in charge of everything ranging across the whole economic governance discussion and the reform of EMU. I do a little bit on the macroeconomic side; we do a forecast a couple of times a year. I deal with taxation as well. I am also responsible for our lines on the EU budget, so it is quite a wide portfolio. Personally, it might be of interest that my career base was in UK Government. I worked for the Department of Trade and Industry, or BIS as it now is, for 12 years, doing economic analysis. During that period I was on loan on to DG Economic and Financial Affairs—DG ECFIN— in the Commission, where I was the national tax expert. I have seen things from different perspectives a little.

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Q149 The Chairman: Let us start with GEMU. Looking at that framework, could you analyse what you think are the essential bits that need to be done and how far we have gone down the line? Could you analyse those bits which are inessential or may need to be done but can go to the back of the queue as we develop? Can you tell us whether there are any elements that have been missed out which it would be purposeful to add to or incorporate into the framework? James Watson: In terms of BUSINESSEUROPE’s narrative of why we had the crisis, we place a great deal of emphasis on, first, a lack of fiscal discipline among member states. Secondly, and related to that, a lack of structural reforms had led to a lack of competitiveness. You would see, for example, that countries which had allowed unit labour costs to increase substantially in the years prior to the crisis saw the largest increases in unemployment. Related to that, what were in part funding those imbalances were weaknesses in regulation of the banking system. If we think about the solutions to EMU, we emphasise those points. I should say first that BUSINESSEUROPE has been a strong supporter of strengthening EMU all the way through. Even at the height of the crisis, we were saying, “There is no alternative. This is what business needs: we need to strengthen the EMU”. The response is in line with those weaknesses. Our members would first and foremost place a lot of emphasis on the failure of the stability and growth pact to enforce fiscal discipline, so we have been very supportive of the measures that have come through the six-pack and so-called two-pack and the fiscal compact, which try to strengthen the governance of the fiscal rules and make them enforced much more strongly. We are pleased to see that coming through, not only in the future proposals for EMU, but it is almost more in the past. The issue now is that we need to see them properly implemented and enforced, rather than to see new measures. Secondly, we want to see stronger enforcement of the structural reform issues. The Commission comes out with country-specific recommendations as part of the semester every spring. We would like to see those have a stronger enforceability, perhaps through a stronger legal basis, to create more incentives for those structural reforms to take place. Thirdly, we have been very supportive of banking union, given the clear fragmentation in financial markets across the EU, which we observe through differing interest rates to similar businesses in similar countries. We can probably go into detail later, but those would be what I would emphasise. You mentioned the term “counterproductive”. We would have concerns about any proposals that reduce incentives for member states themselves to undertake structural reform and fiscal consolidation. Today we will see proposals from the Commission on the social dimension of EMU. I always forget whether they are in the Commission blueprint or the Van Rompuy report, but some of these proposals have come forward for, for example, some kind of unemployment insurance across the euro area. Our concern would be that if some of that insurance is coming from the centre rather than the member states, that would potentially reduce the incentives for member states to undertake their own labour market reforms to reduce unemployment. If you go into the detail of that proposal, for example, it is specifically aimed at short-term unemployment. The Chairman: It is a kind of moral hazard. James Watson: Exactly. That moral hazard theme comes through not only in the unemployment proposals but when we think about eurobonds as well. You have a detailed question, but on eurobonds our position is, “Yes, that is something we could have in the future, but they would have to be devised in such a way that they strengthen rather than reduce incentives for member states to undertake responsible budgetary practices”.

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Obviously, there are various different eurobond proposals, but they would have to be done in that way. The Chairman: We were put in our place by Commissioner Olli Rehn yesterday, when we asked him to give us a sneak preview of the social dimension. You obviously have some fears that that element might be contained and then frustrate the ambitions of the single market, if that social dimension spilt over in to the budget. James Watson: We have seen proposals, as I say. I forget whether they were in the blueprint or, as I think they were, in the Van Rompuy proposals that came in December. We have already seen some proposals—they are, let us say, rather sketchy—that would look towards thinking about some kind of shared unemployment insurance. So yes, we would have concerns with the moral hazard issues around that. The Chairman: Before I bring in the Earl of Caithness, can you just say something about the timetable of GEMU and the ranking of the things to be done? Do you think that is an important issue? James Watson: It is being addressed sensibly, in the sense that the things that are perhaps more politically feasible are being done first. That is pretty sensible. Obviously, the danger is that we have reform fatigue: we do the first things and think that we have solved it but do not get to the latter ones.

Q150 Earl of Caithness: Following up on that last comment, Mr Watson, do you think that the banking union is losing impetus? You said that you supported it strongly. The Commission proposed a three-legged stool. We might, before the elections, get a one and a half-legged wobbly stool. What do your members think of that? Is that a sensible position to be in? What are the problems with it, how do you see us getting even a single resolution mechanism, and in what form? James Watson: That is a fair observation. I should be a little frank. In terms of banking union, our support is extremely strong for the single supervisory mechanism, and I think we would like to see strengthened resolution mechanisms. The support for what we would like to see at a European level probably becomes—how shall I put it diplomatically?—more divergent between our members as we move through those three phases. Perhaps some members would be more enthusiastic than others about, for example, seeing a cross-euro area resolution fund and, similarly, a cross-Union deposit insurance scheme. But I have made my own observation that the deposit part of the proposals—that it was a three-legged stool when it was proposed—seems to have been quietly dropped off. Shall I stay on the point about banking union, while we are here? Take the supervisory mechanism, which we have been very supportive of. If I had one personal concern, it would be that the emphasis is clearly on the mechanism—and it is a mechanism by which the ECB can in theory, and in the event that it wishes to, take over responsibility from those national regulators. As a business federation, we basically want to see all banks being effectively regulated under that single mechanism. My only concern would be that the ECB does in practice have the information and, let us say, that the people working in the national regulatory authorities have the right incentives to co-operate properly with the ECB. I have raised this with the ECB, which have said that they are happy with it, but let us see how it works in practice. That could be the only wrinkle that I see in the mechanism. We will have to see how it works in practice, whereby the ECB have the powers that they need: effective powers so that they can take over banks when they see that there is an issue.

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On the resolution scheme, let us not forget the positive things we have seen in the banking recovery and resolution directive—the common rules for resolution. That was very positive in June. We are at the early stages with the resolution mechanism, are we not? As I say, we would like to see strengthened resolution across the EU. I have talked about fiscal discipline but we—particularly our members from Ireland and Spain—recognise that, for example, you can do all you want on the fiscal side with your annual budgets but if you have not sorted out the regulatory side on the bank, that can cause trouble. We recognise the need to strengthen resolution but it remains a challenge. It is clearly a big political issue as to what extent there is going to be a shared backstop. Earl of Caithness: Can I ask you a bit more about the deposit insurance scheme? For our own edification, your membership is obviously much more split on that, but how is it split? Is it on a geographical basis? Is it on a eurozone/non-eurozone basis? James Watson: On some of these big governance issues, let us say that some of our members are quite close to their Governments. You can probably work it out from there. The Chairman: Do not be backward in coming forward. James Watson: I am aware of that.

Q151 Lord Vallance of Tummel: Let us start with the financial transactions tax. Does your membership have a common view on that? James Watson: In a sense, the FTT is one of my favourite issues because it is completely opposite from what we were talking about before. We have a completely uniform view on that, despite the enthusiasm from the French and German Governments. We have a common position that we are opposed to the FTT. Lord Vallance of Tummel: Does BUSINESSEUROPE see it as one of its tasks to lobby directly here in Brussels to pursue that view with the Commission and others? James Watson: Yes. Lord Vallance of Tummel: Any reaction so far? James Watson: On the FTT, I would say that there is a lot of understanding among officials that this is not a clever move forward. But clearly there has been a lot of political pressure to take forward the FTT. The Chairman: Let me quickly ask you this. We were with Heinz Zourek this morning in Taxation DG. We asked about the consultation. Have you been in there? James Watson: Yes. The Chairman: You have. All right—that is good to hear. Lord Vallance of Tummel: Can you perhaps expand a little on what the grounds are for BUSINESSEUROPE’s antipathy towards the FTT? Are they legal or economic grounds, or a combination of both? James Watson: I think both, but primarily they are economic grounds. The primary case that we have been making is that the Commission’s own analysis, at least before it changed it, has said that this would be damaging for growth and jobs, essentially by raising the cost of capital and reducing investment. That is the argument we have been making. The whole issue changed a bit when it moved from being a Commission proposal that covered everybody to an extraterritorial issue. We then focused a little more on the extraterritorial issues as well as the legal issues around that, but primarily we have been pushing the economic argument:

102 of 441 BUSINESSEUROPE—Oral evidence (QQ 148-156) that at a time when Europe should be doing everything it can to try and encourage growth and jobs, and when its own analysis says that the most damaging form of taxation is that which is on capital and labour, it has put forward something which its original analysis said would be damaging for growth and jobs. Behind the scenes, we have been working closelywith some of the financial services groups. For example, the AFME were particularly helpful in putting their work with Oxford Economics forward to do this analysis of the impact assessment.

Q152 Lord Vallance of Tummel: Can we move on to the integrated budgetary framework and the Commission’s proposal in the blueprint for the creation of a fiscal capacity and an autonomous euro area budget? What we have learnt so far is that it has not been particularly scoped in terms of purpose or size. What is your reaction to this, and if you were to scope it, where would you do so? James Watson: You can see where the logic is coming from. If you think about large currency areas—for instance, in the US there are fiscal transfers between states. It comes back to my principle that we want to see mechanisms put in place that increase the incentives for member states themselves to undertake structural reforms and fiscal consolidation. We are quite happy, for example, although it still has not been explained in scope properly, with some mechanism; there has been talk of contractual arrangements whereby funds—and it is not clear if they are additional funds—would be made available to member states that undertook contractual legal arrangements to undertake structural reforms. We would be quite happy for that to take place. As I mentioned earlier, we would be concerned about the employment insurance scheme, given the potential for that to reduce incentives. The only other thing I would add—it is quite helpful that I have just been working through our response on the social proposals—is that if we think about not only the fiscal capacity but at least the risk-sharing mechanisms within EMU, it is important to see the fiscal proposals within that context. You already have, for example, an EU budget which President Barroso described as larger and providing more funds in one year than the Marshall Fund did. You already have an EU budget; you have seen the ECB massively expand its balance sheet for its non-standard measures through LTRO; you have the prospect of outright monetary transactions, the Target 2 balances as a result of lending through national central banks. You have the ESM being put in place, and a banking union which should improve the flow of funds, at least privately. So a lot of things have taken place additionally in terms of risk-sharing mechanisms between member states, so you have to see the fiscal capacity in that context. Lord Vallance of Tummel: I was going to ask you about debt mutualisation but you have already touched on that. James Watson: It is the same principle. We put out a document a couple of years ago, looking at eurobonds. Again, different members have different views but the compromise we have is that there could be an aspiration in the future provided that they incentivise rather than reduce incentives for fiscal consolidation. One point on the fiscal capacity—a bit I also missed, which comes back to the point I made earlier—is that part of the fiscal capacity needs to come as well from the member states. One of the lessons of the crisis was that because there had been no fiscal discipline in the good, early years of the EMU, when we got into the crisis there were no buffers that allowed at least automatic stabilisers to work in full. That is a clear part of the response to building the fiscal capacity through building member states’ own fiscal capacity.

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The Chairman: That question grows out of the crisis. Despite what you have just said about the activity of the EU, which you describe very well, could more be done in terms of growth? James Watson: There are a few areas that we press. First, there is the structural reform agenda, where we are concerned about reform fatigue, about potentially the lack of pace of structural reforms, most obviously in France and Italy. We also had some concerns about some member states easing off on the fiscal side. We were concerned about that reform fatigue. What else needs to be done? Obviously, on the single market we want to see much more put in place there. Our third emphasis would be on energy prices, which has come up on the agenda recently. We remain concerned about Europe putting itself at a competitive disadvantage through seeking so much to take the lead on climate change.

Q153 Lord Kerr of Kinlochard: On economic policy co-ordination, how much more is required? How much more does BUSINESSEUROPE want, and in what areas in particular? Is there anything on employment policy and tax policy? I imagine that BUSINESSEUROPE is divided on the issue of harmonisation of proper taxes. What about corporate harmonisation of tax bases? James Watson: Let us start from the top. Fiscal discipline and structural reforms—anything that can better enforce the centre’s role in making sure that that happens, as I mentioned before. We would be very pleased to see that sort of co-ordination. On employment policy, basically that is pretty much a no-go; we would like that to remain essentially a national competence. The only thing I would add is that we are encouraging a greater labour mobility between member states to provide an adjustment mechanism. You might, for example, look at portability of pensions—that sort of thing—and generic qualifications that make it easier for people. Lord Kerr of Kinlochard: Supplementary to that, supposing the British were to say that, further to some of the things on social Europe that Major opted us out of at Maastricht, we should again opt out. Supposing that was to be a renegotiation put forward by the British, what would you expect to be the response? James Watson: I will be honest: I am not enough in the loop on the social issues. We have a social affairs department. I am sorry about that. Let us come to tax. Basically, our view on tax is that tax rates themselves need to remain a national competence. On the CCCTB—the common consolidated corporate tax base—we are happy to have a voluntary CCCTB so that as a company you could either opt into the country’s national system or go through the CCCTB system. Of course, the CCCTB itself implies different rates and a common base. In a sense that answers your question. While we are on this, one point on the CCCTB, which is sometimes lost, is the consolidated aspect, that if you make profits in one country and lose them in another, you can offset them. That should be a huge incentive for companies to expand into new markets, that if you lose money in a new market you can offset that. So we have been encouraging about that but it needs to remain a national competence. Lord Kerr of Kinlochard: Sorry to interrupt again. You may be able to answer this: of your UK members, does the CBI take the view that you have just expressed on the common corporate tax base? James Watson: We have had difficult discussions on the CCCTB. The line we take is that we support it as long as it is voluntary. However, I know that the CBI has some concerns. Lord Kerr of Kinlochard: The Treasury concern appears to be about a dangerous precedent: that once you ally with the EU on this ground, you cannot stop at the tax base

104 of 441 BUSINESSEUROPE—Oral evidence (QQ 148-156) but will be on to rates before you can turn around. I have never really believed that. It seems that you can draw a line where you draw a line, but it is a deeply held view in Whitehall. James Watson: Yes. I admit that my experience, when I was with the UK Government going to Brussels, was that a lot of precedents were used. Commission officials can be quite clever at bringing in precedents from other areas. It does not surprise me that officials have been burnt by previous experience when precedents elsewhere were used against them, and so perhaps are cautious in that way. Lord Kerr of Kinlochard: We would be in an area of unanimity, where drawing a red line is up to you. Companies I used to be involved with were rather keen on the measure, for precisely the reasons that have been given. James Watson: Perhaps if you spoke directly to companies, you might get a more favourable response than you do from Governments and member federations. The Chairman: CCCTB is a kind of good form of enhanced co-operation, really, if there is agreement that there are recognised pluses. James Watson: It is a sensitive issue. The Chairman: Let us put it this way: there are members of your committee who would see the virtues. James Watson: As long as it remains voluntary. I think the best thing will be if I send you our position paper on CCCTB, which you can use.

Q154 Lord Hamilton of Epsom: To expand on what Lord Kerr said, can we talk about competitiveness in Europe generally, and in the eurozone in particular? Does it not worry you that Europe’s share of world trade is shrinking, and is guaranteed to shrink steadily in future? Whenever I come to Brussels—I have done so quite often—nobody ever talks about the global marketplace. China, India and South America never come into the equation. I agree that there is a major crisis going on here at the moment, but all the conversations are completely internal, as if Europe were at the centre of the world. It is not. It is a declining part of a big marketplace. On the financial transfer tax, we were told today that one reason why the Americans were going to be so keen on collecting the tax was that they would be able to keep it for six months, and keep the interest. You wonder what world we are living in. The Americans are not going to have anything to do with collecting the financial transaction tax. They are not going to levy it and they are not going to collect it. They are going to say to the international markets, “Come here and you can buy and sell your shares with no tax to pay”. The money will leach away from Europe completely. That is the real problem behind this. There is no gain for Europe; there is only a net loss. The business can only go elsewhere. You are talking on behalf of business here. What is happening to make business more competitive and more capable of competing with these emerging markets— with the Chinese and Indians, who are undercutting us in many areas? What is happening on that front to make Europe more relevant in the global marketplace today? James Watson: I would focus on the last aspect, which is Europe’s relative competitiveness—our ability to compete in exports. To some extent it will be inevitable that Europe’s share of exports, for example, will fall as we see catch-up in the emerging economies. At the same time, Europe’s volume of exports has risen almost certainly in recent years, and certainly over a longer period.

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The Chairman: Is it not a paradox that the more we lose global market share, the implication is that other parts of the world become markets in which we—the UK and the European Union—can trade effectively? James Watson: What we talked about last month as one of the risks to the EU economy, before Italy, was our concern about a slowdown in the emerging markets. In a sense, that illustrates your point. Coming back, you are exactly right that we are concerned about a lack of competitiveness in the EU. This is why the FTT was so incredible. At a time when everything Europe should have been doing should have been about focusing on how it could improve its competitiveness through the types of structural reforms that we all know that it needs, and though genuine measures to develop and improve the single market, we ended up having this worse-than-irrelevant discussion about an FTT. In terms of competitiveness, in a sense it is a glass half-empty or half-full issue. You can look at the steps Europe has taken in structural reforms, particularly in Spain but also for example in Italy and Greece, and think about whether they would have happened five years ago. That is a positive step. At the same time, it still seems an inadequate response, so it is difficult in that sense. Lord Hamilton of Epsom: Are you not worried about the economic model of Europe collectively? There is a view that you can impose almost any burden on business, which somehow can always pay. James Watson: We are extremely concerned about that, exactly. We have made strong points about the business of energy prices and climate change. Our members are very concerned that Europe is taking on too much of a burden in that area, which is damaging our competitiveness. You can see that in the global market share of some of the more energy- intensive industries. So we have been very supportive of the Commission, which has come out with an aspiration for industry’s share of GDP to move back up towards 20%. Lord Hamilton of Epsom: I am told that because German energy prices are now three times those of the United States, chemical industries are voting with their feet and moving their plants to the United States. James Watson: Exactly. That would be quite possible.

Q155 Lord Vallance of Tummel: Do your members have a common view on completion of a single market in services? James Watson: Yes, we want to see it happen, exactly. It is something that we are pressing for. This month the thematic council is meant to be doing telecoms policy. Our letter to the council will focus on the need to complete the market in that area. The Chairman: Have you written a paper on TTIP? Lord Vallance has a particular concern about services. Lord Vallance of Tummel: It is a follow-on from the single market. We are negotiating a deal with the United States, and we do not have a single market in services in our back yard. Does that have any impact on the trading issue? James Watson: I see what you mean. I admit that I am not so much involved in trade issues. The main point is that we are very keen to see a single services market. Lord Hamilton of Epsom: Prime Minister Cameron is at the moment talking about renegotiating the position of Britain in the EU. Always central to this is hanging on to the single market. Is there a deal to be done where we keep the single market and manage to bin everything else?

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James Watson: I do not know the politics of all this. Let me give my response to the question of how the UK can engage with the EMU. That is probably the diplomatic way. I am a little biased, as a UK person working for an EU level organisation. There is a recognition in Europe that the UK over a long period has played an important role in not only helping drive forward the single market but in helping Europe develop more competitively supportive policies more generally. On better regulation, the UK has been a huge driver. It used to send national experts to drive forward that agenda with the Dutch. Our position on the EU budget is that we want to see it more oriented towards spending that is more focused on improving productivity and competitiveness. On that we are pretty much in line with the UK Government. I think there is a recognition in European business that the UK has played an important role in helping it be competitive. In a sense, that should provide some leverage. The only other thing that I would add is that at the same time, if the UK does not want to be part of EMU, it needs to stand aside and allow the rest of the eurozone to build EMU. It is pretty much doing that. All that provides some leverage.

Q156 The Chairman: But is that influence that the UK has exercised in the past beneficially to both the UK and the EU now being diluted, as several witnesses have told us, partly because of our absenting ourselves from the way that the Europeans are moving forward and—you are a UK person working for an EU institution—partly because of a besetting monolingualism? I do not know what languages you have. You clearly have Yorkshire because you went to the University of York. James Watson: Wrong side of the Pennines, I would say. I am from Warrington, but never mind. You guys will know better than me but I think that a number of countries—we can think of the Germans, the Dutch and the Scandinavians—would be concerned about the UK not playing such an active role, let us say, in the EU. Hopefully, one would expect that that would provide some leverage. On the more granular point of the business of EU officials in the EU, first, I am not working for an EU institution. The Chairman: But you would. James Watson: Yes. I am not a great linguist, which is probably partly why I am not working in an EU institution. You are quite right that the UK’s influence in those institutions is falling. The way of working is often not a UK way of working or an Anglo Saxon way, let us say. I think it is often partly a central European way of working. My one observation is that I think it was the Kinnock Cabinet—when Lord Kinnock was Commissioner on the admin side— that introduced a regulation that to get promoted you had to have three languages. That was particularly unfortunate for UK citizens. I am sorry, this is a bit long-winded, but I think we need to recognise that it is not only UK citizens who are becoming less represented in the EU; I think we are also seeing that with Germans and Scandinavians. It is an economic decision in a sense. Clearly, if wages are higher in a given country, the attractiveness of taking a job in the EU is reduced. It was particularly unattractive when the pound was at €1.50 10 years ago. I think that you have to see it in that broader context as well. My personal view is that the Commission needs to take on a few more staff with more experience. It has competitions but they are at an entry professional level—a little bit above graduate. I think it would be helpful if it took on more experienced staff at head of unit level, for example. It does not have open competitions at head of unit level. That would make it more attractive for experienced people not only from the UK but from other member states to enter the Commission. The Chairman: We will wrap it up now but can I thank you for straying into other fields and also for the clarity with which you answered the questions you were not asked by some

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Members of the Committee? We are grateful for that. Again, I say to you: do check the transcript. We would be very grateful for any papers that you think would be helpful. I think I mentioned the TTIP and the FTT. Indeed, please let us know if you have any further thoughts. But, believe you me, that was a good session and we are very grateful. It is really good to see you.

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Professor Willem Buiter and Dr Holger Schmieding—Oral evidence (QQ 55-65)

Evidence Session No. 4 Heard in Public Questions 55 - 65

TUESDAY 18 JUNE 2013

MEMBERS PRESENT

Lord Harrison (Chairman) Lord Boswell of Aynho Viscount Brookeborough Earl of Caithness Lord Carter of Coles Lord Davies of Stamford Lord Dear Lord Flight Lord Hamilton of Epsom Lord Kerr of Kinlochard Baroness Maddock Lord Marlesford Lord Vallance of Tummel

______

Examination of Witnesses

Professor Willem Buiter, Chief Economist, Citigroup, and Dr Holger Schmieding, Chief Economist, Berenberg Bank

Q55 The Chairman: Willem Buiter, Holger Schmieding, you are old friends of this Committee and we welcome you back again on this occasion to help us with Genuine Economic and Monetary Union. Since you have been here before, you know that we make a transcript of all that transpires between us and we send that to you. We ask you to correct it and to improve it because you may have further thoughts that could help the Committee to decide its view on these matters by adding to those first thoughts. You will recognise we are being webcast and the matters will be broadcast, I understand, later on. We would be most grateful if the two of you could just announce yourselves when I ask the first question, just to say who you are. It will be helpful to get that on the record.

My first question is: do you think GEMU does resolve the crisis? Are we on our way in terms of what is being presented to us? If the answer is no, not quite, what further elements might be needed that we should bring attention to in our final report? Holger Schmieding, would you care to take that one, first of all?

Dr Schmieding: Thank you very much. I am Holger Schmieding, Chief Economist at Berenberg. I think we are well on the way to resolving the euro crisis. We have to

109 of 441 Professor Willem Buiter and Dr Holger Schmieding—Oral evidence (QQ 55-65) understand the nature of the crisis, which is that parts of the eurozone had lost competitiveness and had come under market pressure as a result. They are now, and have been for the past two to three years, implementing reforms that are very akin to those implemented some 30-plus years ago here in Britain by Margaret Thatcher and to those implemented 10 years ago by Gerhard Schröder in Germany. These reforms take time to work.

The problem of the euro periphery is and was that, in the wake of the global financial crisis, markets were no longer financing them through their difficult adjustment period and, as a result, the eurozone, with the IMF, had to come up with mechanisms to prop up those countries. As key elements, first of all, we needed a safety net to signal to markets that all countries that do reform themselves will be kept in the euro. The ECB finally delivered that last August. To forestall future crises we need stricter fiscal rules because within the monetary union the fiscal problems of one country can affect other countries. We have, with the fiscal compact, de facto, the fiscal rules we need. They are being phased in. The key rule is that no country can run a budget deficit adjusted for the business cycle of more than 0.5% of its GDP.

What we still need to improve upon is the policing of these rules, where I find the troika not optimal, to put it that way. Personally, I would prefer to have an independent council, like the Central Bank Council, to check whether countries are making what they have to, to check whether they are meeting the requirements of the fiscal rule and whether they are making their fiscal position sustainable for the long term. I would delegate the verdict on the state of where countries are and what they are doing away from the troika to an independent council of experts.

We also need, in my view, a much faster resolution of banking problems. That does not have to be a banking union necessarily, but we need to force every country to tackle its banking issues. Unfortunately, there seems to be a bias in many national regulators to treat their own banks leniently. As a result, it makes sense to delegate the task of finding out what is the shortfall in the banks to an independent organisation that is not national. I think the ECB, as an organisation that we have, is the right one for that.

For the task of supervising major banks and finding out what is the shortfall, the ECB is probably good. The recapitalisation does not have to come from a . For that, it would suffice to have the current institutions, which are the nation first and the European stability mechanism as a backstop if the nation is not good enough. Banking union is an interesting subject but the key is not the banking union. The key is to find the mechanism to force every country first to address its banking issues.

Q56 The Chairman: Professor Buiter, could I invite you to answer the first two questions, but also to reflect on Herr Schmieding’s point about an independent committee that might oversee what is happening? Professor Buiter: Thank you, My Lord Chairman. I am Willem Buiter, Chief Economist of Citigroup, and I am speaking in a strictly personal capacity. We are getting to the point that the resolution of the European crises—there are multiple ones—are in sight, although it will take many years still to put financial matters in order. I want to differentiate the banking crisis of the euro area and the sovereign crises in the euro area periphery from the wider supply-side and productivity issues raised by Dr Schmieding—the agenda 2020 issues of inefficiency, lack of competitiveness. I think these problems can and should, to a large extent,

110 of 441 Professor Willem Buiter and Dr Holger Schmieding—Oral evidence (QQ 55-65) be decoupled. You can be poor but solvent. Countries do not have to get into these kinds of banking crises and sovereign debt crises simply because their productivity growth has been miserable and the unit labour costs have got out of line with underlying productivity both from a domestic and from an international perspective. As I said, I would not recommend the course of action of being poor but solvent, but poverty and insolvency are separate problems. I will focus mainly here on the banking crisis and the sovereign crises. Although we can see now where we will likely end up ultimately, we are nowhere near there. To deal with the sovereign aspect of the crisis—I still think there are a number of most likely insolvent sovereigns in the euro area periphery—we need two things: a framework for the orderly resolution of insolvent sovereigns and liquidity support for those sovereigns that are fiscally challenged but most likely solvent. The euro area must be able to ensure that a sovereign that is doing the right things, pursuing the right policies to restore solvency, cannot be forced into unnecessary disorderly default by a self-fulfilling funding stop, driven by fear in the markets. As regards liquidity support for most likely solvent but at risk of a sudden funding stop sovereigns, we have both belt-and-braces at the moment. We have the ESM, of which part is for sovereign liquidity support (rather than for direct bank capital support), which is far too small a facility, with probably no more than €440 billion available at this point. I would like to see that greatly extended, making liquidity support available against strict conditionality. We have, of course, the OMT, which is the expression of the central bank’s sovereign lender of last resort role as interpreted, again in a conditional way, by the ECB. That is sufficient as regards sovereign liquidity, although there is too much reliance on the ECB/ and too little on the ESM. We do not have a sovereign resolution facility (SDRM) in the euro area and that is unfortunate. We need one. We should have had one when Greece first knocked on the door in the Spring of 2010, and the IMF has belatedly recognised that. We do not have one now. We have a few ingredients of a sovereign resolution regime but they are mainly market-based and contractual, like the collective action clauses (CACs) that have had to be incorporated in the majority of new sovereign debt issues since the beginning of 2013. This will help reduce the severity of holdout problems when sovereign debt needs restructuring. That is good and useful but it is not enough. We need a statutory dimension. I would combine the SDRM with the conditional sovereign liquidity support role of the ESM after taking the direct bank capitalisation role out of the ESM. At the moment, the ESM is a bit of an institutional dog’s breakfast. It provides liquidity support for sovereigns and capital support for banks. Those two functions should not be managed by the same facility. They are quite distinct functionally and financially. I agree with my colleague on dealing with the banking problem. We have overleveraged banks throughout the euro area, core and periphery. Many of them are effectively zombie banks, accounting for the extreme slowness of the unwinding of the crisis in the euro area. Banks will not lend to potentially viable new projects because they have a large overhang of often unrecognised, strategically hidden on-and off-balance sheet losses or assets of doubtful quality. But it needs to be tackled; the stables have to be cleaned. That will require additional capital for insolvent systemically important banks that ought to survive for wider economic reasons. Other not systemically important insolvent banks should, of course, be liquidated. The way in which bank resolution is done—the recovery, resolution and recapitalisation mechanism—does not have to be anything as grand as the full banking union that the Commission is dreaming of. I would be in favour of a European Resolution Authority and 20 years from now we may have one. But a network of national recovery, resolution and recapitalisation regimes, according to a common European template, with a supervisory

111 of 441 Professor Willem Buiter and Dr Holger Schmieding—Oral evidence (QQ 55-65) board-like structure to facilitate co-operation for cross-border resolutions, would be adequate to the task of dezombifying the euro area banking sector, provided it can work, as regards the resources it draws on, as a sort of three-stage rocket. First, you bail in the unsecured creditors of the banks; then, for any legacy bad assets the domestic taxpayer; and, only in the last resort, the European taxpayers through the ESM. What is currently the direct bank recapitalisation facility of the ESM would be the third stage of this bank recapitalisation rocket. The Chairman: We will probably come on to those aspects. Before we leave this territory, Lord Dear, please.

Q57 Lord Dear: Gentlemen, echoing the Chairman’s remarks, thank you very much for coming and helping us today. Can I focus on the ECB and GEMU and look at the role of the Central Bank in GEMU and ask you, first, do you think it has been given enough attention? Is it prominent enough in that equation? Secondly, I suppose allied to that, what do you think is the proper division of labour, of involvement, between the Central Bank and governments, so far as the governance of GEMU is concerned? Professor Buiter: First of all, I must say how poorly named GEMU is. Genuine economic and monetary union, as opposed to phoney or fake monetary union? Who dreamt this up? But never mind; we are stuck with it. Lord Dear: It was not our Committee. It was not us! Professor Buiter: The four pillars of GEMU, the four elements, are three sets of economic institutions and one set of political arrangements. As regards the economic pillars, there is, first, an integrated financial framework that more or less corresponds to full banking union, second, an integrated budgetary framework and third, an integrated economic policy framework to look after the long-run growth and competitiveness agenda. Then, very importantly and much underemphasised, after Mr Van Rompuy very wisely introduced it, democratic legitimacy and accountability. I have a major problem with the growing role of institutions such as the European Commission and the European Central Bank, which basically are run by unelected technocrats without political legitimacy, other than what is bestowed on them by the fact that they operate under the Treaty. There is no ‘input legitimacy’ through elections or through substantive accountability to elected representatives of a European ‘demos’. Output legitimacy (success in the pursuit of one’s mandate) is also problematic, as (a) success or effectiveness is hard to verify objectively, and (b) the subjective popular assessment of the effectiveness of the Commission and the ECB is most likely not very flattering. But there has been, and there promises to be in the next few years, a major increase in the power of these institutions without any commensurate increase in their accountability to the electorate, either through a more effective European Parliament or through a new arrangement involving national Parliaments in a Senate-like setting. This is very worrying, especially in the case of the European Central Bank. Although for most of the world’s central banks operational independence (let alone target independence) is a construct whose time came and went, this is not the case for the ECB. This crisis has effectively ended the operational independence of most leading central banks—in the US, in the UK and in Japan—but it has not ended it in the euro area. This is not because the Treaty makes a lot of play about central bank independence, but simply because in the euro area we don’t have a single central bank facing off against a single Treasury or Ministry of Finance—a confrontation that invariably ends with fiscal dominance. In the euro area it is 17 Finance

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Ministers against one central bank, so every Finance Minister is small, even the Finance Minister of Germany.

The Chairman: I wonder if I could ask Dr Schmieding to answer Lord Dear’s point about the ECB. You may like to know that for our banking union report we interviewed Dr Constâncio, the Vice-President of the ECB, who was very good at coming forward to listen to our questions. What is your view of the ECB’s role? Dr Schmieding: Thank you. The role of the Central Bank should be to safeguard price stability and financial stability. Financial stability is something that central banks, post-Lehman, realised only over time and a role that the ECB has assumed somewhat reluctantly and rather late, but these are the proper roles. It also took the ECB and, say, a number of European countries and Finance Ministers some time to realise that safeguarding financial stability does entail offering a backstop, a lender of last resort to prevent self-reinforcing market panics. It has been a long learning process but we are there, in that sense, with the ECB and can only hope that the German Constitutional Court does not stick to the old view that only price stability, come what may, is what the Central Bank should be concerned with. What I do not like about the role of the ECB at the moment is, as mentioned, the troika. I do not think that Central Bank staff should be among those to pass judgment on the state of public finances in Italy, Spain, Greece and wherever. On that I would rather have an independent body so that the ECB can function on the huge tasks that it has anyway. The Chairman: Thanks very much. I think now we must press on. We have the witnesses for only an hour.

Q58 Lord Marlesford: On what Dr Schmieding said at the beginning is the cause of the crisis, of course we can all see that lack of competitiveness has made it difficult for countries to get out of the crisis. However, to suggest that it was lack of competitiveness that caused it puzzles me a bit. It is almost as though you were saying there is a balance of payments problem. Surely the primary cause was, on the one hand, unsound lending by banks and on the other budgetary imbalances of central Governments. Take Ireland for the first and Greece for the second. The Chairman: I am going to ask Lord Davies to put his question. You may wish to respond to Lord Marlesford’s, which is something we deal with on a regular basis in terms of the origins of the euro area crisis. Lord Davies, would you come in? Please do respond, if you wish, to Lord Marlesford. Lord Davies of Stamford: My point to Dr Schmieding was simply going to be that the idea that central banks have a responsibility for financial stability is hardly new. Bagehot described that as one of the Bank of England’s classic roles back in the middle of the 19th century. It was the main reason for the establishment of the Federal Reserve in 1913. Professor Buiter, you have moved from academe to the private sector, so perhaps you are the ideal person for me to put this question to. How do you see the markets reacting to GEMU? Do they think, on the whole, that these proposals by the Commission are adequate, inadequate or go too far? Do they think they are ill conceived, well conceived? Do they think that the Franco-German paper is more pertinent than the Commission’s proposals? How do they see the merits of the two approaches? Professor Buiter: I do not think that the market much cares about most of the proposals for GEMU, because most of it is a long-term blueprint that has no relevance to the resolution of the current crisis. In the integrated economic policy framework, the third

113 of 441 Professor Willem Buiter and Dr Holger Schmieding—Oral evidence (QQ 55-65) element, for instance, is about the 2020 agenda—competitiveness, growth, happiness—and that has nothing to do with the crisis. On the fiscal capacity of the eurozone, a lost federalist sheep like me likes the proposals in GEMU, but I know this is not going to happen for the next 30 years. There will not be anything smacking of a fiscal capacity, even a minimal one that responds to asymmetric shocks with the automatic transfer of payments cross-border from the centre funded either out of the centre’s own tax resources or out of the centre’s own debt issuance.

Lord Davies of Stamford: You say there will not be. Do you regret the fact that there will not be? Professor Buiter: I regret it because I would like to see a stronger European Union with stronger supranational institutions both because I believe this is the only viable future for Europe, including the UK, and because it would be sufficient to resolve the resolution of this crisis. It is not necessary for the resolution of the crisis and the survival of the euro area, however. For asymmetric national shocks, what we need is proper cross-border borrowing and lending mechanisms, private and public, so we need to get the financial markets going again. At the moment, we have de facto capital controls inside the euro area, not just the explicit ones in Cyprus but implicit ones throughout the euro area. Subsidiaries of cross- border euro area banks headquartered in the periphery have been told by supervisors in core European countries that, for unconvincing prudential reasons, they cannot send funds to the parent in the south. So let us restore the proper functioning of private and public sector borrowing and lending. We do not need centralised cross-border fiscal stabilisation to get out of this crisis. As regards the preventive arm of the pact, which is by now so complicated that I doubt whether even the authors of various bits of it could pass a test on it, we have the six-pack, the two-pack, the Treaty on Stability, Co-ordination and Governance (aka the Fiscal Compact), which all implement and augment the failed Stability and Growth Pact. The whole preventive part of this new potpourri of approaches is as yet untested. Every time in the past when the Commission tried to discourage pro-cyclical behaviour during the upswing—and that is really what these things are about—they have failed. Its recommendations and proposals have been ignored by Germany, France and the UK. The fiscal compact, like the Stability and Growth Pact, is trying to make anti-cyclical fiscal behaviour symmetrical. Counter-cyclical policy is always wildly popular in the downturn, never in the upturn. Counter-cyclical fiscal policy has never been symmetrical, except occasionally in a few countries, and has led to the steady upward drift in public debt and deficit burdens over the past two decades. How can the Commission impose fiscal discipline when the economy is booming and markets are keen to fund the sovereign? The last time two serious countries, Germany and France, got into trouble—in 2003 under the original Stability and Growth Pact—they thumbed their noses at the Commission and got away with it because it took a qualified majority of the Council to enforce the proposals of the Commission. Now it is slightly different in the Fiscal Compact because it now takes a qualified majority of the Council to overrule the Commission. But I personally do not believe that we have anything like the institutional set-up necessary to enforce the preventive arm. As regards a committee of experts ruling on fiscal matters, independent means unaccountable (that is, substantively unaccountable) and I am really concerned about that if the Committee of Experts were to make policy proposals or were to be able to overrule the legitimate national policy makers. I would be very careful before we create yet another collection of eggheads who will tell the citizenry what to do with their votes.

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Q59 The Chairman: Herr Schmieding, would you like to take on that comment and the question about the influence of the markets? Dr Schmieding: To take that comment first, I am a big fan of the way in which central bank councils, the monetary policy councils or the ECB Council, roughly run their monetary policy. I think for an extremely difficult question such as monetary policy and passing judgment on the sustainability of public finances in countries, I would rather have a non-politicised body and that is a council like the ECB Council but not the ECB—a separate fiscal council, as to some extent this country has for itself with the Office for Budget Responsibility.

The Chairman: If it is independent, is it then unaccountable, as Professor Buiter says? Dr Schmieding: To some extent independent is unaccountable. The ECB is, of course, in a way accountable to the European Parliament. Its members are appointed in a way that is ultimately political, but once appointed their political masters who appointed them can no longer tell them, “Oh sorry, I thought you would be doing this rather than that”. That kind of independence, ultimately appointed by Parliaments ideally, for a limited number of years with a clear mandate but within that mandate being the ones to judge how to exercise it, is something that has served the world well for central banks. On the other question: I very much admit this one point: relearning the lesson that financial stability is part of a central bank mandate has been the relearning of a lesson that is not new. Professor Buiter: I disagree with that, My Lord Chairman. First of all, as regards the need for independence, even in monetary policy, the argument for independence is not that monetary policy is incredibly technical and difficult. Basically, anybody can do it. It does not take a genius to do monetary policy: 25 basis points up, down or sideways. What’s hard about that? The reason for de-politicising monetary policy is that it is a high-frequency instrument that is very easily manipulated in a political manner with both immediate consequences (the ones that are sought by political manipulation) and long-term consequences that tend to be ignored by myopic politicians elected by myopic electorates. That is different from saying it is complex or technical. Fiscal sustainability is a deep, complicated, technical problem and I certainly would like experts to evaluate it, but even if the experts’ work is purely technical, advisory, or scenario-building, the experts would have to be substantively accountable. There are two dimensions to accountability. One is to provide information so those to whom you are notionally answerable can make a judgment on how well you did. The ECB has some (minimalist) information requirements imposed on it by the Treaty: it has to publish a weekly this, a monthly this, that and the other and an annual something; and the European Parliament can call the members of the Board for hearings that the ECB perversely refers to as dialogues. Dialogues occur between equals. The ECB is the Agent or the Trustee; it is not the Principal. The European Parliament and the euro area citizens are the Principals to whom the ECB is supposed to be accountable. Agents and Trustees give evidence or are summoned to hearings. They don’t engage in dialogues with the Principals. Substantive accountability means that if those to whom you are accountable do not like what they find out about your performance, they can do something about it: they can reward or punish you. That is clearly not the case with the independent central banks. The European Parliament cannot fire the Board members or the ECB Governors; they cannot lower or raise their financial remuneration. And Governing Council members have not (so far) been sued by euro area citizens for incompetence in the performance of their tasks, for dereliction of duty, or for careless or reckless performance of their responsibilities.

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Substantively, therefore, the ECB is clearly unaccountable as regards monetary policy. As regards monetary policy you might be able to tolerate it, but to extend this to banking supervision, which is a deeply political activity, I think would be extremely perverse. The Chairman: I am going to ask the Earl of Caithness to ask his question but, Herr Schmieding, if you would like to reply to Lord Marlesford in the reply to the Earl of Caithness, please do so.

Q60 Earl of Caithness: I would like to move on to the banking union. First, do you agree that a successful banking union should have three distinct legs: a single supervisory mechanism, a common resolution mechanism and a common deposit insurance scheme? The only leg that has any sort of shape to it is the single supervisory mechanism. What are the risks of a fudge on the other two legs? Will it work and, if there is a fudge, or even if there is not a fudge and we get three good legs, will there be a decisive break between bank and sovereign debt? Professor Buiter: We do not need the third leg, deposit insurance, for a successful banking union, but we need three legs because we need a common regulatory framework, not just in a monetary union but in a single market for banking services. In the wider EU, you cannot have cross-border banking, as the case of Icesave made very clear, on a Passporting basis without having a single regulatory and supervisory framework right across the Union. For meaningful cross-border banking and a single market in banking products and services, you have to do away with national supervisors and get to the EU level, not just the eurozone level. So, yes, we will get progress towards a single regulatory framework, and a single supervisory mechanism. But, of course, the supervisor is fangless if he or she cannot shut down banks or tell them to recapitalise, so you need a recovery, resolution and recapitalisation authority or a cooperating network of national authorities. The network, the minimalist approach, can work for a long time, certainly long enough to clean up the current mess. We have deposit insurance for two reasons in the real world: one is social policy and the other is financial stability. For social policy, I think current deposit insurance is greatly excessive. “Widows and orphans” protection should maybe go to €20,000. A €100,000 deposit protection on “wretched and poor” grounds does not make any sense. What about financial stability—preventing bank runs? That is surely desirable but anther way to deal with bank runs is to provide compensatory financing. You do not need belt and braces. Credible deposit insurance—if it applies to all deposits that can be withdrawn on demand (which it does not of course; a much larger scheme would be needed)—is a way of preventing bank runs. But we already have the ECB acting as lender of last resort, capable of making short- term funding available, through collateralised loans to banks or by outright purchases of bank securities. It would be nice to have mutualised deposit insurance but it is not essential at all, in my view. I would, in fact, discourage deposits withdrawable on demand as instruments. I think they are death traps. We have learnt in this crisis that overnight funding is not a good idea for financial institutions. Deposits, of course, are the ultimate example not just of overnight funding but of over-the-second funding. I would put limits on the ability to withdraw deposits, other than very small amounts of transactions balances. Dr Schmieding: On banking union, the key at the moment is to force banks to face up to losses, whichever way we do that. If a banking union proposal is a way to do that, fine. If we have another way, fine. That is for dealing with the current situation. For the longer-run

116 of 441 Professor Willem Buiter and Dr Holger Schmieding—Oral evidence (QQ 55-65) improvement of the eurozone and the EU, yes, a banking union is good. It should be built on the principle of subsidiarity, ideally. That is, all those institutions that are systemic should ultimately be under a single supervisory regime, subject to a single resolution regime. Deposit insurance, I agree, is a nice complement but is not the major ingredient for me, even in the longer run. Will there be fudges? Yes, there will likely be fudges, as always in international or even national politics. But I am fairly confident that over time—probably over the next year and a half—we will get the key elements of a banking union dealing with systemically important banks, the common supervision and a common approach to recapitalise the banks that are found wanting by the common supervisor. I would not be surprised if the ECB, because it would like to take on banks with a fairly clean slate, came up with much higher estimates of how much capital will be needed for banks than all the stress tests we have seen so far. That will probably politically—late this year or early next year—force much more thorough European thinking about resolving those banks. So much on banking union. May I briefly come to this question on the causes of the crisis? For me, fairly easily, parts of the eurozone had phenomena just like the US and the UK— that is excessive public spending growth and credit bubbles. When these went bust in the US and the UK, we had the backstop through the central bank quantitative easing and the like. In the euro periphery we did not have a backstop for that and, as a result, had the market panics. In the process of building up credit bubbles, real estate bubbles and excessive government spending, wages in a number of countries rose too fast and, as a result, they also have a competitiveness problem. We see now that, in their adjustment crisis, wages are falling fairly fast in those countries. In Greece, wages are probably down 12% to 15% in the private sector on where they were at the start of the crisis. There are similar developments—not quite as pronounced but similar—in Portugal, to some extent Ireland, whereas Germany has wage gain, relative to the start of the crisis, of close to 10%. There has in relative terms been roughly a 20% adjustment in the relative competitiveness between the euro periphery and Germany. That is going a long way towards making these countries sustainable again once they leave the immediate period of fiscal pain, which they likely will do soon.

Q61 Lord Kerr of Kinlochard: Following directly from what you have been saying, Dr Schmieding, and what you said in your opening remarks when you talked about an independent council of experts as the policeman of fiscal discipline, the Franco-German proposal of 30 May runs with the idea of contractual arrangements, which I do not fully understand. It says that they would be backed up by limited and conditional financial incentives, the creation of a specific fund for the euro area, more regular euro area summits and dedicated structures specific to the euro area within the European Parliament to ensure adequate democratic control. I think, by the way, that the proposal for an independent council of experts runs into some difficulties on democratic control. It seems to me that if you are requiring Governments to change their economic policies in the direction of greater austerity, you had better have some kind of democratic mechanism overlooking that decision. But I do not fully understand the contracts proposal, even as spelled out in the Franco-German paper. I would be very grateful if you could tell us what you think it is and whether you think it could work. Dr Schmieding: First, on the independent council, what I am proposing is not a council that takes all the political decisions. The troika does not take the decisions on Greece. That is ultimately the ECOFIN and the parliaments of the countries that then authorise the ESM, for

117 of 441 Professor Willem Buiter and Dr Holger Schmieding—Oral evidence (QQ 55-65) instance. But the troika report as to whether Greece has met 8% or 88% of its commitments. Whether the calculations on fiscal sustainability, ideally for all countries ranging from Greece to Germany, make sense—whether the growth assumptions in there make sense—the expert judgment should not be made by the EU Commission, which is a half-political body. It should not be done by the IMF, which has no idea of Europe and has demonstrated that repeatedly over the last few years, despite the head being European. It should not be done by the ECB, which should stay out of these things as much as humanly possible because it ought to focus on monetary and not fiscal policy. The independent expert committee does not make the political decision of whether Greece should be asked to leave the euro, which I think it never will be, but decides whether Greece has met the commitments and is on the right track, and whether Germany is on the right track as well. That is on that, the expert task. The contracts proposal is, in my understanding, which is a mere political understanding, a sweetener for the countries in adjustment recession. “If you conclude a contract with us on the following structural reforms we will have the fiscal capacity to give you a little money as a reward for that”. That is a little step towards a mini EU budget. You could say it is something like an adjustment fund at the EU, on top of the structural funds or regional funds that the European Union has had for quite a while. That is my understanding of it: a little money from core Europe in an EU fund for countries that conclude a contract on structural reforms and then adhere to these commitments. Professor Buiter: It is fine to talk about an independent council that is merely a bunch of experts doing a forecast—or independent assessments of fiscal programmes—but that is very different, of course, from the ECB, which takes substantive policy decisions. The OBR or the Netherlands’ so-called Central Planning Bureau (I know it sounds vaguely Soviet Union-esque) do that kind of thing. The CPB evaluates each party’s electoral programmes, but it is generally considered to be a useful thing, so I support that. As regards the contractual arrangement, God knows. When I hear the words “contractual arrangements”, I think courts and enforceability. As I said, this is simply a supposedly conditional cookie out of a very small cookie jar for countries that are suffering the indignity of being under a set of fiscal-financial austerity programmes. They are offered incentives for restructuring reforms using the convergence and competitive instrument, the so-called CCI, as a carrot; but since the EU has a minimal budget, 1% of GDP, about half of which is wasted on the Common Agricultural Policy, this is really tokenism at this point. Also, who enforces the contracts? How many bailiffs and arresting police officers does the Commission have?

Q62 Viscount Brookeborough: Would you like to tell us something about what you think of a euro area budget, whether you think it is a long way down the line, how necessary it might be, whether it would really work and how it might be funded, especially with the way they put in resources? Professor Buiter: My view is that ultimately the EU budget will become the euro area budget because I cannot see non-eurozone members of the EU sticking around indefinitely; ultimately, either you join the euro area or you are out of the EU. For the rest of the proposals—that you get another 1% of GDP to play with, possibly with independent revenue-raising capacities; dedicated fiscal instruments, whatever they are; maybe the financial transaction tax, although that is shrinking so fast it is no longer visible to the naked eye; and perhaps even independent borrowing capacities—I think all that is a distraction from what we need to do at this point, which is clean up the sovereigns, clean up the banks and set in operation structures that can force symmetry in the counter-cyclicality of fiscal

118 of 441 Professor Willem Buiter and Dr Holger Schmieding—Oral evidence (QQ 55-65) policy. Those are the things that matter. I think that an independent euro area budget is a dream of Brussels. But it is not relevant to this crisis, nor is it relevant to the prevention or management of the next crisis, nor will it become relevant in the foreseeable future.

The Chairman: Dr Schmieding, will any budget become a euro area budget and is it almost irrelevant, as suggested by Professor Buiter? Dr Schmieding: I hope that the European Union stays wider than just the euro area, as I hope that Britain will remain in the EU, and so some EU budget should remain. As to a euro area budget, that is either a red herring if it is small, or it is dangerous if it is big, because a big euro area budget would mean a lot of room for political decisions on redistribution, which I should not like to see. I much prefer what is currently happening in the euro area: if there is a need for the strong to support the weak, it is a case-by-case decision with a conditionality that is evaluated case by case, rather than having a grand budget that gives transfers from the strong to the weak on a semi or even fully automatic basis, which is just not incentive-compatible.

Q63 Lord Vallance of Tummel: Can we come on to debt mutualisation? Is it necessary and, if so, what form might it take? I wonder if you could look at it in two ways. First, look at it while relaxing the current treaty constraints and perhaps even the concerns in creditor countries about moral hazard. What would be the ideal if you had a clean sheet of paper? Secondly, given that we are where we are politically, what if anything is likely to happen or has it happened already by the back door?

The Chairman: Could I ask Lord Carter to add his question, which links very neatly to Lord Vallance’s?

Lord Carter of Coles: In many ways I think you have addressed this, but it is about competitiveness and the presence of the persistent imbalances across the member states. Does it make a system of permanent financial transfers inevitable if the euro area is to survive or could we do this in some other way? Could we preserve the goals of fiscal union in some other mechanism? Professor Buiter: Debt mutualisation, whether it is backward-looking (that is, it applies to the outstanding stock or to part of the stock, as in the Council of German Economic Experts’ proposal for a Redemption Fund), or forward looking, through joint and several guaranteed issuance of new bonds to fund some share of future national budget deficits, are neither necessary nor desirable unless they are accompanied by the other half of fiscal union: the transfer of national fiscal competencies to the federal level. You cannot have front-door mutualisation by explicit joint and several guarantees without having this surrender of national fiscal competencies. Since that is not on the cards, it is not going to happen. There is, of course, some ex-post mutualisation inevitably in this crisis already, both back door and front door. Front-door ex-post mutualisation refers to the losses that have already been incurred in net present value terms by the various official facilities—the Greek Loan Facility, the EFSF, the EFSM and now the ESM. Ultimately, all the loans provided by these entities to countries on programmes will be turned into zero-coupon perpetuities, promising to pay nothing for ever. With full face value and zero net present value official creditors retain a fig-leaf and official debtors get the substantive gains. It is happening rapidly. We see in the case of Ireland and Portugal the recent seven-year maturity extensions. There were earlier examples for Greece, Ireland and Portugal OSI through maturity extensions, coupon cuts and delays in interest payments. Take that to the limit and you have a zero-coupon

119 of 441 Professor Willem Buiter and Dr Holger Schmieding—Oral evidence (QQ 55-65) perpetuity. There will be a bit more of that but not a lot more because the resources available to the ESM are unlikely to increase significantly. Then we have the potentially much more important ex-post back-door mutualisation through the ECB, or the Eurosystem, as and when the Eurosystem finally takes losses on its sovereign exposures, and on its exposures to mostly likely insolvent banks that have offered, as collateral, securities issued or guaranteed by most likely insolvent sovereigns. The Eurosystem has already bought €210 billion of sovereign debt, or rather periphery sovereign debt, and indeed the worst afflicted peripherally sovereign debt, through the now defunct SMP, the securities markets programme. I cannot see the ECB/Eurosystem being made whole on its SMP exposure unless the ESM were to take it off its hands at the prices at which the debt was purchased. Of course, other than the SMP exposure, the Eurosystem has very little sovereign debt outright on its balance sheet. The Eurosystem balance sheet, unlike most advanced economy central banks, has less than 10% of its balance sheet in sovereign debt held outright. Of course, if and when the SMP gets activated, there will be more periphery sovereign debt held outright on the Eurosystem balance sheet. And it will again be the least solvent sovereigns who will avail themselves of that. There is material credit risk that could in fact ‘go live’ and present the Eurosystem with an actual realised loss. Finally, the existing indirect exposure of the ECB/Eurosystem to sovereigns (and especially periphery sovereigns) is massive through the collateralised loans it has made to banks of doubtful solvency that offer as collateral securities either issued or guaranteed by sovereigns of doubtful solvency. That is not all that different substantively from holding outright sovereign debt with significant credit risk attached to it. I think there will be significant losses before this crisis is over for the euro system but not anything like large enough to endanger price stability. We have estimated the non-inflationary loss absorption capacity (NILAC) of the Eurosystem as being close to €3 trillion, so there is still a bit to go before any capital losses on the Eurosystem would endanger price stability. Central banks can, of course, operate with a large negative conventional net worth or equity without this threatening inflation or other loss of control, as long as the negative conventional net worth is compensated for with a sufficiently large NILAC. Dr Schmieding: Briefly, I do not agree with this assessment of the ECB. It is a normal part of monetary policy for the central bank to have sovereign paper on its balance sheet and to be exposed to bank and sovereign risk. I do not see any need for the ECB to take any losses on its sovereign holdings. The euro crisis, short of a major political accident, can be resolved and will be resolved without further sovereign haircuts. The Greek debt outcome was a major mistake because of the contagion it sparked. It was expensive. I see risks, of course. Life is full of risks, but I do not see them materialising short of a major political mistake in the euro area. As to the questions on debt mutualisation, I am very much against it. I am a German; of course, I ought to be against it because it could be largely at Germany’s expense. I much prefer the current approach of case-by-case support for those who need it on case-by-case conditionality. Debt mutualisation is one empowering law and from then on the weak can borrow with a guarantee of the strong. At least that is how debt mutualisation is being presented. That would not be incentive-compatible. On fiscal transfers, the argument is exactly the same. A system of automatic fiscal transfers distorts incentives. It makes it more likely that some regions, such as southern Italy—or should I mention some regions of the UK?—will for a long time depend on the stronger regions, northern Italy, or Greater London in this country. If there are fiscal transfers, I would much rather have the system of conditional support on a case-by-case-basic to force

120 of 441 Professor Willem Buiter and Dr Holger Schmieding—Oral evidence (QQ 55-65) the weaker regions to either get as strong as the stronger ones or, as you said, just to stay poor but live within their means, which if you are poor you can do. The Chairman: I invite Lord Marlesford to ask his question, which will be the final one, but if there is anything further that the witnesses would like to add to advise the Committee on these issues, perhaps you would add that to your replies to Lord Marlesford.

Q64 Lord Marlesford: My question follows on rather neatly from what has just been said. I find it a little difficult to understand the difference between mutualisation of debt and ECB- held debt. I thought that debt held by ECB was mutualised debt because the ECB is a mutual organisation of the eurozone. What I am really getting at is, in the single market, the British Government have decided not to join most of these outfits, particularly the banking union and so on. Do you think this has any great impact on the single market or do you think the single market can go along quite happily with us staying out of these particular institutions?

The Chairman: And what about the effects on the UK itself, Dr Schmieding? Dr Schmieding: Of course, the ECB is a mutual organisation. Everything that goes wrong in the ECB balance sheet is a mutual event, yes, but this is very different. Having the ECB as an organisation that can accept sovereign paper as collateral or can buy it outright under certain conditions is very different from telling a Government that you can now issue a new bond as Italy with a de facto mutual guarantee on it, which is the debt mutualisation idea. As to the role of the UK in it, the UK is in a very precarious position. The UK once got very close to eliciting a very strong European counterreaction when it vetoed the fiscal compact as being part of normal EU treaties in December 2011. If the UK opts to be out of things but vows not to get in the way of what consenting adults in the eurozone want to do, the current arrangement, from the continental perspective, can work. But if the UK wants to use decisions about eurozone affairs to pursue its own agenda in these things and press its own demands and hence block, potentially, things that the eurozone would want to do, we would be getting into very dangerous territory. The fact is simple. The top priority for the eurozone is to fix itself and the eurozone will not, ultimately, let anybody get in the way.

Lord Marlesford: It depends on whether you have to have treaty change to do these things. Dr Schmieding: Yes, exactly. The clear solution to that is there will be no treaty change forced upon the UK. More precisely: the UK can opt out of everything, but it ought to ratify the changes which the eurozone would like to do for itself. Otherwise we would be going towards a division between the eurozone and the EU that could ultimately lead to the eurozone, rather than the EU, being the genuine common market, which is the dangerous potential end of it.

Q65 The Chairman: Professor Buiter, do you agree that the UK should not interfere with consenting adults in these matters? Professor Buiter: Since it is not part of the eurozone—

The Chairman: May I just stop you there? I understand that Dr Schmieding has to go and I would just like to take the opportunity to thank you if you do have to rush off. We are most grateful to you. Thank you very much indeed.

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Professor Buiter: The old saying, “If you do not play the game you do not make the rules”, applies to the UK in these matters. Of course there are areas in which the single market, as it is, is at risk for those not part of the eurozone. This tends to occur through restrictions imposed on the capacity of non-eurozone members of the EU to engage in transactions and other activities—restrictions that are irrelevant from the point of view of the proper functioning of the eurozone. Instead they amount to opportunistic abuse of the eurozone institutions’ roles in rule-making, resulting in discrimination against legal and natural persons operating in the EU but outside the euro area. Most are obvious violations of single market legislation or of other parts of the Treaty. Fortunately, much of this attempt to impose protectionist barriers against ‘offshore’ euro-denominated activity outside the euro area (i.e. in the UK) seems to have been put to bed in the EU MiFID agreement reached yesterday on the trading of derivatives on organised exchanges and similar platforms. This was one of the more outrageous attempts by eurozone-based financial centres to steal business from London by means mostly foul. That said, the relationship of countries not in the eurozone with countries that are in the eurozone will inevitably get more difficult as the eurozone moves towards deeper integration, even though I see the integration that is both necessary and likely as quite limited for the foreseeable future. I regret to have reached the conclusion that I have trouble envisaging the UK in the EU but out of the eurozone 10 years from now. I just cannot see that. There is one point that was asked a couple of times but I never got around to saying anything about it: the decoupling of banks and sovereigns, and whether this would happen as a result of the kind of banking union we will see. If we find ways of comprehensively resolving and recapitalising systemically important banks without relying on national sovereigns, we will achieve that decoupling. Therefore, a key step toward decoupling has nothing to do with banking union per se. It simply requires the bailing in, by writing down the claims of unsecured creditors of the banks or by converting them into common stock, to the full extent necessary to achieve adequate recapitalisation, going all the way up to unsecured bondholders and possibly, and only if necessary, as in the case of Cyprus, the non- guaranteed, non-insured depositors. The bail-in rules should be common to all euro area member states. Of course, the bail-in requirement does not bring full decoupling of bank credit risk and sovereign credit risk if the capital requirements of banks exceed the maximal amount of unsecured debt that can be bailed in. As long as there is, for legacy losses in excess of the amount that can be squeezed out of the unsecured creditors, a requirement that a contribution has to be made by the national tax payer—that is the current consensus, I think—before mutualised bail-out funds from the ESM or somewhere else are put in, we will not get complete decoupling. I think it is politically unavoidable and also fair that for legacy bad assets the national taxpayer is bailed in, after the unsecured creditors but before the mutualised contribution of the ESM. For losses on any new assets acquired by banks after the ECB takes over as the head of the Single Supervisory Mechanism, a specific national taxpayer contribution, other than through the national taxpayer’s contribution to the mutualised ESM recapitalisation resources, should not be expected. To make this symbolically clear, I think that in the euro area, we should require that all banks that are supervised by the ECB—ultimately all banks in the euro area—be incorporated immediately as Societas Europaea (under European corporate law rather than under national corporate law) to make it clear that these banks are no longer a ward of the nation state. That could be done, of course, without any treaty changes.

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The Chairman: Professor Buiter, as ever, we thank you as a Committee for coming in to see us. You are always thought-provoking, sir, and we will think about the thoughts that you have provoked in us in our further deliberations on this important matter. Thank you very much personally.

123 of 441 Centre for European Reform, John Peet and Open Europe—Oral evidence (QQ 1-18)

Centre for European Reform, John Peet and Open Europe—Oral evidence (QQ 1-18)

Evidence Session No. 1 Heard in Public Questions 1 - 18

TUESDAY 21 MAY 2013

Members present

Lord Harrison (Chairman) Viscount Brookeborough Lord Flight Lord Hamilton of Epsom Lord Kerr of Kinlochard Lord Marlesford ______

Earl of Caithness

Examinaion of Witnesses

Katinka Barysch, Deputy Director, Centre for European Reform, John Peet, Europe Editor, The Economist, and Mats Persson, Director, Open Europe

Q1 The Chairman: John Peet, Katinka Barysch and Mats Persson, you have all been before us before, so I think you know the style of these meetings. I would be most grateful if you could just say who you are and where you are from at the beginning of the meeting when we first speak. You know that you will receive a transcript of what we have exchanged. Please correct that. Very importantly, please improve upon it if there are further thoughts that you have which are useful to our inquiry. We are starting off this big inquiry now on GEMU, as you will be aware, but we will send you the transcript and please correct that. May I just take the opportunity to offer Ms Barysch our very best wishes? Having been here for 11 years and many a time helped a Lords Committee, we wish you well when you return to Munich in the not-too-distant future. When I had a young family, driving on a long journey, the children in the back would say, “Dad, are we nearly there yet?” Can I ask the three of you, on this genuine economic and monetary union, are we nearly there yet? Are we motoring along? Are we getting somewhere? In particular, the two proposals that we have on the table, how do they seem to you in terms of whether they will work, whether they will operate? Do they repair the lacunae in the original set-up of the single currency? Is too much being proposed or too little proposed? Ms Barysch, give us a good start. Katinka Barysch: Thank you. Katinka Barysch, Deputy Director of the Centre for European Reform. The two main proposals that are on the table are obviously quite different. The Four Presidents’ proposals do not go as far in their ambition and vision as Barroso’s

124 of 441 Centre for European Reform, John Peet and Open Europe—Oral evidence (QQ 1-18) proposal, and then we also have the Future of Europe Group of the Foreign Ministers, who go much further in their political thinking. So it depends on which proposal you look at. If we start with the Four Presidents’ proposal, which was relatively modest in its ambitions, given what else is on the table, demanding a banking union that starts off as a resolution mechanism, but puts off a common deposit guarantee scheme, a fiscal union that perhaps thinks about a redemption fund but shies away from full Eurobonds, then absolutely I believe that that is realistic. Whether it will be sufficient depends on your analysis of what caused the current crisis and whether these causes are going to be repeated in the future. Let me explain what I mean by that. In Germany, the Netherlands, Austria, Finland, you will still find a lot of people who believe that the main causes of the crisis are found in individual member states who spent too much and who have failed to control their banking and real estate bubbles. From that perspective, what you really need is stronger central control of the economic policies of the member states. Most people in this country would believe that there is a fundamental flaw in having a joint currency that is not complemented by a full central budget function and some sort of political federation. My personal view is that, yes, it is the introduction of the euro that has brought us into this situation, because it led to a very fast convergence of interest rates at a time when we did not have the central oversight or the national banking oversight to prevent bubbles and imbalances from developing. We did not pick that up fast enough. Even if we did pick it up, we did not do anything about it. That was exacerbated by the fact that we had just, before the introduction of the euro, had German reunification, which means that the largest economy in the eurozone was in a long-term stagnation. On top, we had an unprecedented liberalisation of financial markets, not only at the European but at the international level. This conjunction of factors with surplus savings being available in Germany, financial market liberalisation and a rapid decline in interest rates in the periphery led to these massive imbalances. So it is the euro that caused the crisis, but we will not introduce the euro again, we will not have German reunification again, and we are learning the lessons from the impact of very fast financial market liberalisation. My point is that absolutely we will have future crises in the eurozone, because it is not perfect and it will not be perfect for a very long time, but the crisis will be of a different nature and magnitude. If we build a massive edifice now on the basis of the lessons that we are learning right now from this unprecedented crisis, and a crisis that perhaps will not return, we might not prevent future crises because they might not be the right measures. The eurozone crisis has skewed the political situation in Europe in a way that exacerbates the dominance of Germany. I expect that to be mitigated once the other European economies recover. If you build something quickly now, it will be too rules-based, it will be too German, it will not suit the other Europeans. Very importantly, if you move too fast in the direction of fiscal and political union right now, we leave the people of Europe behind, because we have unprecedented low trust in the European project. I would say we need to make changes, but we need to take our time.

Q2 The Chairman: Mr Peet, do you share that analysis? John Peet: I think most of what Katinka Barysch said I would agree with. I do not regard the Westerwelle report as at all politically likely, and I think increasingly Barroso’s blueprint for a genuine economic and monetary union is not a realistic political possibility. I do think that the Four Presidents’ report, particularly with its emphasis on banking union and this idea of contracts with member countries, would do quite a lot to improve the architecture of

125 of 441 Centre for European Reform, John Peet and Open Europe—Oral evidence (QQ 1-18) economic and monetary union. I think the move towards eventually some kind of redemption fund or Eurobonds is probably a necessary part of resolving the euro crisis. I think increasingly it is not sufficient, because to me the euro crisis has moved from a point at which markets and actors feared the break-up of the currency. That fear has gone, partly because of Mario Draghi, partly because of the political determination of those in the euro to keep it together. It has been replaced by a chronic absence of growth. I think without growth the crisis cannot be solved, and I am not convinced that even these proposals would be enough to regenerate growth, which I think now is the top priority for the economic and monetary union. Mats Persson: Mats Persson, Director of Open Europe. John Peet: Sorry, I should have said: John Peet from The Economist, Europe Editor. Mats Persson: Thank you very much for having me. Just to add very quickly to what has already been said, I suppose we are really looking at four different crises in this eurozone crisis. You have on the one hand a fiscal crisis, you have a banking crisis, you have a competitiveness crisis, which John was talking about, and then you also have a political crisis, which is both the driving force of all these crises fundamentally, but also then reinforces the other three. It is a very complex situation and we can talk all day about each individual element, each of those four. I suppose the plans that are on the table at the moment, in particular those relating to the banking union, will naturally solve primarily the banking crisis, but we will not address to some extent the fiscal crisis and certainly not the competitiveness crisis. As John said, growth is the primary challenge that we are looking at, particularly in the Mediterranean. It goes some way, but in terms of solving the crisis, not nearly far enough. In terms of the political palatability of it all, as people have been pointing out for the last two years now, it is a very tricky Catch-22 situation that we are stuck in, because one part of the eurozone wants supervision first, strong supervisory controls first, the other parts want solidarity, that is more cash or a backstop, first. It is very difficult to see a political way out of that at the moment. Certainly, it is of course true that in order for a banking union to be effective you need to have both a single supervisor and a resolution fund. Otherwise you are stuck with the same situation that we have now, that the resolution fund, the backstop, is ultimately linked to the sovereign, a national government, which means that the sovereign bank loop is still very much there. Indeed, it can even be argued that it has been strengthened by having that kind of environment. Financially, you want to have them at the same time, but politically that is impossible, so I am afraid that what we are stuck with, with the sequence of supervision first and the backstop later, is the most politically sustainable option, but it is not the one that will immediately solve the eurozone crisis.

Q3 The Chairman: Mr Peet, given your knowledge of the affairs of Italy, do you have a perspective how they might view all this? John Peet: I think the outlook for Italy is still fairly gloomy. To me, Italy quintessentially represents what I see as the current problem of the economic and monetary union. Italian public finances are notoriously disordered, but the budget deficit has been brought firmly under control. Although the debt is high, it is at a level that the Italians have lived with for many years. It is roughly the same as it was before the beginning of the economic and monetary union. But Italian GDP has barely grown since the start of the economic and monetary union. I think that is the overwhelming problem of the Italian economy, and Italy is a large component of the eurozone economy, so we are now seeing similar problems in Spain, Portugal and elsewhere.

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Italy also is representative of the loss of competitiveness that Mats Persson referred to, because again Italy, since the beginning of the EMU, has lost competitiveness very obviously against Germany in particular. It seems to be finding it exceptionally difficult to regain that competitiveness, whereas countries like Greece and Spain have done quite a lot to regain competitiveness in terms of unit labour costs. Italy has done much less. Although Italy now has what looks like, for the time being, a reasonably stable Government, it does not seem to me to be a Government which has the political clout or capital to be able to implement reforms to the labour market or to product markets in terms of deregulation that would do enough to restore competitiveness. So Italy is desperately in need of some source of growth, and I do not see one emerging very clearly in the immediate future. The Chairman: We will consider competitiveness in a minute, but Lord Marlesford, would you pursue Mr Persson’s point about the completeness or otherwise of the banking union? There are two elements that are going forward at the moment.

Q4 Lord Marlesford: Yes. Almost the backdrop to the banking union was the Damascus point, when suddenly Europe realised that the conflation of sovereign debt and bank debt was a great mistake. That was a big recognition. But what happened in Cyprus? There it was a banking crisis. The troika signed off on a deal which even failed to honour the one responsibility which the EU does have to banks, which is to underwrite the deposits of depositors up to €100,000. Therefore, one wonders whether they have really fully taken on board that separation. Do you think that the banking union will of itself do enough to implement that separation, which is clearly crucial?

It was very interesting what John Peet just said about Italy, where the public spending is roughly under control, but the role of the banks and the financial sector, and indeed the Government in stimulating growth, is lacking. To what extent is the banking union going to achieve the objectives and why is it only now they have suddenly discovered that the banking union apparently requires a treaty change? When we went to Brussels to study it, they had an impossibly tight programme to get it going. In those days they were even confused between regulation and supervision.

The Chairman: Perhaps we can ask Ms Barysch to reply to that and to embrace Herr Schäuble’s point that there may be a step-by-step approach that may or may not incorporate treaty change. Katinka Barysch: Finance Minister Schäuble’s statement that a resolution authority that is backed up by eurozone-level funds needs a treaty change is an opinion rather than a fact. Not everybody agrees with this. Michel Barnier says we can do it without treaty change, Olli Rehn says we are still studying this. The Austrian Finance Minister says we need a treaty change, Jörg Asmussen says we do not need one. is quiet on this, so I think we do not quite know yet. Obviously Wolfgang Schäuble is not the one who is trying to hold up this thing, because he is the most pro-European person in the German Cabinet, so when he says, “I want to put this on a sound footing that proves it against the inevitable challenge in the German Constitutional Court” that is probably exactly what he means. Whether the two-step approach is a good idea, the jury is still out, because if you first start by strengthening national resolution mechanisms, you might have a divergence of regimes and then later on you have to merge them again, which might cost us extra time and be inefficient. I would argue strongly with Mats Persson that it would be much better to put all your political emphasis into creating a eurozone resolution authority and fund quite early on. I still

127 of 441 Centre for European Reform, John Peet and Open Europe—Oral evidence (QQ 1-18) hope that after the German elections we will get some movement on that. If there has to be a treaty change, it would have to be the kind of surgical treaty change that we have had before, for example, when we set up the ESM, just to give a legal basis to this. But the real question here is political will. I do not think it is legal.

Q5 The Chairman: Mr Persson, that is not just the treaty change but the three elements of the banking union. Are we neglecting the third, the deposit guarantee scheme? Mats Persson: I do not think you necessarily need that as badly as you need the resolution fund, to be honest, because the resolution fund is what really will break that sovereign bank loop. The deposit guarantee scheme can help, but the resolution fund I think is the key part. You could in theory do the resolution mechanism and fund and the single supervisor at the same time, and then wait with the deposit guarantee scheme and the deposit guarantee fund. Just on this point about Germany and treaty change, I do not know if you know this, but the has one treaty change article and story a month and it is always slightly different. So it is very much a moving target, to put it mildly. I do think that the Germans are quite genuine in their desires, as Katinka said, to put this, whatever new construction, on a constitutionally sound footing, because you have the Bundesverfassungsgericht culture in Germany, the Constitutional Court, which always is looming large. I think we should be very careful about rushing ahead with this in terms of the treaty change or otherwise, because that challenge can create a lot more uncertainty down the road than what we have at the moment, and that will be a nightmare. Imagine if the Constitutional Court in Germany were to strike something down. That would be the worst of all worlds. I would say one final thing about Cyprus, which is quite interesting. The Cyprus situation was extremely unfortunate, because the European Commission last year tabled what I thought was a very sensible proposal, the recovery and resolution directive, where they proposed a pecking order, which was basically taxpayers last, but they had uninsured depositors being safe, so any depositor with less than €100,000 in the bank would be safe. That was a very sensible directive or proposal, but no one read it, for some reason. It was not until the Cyprus crisis happened that people started to realise that the European Commission tabled something that provided for a pecking order. If they can firmly stick to that plan in that proposal, then I think that would be a very good thing, and that in turn could facilitate a resolution fund, because you have a clear pecking order and you have more certainty.

Q6 Lord Kerr of Kinlochard: The second leg of GEMU is economic co-ordination, co- ordination of national economic policies, which of course has been with us since the world began, with mutual surveillance and enhanced surveillance of each other’s policies, but the intention seems to be to give it a bit more by way of teeth, with rewards for those carrying out structural reform and sanctions for those not carrying out structural reform. How does this work? There is a sort of paradox here, is there not, a risk that those who most need structural reform will not be assisted to do it. Could it be legally binding? Could sanctions be legally binding unless there were a treaty change making them so? And should the UK just sit on the side? I would like to ask Mr Persson why Sweden, for example, thinks that this element of fiscal union is fine and why Mr Persson thinks the UK thinks it is not. Mats Persson: Should I start? The Chairman: Please. Mats Persson: I do not know if Sweden does think that it is fine. Sorry, John, do you want to—

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The Chairman: No, you start and then we will go on to Mr Peet. Mats Persson: I remember I was here I think last year, two years ago, and we had a bit of a conversation about whether Sweden would join the banking union. I said no and you said they would. I think I was right on that one. So hopefully I am right on what I will say now as well. There is no guarantee, but I think countries like Sweden are also quite uncomfortable with the prospect, not so much of fiscal supervision or that they are not happy about it, but where that will take the EU. If there is one red line that even the most ardent Europhile in Sweden will tell you about, that is the transfer union and that is something that Sweden will never sign up to. But certainly it is more contentious here in the UK than Sweden. To what extent the UK should sit on the sideline or not, I just think it is very tricky for the UK to be part of this for various political reasons. But it does not mean that it should not make all the efforts it possibly can to sit at the table. We all agree with that.

Just on the enforcement mechanism, on this idea of contracts where Germany basically provides cash in return for guaranteed structural reforms or what-have-you, fiscal structural reforms, it is intellectually and politically much more appealing at the end in Eurobonds or the current system, where you have long guarantees, because it does give the Germans and other creditor countries much more control. But as we all know, you put your finger on the key point, which is: how do you enforce it and can you achieve the kind of court-style supervision powers that will be needed to guarantee that these countries will stick to the contracts? For that to happen I am pretty confident that you would need a rewriting of the European treaties, and indeed possibly of the entire European order, and even in some sense the entire Westphalian order, because taxation spending will no longer be the core competence of nation states, it will be outsourced to foreign capital. So it will require a lot of political will to get not only the proposal but also the enforcement powers needed for this to work.

Q7 The Chairman: Mr Peet, would you take that up, and particularly the point you made earlier about competitiveness, the need to turn attention to doing something about unemployment? John Peet: I think conditionality is a perfectly sensible approach, and in a sense we have seen, with the involvement of the IMF and the successive bailouts—Greece, Ireland, Portugal, Cyprus, possibly Slovenia looming—that conditionality clearly is enforced. That is how bailouts work, but I do think there are always big questions about the application of sanctions in practice. President Van Rompuy is very attached to the idea of these contracts and he believes that they can have teeth as well as, if you like, carrots. I have more doubts about them. I think when it comes to structural reforms to improve competitiveness, countries have to believe in them for their own sake. The idea that they will only do them if they have signed some contract, and if they deviate from them they will lose access to funds, is very questionable. I agree with Mats Persson that if you rewrote the whole treaty you could make this a requirement, but I find it hard to see that happening. I think the experience of the Stability and Growth Pact does weigh here. Everybody signed it and it was a binding commitment, but when it came to applying it, if two big countries decided they wanted to ignore it they were able to ignore it. I think a similar question has arisen—which I know this Committee has discussed—on outright monetary transactions. If we were in a situation where the European Central Bank had promised to assist one particular country’s bonds provided it observed the rules, it is very difficult to see how the European Central Bank could suddenly say, “You are no longer

129 of 441 Centre for European Reform, John Peet and Open Europe—Oral evidence (QQ 1-18) observing the rules, so we are going to cut you off” because cutting a country off could be tantamount to throwing them out of the euro. So sanctions are extremely difficult to apply if a country, particularly a big country, does not believe in what it is required to do. You need to establish, and I think we have established, a general consensus in favour of structural reforms to regain competitiveness and growth, just as we needed to establish—and I think we have to some extent established—a general consensus in favour of fiscal discipline. But it is always going to have to be done, in a sense, by negotiation and consensus rather than by sanction and punishment.

The Chairman: Ms Barysch. Katinka Barysch: I would like to reinforce the point that John Peet has just made, that once a country is within some sort of support mechanism it is very hard to cut them off. That also applies to the debt redemption fund, by the way. The general point on how to force reforms on to unwilling countries is of course the big issue here at the moment. At the end of last year, Germany was very enthusiastic about these reform contracts, and it was absolutely willing to complement that with some sort of eurozone budget to incentivise countries. I think the fact that France then started talking about, “Then why do we not do a eurozone-wide unemployment scheme?” killed off the idea of a eurozone budget for now, because it looked a little too ambitious for the German taste for now. There is another mechanism beyond Brussels’ imposed conditionality that can get countries to reform and that is market pressure. That is another reason why people in Germany are so reluctant to go down the route of debt mutualisation, because what we have experienced in the first decade of monetary union is the effective economic situation when you have debt mutualisation, i.e. we all had German interest rates and countries were not doing anything to reform their economies, they just enjoyed the good economic times. Spain and Ireland, yes, they kept their budgets in order, but in terms of structural reforms, it seems that whatever we had in terms of central co-ordination mechanisms did not work at all. That is the experience that makes Germany now very cautious in moving towards a situation where once again the market pressure is blunted because we all have the same risk-free German interest rates. So I think a combination of tougher and, may I say, easier to understand central supervision and market pressure could make a difference. Since the eurozone crisis started, we have implemented so many reforms in the eurozone governance mechanism that now we are at a point where it might become ineffective, because there are so many different layers—the six pack, two pack, the imbalances procedure, the Stability and Growth Pact, the fiscal pact, which also has a structural reform component—that I would say before we go down the road of thinking about reform contracts we have to clean the system up because we are losing the overview. The last point that I would like to make when it comes to Brussels oversight, the Constitutional Court constraint in Germany applies to that as well because the Constitutional Court does not think politically. It does not say, “I let this go through because it will not apply to Germany”. That is not how the court thinks. So if you want to have a budget commissioner that can really tell eurozone Governments what to do, or if you had a European Commission function that can enforce structural reforms that would at least in theory apply to Germany, at the present point in time it would be incompatible with the German constitution.

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Q8 Lord Kerr of Kinlochard: Can we look at the tax volet of this, which seems to me to be a rather unlikely extension of economic policy co-ordination. As John was saying, tax is the Ark of the Covenant for various member states, and yet there is talk of an EU fiscal capacity and so on. Do our witnesses agree that that is quite a long way down the road, if at all? I personally would like to know whether they also feel that it is unwise to pursue tax harmonisation as an element of economic and monetary union. Where it is most likely to get somewhere, it seems to me, is as an element in the single market. I have never understood why Governments were so reluctant to buy what business certainly wants, which is a harmonised corporate tax base, with member states free to set whatever rates they wish. But the savings to companies from doing away with the inefficiency of completely different tax bases in all our countries would be enormous. Anyway, can I ask whether our witnesses think the tax dossier is going to go anywhere as part of this programme? The Chairman: Mr Peet, if you will be kind enough to answer that and perhaps even bear in mind the UK, which sees the single market as pre-eminent. John Peet: I would offer two responses. No, I do not think tax harmonisation is likely to go anywhere and I do not think it should, in the sense that some countries have for a very long time wanted to see more tax harmonisation in the European Union. But this is because they see other countries, as it were, with some competitive advantage because of having low taxes and they want to get rid of that or find some way of getting rid of that, and I think they tried to do this through the single market. To some extent they may be trying to do it now through membership of EMU, and clearly some pressure has been applied during this crisis, particularly to Ireland, on this. But tax continues to be a matter for unanimity in the European Union, as it should be. I think Lord Kerr is perfectly correct that it might be sensible to have some forms of harmonisation, for instance, with corporate tax bases, just as we have had some forms of harmonisation in relation to value added tax. But the reason countries like Britain, Ireland and one or two others resist this is because they see it as a prelude to harmonisation of rates, which they clearly want to resist. In my view, taxation should continue to be a matter for the single market and I think tax harmonisation, in the sense of rate harmonisation, should be something that Europe should studiously avoid.

Q9 The Chairman: We are now so interested in raising tax. We have a separate issue on Google, which is placing Ireland as its headquarters and so on, and other companies like that. Does it all betoken that we are going to have to rationalise, maybe at an EU level, but maybe at an international level, this tax take? Mr Persson, could you help us with that? Mats Persson: The short answer—if I can help you with that—is probably no, to be honest, because I think it is a slightly different issue. But I think it is quite an interesting one that will probably come more and more to the fore, whether this has to be done at an international level. That pressure may bring forward some sort of international solution and perhaps an EU one as well. The UK has been very active on this front, which is quite interesting. But maybe I can offer a more fundamental point about this idea about harmonising tax and harmonising fiscal policy and related policy as well in the eurozone. I agree that there is a strong case in some ways for CCCTB, a strong business case. I do not take issue with that. It is politically complicated, but there is a strong business case for it, but I would be very cautious of going down the road of tax harmonisation, partly because of the reasons I mentioned. You need that national ability to adjust to different business cycles, to different economic circumstances, and you need systems competition. If one country does not get it

131 of 441 Centre for European Reform, John Peet and Open Europe—Oral evidence (QQ 1-18) right in Europe, you need to have the ability to have the right of exit, for example, if you are a business, and you need to have the ability to follow best practice. I think there is a very powerful school of economic historians out there who have shown that one of the reasons why Europe grew wealthy and successful in the first place was precisely because you had competing systems and competing national systems, and I would be very worried about taking that away as part of further eurozone integration. The Chairman: Lord Marlesford, you were trying to come in on a question.

Lord Marlesford: I wanted to go back to something Katinka said, which is very interesting, to establish whether I have it right. The German Constitutional Court, is clearly very important in these matters. Am I right in saying that you were suggesting that the way they look at issues is not as to whether or not they affect Germany, but on the basis that if they were to affect Germany that must be the criterion for deciding whether they are acceptable or not, because that is a much broader interpretation and could make their influence on all reforms quite important? Am I correct? Katinka Barysch: That is correct, yes. Lord Marlesford: Fine. That is very interesting.

Q10 Viscount Brookeborough: I should declare the interests as laid down in the register that is available to you.

Could I ask a different point just to begin with? It is about Germany. Germany has an election coming up. We know quite a lot about German policy and yet we are often told that they are playing to the electorate at the moment. First, do you think that their policy, especially on such things as bailout, will continue to be the same after an election if Angela Merkel is successful?

Secondly, a more general question: obviously we cannot have single dates for elections throughout Europe, but are we not always going to be plagued by this, because countries will be playing to their electorate? At the moment it happens to be Germany, which happens to be the most powerful. The Chairman: Perhaps we should tell Ms Barysch that—I think the election is on 22 September—we, as a Committee, are hoping to come over to both Frankfurt and Berlin in November to gauge the mood.

Viscount Brookeborough: If there is going to be a change in policy—obviously you cannot tell us, or you do not necessarily know—but if that could occur, then this is always going to distort these sorts of things, and at the moment it is Germany that is more powerful. Katinka Barysch: My prediction is that the broad approach of Germany to handling the euro crisis will not change after the election, irrespective of who is going to be elected. Angela Merkel certainly would not change her stance very much, but even if we had Peer Steinbrück in power afterwards, although he calls more for European solidarity at the moment, but being very careful not to mention Eurobonds and being ambiguous whether he would even support a European debt redemption fund, consider this: the Germans overwhelmingly support Angela Merkel’s handling of the euro crisis. This is one of the main reasons why, at the end of her second term, her approval ratings are an astonishing 70% and

132 of 441 Centre for European Reform, John Peet and Open Europe—Oral evidence (QQ 1-18) the people overwhelmingly want her for a third term as the Chancellor. They believe that the way she has handled the crisis has looked after their money well. If you had Peer Steinbrück—who does not enjoy the trust of the people, although he used to be Finance Minister—who talks about solidarity and, “Why do we not make some more money available for our neighbour?” he might have less room for manoeuvre in the Bundestag because people trust him less with their money than Angela Merkel. So if there is any idea that after September you will see a massive outbreak of German generosity, I think that idea must be disappointed. Of course we have elections playing into European policy-making, as they do in this country. That is called democracy. I think that is entirely normal and I always urge people to start paying more attention to small countries because what happened in the euro crisis is that the old principle, where we at least like to pretend that in Europe all countries are equal, has broken down. This is a crisis, this is a matter for the big guys to get together on the phone and sort things out between France and Germany. The smaller countries are usually just informed about what has been agreed and they occasionally will vote with their feet and throw a spanner in the works, and all of a sudden you have a little crisis in Slovakia or in Finland or perhaps in Austria. So maybe it is small countries rather than the big ones that cause the next crisis. John Peet: Can I just add a supplement to what Katinka has said, which I agree with, particularly that German policy is unlikely to change after the election, whoever wins, and whether there is a grand coalition or a coalition led by Steinbrück. There is almost always a German election. If it is not the federal election it is a state election, so my experience over the past 10 years is always there will be a German election on the horizon that you need to worry about. The Chairman: Let us have Mr Persson, and then come back to you. Mats Persson: Yes, there are also the Bavarian elections coming up, by the way, which will be quite interesting for a whole range of different reasons. But I think you make an excellent point. Fundamentally, I think this is the problem, the deepest problem with the eurozone: it is a supranational currency governed by 17 national democracies. Again, short of rewriting the Westphalian order that was created in 1648, it is difficult to see a way out of that. So we will live with that for quite some time, I think. But on Germany, I really want to reinforce what Katinka said, and since Swedes are basically Germans speaking English, I suppose I can wear both hats here. What I usually tell people is for a German to advocate loose money policy or this unconditional solidarity, it is a bit like an American presidential candidate proclaiming that he is an atheist or for a Swedish politician to deny climate change, which is almost punishable in Sweden. So I think this will not change—it goes so deep. You see some tweaks to the policy, but the basic German belief in sparpolitik, in saving politics, in doing your homework, is so deep that it will not change. I think it is too strong to change due to electoral cycles. So we will be living there for quite some time.

Q11 Viscount Brookeborough: Could I ask you about the integrated budgetary framework and fiscal capacity in the short term and euro area budget in the longer term? Even in the light of what you said about harmonised taxes, why is such a budget necessary and can it be achievable, even in the longer term, if we remain taxed as nation states at the moment rather than harmonised tax? How would it be funded and would it require new institutions and how might it affect non-members?

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Mats Persson: So EU tax and EU budget? Viscount Brookeborough: Whether or not a euro area budget is really achievable. Mats Persson: It probably could be achievable because we have an EU budget that already has some transfer elements to it, and I think the way to do it is through this contract idea that you get cash in return for firm commitments and firm conditionality.

Viscount Brookeborough: But if you fail to conform to that, then you are hitting the people who need hitting the least. Mats Persson: Yes. That is where it becomes tricky, which we discussed before. First, is it credible to impose sanctions on the countries that can least afford it, probably smack in the middle of a crisis where you have possibly liquidity problems, for example? So it is quite tricky. You can always have a eurozone budget—that is not the hard part. The hard part is to get credible enforcement, and that is where you get back to that Catch-22 again: will Spain or even France allow such a dent into their parliamentary and budget sovereignty to allow basically sanctions imposed by the eurozone north via the institution? It is a very tricky one. You probably need a new EU institution, or at least a strongly beefed-up European Commission to be able to act as the budget police or the structural reform police. That again probably will require a treaty change. In terms—

Viscount Brookeborough: Also very large funds. Mats Persson: Quite large funds. If you look at the proposals out there for a eurozone budget, they vary. The Germans, when they talk about this, imagine a fund and budget worth around, what is it, €30 million to €34 billion, whereas the French are talking about €150 billion. If you think about this as a budget, it is supposed to pay for unemployment benefits. You can just imagine, for example, extending that to Spain, a country that spent €30 billion to €40 billion alone in 2012, I think, on employment benefits, so it would have to be a very large budget. It can be from the German idea, which is 0.3% of eurozone or EU-wide GDP or it can be the French/Spanish idea, which is a massive budget, where we move into a whole new territory. That is very much an open debate, and of course how to raise the cash for it. Will it be through EU taxes? Will it be through the current type of contributions where you have a mixture of different sources? All of these are open questions, but we know that they will be politically extremely difficult to handle.

The Chairman: Mr Peet, perhaps a beefed-up Commission and a beefed-up budget? John Peet: I have to say I have become quite sceptical about this proposal. I think the theory underlying it makes perfect sense and goes back to what the MacDougall report said, that if you have a single currency, because of the need for explicit transfers between certain regions and because of the inflexibility of the European economy, a large central budget—I think he had in mind 7% of GDP—would make a lot of sense. I think from an economic point of view, looking at the United States, with a substantial federal budget, there is a lot in the MacDougall analysis. But politically I think it is almost out of the question because it would explicitly formalise the establishment of what in Germany certainly would look like a transfer union. I am not convinced that a central budget for the eurozone is necessary to help the euro to survive. I think banking union and some of the other measures we have been talking about to improve competitiveness are far more important. A banking union would probably entail a form of transfer and so indeed would some kind of Eurobond or redemption fund. But a central budget with a new budget commissioner would be politically extremely difficult to

134 of 441 Centre for European Reform, John Peet and Open Europe—Oral evidence (QQ 1-18) sell, and I think it would pose difficult problems for countries that are not in the eurozone, because it would be another large step towards the creation of, in a sense, a separate organisation that is different from the European Union, and I think a further division inside the European Union would not be helpful.

Q12 The Chairman: Before I pass on to Lord Flight, perhaps, Ms Barysch, you would like to take the point made by Viscount Brookesborough, and throw into the pot sometimes the comment you get of a Marshall Plan perhaps reinforcing any such budget. Sometimes it is called a Merkel Plan, which helps in some of the objectives of reviving the economy. Could you entertain that? Katinka Barysch: Do bear in mind that the Germans do not feel rich enough to bail out the rest of the eurozone. Yes, to help them regain market access and to provide emergency cash, but they certainly do not feel rich enough to give them any kind of permanent transfers. Do bear in mind that the German transfer union, the Länderfinanzausgleich, is once again in the headline news; some states are suing against it because they are fed up with permanent transfers from Biengen and Baden-Württemberg to the Neue Länder in eastern Germany. So if that is controversial at the national level, you can imagine how controversial it would be if we had permanent transfers from the south of Germany to the south of Italy. Why would we need a central budget? I think the economic rationale for this is that in a monetary union we lose a degree of flexibility to react to external shocks to your economy. So we want to have a stabilisation mechanism. It is my experience, when I look at how countries handle that, that the discretionary fiscal stabilisation over the cycle does not seem to work very well. Very few countries save enough money in the good times then to have enough cash available in the bad times to stabilise their economies without getting massively into deficit. I do not expect that to be different if we had a eurozone level budget. If we do move down that road—and this is a very long-term perspective—it would have to be entirely automated so that these transfers do not depend on squabbling between Governments that are beholden to their electoral cycle, as you point out. So we would have to have it entirely automated, some sort of European tax revenue. There are some proposals out there where you collect money through European corporate tax and then pay it out in the form of European unemployment benefit, in which case of course you would have to completely harmonise how we run our unemployment benefit system, because it could not be that it is easily available cash in Belgium but you have to work very, very hard for it in Estonia. So countries need to be aware that when they go into this sort of eurozone level stabilisation mechanism, it has to be automated, it has to be individual claims, not Governments squabbling, and it has to be based on harmonised institutions. Again, I am not saying it is impossible in the long run, but I certainly do not think it is a resolution to the current crisis, and partly because at the moment the debtor countries are too panicked to agree to anything like this. Once the economic situation is stabilised in Europe, you might well find that Germany, Finland, Austria and the Netherlands feel more generous than they do at the moment in this situation where they are really deeply panicked.

Q13 Lord Flight: Can I push further in the territory of debt mutualisation? I think it is clear that Eurobonds are politically absolutely out, although long term, if the currency union is to survive, it will probably have to be structured like the US. But there are other aspects of debt mutualisation, and it seems to me somewhat strange that while the German

135 of 441 Centre for European Reform, John Peet and Open Europe—Oral evidence (QQ 1-18) mentality is, “Oh, we cannot afford this, must not do that” through the back door the Bundesbank is owed €600 billion or €700 billion by the weak economies of Europe, and to the extent the ECB may at some stage in the future have to buy the bonds of weaker economies on a large scale, again Germany has the largest single stake in the ECB, so if the ECB gets into trouble there is another massive cost to Germany. So I think it is political rather than for real, because for real, Germany is in it up to its neck in terms of sustaining the rest of Europe while there is a common currency. But I would like to ask particularly about debt redemption fund proposals put forward by the German Council of Economic Experts, in that although it is yet another kind of one-off, I can see that it might be acceptable and might be another pot of money to keep government debt afloat. The Chairman: Ms Barysch or Mr Persson, perhaps you have got a view on that one. Mats Persson: It sounds very good and it has more legitimacy in Germany, I think, than a lot of the other eurozone proposals because they come from that group of economic advisers who are generally regarded as very credible. Fundamentally, you have the same problem with that proposal as with some of the other proposals. What happens if Germany, other credit or countries, buy up jointly the debt of southern member states and the reforms are not happening? The idea is that you buy up, you have any debt above 60% of GDP basically jointly underwritten, and the creditor member states are supposed to take almost responsibility, take charge of that debt to wind it down. Then of course it still requires that mutual agreement between a debtor country and a creditor country, where the debtor country must reform, must execute the decisions coming from the eurozone north. Again, you can easily see how that breaks down through the political bickering that we have seen throughout the eurozone crisis, and what is supposed to be a temporary mechanism becomes awfully permanent. I think that is the worry. Then you have the whole issue of moral hazard. Then of course you have a lot of other problems as well, such as how do you actually implement this on existing stock of debt? What is national debt? What is euro debt? It may create quite serious distortions in the bond markets because the national debt will obviously be infinitely higher. Sometimes the yields will be infinitely higher than on the euro debt. So there are a series of problems. I think if you can avoid this proposal it definitely should be avoided. Then of course the idea behind this is that it is supposed to be legally sound or at least it can be done legally without a rewriting of the basic law, I think. That is the theory. To be honest, I have my doubts about that because as soon as you move to joint and several liabilities, that is why the Bundesverfassungsgericht—the German Constitutional Court—has said that is when you need a new constitution in Germany, and this might just trigger it. That would create all kinds of headaches.

Lord Flight: It sounds as if you are saying it is not on. Mats Persson: I would think it has more political legitimacy in Germany, but I am a huge, huge Eurobond sceptic, no matter what the form is.

The Chairman: Mr Peet, are you a sceptic? John Peet: I think in political terms “debt mutualisation” have become two words that are almost unusable in Germany, and we just have to accept that. In logic, I think there is still an argument for some form of debt mutualisation, probably at the end of the process rather than, as some of the debtor countries hoped for, at the beginning of the process. If you are going to have any kind of debt mutualisation scheme, I do think that the debt redemption fund of the Council of Economic Experts is very appealing because it has the advantage of

136 of 441 Centre for European Reform, John Peet and Open Europe—Oral evidence (QQ 1-18) incorporating some debt mutualisation but still, formally speaking, leaving the debts as the responsibility of the national countries that incurred them. Whether you need something here in order to solve the euro crisis, I am in two minds about. At one point I thought you probably did, but I think the action of the European Central Bank in holding down interest rates over the past six months has suggested that you can almost achieve this by the back door, provided the European Central Bank is operating on your behalf. The political acceptability of the European Central Bank achieving a form of debt mutualisation—which I think Lord Flight hinted at—is itself questionable, but it may be that it is easier to sell to the German public than an explicit form of debt mutualisation.

Lord Marlesford: Is not the Eurobond a pretty explicit form of debt? John Peet: Yes, it would be. It would indeed be an explicit form of debt mutualisation and that is why I think it is not acceptable to Germany. The European redemption fund, had it been taken up at an earlier stage, might have become something that was politically more acceptable in Germany, but I think we are now in a situation where the European Central Bank is operating, as it were, through the back door. That perhaps is more acceptable too, although it remains to be tested.

Q14 The Chairman: Ms Barysch, can you just tackle Lord Flight’s point, but I would be very interested to know from you your view of the ECB and its interventions. Do you foresee this growing? Is the ECB growing in strength in that way and having a more and more influential role? Katinka Barysch: The ECB is already today easily the strongest organisation in the eurozone as a result of this crisis. The beauty of the TARGET2 imbalances is that nobody understands them, so although Hans-Werner Sinn has done a very good job in talking about this incessantly on the German media and on our daily talk shows on television, most Germans still do not understand what he is on about. It is not an easy thing to understand, because even if the eurozone broke apart tomorrow, it is not entirely clear that the Bundesbank would have to repay that money because it is not an immediate claim from somebody else. The best economists in the world have disputes about what these TARGET imbalances actually mean and whether they constitute a debt of one party against another, so that is indeed a form of mutualisation that is politically acceptable because it is quite so complicated. Let me make a wider point about central banking and Germany. At the beginning of the crisis many commentators in this country were always saying, “Why does Angela Merkel not tell the European Central Bank to buy more bonds?” What they fundamentally do not understand is that Germans really believe in central bank independence. They think they invented it and they take it very seriously. So you will not have a German politician, of whatever colour, ever going to a microphone and telling a central bank what to do. It is just not done. They do not tell the Bundesbank what to do and they do not tell the ECB what to do. Of course in the newspapers now you have a debate about whether the ECB’s more unorthodox monetary policies and the vast extension of its mandate that the crisis has brought about is a good thing or a bad thing, but politicians in Germany will always be extremely careful to talk about this in public. If you talk to people around Angela Merkel in private, they have from the very beginning said that the sums that we ultimately need to get through this crisis in terms of short-term liquidity, the German Government cannot make available for fiscal reasons, but also for political reasons.

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So the ECB is the only body that can stand ready to make these vast sums available. The Germans do not like it. They think it is dangerous, but they know there is no alternative. So the German political leadership stands behind what the ECB does. Jens Weidmann, head of the Bundesbank, keeps criticising it. That is exactly his job. That is how we want our central bankers to be: orthodox and arrogant. But the Germans basically know that there is no alternative to what the ECB is doing at the moment. The question then is: how do we get out of this once the crisis is over, because you build up expectations that somehow the ECB is now responsible for growth in southern Europe and that is of course a problem.

Q15 The Chairman: Colleagues, I will ask a question and then Mr Persson, you answer, only because I think you want to say something, but we are now beginning to get short of time. I wanted just to move on to the institutional aspects, just to say to Ms Barysch: in our most recent publication on the euro area crisis, we interviewed the ECB Vice-President, Mr Constâncio, who was very open with us. That was on the banking union aspects, which of course are separate from the main ECB functions, but I wondered whether the three of you had any thoughts you could offer us about institutional changes, especially enhancing democracy within the European Union about many of the institutions that we have currently. Mr Persson, you wanted to come in on the other one, but perhaps you could incorporate your answer there. Mats Persson: Thank you very much. I will try to be brief. I am going to add two points about the ECB. I obviously 100% agree that this is a more politically palatable way of doing it than to have outright transfers or explicit debt mutualisation. But the question is: is there a limit to that as well? I think what is interesting politically in Germany—and it is of course true, as Jacques Delors said—that not all Germans believe in God, but all Germans believe in the Bundesbank. That still very much holds true, there is that central bank ideal. So at the moment the Germans do not really feel the crisis, but if there is some point in the future where, for example, savers start to feel that there is a cost to the eurozone crisis or if the German economy starts to deteriorate, will also the view of ECB intervention change in Germany? Is there a political limit in Germany to what the ECB can do? The second point I want to make is that there is a very interesting court case coming up, because the OMT programme has been challenged at the German Constitutional Court. So it will be key to watch the Constitutional Court’s reasoning around that. It probably will not strike it down, but the question is: how tough will it be on the OMT and its legality? The third point I want to make about ECB liquidity is that there is a political limitation to countries accessing that, and we do not know exactly how it will work once it is tested, because in order to get to the ECB OMT you have to go via the European Stability Mechanism, meaning that you need to be on a bailout programme. So it is not a political liquidity provision, it is actually a very politicised one that still requires countries to be on a bailout programme. So you still have that need for Bundestag approval, for example, and the risk that Spain and Germany, for example, play ping-pong over conditionality at a time when the crisis can erupt again. So it is not as simple as it may seem, but I just add that. In terms of the institutions, I think the key question is: how to make all of this more democratic and with democratic legitimacy. I think there is one key reform that has to take place, and that is national Parliaments simply have to be involved to a much greater extent, and they have to be involved prior to decisions being made. I disagree with people who say this will force a deadlock on to the eurozone or that will make us lose time, because the great advantage of having national Parliaments involved and anchoring a decision with them is that you get away from this ridiculous situation that we had in the eurozone in the last three

138 of 441 Centre for European Reform, John Peet and Open Europe—Oral evidence (QQ 1-18) years, where EU leaders agree to something during a panic-stricken weekend and then they spend months, or even years—as was the case with the EFSF’s actual lending capacity—to try to figure out what they actually agreed, because their national Parliaments have uncomfortable questions. If you instead anchor this for the national Parliaments beforehand, I think you can save time in the long term. So I think that is a key element that has to take place. The Chairman: Ms Barysch, do you agree with that? Involve the national Parliaments? Katinka Barysch: Yes, I do agree, and already, especially in Germany, the Constitutional Court rulings, which have ruled on every aspect of the eurozone crisis, are usually to call on the Bundestag to get more involved—the Government now has to go to the Bundestag during negotiation and keep it up to date. Not get a mandate, as they do in Denmark, but keep them up to date and not just present them with a fait accompli. When I read Barroso’s report on genuine monetary union and also the report of the Foreign Ministers, I would caution against the idea that you can close the EU’s democratic deficit, as it is usually referred to, through some institutional fix. The natural reaction to the rapidly falling support we have for Europe at the moment is once again to strengthen the role of the European Parliament. That almost certainly will not work. I cannot imagine that the people in Europe will start loving Europe again if the European Parliament has a debate on the Commission’s annual growth survey ahead of the European semester, which is one of the proposals that is being floated around. I also do not believe that the direct election of the Commission President will make a difference. I think it could backfire in the sense that you have several candidates travelling around Europe—and I still wonder how a German candidate would fare in a Portuguese market square, but that is by the by—and promising things that people care about: jobs, growth, social security, better education, then getting into office and not having the resources or the powers to deliver any of these. In a way that could make the people even more disappointed with Europe if they start believing that Brussels could be responsible for these things. But it really is not. So I agree with Mats that the best hope we have is to get national parliamentarians involved, and moving very slowly towards more of a European debate of economic policy, so that people become aware that what their Governments are doing in terms of budget, employment legislation, and pension reform is part of a wider European picture. That will take many years, but I am really cautious about having a quick institutional fix to what is indeed a very, very deep political problem in Europe. The Chairman: Before I ask Mr Peet to reply, Lord Flight, did you have a supplementary there?

Q16 Lord Flight: I had a supplementary. You did not pick up the point that the Bundesbank was ending up financing everything because what happens is that as banks withdraw their lending in countries with problems, their central banks have to take over and the balance of that washes through to the central banks of Italy, Spain and so on, mounting debt to the Bundesbank. That is how the Bundesbank has come about funding €600 billion or €700 billion—it is moving around—of the failing economies. That seems to be hidden and no one talks about it, and my key point is that it is a major form of backdoor debt mutualisation, more direct even than what may go through the ECB, which is contingent. The Chairman: Ms Barysch, do you want to pick that up and then I will go to Mr Peet.

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Katinka Barysch: In just one or two sentences, the Germans are having a debate about these TARGET imbalances. They have been very much in the news. This is a very complicated subject, which is why it does not frighten the Germans as much as perhaps it should, and I think most Germans are by now also aware of the fact that these imbalances will only matter if and when the eurozone breaks apart, because so far it is only an accounting system—they are not real claims. So since we do not assume that the eurozone will fall apart, it is in the German debate, but it is also a well known fact in Germany that these TARGET imbalances seem to have peaked and they are now coming down again. Mats Persson: Also no new credit is created, which I think is quite important. Sometimes from looking at the German debate you get the impression that this is new credit, new money is being created and that is not happening.

Lord Flight: The transfer of debt. Mats Persson: Yes. The Chairman: Mr Peet, institutional change and then we must go to Lord Kerr for our final— John Peet: Yes, and I think I can be brief, because once again I agree with both the previous witnesses. I have been struck, during the debate over the last two years, how few people— even people who I regard as enthusiastic federalists—think that the solution of this problem is to increase the powers of the European Parliament. There are still some who think that, but a larger majority believe that when it comes particularly to fiscal policy, public spending and taxation, a bigger role for national Parliaments is absolutely essential. I do think that the European Parliament could be a problem for this, because there is a bit of a power game within Europe. Greater powers for the national Parliaments in these areas might come at the expense of the European Parliament. If we ever get to another round of treaty change I would expect this to appear on the table. At the moment, the European Parliament’s powers have increased under the Lisbon treaty and they will play a bigger role in the choice of the next European Commission President. The Chairman: Lord Kerr, our final interest.

Q17 Lord Kerr of Kinlochard: Yes, I should declare my interests. They are in the register, but one of them is that I am chairman of a think tank where Katinka Barysch has been deputy director for several years. I have always made it my practice to agree with everything she says. That is why this has been such an amicable session.

I would like to test John Peet on one thing he said about the central bank and about resolution mechanisms and mutualisation of debt. He said that he had believed that it would be necessary to have some sort of resolution mechanism, mutualisation mechanism, but the ECB's use of the back door was working so well that he no longer believed that. But supposing that Europe adopted the Peet prescription and got some growth, and supposing it got some inflation—which might not be a bad thing—the central bank might then feel that use of the back door had to stop, and then what happens? A question for Mr Peet.

You want me, Chairman, to address the singularity of the UK in all this and what our position should be. Our three brilliant witnesses are describing the future. What we see in the present, and we will see in next year’s European Parliament election, is that the British can no longer hold any of the key jobs at the centre or any of the key jobs in the Parliament, because so much of the agenda of the European Union is to do with monetary union, from

140 of 441 Centre for European Reform, John Peet and Open Europe—Oral evidence (QQ 1-18) which the UK has stood aside. This I think is quite a dramatic development, and a rather sad development.

The British Government say that the important thing is to retain the integrity of the single market. I quite agree. I am sure the Commission quite agrees. But will it be achievable? Will it be possible, as the members of the fiscal union, the members of the monetary union, the members of banking union meet together, and they tend to be mainly the same people, except that we are never there? Will they not, with their qualifying majority, be inclined to push the single market in directions that suit them, and because we have not been at the table, will we miss out? Is there anything that can be done about that or is that just the way the world is going? Lord Lawson says that people like me should accept that this is a natural consequence of not being in the euro and we must learn to live with it. Is that right? The Chairman: Ms Barysch, I am aware that you have to leave very shortly. Would you like to tackle Lord Kerr’s question first? Katinka Barysch: I will leave that to John Peet. John Peet: Perhaps I can tackle briefly both Lord Kerr’s points. I think he has a good point on the first detailed question. The reason why I thought some form of debt mutualisation, possibly through the Council of Economic Experts’ plan, might be necessary was because I found it difficult to see any other way of being sure that you could bring down the bond yields of peripheral members of the eurozone to tolerable levels, but in fact the European Central Bank has found a way of doing that. If they stop doing it, then we might have the problem emerging again. In that case, I think it would be desirable to move to some kind of debt mutualisation scheme. But I think the central bank has now gone down this road so deeply that it will probably continue to do this even when growth returns. On the role of Britain, I do think that it is highly unlikely that a British candidate could ever become President of the European Commission or take the Economic and Monetary Affairs portfolio. A British candidate could take the single market portfolio, and I think that might be a desirable thing in the next Commission. I do not know whether the European Parliament would reach similar conclusions, but it would not surprise me if some people in the European Parliament think that a British Chairman of the Economic and Monetary Affairs Committee is an anomaly. It has been said that Sharon Bowles’s position is anomalous. I think that so long as Britain is out of the euro, Britain does just have to accept that, but that does not mean that Britain loses any influence in the single market and in the wider Europe. If there is a positive interpretation of David Cameron’s agenda on Europe, to me it is to sustain British influence throughout the European Union, with the exception of the business of the European Union that pertains directly to the euro. I think there are countries both inside and outside the euro that would want to see that British influence sustained, including Germany. It is the job, if you like, of a British Government to make sure that continues to happen. Sometimes I worry that the British Government is not as good at this as, for example, the Swedish Government, because the British Government has often not been as good at making sure that it has allies to try to ensure that that happens. I think that even most members of the eurozone would find it undesirable for the eurozone to dictate everything to the rest of the European Union, not necessarily all, but most, and I think we should continue to play on that view.

Q18 The Chairman: Ms Barysch, you are nodding your head there in agreement.

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Katinka Barysch: Irrespective of the broader picture of where this multi-directional Europe is going, a country’s influence, in my experience in European policy-making, also depends on two factors: first, that it sends lots of clever people to Brussels who come up with clever ideas and fight for them, and second, very importantly, how their country is doing economically. Countries that are doing well economically have a lot of clout in Brussels and countries that are flat on their back economically do not have a lot of clout in Brussels, so that also depends on whether Cameron’s economic strategy pays off. The Chairman: Mr Persson. Mats Persson: Thank you. I think this is a key question obviously, and I think we have had this conversation before. I think it is a challenge and I must say this: I am always surprised by British Eurosceptics who are so sceptical about everything in Europe, apart from the belief that the eurozone can automatically press ahead with a full-scale fiscal and banking union tomorrow. I call it Eurosceptic fiscal federalism, which is quite an interesting concept. So by saying that, I also want to put on record that I fundamentally disagree with Lord Lawson. I think his analysis is overly pessimistic and defeatist. But there is a challenge for Britain, of course. That challenge is most conspicuous, as we all know, in the area of financial services because that is where you have the most overlap between the single market and an evolving banking union. The exact extent of that challenge will depend on how much the eurozone will be able to do in common, and as we have discussed, there are tons of political challenges to that, but it is something that Britain has to take seriously. I am a bit disappointed in the UK Government, because during the first two years of the eurozone crisis, the Treasury—and No. 10 in particular—made a habit of lecturing the eurozone on the need to move ahead with a fiscal and banking union, but at the same time they were saying, “If you do that we are going to veto the treaty change that may be required to do so”. It is quite inconsistent, and I would have preferred the Swedish approach with Anders Borg—being more German than the Germans—saying that, “We need to be very cautious here, not only because you have moral hazard and the rest of it, but also because, as a non-eurozone member, we are genuinely worried about this. At the very least we want to be there and discuss this to the very end”. So there have been mistakes made. But fundamentally I do not think Britain can be part of a banking union, not only because of the UK itself, but also because of the other end of the bargain. From a eurozone point of view, if you press ahead with a resolution fund, it is a pretty big ask to ask German taxpayers to underwrite €10.2 trillion worth of UK bank assets, for example, three or four times the size of German GDP. “Not only do you have to underwrite Greece, you also have to underwrite greedy bankers in the City of London.” That is a very difficult political sell. So I think the bargain is unacceptable on both sides. But the question is what to do about it, and I think there are numerous things that Britain can do. First, the ECB and the Bank of England will take macroprudential supervision, will need to have a very good relationship, and I think they have that. One of the encouraging things coming out of the banking union deal last year is that they acknowledged that. The second thing that needs to happen is that when the portfolio for the next Commission is being put together next year, if Britain cannot get an economic portfolio in the internal market portfolio itself, it needs to make sure that a non-euro liberal country holds that portfolio. So Sweden or Denmark, for example, would be very strong contenders.

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The third thing I think that needs to happen to make sure that, for example, eurozone caucusing does not take place is that you need to work with these safeguards. We already have an excellent precedent at the European Banking Authority with the principle of double majority—which Open Europe first put into writing—where you now need a majority both among the outs and the ins for a decision to pass, which I think is a very good precedent. Perhaps that can be elevated to the Council level as well. At the moment it is only the European Banking Authority. The fourth thing that needs to happen is that Britain needs to really, really push the single market, not only in financial services, but also in other areas as well to make it clear to everyone that this is still the EU’s foremost invention and the one that we should put our money in, and the single market is the EU’s core, not the single currency. I think you can, for example, work with the service agenda to make that case. So there are several things that Britain can do. It is doing some of them already, but they can do a lot better. The Chairman: I conclude this session, colleagues, by thanking our witnesses and reminding them we will be forwarding a transcript. We would be most grateful for corrections, but also there may have been other questions that you would like to answer in the course of the discussion we have had. We are extremely grateful to you. We have ranged far and wide in our discussion about GEMU and we have talked about some of the larger countries and their importance, but we have talked about some of the smaller countries. I turn to Mr Persson and say if we could be as successful as Sweden was at holding the Eurovision Song Contest on Saturday night and Denmark was at making sure that they won it—they had the very best compere in putting on the Eurovision Song Contest—if we had the same inspiration with regard to the EMU, then we would be a most successful continent. Thank you very much indeed.

143 of 441 Professor Jagjit S. Chadha and Professor Michael Dempster—Written Evidence

Professor Jagjit S. Chadha and Professor Michael Dempster— Written Evidence

In a monetary union, output from each of its constituent regions is priced in the same currency and a single rate of interest on short term borrowing is set by a single central bank. For member states, the microeconomic gains from price revelation are thought to over-ride the consequences in the loss of monetary autonomy. Even at the best of times, such an arrangement leads to tensions within an economic region, as over the business cycle output may require different a relative valuation and interest rate in order to foster adjustment. But when the union comprises a collection of disparate nation states, the problems are likely to be amplified. Ample, some might say excessive, financial market liquidity in the period prior to the crisis masked the scale of the economic divergences as both fiscal policy and financial markets allowed member states largely to offset persistent economic divergences.

The financial crisis had the twin impact of crippling financial market intermediation but also placed effective limits on governments' abilities to borrow from future taxpayers and thus limited the scope for fiscal stabilisation of the economic regions and their fragile financial institutions. The ongoing economic divergences were thus decisively exposed and led to a long existential crisis for the Euro Area that required imaginative and rapid structural reform. Accordingly, many aspects of the 2012 Blueprint for Genuine Economic and Monetary Union are sensible and worthwhile. But we are concerned along four main dimensions:

• We cannot quite see how any meaningful agreement will be reached in a timescale sufficient to prevent further existential crisis for the Euro Area because the kinds of measures suggested are both urgently required but also are far-ranging and require deep institutional reform It would seem to us that the seeming success of the ECB's announcement on outright monetary transactions (OMTs) and, what might be thought of as, the creation of a lender of last resort function, has led to a slowing in actual reform at the Euro Area level. In some sense rather than operating in the normal manner of monetary policy, which is to help adjustment, the positive response of the financial markets to the announcements of OMTs has been associated with a cessation in effective reform.

• Secondly, in a monetary union with fiscal decentralisation there is an economic need for more not less financial and fiscal flexibility. The key problem is that the Euro Area does not constitute an optimal currency area and so monetary policy will not typically be sufficient to stabilise the Euro Area economy from shocks. And so fiscal policy will be required to provide further support for economies as they adjust to shocks. The straightjacket of the Stability and Growth Pact not only lacked credibility because many of the countries had not observed the targets prior to the creation of the Euro but also because over-restrictive targets were unlikely to be achieved in such a monetary union. The current proposals have not really suggested how we arrive at a mechanism for public debt that allows considerable short run flexibility to be run in conjunction with credible long run solvency.

144 of 441 Professor Jagjit S. Chadha and Professor Michael Dempster—Written Evidence

• If we, for the sake of argument, simply divide the Euro Area in slow growing debtor states and faster growing creditor states, there is a need for either specific co-operation in demand management or simply for more leadership from the growing states. Normally slow indebted growing states require an external depreciation against high growing creditor states. The alternative here in a monetary union is for considerably more expansionary fiscal policy in the creditor countries alongside an external depreciation for the whole currency area. Clearly in the future other permutations of internal and external policy may be required and so a framework for policy co-ordination is urgently required.

• Finally, we wrote (The Euro in Danger, 2012), and other commentators have subsequently followed us in this call, that serious thought needs to given as to how to allow countries to leave the Euro Area, perhaps for a prolonged period. We noted that even the UK left the gold standard for some 20 years during the Napoleonic Wars. In such a period, countries will need to go through a period of debt restructuring, gain from exchange rate depreciation and be subject to capital and credit controls. The specific aim to return to the Euro can be adopted but the date can be left uncertain. The Euro Area needs to confront and accept that it might be stronger in the long run by allowing countries to leave with a view to a return.

The problems with the Euro Area are in danger of being masked once again by accommodative monetary policy and early signs of an economic recovery. Actually, it has always been the case that the problems of the Euro Area would become even more apparent in a recovery because areas which are growing will soon require higher rates and those that are still in recession will continue to require low rates, whereas, in a widespread recession all regions require low rates. The absence of concerted structural and institutional reform in the past couple of years has left the Euro Area highly vulnerable and so its economic weakness will continue to offer a significant threat to the UK recovery.

12.08.13

145 of 441 John Chown—Written Evidence

John Chown—Written Evidence

1. INTRODUCTION

This evidence will deal mainly with Questions 1 and 2, and 7, 8 and 9.

The Eurozone was introduced with serious design faults and many economists, including myself, said and wrote that it was a disaster waiting to happen, unless the problems were recognised in time and there were policy changes. This has not happened, but the problem now having hit, there still remains a huge political will to preserve the experiment. The relative optimism generated by September’s measures seems to have survived even events in Cyprus. These short-term measures are potentially prohibitively expensive and it is now generally accepted that a long-term survival will require the Eurozone, or at least a core of its members, to move in the direction of a “Genuine Economic and Monetary Union” on the lines suggested in last November’s Blueprint to which I will refer: there is a brief summary in Section 2.

Will this happen and what will be the consequences? If it fails, is there a danger that the obsession with doing “whatever it takes” to rescue the Eurozone will prove to “take” too much and the effort could risk seriously damaging or even destroying the European Union in in its present form. For all its faults, the many benefits for all of us surely still outweigh the costs and inconveniences.

Section 3 explains where I am coming from on this issue while Section 4 is a brief summary of the economics and lists the prerequisites for a successful continuation of the Eurozone. Without agreement on this, it will probably be impossible for even a core Eurozone to survive, and as implementation is very unlikely to be acceptable by several countries, including the United Kingdom, a multispeed EU may become inevitable. This raises three general questions:

• What are the problems in creating a closer union between a smaller core of countries (presumably on the Enhanced Cooperation Procedure), will these be resolved and indeed will it happen? The analysis in Section 5 deals with the main issues and shows that the problems are even more substantial if most of the Eurozone members are involved. Two of these, pensions and taxation are discussed in detail in Section 7 and Section 8 respectively. • What are the consequences for ourselves (and other solvent EMU “outs” such as Sweden) and what do we need to do to protect ourselves against any adverse consequences? (Section 6.) • How will other groups, EU members such as Poland, which are on track to join EMU, and the weaker EMU members who may wish to remain outside be affected? It may be important to us to follow their individual attitudes very closely and liaise with them.

146 of 441 John Chown—Written Evidence

2. THE BLUEPRINT

The Blueprint regards the introduction of the euro as “one of the most far-reaching achievements” of European Union but correctly says that “EMU is unique” in combining centralised monetary policy with other economic policies remaining decentralised, and this clearly envisages a move towards a fiscal and transfer union, the implications of which it discusses at length. The language is a little inconsistent on whether it is referring to the “Eurozone” or the “EU” perhaps because its authors were not particularly interested in the second question. For instance, the opening paragraph of section 3.3 says “the European Union should move towards a full banking union, a full fiscal union and a full economic union” but goes on to refer to the creation of an EMU Treasury.

Given its terms of reference, and its assumption that the over-riding aim is the survival of the Eurozone, there is a lot of good material in the document but, as I show, there are many problems to be overcome. Many of us who might have no objection in principle to the bottom-up construction of a Federal Union would not want to be rushed into one. The Blueprint does discuss the need for democratic accountability in their Section 4 and we should praise them for this and encourage them to build on it. We should be very aware that there is a danger that if the venture is tried and fails we risk finishing up losing many of the benefits of the EU while actually suffering an increase in the power of an inadequately accountable bureaucracy.

3. WHERE I AM COMING FROM

Although educated in monetary economics, I made my career and reputation in international tax, becoming a co-founder of The Institute for Fiscal Studies. As an economist, and a general supporter of the ideals of European Union, I worked actively with Christopher Johnson’s “Sherpas” with the accepted role of drawing attention to the technical problems of monetary union – in the hope that these problems would be addressed and solved. They were not and (in my view) the 1995 Green Paper was economically illiterate and sowed the seeds of the “disaster waiting to happen”. In spite of this we continued to believe and hope that, given the tremendous political goodwill behind the project the problems would be recognised and appropriate actions taken in time to escape disaster. We have been disappointed.

One specific problem involved pensions, an issue which comes up so many times in policy discussions and specifically with the time bomb. In 2001, I gave a paper to the Chatham House economics group: "Will the Pensions Time Bomb blow apart EMU?" which analysed the figures produced by that year suggesting the collapse of the Eurozone by about 2030 unless there were major changes in policy or unless, as we recognised, another problem came up first. We, and indeed Eurostat, intended this as a warning rather than a prediction. Again, we were disappointed: the problem is still with us and is examined in detail in Section 7 below.

As an international tax specialist, I took a very active role in analysing proposals for tax harmonisation, and this background has proved very valuable in examining the implications of moves towards a fiscal union. (Section 8).

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4. THE BROADER ISSUES

It is accepted that a longer term approach will have to involve the Eurozone, at least, moving towards a Fiscal Union and a more central approach to banking regulation. Given the tremendous political will behind the EMU project, such a package could succeed, but the danger is that governments under pressure sometimes adopt a solution without considering the “law of unintended consequences”: solving one problem can, and often does, create others. Problems need to be solved, but first they must be recognised, acknowledged and analysed in depth. Both history and economic analysis suggest that a monetary union cannot survive without eventually becoming a political union, meeting the following prerequisites.

• effective arrangements for ensuring that each country maintains fiscal discipline. • absolutely clear provisions that (as with long-standing and fully fledged Federal Unions) each State is responsible for its own debts. “No bail out”. • adequate arrangements for emergency inter-state transfers – with IMF type safeguards and conditions - as happened in the days of Bretton Woods.

Harold James (“Making the European Monetary Union”), which I reviewed in the February 2013 issue of Central Banking, had had access to archives covering the period to 1993 a period notably covering the earlier attempts to create a monetary union – Werner and the Snake, and Delors and the ERM. It was fascinating to have a detailed account of the really informed discussions which then took place about the key questions: does a monetary union need a comprehensive fiscal and economic union, a central fund to support the currency of countries in trouble, a central authority to coordinate banking regulation and overall control of the budgets of participating countries? Some participants thought these changes were inevitable while (highly predictable) others regarded them as grounds for rejecting the proposals. These are precisely the issues which appear to have been ignored by those responsible for creating and now attempting to save the Eurozone, but we may have to wait 20 years to find out what really was discussed.

5. TOWARDS A FISCAL UNION?

A well-conceived and managed fiscal union, which will ensure the future of monetary union, is not easy to achieve and would require a new Constitution agreed by all those joining. What are the requirements for it to be well -designed? I set out the prerequisites in section 4 above, and the Blueprint comes fairly close to these, given that their priority target is the survival of the Eurozone. It would surely not be possible to get all 27 (soon to be 28) members of the EU, and maybe not even all of the existing eurozone members, to agree on what powers would be delegated to the centre. Differences are already apparent and this Section discusses the questions they should be asking before making a decision: Section 6 deals with the possible implications for the rest of us and the dangers we have to avoid.

148 of 441 John Chown—Written Evidence

The essential conditions for an optimum currency area are balanced budgets and labour market flexibility, including wage flexibility. (This does not necessarily imply labour mobility, difficult to achieve without a common language) As history shows, 14 no previous unions have survived unless they have become full political unions.

Would a fiscal union imply a transfer union or pooling of budgets in any way? Monetary union means that a country, denied the independent use of monetary policy as a tool, has to rely on fiscal policy, The Blueprint certainly assumes that there will be fiscal transfers but has suggested safeguards which may or may not be adequate.

In spite of “no bail out” provisions, huge sums have crossed frontiers in recent years and this would certainly continue under anything approaching a fiscal union. These days, companies considering a merger will, if they are well advised, look at far more than the published accounts and look very specifically at the real liabilities of the other’s pension responsibilities. Countries should do the same. Companies have run into problems by missing out this step because their advisers did not want to delay the collection of fees and the payment of bonuses, and something very similar may well happen here.

The countries concerned would have to look ahead at the financial assets and liabilities, both now and in the future, actual or contingent or merely possible. They would also need to do the same comparison with all the other potential members involved in a transfer union. They would obviously need to analyse, for instance, the actual and predicted budget surplus or deficit and the balance of payments, public debt as a percentage of GDP, foreign currency assets and liabilities in both the public and private sectors. They would begin by looking at the published information, which is not always comparable or even reliable, but also consider the effect of policy changes and whether these are likely to be adopted or achieved. Countries with bad present policies will, perhaps paradoxically, actually have more room for improvement when the pressure is really on.

Countries considering signing up to a fiscal type union will find that the calculations of whether they should join will vary according to whether they assume that these countries will or will not be allowed to become members. This raises the point of a two-speed Europe discussed in Section 6.

The published information is possible, but not easy, to analyse but we also have to take into account many “off balance sheet” ways in which the nation's solvency (and therefore whether it will contribute to, or make claims upon, the group as a whole) can be seriously affected.

Competitiveness

This is a major issue. Since the introduction of the single currency, Germany has had a much lower rate of inflation than its fellow members and the latter have, to a substantial and variable extent, lost competitiveness. Comparisons of WPI used to give a fairly reliable answer but the figures I have seen recently for several measures, notably including labour

14 “Lessons from Monetary History”, John Chown, in “The Euro, The Beginning, the Middle … and the End?” Editor Philip Booth. IEA Hobart Paperback, 2013.

149 of 441 John Chown—Written Evidence costs, seem inconsistent. I therefore hope that others will be giving evidence on this, but it was certainly clear at the start of the crisis that the weaker members should either have had a properly planned devaluation, and possibly default, with the only alternative, now being followed, being a very substantial deflation which has actually been more successful than many of us expected.

Pension liabilities

These are a major liability for countries and here I am offering a more detailed analysis in Section 7. These are not and cannot be definitive but show they can become very serious indeed. They have, perhaps belatedly, been a major impediment in company mergers.

Public private partnerships

These, an excellent idea if properly managed, have often been abused by promoters seeking an unholy alliance between government, wanting to fund public projects while keeping their liabilities off balance sheet, and investors looking for a percentage point or two extra yield of security where the main (and in some cases nearly all) risks were effectively guaranteed by the government. More recently public accounting rules have been changed to check this and in the United Kingdom (I’m not sure about elsewhere) the outstanding liabilities have been publicly analysed

The banking system

Deposit guarantee arrangements mean that a bank failure is a necessary contingent liability of a government and the preservation of a banking system may require a government to go beyond that and help recapitalise it. One proposal is to unify bank regulation, probably essential for a workable Eurozone, whether large or small, and possibly desirable and acceptable on the right terms across the European Union. I don’t think this is going to be a major factor in the future of the Eurozone but does raise related issues notably the now obvious danger of bank lobbies and regulatory capture. Would a more `European’ approach help solve this problem or make it worse?

Taxation

Section 8 discusses the important question of how far a fiscal or even a monetary union needs to eliminate “tax competition” within its borders or whether, as I shall suggest, some flexibility (as there is in most Federal Unions) makes adjustment between countries much easier. This, although not an immediate issue, has long been a preoccupation of mine.

Other factors

There are many other factors, some positive and some negative. Governments have off- balance-sheet assets potentially available for privatisation although many have already taken advantage of them. How much further scope remains can be an important element in the calculation. We would also need to know how a country could improve its performance by the type of sensible measures which some of them may only take under pressure. From this point of view, a country with bad economic government may be better placed than one which already has the right answers.

150 of 441 John Chown—Written Evidence

Transfer Payments and the Blueprint

The Blueprint does face up to these issues and, in discussing the need for future transfer payments, they make two good points. They say that schemes should be designed “to avoid that … any country is a net loser or gains from the scheme. A necessary condition is that cross-country differences and net transfers to the scheme do not depend on absolute income differences but rather on differences in cyclical positions. Income level differences may persist over decades” (page 21). They also correctly point out that transfers should enforce and support, rather than give an excuse for postponing, necessary reforms. page 15 “the financial support should be designed as an overall allocation to be used to contribute to financing measures flanking difficult reforms.”

They also say (page 7) that “policies should cover also taxation and employment, as well as other policy areas crucial for the functioning of EMU. Such an EMU can also be underpinned by an autonomous and sufficient fiscal capacity that allows the policy choices resulting from the coordination process to be effectively supported. There are several other references to taxation without any discussion of whether and how coordination can be applied to the Eurozone without breach of threat to the unanimity principle.

Existing Federal Unions

In the United States, the individual States have their own credit ratings even though the country is far better placed to be a Union, having a common language and much higher degree of labour mobility then multilingual Europe. Switzerland is a rare example of a multilingual federation - but will those pressing for an `even closer’ union welcome the degree of taxing rights enjoyed by Swiss Cantons and Communes? The Australians have complex arrangements for leaving their States with a degree of control over some taxes and expenditure, calculating the Federal contribution on perceived standard needs rather than on actual expenditure.

6. TOWARDS A TWO SPEED EUROPE

This brings us to Questions 9, 10 and 11. A likely outcome, given the political determination to retain the Eurozone, will be for some or all of its members to agree to form a Fiscal, probably Transfer, and maybe eventually Federal, Union, as already discussed. We now have to consider the consequences for the United Kingdom and other countries which do not join. The core group round Germany would probably consist of Austria, Belgium, Finland, Luxembourg and the Netherlands plus some, if not all, of the existing euro zone members. Others will not want to participate.

Whether the group is large or small, we will have a “two speed Europe” and have to ask how the “ins” can achieve their objectives without being impeded by, or damaging the economies and interests of,’ those who remain “outs”? What would be the implications for, and political issues facing, the latter who would be a far less homogeneous group than the “ins”? The latter might well become something approaching a Federal Union and with the rest of us would also be members of a broader organisation. This would surely be more than a Free Trade Area, just possibly with a choice of how much centralisation each `out’ wants to accept. The Blueprint does not really discuss these issues. Although it is often explicit

151 of 441 John Chown—Written Evidence about the changes taking place within the “Eurozone”, it sometimes refers to the “EU” without any obvious consistency and no explicit discussion of the implications for a two speed Europe.

In an ideal world, the core group should be free to go as far as they mutually agree to centralise budgetary control, bank regulation, tax harmonisation, control of the Euro money supply, have their own Central Bank and generally move as close to a fiscal and transfer union as they wish. If they eventually choose to become a fully fledged Federal Union, or indeed even a Unitary State, so be it. The only provision, and it is an important one, is that this arrangement should not have any adverse effects on the rest of us. We do not live in an ideal world, so how can this be achieved?

This is a real constitutional legal and political, rather than economic, problem. The rules governing the Enhanced Cooperation Procedure particularly articles 326 and 327 are intended to give the protection we would need but the apparent determination of Commissioner Semeta to impose a Financial Transactions Tax on non-signatories will well illustrate the problem, and we will need to make absolutely sure that the protection we are given is really adequate. This will surely involve a new constitution, which should, for clarity and transparency, be in two parts. One would be for those joining, including procedures for amending it and provisions for both admitting new members and including provisions for the new members to join and for existing ones to leave. The second would be the constitution for the broader European Union with clear States’ Rights provisions to ensure protection against infection by the inner group.

Member States intending to join would one hopes undertake the type of stringent analysis suggested in Section 5: their decisions may well depend on who is and who is not allowed to participate in this inner group. If all goes well with the core group the Euro would become a sound and stable currency able to challenge the dollar as an international currency.

What of the rest of us? We certainly do not need to `protect’ our financial industry but we do want to make sure that it cannot be damaged by a non-communitaire approach to healthy cross- border competition and must continue to press for action on free trade in services both in the EU and the international context. This has sadly lagged behind the development of freer trade in goods..

The solvent "outs" (United Kingdom, Sweden and Denmark) would almost certainly stay out, at least until they saw how the project was going. The United Kingdom in particular will have to use superb (subtle rather than confrontational) diplomacy, with first-class advice from monetary economists and specialist lawyers, in its negotiations. The present applicant members, notably Poland, would probably postpone any decision until they saw how the whole project was going. We should, and presumably are, liaising closely with them at the diplomatic level.

We should aim to ensure that this arrangement will offer even more flexibility than there is today for individual Member States to delegate more, or less, powers to a more central government. There would definitely have to be improved democratic procedures for the inner, and, we hope, for the outer group.

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A brief word about currency strategies. Members of the outer group might still welcome some form of monetary integration which could achieve most of the advantages if they were encouraged to use the newly credible Euro as a universal secondary currency.

7. PENSIONS

I had thought for some time that pensions policy was a major potential obstacle to Fiscal Union. At the beginning of this century, there were typically four people at work for everyone retired and drawing a pension, but by mid-century this figure will be down to two, a major problem for everyone, including the UK. My 2001 paper for a Chatham House economics meeting "Will the Pensions Time Bomb blow apart EMU?" was based on the then recent figures by Eurostat, for which I had been waiting, projecting the cost of pension provisions as a percentage of GDP, for the then Member States out to 2050.

These figures explicitly assumed “unchanged policies” and I pointed out that the collapse of the Eurozone around 2030 was inevitable – unless there were major changes in policy, as did the Eurostat authors, this was all intended not as a prediction, but as a call for action. We have been disappointed. New Eurostat 15 figures published in 2009 on 27 Member States, going out to 2060 gave a very similar picture. I summarise these and some other figures, with a little analysis, in an appendix.

Britain and France have very similar economic (and population) statistics (they are about to exchange their positions as the second and third largest economies in the European Union) and the citizens have very similar expectations of earnings related pensions. There the difference ends: as the appendix shows, the British ones are backed by some $3 trillion (about 80% of GDP) of independent fund assets, while in France these are an “off balance sheet” liability of the State. The new Eurostat figures show that on “unchanged policies” by 2060 the French government will be paying out 17.5% of GDP to pensioners every year – double the UK figure of 8.4%. Policies have “changed” – sometimes for the worse, when one of the first actions of M. Hollande was to reverse the modest increase in the pension age introduced by his predecessor! My original paper was intended to warn the UK against signing up for anything that might constitute a raid on these now (arguably) inadequate funds.

France, like most, but by no means all, members of the Eurozone have “Bismarckian” rather than “funded” pensions system by which pensions are paid out of current revenue rather than via independent funds. This is brought out strongly in the analysis in the Appendix which shows that even between the Bismarckian countries there are substantial differences in the effect on costs.

The Netherlands and Finland, both expected to be part of a core Eurozone, also have substantial funds, 148% and 75% of GDP at the end of 2011. Why would they sign up? Sweden, 75% and Denmark 200% will like the UK obviously keep well clear of the Eurozone, especially if this moves in the Fiscal Union direction.

The Blueprint as noted above said that they wish to avoid precisely the type of permanent transfer that this involved. Looking 20 - 30 years ahead if they really have by then moved to

15 Eurostat's “2009 Ageing Report” gives updated and very detailed figures covering all 27 members.

153 of 441 John Chown—Written Evidence an even “ever closer Union”, if one of the worst performing countries is having itself to finance the cost of an ageing population it would have to do this either by increasing taxes or reducing public services, including social services. There is already free movement of labour and the young in particular will become increasingly willing to move across frontiers. Raising taxes above levels ruling elsewhere would significantly reduce the tax base, would result in a significant loss of skilled labour and business enterprises making the problem much worse. It is hard to believe that an “ever closer union” will be able to resist pressure for cross border subsidies. In the short run, the greater propensity of the old to vote will keep the balance in their favour but sooner or later the young will revolt. This may indeed have started to happen in Italy.

8. TAXATION

Over the years, The European Commission has produced a series of draft directives on what they called “tax harmonisation” but really aiming at standardisation”. As summarised briefly below this attempt was abandoned before the introduction of the Eurozone and indeed the UK now has a veto included in the Lisbon Treaty. It was then argued by some that a Monetary Union needed standardised tax systems but this would have left members, already deprived of monetary policy as a tool, with "expenditure" as virtually their only independent economic policy weapon. The Blueprint has a lot to say about the central control of expenditure and although it discusses the coordination of tax, does not explicitly say that taxes have to be “harmonised”. In any case, established Federal States, including Germany, all permit significant tax variations between members.

As a long-standing commentator on various “tax harmonisation” initiatives launched by the EU 16, I was all in favour of “eliminating tax obstacles for cross-border operations” (of which there were many) and also for simplifying the compliance problems for American and other foreign multinationals investing into the EU. However, I also believe in the virtues of tax competition. One Draft Directive suggested that member states would be allowed to choose a corporate tax rate with a range 45% to 55%! After Lord Lawson’s initiative in slashing the UK rate, competition did a better job of bringing rates more into line (and at a more economically sensible level) than any Directive could have done.

There were two problems. First how could we reduce the administrative burden, on small as well as large enterprises, of jurisdictional battles between different Revenue authorities? This was, and remains, a worldwide problem being actively addressed by OECD.

Second why were trans-national EU mergers so difficult and why was the typical reaction to a larger market for national companies to merge into “national champions”, when surely cross- border alliances would be more appropriate in preserving competition, and helping to create a genuine United Europe? The earlier attempts at tax harmonisation would have eliminated tax competition without facing up to the reality that a tax collectors’ cartel in the EU would damage competiveness with the rest of the world.

16 The most recent overall summary was John Chown, "Eliminating Tax Obstacles for Cross-Border Operations" at Conference "Recent Developments in European Company Law"(206D21), Academy of European Law, Trier, 16 February 2007. This was republished by Tax Analysts.

154 of 441 John Chown—Written Evidence

As my Trier paper, summing up previous work, showed, there were many steps which could have been taken, but weren’t, for “Eliminating Tax Obstacles for Cross-Border Operations” within the EU which would not interfere with each country’s right to run an independent tax policy.

The Parent Subsidiary Directive was meant to facilitate cross-border flows of income from subsidiaries to parents but was too narrowly drawn. Oddly, it provided that when subsidiary profits are paid as a dividend to a parent the former’s country of residence collect the tax on the profits while the latter company gets nothing on the dividend. In contrast, profits crossing the frontier as loan interest are deductible from profits at subsidiary level and only taxable to the parent. This not only permits, but encourages, simple legal tax avoidance.

Similarly, the Mergers Directive was, at least then, less than wholly successful in minimising the capital gains tax and stamp duty costs of cross-border transactions.

In both cases, we in the professional community had suggested straightforward reforms, but these were resisted both by the Commission (possibly on the grounds that it would make their then beloved “standardisation” less necessary) and by certain Member States who wished to retain certain anti-communitaire practices. To us, “harmonisation” meant overcoming these cross-border problems.

A major issue on which I took the lead was what was known in the UK as the "surplus ACT” (or elsewhere as the “precompte”) problem by which there was a significant rise in the tax burden when a company has to draw on profits earned in a `foreign’ country to meet its dividend. In this context, the income source was "foreign" even if it was within the Single Market of the European Union. Simple arithmetic shows that a company resident in the European Union which earns more than a half of its profits outside its parent company state would almost double the cost of servicing its dividends from such profits. This problem, which had previously only affected a few major UK multinationals such as the oil companies made it impossible to create EU wide companies of the type taken for granted in the United States: surely a contradiction of the ideals of European Union.

This was the most critical, and most misunderstood, of the issues. The “problem behind the problem” here was that there were and remain three related issues and whenever one of them gets to the top of the political pile and is dealt with, the other two become worse. Gordon Brown’s notorious raid on pension funds which made the third issue far worse, while doing little to address the second found a partial (UK) solution to the first far worse and not helping the second. This is now a very live issue and a major current concern for many of us.

• Securing appropriate tax treatment on international profits, really eliminating double taxation without creating tax avoidance opportunities. • Rationalising the tax treatment of profits extracted from the company via dividends or loan interest. • Giving appropriate and intended tax relief to pension funds without distorting their investment decisions.

The last EU attempt at tax harmonisation was the Ruding Committee which, partly thanks to an inaccurate Technical Appendix, misunderstood this issue and again went on about

155 of 441 John Chown—Written Evidence standardisation. (My name had been put forward as the UK member of that Committee, but I was vetoed because of an article I had written on just this issue.) In any case, this was the last formal attempt to interfere with national freedom of tax policy, and was to be followed by Article 113 (not, it seems, wholly effective) requiring unanimity on tax directives.

APPENDIX TO SECTION 7 PENSIONS

Pensions for ageing populations is everywhere a major policy issue. Being aware of this and knowing that this would have very different impacts of different countries I was delighted when in 2001 Eurostat published figures, which I used as the basis for a widely reported and repeated talk at Chatham House. This really brings out the differences between the funded and Bismarckian countries. The next promised, but delayed, update only included the demographic information, Eurostat having apparently been instructed to omit the figures on the financial consequences to the various countries. The 2009 Ageing Report covered all 27 European Union members with the full figures out to 2060. What we, and they, were saying were not intended as predictions but as warnings of the urgent need for policy changes.

Table 1 [not printed] sets out their estimate of public pension expenditure as a percentage of GDP for 27 EU members to which I have added three columns. The first is deviations from the EU 16 average which shows unsurprisingly that the `funded’ countries, the United Kingdom, Denmark, the Netherlands and Sweden do better.

The second shows the increase between 2007 and 2060 (a measure of the extra burden to be faced by governments, and again followed by the deviation from the EU 16 average. (In both cases a negative figure means a relative deterioration in the finances of that country.) The figures of course include the non-Eurozone countries of the EU, but note that the weighted average of all 27 is very close to the one actually used. Poland actually shows a reduction in the forecast cost of pensions: the reasons are explained below

The difference is of course the size of private pension assets supporting the future commitment. Table 2 [not printed], from CityUK shows the last fully available year, 2010, the size of national independent pension funds alongside GDP and the percentage comparison. I have added another column during the 2011 CityUK figures for the major countries. Table 3 [not printed] gives the available percentage figures since 2006 from the same source. The differences are striking and really bring out the difference between the funded and the Bismarckian countries.

The former Communist CE countries which have joined the EU are not strictly comparable, but are interesting. It obviously takes a working lifetime for a country to build up mature pension funds while it is a relative newcomer. Poland, and less spectacularly Estonia, are quickly building up a proper pension provision and score well in both tests. Others have a mixed record which is not relevant to the present enquiry

During the four years since the Eurostat figures were prepared, much has happened but there has really not been much in the way of dramatic changes of pension policy. Even the “funded” countries are finding that many of their private pension schemes are actually

156 of 441 John Chown—Written Evidence underfunded. This might slightly reduce their advantages over the funded ones. However, could it be an early symptom (more obvious in such cases) of a general worsening of the expectations.

12.06.13

157 of 441 City of London Corporation and British Chambers of Commerce—Oral evidence (QQ 39- 54) City of London Corporation and British Chambers of Commerce— Oral evidence (QQ 39-54)

Transcript can be found under British Chamber of Commerce and City of London Corporation

158 of 441 City of London Corporation—Supplementary Evidence

City of London Corporation—Supplementary Evidence

You may recall that the Chairman of the City of London’s Policy and Resources Committee, Mark Boleat, gave oral evidence to the Committee in June. This short note follows up on and echoes Mr Boleat's remarks in his oral evidence particularly the emphasis on the importance to the City of the Single Market.

The Corporation’s work on financial regulation and tax matters is informed by the International Regulatory Strategy Group (comprising senior representatives from a variety of industry sectors including investment banking, asset management, insurance, legal and accountancy services, exchanges and market infrastructure). Its role includes identifying strategic level issues where a cross-sectoral position can add value to the expression of views from particular sectors.

We consider that the Single Market is Europe’s most valuable asset. The UK’s priority must be to oppose policies that could lead to the fragmentation of that Market. Harmful measures include efforts to compel the clearing of euro-denominated trades within the eurozone and the partial introduction of a financial transaction tax. UK-based financial services need to remain competitive if Britain is to continue both to attract international business and to prosper in global markets.

Banking Union is an essential element to underpin the stability of the Eurozone’s banking sector. It is important that the UK and its regulators are fully engaged in the creation of the new structures (even though the UK will not be subject to them) to ensure a smooth, efficient interaction between the UK’s regulatory framework and that of the eurozone. From a City perspective there might be aspects of the banking union that could have benefits, for example, common rules on bank resolution. Clear rules on bank resolution are essential for investors’ ability to understand the risks involved in different types of asset class and hence to have confidence in investing in EU assets.

The December 2012 Council agreement on the Single Supervisory Mechanism and related voting rights in the European Banking Authority was a success for the UK, and protects the Single Market for all Member States whether in or out. The agreed non-discrimination clause placing an explicit duty on the ECB to protect the Single Market further guards against any future discrimination and protects London’s position as the pre-eminent financial centre for the whole EU and Single Market.

The UK, its regulators and industry, should continue to be as actively involved as practical in the construction of the Single Supervisory Mechanism, providing solutions to technical issues rather than simply identifying the problems. A key City interest is the development of a single rulebook of high quality common rules that are consistently enforced inside and outside the eurozone to avoid regulatory fragmentation and the polarisation of the Single Market.

06.09.13

159 of 441 Lorenzo Codogno—Oral evidence (QQ 197-208)

Lorenzo Codogno—Oral evidence (QQ 197-208)

Evidence Session No. 17 Heard in Public Questions 197 - 208

TUESDAY 15 OCTOBER 2013

Members present

Lord Harrison (Chairman) Viscount Brookeborough Lord Dear Earl of Caithness Lord Davies of Stamford Lord Flight Lord Hamilton of Epsom Lord Kerr of Kinlochard Baroness Maddock Lord Marlesford Lord Vallance of Tummel ______

Examination of Witness

Lorenzo Codogno, Department of the Treasury, Italian Ministry of Economy and Finance

Q197 The Chairman: Buonjourno, Signor Codogno. Mi chiama Lyndon Harrison. Primo, vorrei dire che siamo molto contenti di discutere con lei stamattina tutti i problema finanziari Europei. Ora parliamo in Inglese. Thank you very much for appearing before the Committee this morning. I hope you can hear us very plainly. We have a number of questions to ask you. Perhaps I should tell you that we will send you a transcript of our exchanges. We would be most grateful if you could correct that and improve on it if you have further thoughts later on when you see it. We would be so grateful to you if you had any further thoughts to help us with our study, which we hope to publish around Christmas. Do you want to say anything to start? Lorenzo Codogno: First of all, thank you Lord Chairman. It is a privilege and I very much appreciate being here today to act as a witness to your inquiry. I hope that I will be able to provide you with a small contribution. The Chairman: Thank you very much. Perhaps we can start with the question of which elements of genuine economic and monetary union you believe are necessary to pursue and which are unnecessary. In fact, which elements might be harmful to the ambition to achieve a genuine economic and monetary union? Lorenzo Codogno: You are certainly aware that a roadmap has been put forward by the President of the EU Council and that several documents have been published on the topic already by the Commission. It is clear that in order to achieve a successful union, we have to go the full way, meaning economic, monetary, fiscal and eventually political union. All these steps are necessary. Of course, some steps are more urgent than others. I am referring to

160 of 441 Lorenzo Codogno—Oral evidence (QQ 197-208) the banking union, which is the key achievement that needs to be decided in the very near term. The Chairman: Do you think that the supervisory mechanism, the resolution mechanism and the deposit guarantee scheme are all essential, or do they have to line up in a queue before they are done or achieved? Are any of them expendable? Lorenzo Codogno: As you certainly know, there are three elements of banking union: the single supervisory authority, the single resolution mechanism, and the depository insurance. The latter is probably not strictly necessary, although it would be desirable. The first two are absolutely essential. A decision has already been made on supervision, and the ECB, together with the system of European central banks, will deliver on that over the next few months. There is still debate over the single resolution mechanism and negotiations are probably not proceeding with the speed that would be desirable. The Chairman: On Thursday of this week we may have the financial markets in turmoil if our American colleagues do not find a resolution to their own financial problems. Do you think the new set up of genuine economic and monetary union is capable of suffering and dealing with an asymmetric shock of that kind? Lorenzo Codogno: That is its purpose. Whether that will be the case is still to be seen, but the economic and monetary union is now in better shape to withstand such a shock should it occur. The idea is to make the whole economic and monetary union more resilient to any shock in the future, including shocks like the one you mentioned. The Chairman: Thank you very much indeed.

Q198 Lord Kerr of Kinlochard: Director-General, you have spoken so far about what is necessary for Europe. You are in a very strong position to do that because, like some of your predecessors, you play a central role in the Brussels debate. Could you enlighten us on what is necessary for Italy and how Italy sees the priorities, if you can distinguish between Italian and European interests? Lorenzo Codogno: First of all, European interests are not different from Italian interests. We are very much committed as a country to achieving economic integration. Certainly you are aware that Italy over the years has always been very keen to achieve integration. I still remember my Minister, Mr Padoa-Schioppa, claiming long before the crisis that we needed to achieve a banking union and a much more integrated financial system in Europe to withstand potential shocks. Indeed, he was right. We have unfortunately learnt the hard way that we need a much more integrated financial and economic system to make it resilient to any given crisis coming from outside the region. There is a strong rationale for making the monetary union resilient to exogenous and asymmetric shocks. It is a matter of priority for European authorities to make sure that that happens. There is a long road, however, between the current situation and reaching the final objective. Europe is still a work in progress, which inevitably means that, to some extent, the monetary union is still vulnerable. Europe has made significant progress since the outset of the crisis in putting in place mechanisms and facilities that can respond quickly to any shock that might come from outside the region. Lord Kerr of Kinlochard: You are quite right to disagree with me. Had we listened to Mr Padoa-Schioppa at Maastricht, the world would be a better place today. I would like to press you a little on the Italian position. What about mutualisation of debt or Eurobonds? These do not look to me to be a high priority in German policy. Are they a high priority in Italian policy?

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Lorenzo Codogno: You are certainly right that at the moment it seems that the issue of Eurobonds is a bit outside the radar screen of the debate in Brussels. Certainly some countries are strongly opposing any such development. The Italian position has always been in favour of some sort of mutualisation of the European debt. We also understand that to achieve mutualisation of debt Europe has to achieve a higher degree of integration, particularly fiscal integration. Of course, Europe also needs a centralised fiscal authority. The two things come together. In other words, if you have to have a single debt in Europe, you must also have a fiscal authority that is in command. That is clearly an essential requirement. Of course, to the extent that you have a common debt in Europe, you also have to give up some sovereignty to European authorities. That is the other essential ingredient. Italy understands that. Historically, the position of the Italian Government has always been in favour of some form of mutualisation of debt over time. This is not going to come over the next few months or even years, but it should be an overreaching objective for the economic and monetary union going forward. Lord Kerr of Kinlochard: If there was debt mutualisation, how much conditionality would the Italian political system be prepared to accept? Lorenzo Codogno: I think there is a growing understanding that we live in an increasingly integrated world. Europe is increasingly integrated as well. Not long ago, European leaders were unwilling to accept that their economies were strongly linked with each other. Now, perceptions have changed a lot. Public opinion has not yet fully changed, but it will over time. It is key for the future of Europe to make sure that voters and the general population fully understand that the situation calls for achieving a higher degree of integration, which inevitably means that each country has to give up some power at the national level, some sovereignty. I think political leaders are increasingly aware. Public opinion is becoming increasingly aware as well, but it will take more time. Lord Kerr of Kinlochard: Can I press you once more on Italy, specifically? Going back to the Italian presidency in 2000, the Italian economy has grown since then by 0.3%, the Commission tells us. That is in the 13 years that have passed since then. What is needed to shift the Italian economy into a higher gear to bring back growth? It seems to me that the domestic acceptability of Brussels conditionality is bound to be dependent on perceived results, and so far, if I were Italian, I would say that for all my ambitions and beliefs in Europe, it has not exactly delivered since 2000. Lorenzo Codogno: You are probably right in the sense that the general perception is that Europe has not delivered on the ambition of bringing stability and growth for the countries participating in monetary union and the European Union. At the same time, the responsibility for that lies as much in European capitals as in Brussels. There is a growing understanding that our objectives are not disentangled from those of the whole Union and the objectives that are pursued in Brussels. Italy has done quite a lot over the years to improve its structural position. Needless to say that especially the past couple of Governments have done a lot to introduce structural measures. Let me mention that Italy has introduced a significant pension reform that brings its pension system up to state of the art internationally. Italian Governments have introduced a number of product market reforms over the years that are now gradually showing their results, and a major labour market reform last year. The Italian economic situation is in a much better position now, on a structural basis, than 10 years ago. I certainly acknowledge the fact that Italy needs to do more. Europe provides some help with that.

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The pressure from European leaders and other countries goes in the right direction. The European surveillance process and the European semester basically provide support to our own reform process and will be beneficial over time.

Q199 Lord Flight: Particularly given your experience in being involved in EU policy co- ordination, are you optimistic that the effective co-ordination of a more integrated economic policy framework can be achieved? What needs to change to improve the prospects of achievement? In particular, no currency union that I am aware of has not had to involve transfer payments from the more successful economic areas to the less successful and competitive ones. Even within the UK itself, there are substantial transfer payments from the south-east to other parts of the country. Lorenzo Codogno: You are absolutely right. The problem with economic and monetary union is that we started this process, which is very important for the future of the European people, without knowing what the final goal is of all this. There were different perceptions in different countries and among different political parties and parts of the electorate in Europe about what that final goal was. It is becoming clear that monetary union is only a transition to something else. It is not a goal in itself. As such, it requires additional steps in banking and fiscal union and so forth. There is a growing acceptance that this has to be the case going forward. Where do we stand? Europe has made tremendous efforts over the past three years to increase integration and improve governance. Europe is now in much better shape. Admittedly, European policymakers have made a number of mistakes that have resulted in some economic suffering and delays in the process. Now, European integration is proceeding, but maybe not with the speed that would be desirable, in my view. As you are certainly aware, the next two important steps in the European process are defining more clearly the issue of convergence and competitiveness instruments, which basically implies some contractual arrangements with States and delivering ex ante co-ordination of policies. It is proceeding gradually but the process is very encouraging. However, it is absolutely urgent and essential that banking union progresses. The European financial system is still broken and markets are still dysfunctional. There is very little financing across European countries at this stage. Policymakers need to overcome this situation. The only way to overcome this is to speed up banking union. There is a list of actions that need to be undertaken between now and the end of next year. Most of them are the responsibility of central banks. A balance sheet review will be done soon. There is an asset quality review and of course there will be a stress test. All these things together will basically set the ground for banking union going forward. These are the essential steps, and the sooner Europe takes them the better, in order to overcome remaining problems and the current still not ideal situation in financial markets in Europe. The Chairman: Before I bring in Lord Vallance, could you recognise that there is still a sharp divide in Italy North and South, despite the fact that there have been big transfers within the country to try to ameliorate the economic problems of the South? Lorenzo Codogno: Yes, absolutely. Unfortunately, the efforts of many Governments over the years to close the gap between the northern part of the country and the southern part have not been particularly successful, which probably also means something for Europe. Transfers are probably necessary on some occasions for shocks but they are not necessarily the recipe to close the gaps in economic development between different areas. At any rate, I do not see the whole issue of transfers as one of solidarity because this issue has been overplayed. It is more a matter of common insurance against economic shocks. It is necessary for Europe to have a common insurance to prevent asymmetric shocks from

163 of 441 Lorenzo Codogno—Oral evidence (QQ 197-208) having significant effects across the whole Union. We have learnt that during the crisis. Institutions and facilities need to be set up to make sure that the current crisis does not happen again in the future. It is not a matter of solidarity but one of insurance. Lord Flight: Can I just make the point that transfer payments have rarely been successful in bringing the less successful areas up. They are a political necessity to keep the people in the less successful areas happy with the institutions as they are. They have continued in America ever since the civil war, with 30% of federal spending. They have existed in the UK and Italy. The point I make is that you need them if you want to have political consensus to union. Lorenzo Codogno: I would agree with that. They are necessary to maintain support for the process because otherwise European voters would basically perceive that the whole process is not in their best interests. The Commission has put forward some proposals to speed up the reform process and at the same time put in place contractual agreements that would provide some financial support for the areas and countries that are more in need and are willing to engage in a deeper and more profound reform process. All aspects have to come together. People’s engagement and commitment to the whole project needs to be maintained. The risk of losing the support of the people is probably the most important and relevant risk at this stage.

Q200 Lord Vallance of Tummel: Director-General, the first question I was going to put to you you have answered in part, en passant. I will put it to you anyway in case there is anything that you want to add. Do you think that there is a clear understanding of what the integrated economic policy framework should encourage? You were good enough in the context of the banking union to distinguish between essential and desirable elements. You might like to do that in the context of my question. Lorenzo Codogno: Thank you for your question. As I said before, it is absolutely essential and urgent at this stage of the process to achieve banking union because of the still poor and fragmented state of European financial markets. This is absolutely the key target in the near term. Over time, more co-ordination in economic policy needs to be achieved. The process is ongoing. The so-called European semester has been very successful in streamlining budget processes in Europe, and has made all these processes aligned so that we have a single European calendar to co-ordinate economic and fiscal policy in Europe. There is a need to move beyond the current situation and achieve a higher level of co-ordination over time. This is again quite important, but I would say that banking union is the key priority right now. Lord Vallance of Tummel: I have a specific question on convergence and competitiveness instruments, which are being proposed to encourage structural reforms through a system of rewards or sanctions, sticks and carrots. Do you think that that proposal is likely to be effective, and specifically how could it be enforced? Lorenzo Codogno: It is still a tricky issue. Italy is in favour of further integration. However, it is still not clear how these instruments will work. I think we need a bit more clarity and transparency on how this will proceed. There is still an open debate in Brussels and the design of these instruments for convergence and competitiveness is not clear cut yet. I hope it will become clearer in the near future. On our side, Italy is keen to co-ordinate policies, provided that there is a clear framework and a clear setting as to how and when financial support would be given in exchange for giving up some sovereignty over policies. Now you might argue that there should be no need for financial support when you do the right things. Doing the right thing should provide the benefit in itself. That is the usual argument, I would say. At the same time, going through a deep reform process inevitably

164 of 441 Lorenzo Codogno—Oral evidence (QQ 197-208) implies some social cost and some near-term pain, which might be eased if you have the support of Europe. So I think— Lord Vallance of Tummel: We have lost volume, I fear. We cannot hear you at the moment, Director-General. We will try to sort out the technical hitch first. The Chairman: Could we just have the last paragraph of your answer to Lord Vallance? Do you want to start again? Lorenzo Codogno: I will answer again. Can you hear me? There is ongoing debate in Europe right now as to what exactly these new convergence and competitiveness instruments imply. They are ways to combine contractual arrangements between countries and European institutions with some financial support. The usual objection to this is: why should you have some financial support while you are doing the right things anyway? You should not really need financial incentives in order to do the right things because reforms should provide a nice payoff over time anyway. That is absolutely correct. However, sometimes making painful reforms necessarily implies some social cost and some near-term pain that might be eased if there is some support at the European level. These tools might be useful and instrumental in supporting the reform process in Europe, so Italy’s view is that it would certainly be helpful to have this facility, provided that the setting is clear and transparent. At the moment, we do not have a clear and transparent setting for this type of co-ordination of policies in Europe. The debate is still ongoing, and we look forward to clarifying the issue so we may give our support to the whole process. Lord Vallance of Tummel: Do you think the Italian Government might use such instruments once they are clarified? Lorenzo Codogno: There is a very strong incentive to use these instruments to ease the possible social tensions and potential social costs of painful reforms. Having said that, Italy has already gone through painful reforms. The most important one is the pension reform, which is a very touchy reform, but again Italy has already gone through it, so we do not need that facility for it because we think that Italy’s pension system has already been adequately reformed. However, it might be useful in the context of additional changes in the labour market, for instance, even if not in the immediate future. The labour market in Italy may need to be reformed again in the future, once we have a better understanding of its response to the reform that has recently been introduced. At that stage, it would probably be helpful to have some support in the form of European co-ordination and finance to ease social resistance that might develop.

Q201 Lord Davies of Stamford: Director-General, you mentioned the asset test and the stress test, which will be a feature of the Italian banking system over the next few months. You have very considerable experience of that system, both as a commercial banker and now as a policymaker and regulator. Are you confident that the Italian banks will come through that process satisfactorily, because if not and if further significant provisions have to be made by them, presumably Italy will face the choice between seeing its banks reduce their balance sheets, which will have a contractionary effect on demand and growth in the Italian economy. Alternatively, they will have to recapitalise. In those circumstances, will the banks be able to recapitalise themselves from the capital markets, or will the Government have to step in with public money? In that event, could there be contagion between the banking market and the government bond market, as happened in Spain? Lorenzo Codogno: That is a very good and certainly very timely question. There is some concern in financial markets at this stage about the stability of Italy’s system, but let me say

165 of 441 Lorenzo Codogno—Oral evidence (QQ 197-208) that the Italian banking system has been resilient throughout the crisis. Initially, at the end of 2011, it suffered because of liquidity issues, and then because of undercapitalisation, but the Italian banking system has been able to get the capital from the market and by translating some hybrid instruments into proper capital so that now the so-called tier 1 capital is more than adequate in the current situation for most banks. In effect, the Italian banking system has been able to cope with a difficult situation without government support. The Government introduced facilities to provide some financial support to banks at the very beginning of the crisis and, contrary to many other countries, these facilities have been used very little. The Government only provided financial support to banks in the order of 0.2% to 0.3% of GDP, which is far below what any other country provided during the crisis. Now, with the weakness of the economy, non-performing loans are rising. If that continues it might eventually lead to more need for capital. However, at the moment we are confident because the Bank of Italy is doing a wonderful job in pushing Italian banks to restructure themselves to be prepared for the asset quality review and to recapitalise where needed. By the time the European institutions carry out the asset quality review the Italian banks will be ready and well capitalised, so we are not too concerned. Clearly, there is one major bank that has gone through a difficult time, but the Government has already fixed the problem through intervention in the form of a bond, which might be translated into equity if the restructuring process does not eventually work. Other bits and pieces include some small regional banks that have some problems now, but these problems are limited and the overall banking system is in a sound position. So again we are quite confident that the Italian banking system will be well prepared for this European test so that Italy can actually enter the banking union without causing problems whatsoever for the rest of Europe.

Q202 Lord Marlesford: Director-General, it has been suggested that while north Italy and south Italy were for some years moving closer together, they are now moving further apart economically, socially and politically. Do you agree, and if so what do you think can be done to bring them closer together? Lorenzo Codogno: It is probably not fair for me to say that northern and southern Italy have been moving farther apart. I do think it is fair to say, however, that there has been no convergence over the years. My personal feeling is that rather than using transfers and pumping money into the southern part of the country, the best way would be to change the incentive structure, basically moving more and more towards a fully market-based economy. Having the proper incentive structure even in the southern part of the country might move the animal spirits so to achieve higher growth over time. I think the Government is moving in this direction now. There has been a clear shift in policies for the southern part of the country and this is slowly but surely becoming more effective to address Italy’s divide. The Chairman: Before I turn to Lord Dear, can I just ask you about the single resolution mechanism, whether you have any expectation that a deal might be done at the December council, and indeed whether the timeline of 2018 is insufficient, given that you have talked about the necessity of having greater dispatch than hitherto? Lorenzo Codogno: This is a very good question, because it is exactly the state of the European debate at this stage. It is clear that some Eurozone countries are not in favour of a single resolution mechanism that is pan-European and that has a centralised authority able to push national banks towards resolution. The debate is still ongoing. It is a difficult debate. I

166 of 441 Lorenzo Codogno—Oral evidence (QQ 197-208) hope Eurozone Countries will be able to come up with a compromise solution that is ambitious enough to guarantee that banking union is credible and effective because, as I said at the beginning, you cannot really have a single supervisory institution in Europe without a single resolution mechanism. The two things must come together and must be efficient and effective in preventing a banking crisis in Europe. It is absolutely essential that policymakers deliver as soon as possible, and I hope it will be done by December. Markets are still fragmented. Banking union is a key ingredient in resolving the so-called negative feedback loop between banks and sovereigns, which is still a problem and has not been solved so far. By delivering the single resolution mechanism I think the Eurozone would make a big step in the right direction.

Q203 Lord Dear: Director-General, good morning. Early in your presentation, you helpfully talked briefly about the three-pronged model of the banking union. You said that in your opinion the single supervisory mechanism and the single resolution mechanism were essential, but you had some doubts about the common deposit insurance scheme. I understand that, but I wonder whether I could take you a little further on that point. How realistic do you think a banking union such as that would be, were it to be put in place? Would it work? Lorenzo Codogno: It must work. Otherwise Europe would not proceed with integration. The UK position has always been in favour of a single market in Europe and a level playing field for companies. This is also true for banks. It is absolutely essential. At the moment, we have a financial system in Europe that is dysfunctional, and there is a massive misallocation of resources. At the moment, a top quality credit in Italy has borrowing costs that are equal to a junk company in Germany, simply because of the current European situation. This produces a massive misallocation of resources within Europe. This issue needs to be addressed. There must be a level playing field for all banks in Europe. I think it is an essential step in order to proceed towards integration. It is the first step and the most urgent one, and I hope that Europe can deliver on it. Lord Dear: Thank you for that. I wonder whether you are a little confused, as I think some of us are a little confused, about the recent comments of the German Finance Minister, Wolfgang Schäuble, who famously described the SRM—the single resolution mechanism—as being only timber-framed rather than steel-framed, which seems to have caused some doubt as to its longevity. Can you give us a view on that? Lorenzo Codogno: I hope that it is steel-framed, because it will have to resist many shocks in the future. Europe needs something that is well framed, so to speak. Again, while we are on the deposit insurance, it would be desirable to have it, but strictly speaking it might not be necessary. However, a single resolution mechanism that is credible and effective is absolutely essential. Europe cannot do without it. It needs to be steel-framed. It needs to be very strong and very credible for financial markets. In order to go to the next stage of monetary union, fiscal union and integration in Europe, banking union has to be achieved, which, again, is absolutely essential in the near term to address the issue of dysfunction and fragmentation in financial markets in Europe. Lord Dear: As you said, if you are going to have a single resolution mechanism, you have to have a supervisory mechanism to go with it. Lorenzo Codogno: Yes, absolutely. The supervisory mechanism does not seem to be a major issue at this stage, as it has already been decided. The European system of central banks will deliver on that. Clearly it is not an easy task—it is a massive task to harmonise all the banking systems in Europe and to have effective centralised supervision. That implies a

167 of 441 Lorenzo Codogno—Oral evidence (QQ 197-208) lot of co-ordination between the European Central Bank and national central banks, but it can be done. I am sure that the central banks will do a wonderful job. It will take some time, but it will be done. That is no longer perceived as a big issue in Europe, but the single resolution mechanism remains an issue. As you mentioned, there are different views in Europe at the moment. I hope that these differences will be sorted out soon, because it is absolutely essential to solve the issue of fragmentation and dysfunctionality in financial markets in Europe soon. The Chairman: To buttress this steel-framed house, do we need a taxpayer backstop? Lorenzo Codogno: Yes, we do. The way it is developing in Europe is that in order to have a fully-fledged banking union we need a backstop. The debate now is whether this backstop needs to go through different national layers first and then go to Europe or whether we should have a mechanism—the ESM—that can intervene directly on individual banks. That is still to be seen; the debate is on. The so-called cascade system prevails in Europe at the moment. In other words, if you need to recapitalise your bank you first go out and ask financial markets, then as a second layer you have your equity holders and then your senior debt holders. Then eventually you go to the national backstop and, if that does not work, you go to Europe and the ESM. That might not be the best solution; it might not be fully satisfactory. I think that we need to be bolder in that regard. We need to make sure that there is a proper backstop that is fully functioning and fully available also at the European level, in order to make sure that the negative feedback loop between banks and sovereigns is broken as soon as possible. Again, this is a key issue for Europe right now.

Q204 Baroness Maddock: Good morning, Director-General. The European Central Bank is going to take over as the single supervisor. You referred in your remarks to the asset quality review that is being undertaken. I wonder how credible you think this review will be. How should any problems exposed by it be financed? Lorenzo Codogno: It needs to be credible for the very reason that if it is not credible there is no point doing it. I fully acknowledge that the reviews done in the past were not sufficiently ambitious or strong—those done by the European Banking Authority. However, we need to move to the next stage. One problem of the reviews done in the past was that the accounting rules and regulations in Europe were not harmonised. Therefore, you might end up with totally different outcomes. Let me give you an example. The Bank of Italy is much more strict in the accounting of non-performing loans than other supervisors, so in effect if you have a loan that has been restructured in Italy it is still considered as non- performing even a year after restructuring. A number of loans are backed by real estate assets and are still considered to be non-performing despite the fact that they have large collateral that might be used in case of default. There are different rules in Europe. They need to be harmonised in order to achieve effective supervision across European countries. I think that the ECB, together with the system of European central banks, has all the instruments and skills to do it. I am not saying that it will be an easy task, but I think that all the conditions are in place for it to be a successful exercise. It needs to be credible for the financial markets. If it is credible, effective and transparent, it might go a long way towards solving the issue of fragmentation and dysfunctionality in financial markets.

Q205 Viscount Brookeborough: Director-General, just before I go on to question 12, let me follow up on Lord Marlesford’s question about the north-south divide, which we of course have in the United Kingdom as well. However, would you accept that yours is different, because of climate change and global warming, which are affecting the southern areas of countries in Europe? This could become a big issue socially in the future.

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Lorenzo Codogno: I am not sure that this is really the key element of the north-south divide, although probably it is part of it. At any rate, if you look at the European Union, there are a number of areas that show differences. At this stage, regional differences are more important than national differences. This issue is relevant not only for Italy but for many other countries. Spain has the same problem, as well as Germany with respect to eastern Germany. Even in the UK there are differences between regions. It is a pan-European problem. In each country there are differences in economic performance among regions. Most of the time they are more important than national ones. These problems need to be addressed so that these areas can converge and have the standard of living of the best- performing areas. Viscount Brookeborough: We understand the aspiration of the Commission for a separate euro area budget. Does Italy support this additional fiscal capacity? How might it be funded, do you think, and what might the timescale be? Lorenzo Codogno: I do not think that this is absolutely urgent or a top priority, but it would be useful that over time Europe builds up some fiscal capacity at the central level. That is an important ingredient to any kind of union. If you look at the United States and how it has developed over time, it took much longer than Europe to achieve some form of integration. Having a centralised budget with some fiscal capacity at the central level is key. Again, it is probably not the most urgent element at this stage, but over time it needs to be addressed. How will it be financed? Clearly it has to be financed by European taxpayers, so part of the national budget will have to be allotted to a European budget.

Q206 Lord Vallance of Tummel: Director-General, I apologise for taking you back to an earlier question—on the ECB’s asset quality review. You said that you thought that it was essential that that review should be transparent. In your view, should that transparency go as far as making public the results of the asset quality review for individual banks? Lorenzo Codogno: I think it would be desirable, yes. Even more important, it would be desirable to announce, well in advance of the outcome, exactly the criteria and methodology that will be used. I think that this is the level of transparency that is needed in order to make this whole exercise credible in the eyes of the financial markets. Lord Vallance of Tummel: Thank you very much. That is very helpful. The Chairman: If it is shown to be credible, how would you finance any problems that were exposed by that asset quality review? Lorenzo Codogno: First of all, I hope that there will be no problem, at least in Italy, with the recapitalisation of banks. I hope that, if there is a problem, it will be addressed ahead of the asset quality review—ahead of schedule. It can be done through the financial markets in the meantime. If, however, there is a need for some kind of intervention, again I think that we have to build up a backstop of government money to complement equity holders and bond holders. Together with that, there must be some kind of European backstop. In order for this whole exercise to be credible, you need to have a credible backstop at European level to break the negative loop between sovereigns and banks. If we rely exclusively on national backstops, Europe will not achieve that. European backstops should be fully effective and ready to be used in case of need.

Q207 Lord Marlesford: Continuing to talk for a moment about government debt, first of all, as an economist, what do you believe the constraints are on the level of government debt that a country can have in general economic terms? Secondly, going on to Italy, your government debt is the third biggest in the EU. It is nothing like as big as Greece’s but it is

169 of 441 Lorenzo Codogno—Oral evidence (QQ 197-208) pretty close to Portugal and is expected to go up slightly next year. What is the situation with your government debt in Italy? I would like to know your view on the macroeconomic question first, please. Lorenzo Codogno: It is certainly well known that Italy has a very high public debt to GDP ratio. This year and next year it will be slightly in excess of 133% of GDP. From 2015 onwards we project a steady and significant decline. Part of the rise in the debt to GDP ratio was due to the payment of arrears by the Government. It was decided to clean up the backlog of commercial debt in arrears, which resulted in a rise in the debt to GDP ratio. Of course, the debt to GDP ratio was also pushed up by help provided by Italy to other European countries through the ESM and bilateral loans. Debt dynamics in Italy are much more favourable than in many other countries. In other words, despite the high debt to GDP ratio, Italy has already achieved a significant improvement in its fiscal position. Let me just mention that in 2012 the change in the structural deficit, that is net of the cyclical components and the one-offs, was 2.4% of GDP, and this year it is estimated not far from 1%. So, basically, in only a short period—a two-year period—Italy delivered more than 3 percentage points in fiscal consolidation. Italy is now in a much better fiscal situation than many other countries in Europe, because in effect it has already delivered a big chunk of the adjustment that is needed. With what has been done and with current projections, Italy already has a surplus of 2.5% in the primary balance. The deficit will be close to 3% this year and will steadily decline over the years. The Government aims to balance the budget in 2017. In structural terms, it is already close to balance, and the Government expects it to stay close to balance next year. Although the debt to GDP ratio is, admittedly, very high, the debt dynamics are favourable and Italy has already accomplished most of the fiscal consolidation needed. Barring additional economic shocks, there will be a steady decline in the debt to GDP ratio over the coming years on the back of what has already been delivered. The Chairman: Signor Codogno, the good news is that we have come to our last question. It is to be asked by the Earl of Caithness. I know that he is also anxious to ask an additional question that is not particularly to do with the subject today. Please answer it as you would like.

Q208 Earl of Caithness: Director-General, could I change from the subject of GEMU on to the financial transaction tax? What do you think the future of the proposal of the 11 member states for the financial transaction tax is given the devastating opinion of the legal services of the Council? Lorenzo Codogno: That is a very touchy issue. As you are certainly aware, the Italian Government basically went ahead with the financial transaction tax alone last year. The Government was keen not to have a tax that might affect business behaviour, particularly for retail investors, and it was designed to be small enough to prevent any transaction from moving abroad. Having said that, it would be desirable to have a single approach in Europe. I would be very much in favour of a single approach to the financial transaction tax. On a personal basis, I would be more in favour of taxing banks directly, if you want to tax banks, rather than through transactions, but in that regard we need to make sure that we have a common and single approach in Europe so that we maintain a kind of level playing field in the financial industry in Europe. Otherwise, we end up again with fragmentation and dysfunctionality, and this is not what we want. So again, regardless of whether the financial transaction tax goes ahead or not in Europe, we absolutely need to have everyone on board

170 of 441 Lorenzo Codogno—Oral evidence (QQ 197-208) and on the same page in the way we tax and in the amount of the tax, if there is any, so that we do not cause any kind of dysfunctionality or fragmentation. Earl of Caithness: Thank you for that. You have stressed throughout your evidence to us, and again in answer to that last question, the need for a single cohesive approach in Europe. As you know, the UK has opted out of, or is not going to participate in, many of the things that we have discussed this morning. How do you reconcile that? How do you get a single approach in Europe with non-participating member states, and as more and more items are decided by the eurozone countries, where does this leave Britain? What would your recommendations be to us, given this situation? Lorenzo Codogno: First of all, let me say that the Italian Government has shared a number of positions with the British Government over the years, as we are very keen to have an efficient single market, which I believe is one of the key priorities for the UK as well. The Italian Government have sided with the UK Government on a number of issues, and there are a lot of areas where both countries have a common interest. In that regard, it is a pity if the UK does not really join the debate as a core country at this stage, because if the British Government is not part of the debate, clearly it may lose the possibility of being influential. Having said that and having followed the UK position in Europe, I must say that it has always been very constructive and the British Government has always tried to provide the most comprehensive contribution to the European debate. So I hope that the role of the UK will be important in the future, particularly on matters that relate to financial markets, because clearly London is the most important financial centre in Europe and we cannot do without it. London as a financial centre needs to be considered very important in any debate in Europe. It is unfortunate that the UK is not fully participating in some of these debates that are now taking place at the monetary union level. Again, it would be desirable to have a single European position on all matters, including the financial transaction tax, because we cannot afford to have segmentation or divisions between financial markets in Europe or between London and the rest of Europe. Earl of Caithness: Finally, can I ask your opinion from Italy of the question of public opinion? You said that it was important that the leaders took the public along with you, yet given the recent election results in Germany and Holland and what is happening in the UK, do you think that the leaders are getting too far ahead of public opinion, which will cause problems for Europe in the not too distant future? Lorenzo Codogno: I would agree with that statement. A combination of the economic and financial crisis in Europe and some responses to this crisis have not facilitated the closing of the gap between policymakers and voters in Europe. This needs to be very high on the political agenda. It is absolutely essential that the population is on board in any move towards integration in the future. Also, there is the non-negligible possibility of a significant anti-European group in Brussels in the not-so-distant future, in the next European elections, although I have to say that anti-European groups are such sometimes for very different reasons; we are not talking about a coherent, cohesive group of people, so to speak. This needs to be addressed by European leaders, because again you cannot have integration in Europe or go farther ahead in integration without having the population on board. It is a matter of having political leaders who can credibly deliver and tell European voters a credible story on the future of Europe. We have lost a little of the optimism and commitment to a common goal that I think was present a few years ago. I think we have probably now lost that because of the crisis and because of some bickering in Brussels. We need to go back to the original idea of Europe: a Europe that should benefit people not just the leaders.

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The Chairman: Signor Codogno, let us come to a conclusion there. As I advised you at the beginning, we will send you the transcript of all that has passed this morning. We would be most grateful if you could check it, and indeed for any further thoughts you might have to be sent to us. Can I say to you that the wisdom and common sense that you have displayed today has enormously impressed the Committee? We are most grateful for the quality of your answers and for your providing the time that you have. It will be a very substantial contribution to the report, which, as I say, we hope to publish one side or other of Christmas. In conclusion, may I say tante grazie, mille grazie, buona fortuna all’Italia, and thank you very much indeed. Alla prossima. Molte grazie, Signor Codogno, per oggi. Arrivederla. Lorenzo Codogno: Thank you very much, Lord Chairman. It has been a pleasure for me as well.

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Tim Congdon—Written Evidence Part 1: Answers to questions in call for evidence Genuine Economic and Monetary Union 1. How realistic are the plans for Genuine Economic and Monetary Union (GEMU)? Do they go far enough to correct the flaws in EMU revealed by the euro area crisis, or do they go too far to be palatable for some Member States? 2. Will the proposals work, and if not, what other steps need to be taken? An integrated financial framework (Banking Union) 3. Will the proposals for banking union decisively break the link between bank and sovereign debt? If not, what more needs to be done? Is the three-pronged model of a single supervisory mechanism, a common resolution mechanism and a common deposit insurance scheme realistically achievable, how long is likely to be needed to achieve it and what are the risks of long delays? These three questions can be answered together. Bank deposits are protected by what might be termed ‘a chain of security’. If a bank or a group of banks suffer(s) heavy loan losses, it/they can still repay depositors in full if money can be found from any or all of the following, i. Banks’ capital resources, ii. The capital resources of other still profitable banks, which might want to acquire the business of the troubled bank(s) because of the promise of future operating profitability, iii. The capital resources of the central bank, and iv. The deposit insurance fund (if there is one). But – if all of these have been exhausted – the ultimate backstop is the government. One purpose of the Eurozone experiment in monetary union (and it remains an experiment) has been to create a common financial market and banking system. In other words, banks are to become truly multinational, with shareholders and customers across the Eurozone. But that begs a critical question, ‘when a banking system has immense losses relative to its capital, and the various links in the chain of security have all been broken, which of the member governments –which of the 17 governments – is to act as a backstop?’. Recent events have shown that Europe’s leaders have no organized answer to this question. (Enthusiasts for the project of European integration might say that the €60 billion slice of European Stability Mechanism resources available for bank recapitalization disproves my contention. I would simply note that it has taken Europe’s leaders a very long time to agree the €60 billion and the amount is small relative to the problems with which the ESM has to contend.) The governments of the Eurozone could agree to confer the powers to tax and to print money to a newly-formed Federal government, which would replicate the situation in the USA. (In the USA the Federal government has had such powers since the 1780s.) The Federal European government could then act as backstop to the banks. However, there is no sign that the national governments of the Eurozone and/or the EU are prepared to confer extensive fiscal powers on a new Federal government that would be above them in the constitutional hierarchy.

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Without a fiscally-empowered Federal government, the talk of ‘GEMU’, ‘a banking union’ and so on is just talk. An integrated economic policy framework 4. Binding contracts, known as “Convergence and Competitiveness Instruments”, have been proposed as part of the plans for GEMU, which would encourage structural reforms through rewards or sanctions. Is such a proposal credible, would it be effective, and how could it be enforced? 5. There are also indications that, in the longer term, there could be deeper economic policy coordination amongst euro area countries, particularly in the areas of taxation and employment policy. Which areas of economic policy would you regard as appropriate for deeper integration? The suggestion of ‘binding contracts’, to act as sticks and carrots for more responsible behaviour by national governments, recalls the ‘excessive deficit procedure’ in the 1997 Stability and Growth Pact. The Commission has opened an excessive deficit procedure on many occasions. In fact, a European Commission press release of 29th May reported that 20 nations, including the UK, had an ongoing EDP in place. But I believe that so far not a single nation has been fined by the EC under the terms of an EDP and, in that sense, the EDP has proved unworkable. Without the central powers of coercion found in a traditional sovereign nation state, I suggest that ‘convergence and competitiveness instruments’ – just a more highfalutin term for the EDP – would also prove unworkable. An integrated budgetary framework 6. In relation to the Commission’s proposal of the creation of a ‘fiscal capacity’ in the medium term and the creation of an autonomous euro area budget in the longer term: • Why is such a budget necessary, and what would its purpose be? Are there any alternative models that would achieve central fiscal stabilisation? • How would it be funded, and how large would it need to be? • Would it require new institutions? How would it interact with the EU budget? • How might non-members of the euro area participate (voluntarily) in such a mechanism? 7. The creation of a European government bond (‘Eurobond’) jointly issued by euro area Member States has been suggested by a number of academics and commentators. What is your view on debt mutualisation? How plausible is it that such a scheme can be implemented? 8. Do the varying levels of competitiveness and the presence of persistent imbalances across Member States make a system of permanent fiscal transfers inevitable if the euro area is to survive, or could the goals of fiscal union (or integration) be attained without transfers? I have long believed that the Eurozone single currency experiment will require fiscal centralization (i.e., with the powers to tax and to print money conferred on a Federal government) if it is to work effectively. I set out some of the reasons in papers I wrote in 1992 and 1998, which accompany this evidence. But – as I have just said – there is no sign that EU governments are prepared to make that massive constitutional leap. Since they are not prepared to make that leap, there seems little point in discussing the details of how that leap might or might be translated into specific institutional arrangements.

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The German government has made clear that it is opposed to the mutualisation of Eurozone member governments’ debts. It is therefore recalling the ‘no bail-out clause’ of the Maastricht Treaty, even though the spirit of that clause has been breached by, for example, the European Central Bank’s large purchases in 2010 and later of Greek, Portuguese and Irish government debt. Institutional issues 9. Does the current Treaty framework allow the euro area to go as far as is necessary in terms of integration within the current Treaty framework, or will GEMU inevitably require Treaty change? Should other mechanisms, such as further inter-governmental arrangements or enhanced cooperation, be considered? The Eurozone member states, and in a sense all EU members, are in a weird constitutional limbo. On the one hand, many European politicians say that they want ‘more Europe’ and they have indeed created a common European currency, however dysfunctional that currency has become. On the other, as I have just noted, governments are not prepared to confer fiscal powers on a new Federal government. Until it is clear what European nations and their leaders want, it is a matter of conjecture whether a new Treaty is needed. If fiscal centralization is envisaged (i.e., the conferring of fiscal powers on a Federal government), of course a new Treaty would be required. Of course. That would establish in Europe the same constitutional arrangements as exist in the USA and hence forge ‘a new nation’, the United States of Europe. 10. How will EU institutional arrangements need to change in order to accommodate deeper integration? • In the event that not all Member States choose to participate, would the need to ensure democratic legitimacy for contentious GEMU decisions require reform to the decision-making process, either in the European Parliament (e.g. through differential voting and Committee arrangements) or the Council? • What are the implications of GEMU for the role of national parliaments? In the event that a United States of Europe came into being as a result of fiscal centralization, national parliaments – including our own Houses of Parliament – would be reduced in status to the level of the state legislatures in the USA. Impact on the UK and the Single Market 11. The UK Government have stated that any proposals must take account of the interests of all Member States, in particular with regard to the Single Market. How can this be achieved? 12. The UK Government have made clear that they will not participate in the majority of these measures. Do you think this is the right response or are there specific elements of the proposals for which it would be in the UK’s interest to take part – whether fully or partly? • Are there alternative ‘models’ for banking union which the UK would find more consistent with its preferences? 13. Since the majority of non-euro area Member States are likely to participate in many components of GEMU, are there particular risks for the UK finding itself in a small minority of non-participating Member States? How can the UK ensure that the voice of this minority continues to be heard? Do you anticipate any institutional changes that would prove problematic for the UK?

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• What are the likely indirect impacts of non-participation on the UK’s economic prospects, for instance in terms of its ability to attract inward investment and the impact on the position of the UK financial sector? Most of the world’s nations do not belong to the EU and they have their own national currencies, banking systems and so on. They have for many years enjoyed higher economic growth than the EU, while the vast majority of these nations have been at peace both at home and in their relations with the rest of the world. I cannot think of any good reason why the UK should remain in the EU, given the EU’s marked economic underperformance, its growing internal political tensions, and the threat to the UK’s independence and sovereignty that the development of the EU now undoubtedly poses. American and Japanese banks operate in the EU at present, and much excitement is being generated by the prospect of Chinese banks following in their footsteps. British banking organizations – like those of these non-EU states – would be able to operate in the EU if we have nothing to do with Eurozone banking union and indeed if we left the EU altogether. Part II: Submission, as written evidence to the House of Lords’ EU Committee’s inquiry into ‘Genuine Economic and Monetary Union’ in the European Union I would like to offer a newly-written note on “Asset price inflation and deflation, and banks’ capital requirements” as written evidence to the committee’s inquiry. The main points of the note are summarized below. The current note is only a small part of my critical writings on the project of European monetary integration, which date back to the late 1980s. I would like, in particular, to bring the committee’s attention to two previous pieces of work,

- ‘Problems that were neglected at Maastricht’, pp. 54 – 62, Central Banking (London: Central Banking Publications), Summer 1992 issue, and

- ‘Could EMU be Europe’s “Maoist leap forward”?’, pp. 187 – 204, in Paul Temperton (ed.) The Euro (Chichester: John Wiley & Sons, 1998) (A similar paper appeared as ‘Sense and nonsense about the single European currency’, pp. 23 – 37, The Single European Currency, Special 150th Anniversary Issue of the Journal of the Staple Inn Actuarial Society [London: Staple Inn Actuarial Society, 1998], and was also published as a pamphlet by the Monday Club.)

Although these papers were written quite a long time ago, they give my views on several of the questions now being asked as part of the committee’s current inquiry. Indeed, the questions now being asked relate quite closely to the problems which I said, in my 1992 paper, had been neglected by the Maastricht Treaty.

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One-page summary of main points of note on ‘Asset price inflation and deflation, and banks’ capital requirements’:

The main points of the note are i. banks’ risks of future loss, and hence their need for capital to protect depositors, depend heavily on future movements in asset prices, since these asset price movements determine the value of loan collateral, ii. a single set of capital rules (such as the Basle III rules now being imposed on advanced country banking systems) cannot be appropriate for all countries at all times, and undermines the flexibility of national regulators to deal with specifically national problems, iii. banks’ loan losses in the Eurozone periphery nations are so large that depositors can be repaid in full only by capital injections from the state which affect these nations’ credit rating, iv. the interaction between banks’ solvency problems and their host nations’ sovereign default risk has created a vicious downward spiral of fiscal and monetary retrenchment, and losses of output and employment, and v. this downward spiral is much worse than in a traditional monetary jurisdiction because governments in a multi-government monetary union such as the Eurozone cannot borrow from the central bank.

In these important respects a multi-government monetary union is highly dysfunctional compared with the one-currency-per-nation pattern found almost universally nowadays, except in Europe.

Asset price inflation and deflation, and banks’ capital requirements: an aspect of the Eurozone banking crisis

Since 2008 the so-called ‘periphery’ of the Eurozone (i.e., Italy, Spain, Ireland, Portugal and Greece, also known as ‘the PIIGS’ and ‘the Club Med’) has faced an unremitting financial crisis, in which the various countries’ banking systems have been the focus of concern. Banks have incurred losses that have been substantial relative to their capital. Regulators, including international regulators from the European Commission and the Bank for International Settlements, have demanded that capital must be rebuilt. With stock markets reluctant to provide new equity capital, governments have had to step in to fill the gap and so have become injectors of capital ‘of last resort’. However, these injections of capital have in turn had to be financed by the state and so have increased governments’ budget deficits. Unfortunately, even aside from the turmoil in financial systems, Eurozone budget deficits during the Great Recession have been well above the levels envisaged in the 1997 Stability and Growth Pact, one of the Eurozone’s defining documents. The burden of bank recapitalization has therefore interacted with a larger sovereign debt crisis in the Eurozone; it has been associated with a large-scale macroeconomic malaise of financial retrenchment, weak demand and high unemployment. That malaise has now lasted over five years and shows no sign of early resolution.

How did significant nations, with large numbers of undoubtedly capable central bank and finance ministry officials, get into a mess of this kind? And why have these nations’ banking

177 of 441 Tim Congdon—Written Evidence institutions, which until the crisis had impressive records of profitable growth, been so badly embarrassed? My argument here will be that the fortunes of a nation’s banking industry are inextricably linked with one aspect of that nation’s macroeconomic fortunes, namely the rate of change in asset prices. More particularly, the prudent level of banks’ capital/asset ratios depends heavily on the prospective rate of change in asset prices.

Banks’ managements have always to take a view on that prospective rate of change, and they may ‘get it wrong’, with disastrous consequences to themselves, their shareholders and the nations in which they operate. But that does not mean they are necessarily to blame, for at least two reasons. First, they do not control the levers of macroeconomic policy, including critically the rate of change in the quantity of money, which determine the rate of change in asset prices. Secondly, compliance with a capital adequacy regime imposed by international bodies may give false confidence in the banking system’s sustainability. I will suggest that bankers have their reasons for basing corporate strategies on asset price expectations arising from past experience, even if past experience is not always a good guide to the future.

Keynes’ remarks on bank solvency and changes in asset price levels

In the depths of the Great Depression, in August 1931 soon after the Credit-Anstalt failure, Keynes wrote an article on “The consequences to the banks of the collapse of money values”. In that article he noted that banks lend against the collateral of ‘a multitude of real assets…which constitute our…wealth, buildings, stocks of commodities, goods in course of manufacture and of transport, and so forth’. In taking deposits from members of the public, they promise to repay in full (at 100 pence in the £, 100 cents in the dollar and so on). But, if those who borrow from the banks cannot themselves repay their loans, the ability of banks to honour this promise is compromised. The promise – or ‘guarantee’ (to use Keynes’ own word) – can then be honoured only from the banks’ own capital resources. In other words, banks’ capital acts as a buffer against expensive defaults in their loan portfolios.

To protect themselves banks rarely lend more than the value of the collateral offered to them by the borrowers. In Keynes’ words,

banks allow beforehand for some measure of fluctuation in the value of…assets, by requiring from the borrower what is conveniently called a “margin”. That is to say, they will only lend him money up to a certain proportion of the value of the asset which is the “security”…The amount will, of course, vary in different cases within wide limits. But for marketable assets a “margin” of 20% to 30% is conventionally considered as adequate, and “margin” of as much as 50% as highly conservative.

As long as the value of the collateral varies only a little, the banks are safe. If a borrower for some reason foolishly does not service the debt, the bank can seize the collateral, sell it and cover its deposit liabilities. But suppose that the value of the collateral falls by more than the margin. Again in Keynes’ words, ‘The horrible possibilities to the banks are immediately obvious.’ If borrowers in general cannot service their debts, the banks’ seizure of collateral leads to losses and depositors can be repaid in full only from banks’ capital. Indeed, if banks’ capital is insufficient to meet loan losses, the banks are bust and depositors will not receive back the full amount of their original claim (i.e., 100p in the £, etc.).

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Evidently, in extreme conditions banks’ solvency can be undermined or even destroyed by large falls in the value of the assets pledged to them as collateral for loans (i.e., of the ‘buildings, stocks of commodities’ and so on mentioned by Keynes). The ‘horrible possibilities’ latent in such a situation were made actual in Cyprus earlier this year, when quite large banks – such as the Laiki Bank – had to declare insolvency and some depositors received less than 50 cents in the euro. So far banks in other Eurozone member states – including Greece and Portugal – have been able to repay deposits in full, but the debacle in Cyprus shows that this cannot be taken for granted.

Banking in an economy with rising asset values

So far I have been talking about banks in societies with falling asset values. Happily, the normal experience of modern economies is that asset values rise over time. The long-run upward tendency of asset prices reflects two key forces, the persistence of inflation, even if at low rates, and the growth of real output and incomes due in part to the increasing productivity of capital. For example, in the UK house prices in the second quarter of 2013 were 88½ times higher than in the second quarter of 1952, according to data prepared by the Nationwide building society. The compound annual rate of increase in house prices was 7.6%, somewhat above that of national income and average earnings.

It is clear that the solvency of a bank or building society involved in housing finance, and able to take residential property as collateral, benefits from an increase in house prices. If a mortgage bank insists on a maximum loan-to-value ratio of 80%, it does have some risk of loss even if house prices are rising steadily. A mortgagor may fail to service his or her loan in its first year, so that action has to be taken to repossess the property. The legal costs and the estate agency fees when it is resold may come to more than 20% of the house value, and allowance has also to be made for the bank’s internal management expenses and the financing cost of the loan. However, after a few years of 7.6% house price inflation, the loan- to-value ratio falls and the bank’s safety ‘margin’ becomes comfortable. Even with an ‘interest only mortgage’ (i.e., one in which no repayments of principal are made), the loan-to-value ratio drops to under 56% after five years and to under 39% after ten. At such levels of the loan-to-value ratio, it is almost inconceivable that repossession costs could exceed the margin of safety on the loan.

Banks and building societies compete in the housing finance market, with one aim being to attract first-time buyers who have only limited savings and cannot afford a big slice of equity in their first home. Competition for such borrowers is partly a matter of price, but also important is the loan-to-value ratio. The last paragraph explained how, in an environment of 7.6%-a-year house price inflation, an apparently quite risky mortgage with an 80% loan-to- value ratio in its first year improved in quality and after a decade was almost riskless as far as the lenders were concerned. Bank managements may be tempted to raise the loan-to-value ratio on first-time-buyer mortgages to 82%, and then to 85%, and then to 92%, and so on. The longer the period of rising house prices, the greater is the prospect that competition will encourage the industry to offer loan-to-value ratios – perhaps even of over 100% – that , at least superficially, are very dangerous. However, it is clear that – as long as house prices are rising strongly and are expected to continue doing so – even 100%-plus mortgages may in the end be serviced and repaid without difficulty. With a 7.6% compound rate of house price increase, a 110% loan-to-value interest-only mortgage becomes a 53% loan-to-value ratio after a decade.

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Banks’ capital requirements in an economy with ever-rising asset values

How much capital do banks need in an economy where

i. their assets are almost entirely loans to the private sector, ii. the value of the houses, buildings and securities pledged to them as collateral is rising continuously, and iii. loan-to-value ratios also leave a comfortable safety ‘margin’ of at least 20% ?

The answer is ‘very little’. Of course, they need some capital to anticipate the occasional delinquent borrower, with the attendant costs of taking the collateral and selling it. But it should be clear that – even if there are a large number of such delinquents – the 20% margin means that loan losses should be negligible. Indeed, several examples could be cited of banking systems operating on extremely low capital cushions after long periods of general asset price appreciation. In the late 1980s Japanese banks had equity-capital-to-asset ratios of about 2%, as the relentless boom in Japan from the 1950s had been accompanied by continuously rising asset prices and negligible loan losses. In 1960 the USA’s money centre banks (such as the New York-based businesses that belonged to the major clearing houses) had an equity-capital-to-assets ratio of 9.0%. Twenty years later, after the prosperity of the 1960s and much of the 1970s, that had dropped to 3.6%.

The conclusion I have just drawn may seem shocking. As I write, international officialdom, with the full backing of the media and interested academic experts, is pressing for banks to maintain ever-larger capital cushions. But I have just said that in a macroeconomic context of rising asset prices, which has in fact been normality since the 1930s, banks can protect their depositors with extremely low capital ratios.

Two further points need to be developed before moving to the next stage in the argument. First, some banks may have boards of directors with a handful of old fogeys who can remember the last big crisis. These stodgy, ultra-safe banks could of course stay aloof from trends in their industry. They may notice that equity capital cushions are becoming exceptionally thin and simply decide that they will keep their ratios close to traditional long- run norms. They might seek to uphold – say – a 6% equity-capital-to-assets ratio rather than the sub 3% equity-capital-to-assets ratio that is emerging among their competitors. The decision to ‘opt out’ of the race may prove correct in the end, if asset prices turn downwards and overleveraged competitors face heavy losses. But, until that happens, a decision by one bank to persevere with a high capital-to-assets ratio is itself risky. It implies either a poor return to equity and hence disgruntled shareholders or an expensive lending policy, which may alienate customers. (Banks’ return on capital is equal to the average return on assets multiplied by the inverse of the capital-to-assets ratio. A bank with a capital-to- assets ratio above the industry average can achieve the same return on capital as the industry as a whole only by having a higher average return on assets, i.e., by charging more for its loans.)

Second, when they determine their corporate strategies, bankers have to take a view on future asset price movements. It is easy for uninvolved commentators to regard the situation as static, with capital requirements geared to expectations of loss arising from the occasional delinquent. But that is not the real world. Banks’ loan portfolios are in constant flux and yet also have an indefinitely long life, since the banks must aim to replace maturing loans with new ones that may extend out 20 or more years into the future. Their solvency, and their

180 of 441 Tim Congdon—Written Evidence ability to make a promise to repay depositors in full, depends on the existence of a safety margin over the value of the collateral lodged with them and an implicit assumption that the value of the collateral will not collapse while the loans are outstanding. One of the most important risks that banks take is to operate in the belief that macroeconomic policy will be conducted with sufficient skill to prevent asset price slumps.

Ireland as an example

I have already cited some examples of banking systems (Japan in the late 1980s, the USA in the early 1980s) that had become lightly capitalized after long periods of asset price gains. I now want to bring the subject closer to current Eurozone concerns by looking at Ireland and, specifically, its housing market. Ireland’s accession to the then European Economic Community in 1973 was accompanied by a drastic opening of trade to the rest of Europe and indeed the whole world. The next 30 to 35 years saw extremely rapid growth of output and employment, as its productivity levels became among the highest in the continent. This 35-year period also experienced massive appreciation in the values of houses, farmland and commercial property, the assets that are standard collateral for bank loans. Ireland’s banks, which had been sleepy and provincial organizations in the 1960s, provided fabulous returns to shareholders in these decades of economic dynamism. Because asset prices were rising almost without interruption, bank suffered little by way of loan losses. Bank managements came to assume that asset prices would keep on increasing in future.

Although Ireland did have one or two years in the 1980s when house prices fell fractionally, the relentless character of the asset price gains is clear if five-year periods are examined. The chart below shows the change in house prices over five-year periods beginning in 1980. (Note that the 1980 value relates to the five years from 1975.) There is not one single negative value before 2009.

The Irish housing market:

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The Irish housing market - Chart shows % change in house prices in five years to date shown

250 In 2006 every five-year period for over a 200 generation had seen rising house prices

150

100

50

0

-50

I have explained that bank managements must have a view on the future change in asset prices when they form their lending strategies. What in 2006 was the sensible and realistic central house price assumption to be made by bank managements in Ireland? Given their past experience, what number would banks’ loan officers have used for the likely change in house prices in the five years to 2011? Surely the answer would have had to be positive. A one- or two-year reverse like that in the 1980s might be envisaged, but – looking ahead to 2011 – nothing in the collective memory of the Irish financial sector could justify a forecast of a large fall in house prices.

The collapse in Irish house prices:

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The collapse in Irish house prices - Chart shows % fall in house prices from their Q2 2007 peak

0

-5 Eire as a whole Dublin by itself -10

-15

-20

-25

-30

-35

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-45

-50

But that is what occurred in practice. The chart above shows the collapse in house prices both in Ireland as a whole and in Dublin by itself from the peak in the second quarter of 2007; it brings out the suddenness and abruptness of the change in housing market conditions from the middle of 2007. In little more than two years house prices nationally fell by about 30% and in Dublin by itself they collapsed by 45%. Keynes warned in his 1931 article about the ‘horrible consequences’ to the banks if asset price movements were much larger than expected. Needless to say, by mid-2009 the entire Irish banking system was insolvent, although the legal formalities and tidying-up continue four years later.

The question now becomes, ‘what level of banking system capital would have been required in spring of 2007 to maintain Irish banks’ solvency in view of the imminent housing market catastrophe?’. The answer is ‘more capital, relative to assets, than has been held by any banking system in an advanced economy since the 19th century or indeed than has ever been demanded by regulators of a previously profitable banking system’. (And the Irish banking system was unquestionably profitable, in the eyes of most observers, in early 2007.) At present international regulators – including regulators under EU auspices working with officials from the BIS and the International Monetary Fund – are visiting the Eurozone periphery countries. They are trying to persuade or cajole national authorities to recapitalize their banking systems to Basle III standards, with the Basle III standards supposed to make bank resilient to shocks. Most important, in the regulators’ judgement, the purpose of the Basle III standards is to ensure that ‘in the next crisis’ governments will not have to recapitalize insolvent institutions. The essence of this regulatory process is standardization

183 of 441 Tim Congdon—Written Evidence on an international norm, in the belief that a particular ‘norm’ is both optimal and non- discriminatory between nations.

My point is that the whole exercise is misconceived. If the Irish banking system had complied with Basle III in mid-2007, if indeed it had over-complied with international norms in the manner of the Vickers Report gold-plating of Basle III now being imposed on the UK banking system, that would not have stopped Irish banks going bust in the two/three years from mid- 2007 given that house prices and other asset values were about to crash by 30% - 45%. More generally, the appropriate level of banking system capital, relative to assets, varies hugely from nation to nation, and from period to period, and the imposition of a uniform set of capital rules for all nations is a mistake. Most of the time, when asset prices are rising gently, banks can operate with quite light capital buffers. The occasional recession may inflict quite serious loan losses and wipe out some capital, but a couple of years in which all operating profits are retained (i.e., the shareholders receive no dividends) plus a rights issue should be sufficient to rebuild capital to an adequate level. The only circumstances in which the state should be involved in bank recapitalization (with the ultimate purpose of protecting depositors) is when an asset price crash has had the ‘horrible consequences’ for the banks that Keynes wrote about in 1931.

But that asset price crash ought to be avoidable by the sensible conduct of monetary policy, while the sensible conduct of monetary policy is the task of the central bank, not of the commercial banks. At any rate, these matters are both complex and specific to particular nations. They are specific to particular nations not least because different nations have different trend growth rates of output, different demographics and so on. In my opinion the imposition and enforcement of a single set of international rules is not the way ahead. (Do I need to observe that those nations that do not belong to the BIS [and hence do not have to comply with the wretched Basle III rules] are at present much happier economically than those that do? Isn’t that obvious?)

As I have explained in this note, it is easy to describe one set of circumstances in which banks can – very reasonably – have very low capital-to-asset ratios. It is also to describe another set of circumstances in which banks need to have such immense capital resources that no sane private-sector investor would buy their equity (and when in fact either depositors must lose money or the state must step in). I agree that this second kind of situation should never be allowed to develop. But the job of avoiding this second kind of situation falls, above all, on a nation’s monetary authorities. These authorities should prevent asset price crashes, and of course the preceding asset price booms, by the appropriate conduct of monetary policy (i.e., in my view, by maintaining a more or less constant low rate of growth of the quantity of money, since over the medium term the rates of change of the quantity of money and national wealth [or ‘the total value of all assets’] are related). The appropriate conduct of monetary policy is not the responsibility of individual banks or bankers.

Can nations go bust because their banking systems are insolvent?

I do not have time here to explain why the operation of the Eurozone in its first eight years, from 1999 to mid-2007, was accompanied by such a dangerous and extreme asset price boom in its peripheral nations. Ireland was only one example of the boom and the troubles that came with the subsequent bust. I also do not have space to consider the interaction between the closure of the international inter-bank market in August 2007 and the

184 of 441 Tim Congdon—Written Evidence subsequent financial turmoil. However, there is another feature of the Eurozone that needs comment. This feature is both unique to a multi-government, multi-nation monetary union like the Eurozone, and has made a solution more elusive and problematic.

In a standard monetary jurisdiction – that is, in a single sovereign nation state – a currency is issued by one central bank which is answerable to one legislature and responsive to one government. Further, a number of commercial banks maintain accounts at the central bank in order to complete settlement between themselves, and both the commercial banks and the central bank are concerned that the claims of depositors (who use the banks to carry out payments services) should be honoured in full. The regulatory machinery, including such arrangements as deposit insurance, is specific to the one nation and the one banking system. The central bank is banker to the government, which – in the extreme – can require the central bank to lend it whatever sums it (the government) commands. In other words, the government – let it be repeated, the one government of the one nation – has the power of the printing press. This set of institutions has a weakness. It carries the risk that the government will abuse its power, by printing too much money and causing rapid inflation. But it also has an important strength. Since the government can borrow without limit from the central bank, it can always honour debts expressed in its own currency. Within its own borders, for debts expressed in the local currency, the government can never go bust.

This characteristic of a standard monetary jurisdiction is of great value in an extreme financial crisis of the kind now being experienced in the Eurozone periphery. The discussion has demonstrated that, after a severe asset price crash, banks’ loan losses can exceed their capital a few times over. If the depositors are still to receive 100 pence in the £, 100 cents in the euro or whatever, the state must step in and recapitalize the banks. In a standard monetary jurisdiction that is easy enough, because the government can borrow from the central bank and use the loan proceeds to finance the capital injection. Sure enough, the ratio of public debt to gross domestic product is likely to rise sharply. But, as long as the public finances are otherwise in good order and the debt is easily serviced (i.e., with low interest rates), nothing very dramatic will ensue. The banks can be recapitalised, depositors are repaid in full, the government can service its debt, after a few years the banks can be privatized again, and life goes on as before.

Unfortunately, the Eurozone is not a standard monetary jurisdiction. Under the terms of the Maastricht Treaty governments cannot borrow without limit from the central bank. Indeed, they are supposed not to borrow from the central bank at all. As a result, governments can go bust within their own borders. In most countries the capital stock is worth about five times national income and the banking system’s claims on the national population in local currency rarely exceed 150% of national income. However, in exceptional asset price booms the capital stock may be valued at seven or eight times national income, while the debt of the domestic private sector to the banks may be more than twice GDP. The asset price bust may consequently result in loan losses to the banking system that exceed its capital by 50% - 100% of GDP. Something of this sort does seem to have happened in Ireland, Cyprus and Greece. Spain may be better placed, but it faces the same kind of difficulty. The governments of the Eurozone periphery have therefore to make capital injections into the banking system that are enormous relative to GDP.

But how can the government raise the necessary funds? Because they cannot borrow freely from the central bank, the task of bank recapitalization – the task, in other words, of making sure that depositors are paid back in full – is far more painful than in a standard monetary

185 of 441 Tim Congdon—Written Evidence jurisdiction. In a monetary union like the Eurozone banking insolvency interacts viciously with sovereign default risk. This vicious interaction is not found in the one-currency-per- nation system which is normal in the modern world.

The Eurozone suffers from basic design flaws

If Europe’s political leaderships are intent on keeping the Eurozone in being with its current membership, this paper does not have any easy answers. The nations of the Eurozone periphery have crippled banking systems, with loans losses that are higher than – and indeed sometimes are multiples of – the equity capital they held before the crisis. Officialdom’s response has been to demand that banks rebuild capital, if necessary by capital injections from the state, but the amounts involved are substantial relative to already strained public finances. The Eurozone is so structured that governments can go bust within their own borders. The banking problems therefore aggravate the fears of sovereign debt default that have beset these nations in the last few years.

In my view the nations in the Eurozone periphery could solve their macroeconomic problems more easily, with less damage to output and employment, if

- they did not belong to the Eurozone and their governments could therefore borrow freely from the central bank in order to finance bank recapitalization, - they had their own currencies and could therefore devalue them to a level necessary to generate an external payments surplus large enough to honour debts to international creditors, and - they did not belong to the BIS, and had the freedom to set capital and liquidity rules for their banking systems which would again let the banks expand lending to domestic private sectors.

I am well aware that the ruling elites of such countries as Ireland, Portugal, Greece and so on regard membership of the Eurozone, the EU and the BIS as vital badges of national respectability. That is bad luck for the people who have to endure the result, which is prolonged macroeconomic trauma.

04.07.13

186 of 441 Professor Michael Dempster and Professor Jagjit S. Chadha—Written Evidence

Professor Michael Dempster and Professor Jagjit S. Chadha— Written Evidence

Written evidence can be found under Professor Jagjit S. Chadha and Professor Michael Dempster

187 of 441 Hugo Dixon, Graham Bishop and Megan Greene—Oral evidence (QQ 19-38)

Hugo Dixon, Graham Bishop and Megan Greene—Oral evidence (QQ 19-38)

Transcript can be found under Graham Bishop, Hugo Dixon and Megan Greene

188 of 441 Eurogroup Working Group—Oral evidence (QQ170-178)

Eurogroup Working Group—Oral evidence (QQ170-178)

Evidence Session No. 14 Heard in Public Questions 170 - 178

WEDNESDAY 2 OCTOBER 2013

Members present

Lord Harrison (Chairman) Earl of Caithness Lord Hamilton of Epsom Lord Kerr of Kinlochard Lord Vallance of Tummel ______

Examination of Witness

Thomas Wieser, Eurogroup Working Group President

Q170 The Chairman: Welcome to our last meeting of the day. Thank you for coming before us. As you know, we are looking into genuine economic and monetary union; en passant, we have also been following up our earlier reports on the financial transaction tax, which you might like to know about. We started off with Commissioner Rehn, and we have seen various other colleagues—just to put you in the picture. We are supplementing this visit with a visit to Germany in November. We have three days scheduled there—one in Frankfurt, where we will meet Mr Constâncio, who contributed to our most recent report, published last December, on banking union—as did you. We will also talk to what we hope will be representatives of a German Government by then, to others who can speak about German economic and monetary union. I give you that information because there may be parts of your answer that you would like to supplement the work that we do in the UK Parliament, to advise us. We would be very grateful for that advice.

We will be very interested in this session—and you may want to start off with one or two of your own ideas—to learn about the relationship between the Euro working group and the United Kingdom Government, what nature it takes and how engaged it is. I think you came in during the last session. We are interested to hear whether the UK is at least an interested and observant shareholder in the process, or whether we are totally absent. Perhaps I can start with GEMU. Have certain elements been identified as necessary, pressing and required to be done, while other elements are less necessary? Indeed, some may even be counterproductive. Then there are other elements that may need to be added to the structure proposed by the four Presidents of the Commission, Van Rompuy, which you might aid the Committee by telling us about. That is quite a long introduction, and an open field. Would you like to introduce yourself? You are known to many of the members of the Committee, but perhaps not all. : Thank you for the invitation. I was saying to Dominique how fascinated I am by the interest that you evince in European affairs, and I wish that many of the other 27 Parliaments would show the same degree of interest and engagement. My job is to chair the

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Euro Working Group, which prepares the meetings of the Eurogroup. Britons participate in the deliberations of the Eurogroup and the Euro working group if they are Commission officials, so the UK is not completely disassociated from that. I also chair the Economic and Financial Committee, which is the pendant, as it were, for the 28. We have regular items of euro area policy matters which are also discussed with the 28; so we try to achieve as much transparency as possible among the 28. As you know, no legislative matters can be discussed in the Eurogroup, so it is more a matter of economic policy co-ordination. Some might argue that it is co-operation, and one could have a long philosophical debate on the difference between co-operation and co-ordination. For those who do not know, my job was created one and a half years ago; it used to be done in parallel with one’s home job, usually as secretary-general of the Treasury. In the case of the UK, Nigel Wicks chaired the committee for many years, and is still regarded as one of the best chairs the committee ever had. With the increasing severity of the crisis and the workload associated with it, the Heads of State decided to make the post permanent. So here I am—and it is not raining, for a change. I suppose that most of your interlocutors have repeated many things that you know already, such as the contents of the Four presidents’ paper, which you will not want to hear for the 17th time. Therefore, your question is how much of that question can realistically be expected to be brought into being in the short term, medium term and long term. When we first started drafting the paper at the beginning of the summer 2012, my contribution was entitled Putting the E into EMU; when I showed it to a friend, he said, “Where is the U?”. So we then called it Putting the E and the U into EMU. Of the four—the banking union, economic union, fiscal union and democratic accountability—I have always regarded economic union as being nice to have but not necessary to guarantee the stability of EMU as a whole. Many of the things described in the “E” chapter, under economic union, are necessary for each member state to increase its competitiveness. There are many things in there which an enlightened Government would have done a long time ago; there is nothing in reality which smacks of federalism, supranationality or the like. That is not so for the other chapters. Depending on how the coming weeks unfold, we will emerge from this industrialised world debt crisis with what I would describe as more or less a banking union. It will encompass a single supervisor, a resolution mechanism with a resolution fund, possibly some kind of system of deposit guarantee schemes, and that will be it. Will it be the complete banking union that you would have in the best of all possible worlds or that is comparable to what you would have in one single nation state? There, the answer is a completely clear no—the reason being that especially on the resolution of banks, the question arises of who orders a bank to be resolved. This is very much part of the ongoing negotiations on the single resolution mechanism. While opinion is still divided on what role the Commission should play, or that committees could play, it is quite clear that it is not the national resolution authority, composed only of nationals of that member state, that will do the analysis and order a bank to be resolved. If it is then the case that somebody else is taking these decisions, those of course may well have fiscal consequences. The way the resolution fund should be funded, by industry contributions—the jury is still out as to whether it will be a resolution fund or many resolution funds—gets around the problem of constitutional issues as long as we are concerned with using up the money in the resolution fund, because it is not sovereign money. In the end, will markets trust a resolution fund that is funded only by industry contributions and without a guarantee, i.e. a contingent liability from the member states? I think the answer is no. If you then have a system whereby Germany guarantees 22% of the contingent liabilities and France maybe 16%, then Italy 12% and Austria 2%, the markets may value some of these guarantees to a higher degree than some of the other sovereign

190 of 441 Eurogroup Working Group—Oral evidence (QQ170-178) guarantees. A truly well functioning institution that is accepted by markets would therefore require a joint and several guarantee by all member states together, which would put your big toe firmly into fiscal union. As soon as you start sharing a contingent liability among member states, in constitutional terms it is just the same thing as sharing a liability or expenditure. Therefore, being quite obviously a first step into fiscal union, this would require not only a treaty change but significant changes to national constitutions. So we will emerge with a banking union of 90% but without any aspect of fiscal union, and because we do not tread on anyone’s constitutional toes there will be no impetus to change elements of democratic accountability.

Q171 The Chairman: That is clear. You may be heartened, to know that we are indeed meeting Nigel Wicks next week, so we will pass on your regards to him. You gave a clear indication there of the progress that is likely to be made on resolution. Do you think this will be done by the December Council or in the new year, before the parliamentary elections? Thomas Wieser: I think we stand a 50:50 chance of being able to agree politically in a Council on the single resolution mechanism before the end of the year and have an agreement with the European Parliament before it breaks in early April. The Chairman: That is helpful. Before I pass on to the Earl of Caithness, can I ask you about the European Central Bank, which, as I indicated, we are visiting in November? Do you think sufficient attention has been paid to them, given their quite striking role last year in the form of Mario Draghi and his famous announcement, which certainly calmed our markets? Does the role of the ECB, especially its capacity to do what it does vis-à-vis the treaties, need to be analysed and understood or accommodated more? Thomas Wieser: Do you mean in the field of banking union specifically or in the monetary policy field? The Chairman: We have alluded to the potential clash in its role on monetary policy and then in the supervisory function. Some people may say, “Gosh, they are getting away with blue murder in what they are doing and how they are going ultra vires, and so on”, whereas most of the witnesses we have spoken to think it a jolly good thing that somebody has taken it by the scruff of the neck and pronounced in the way that Mario Draghi has. Thomas Wieser: On banking supervision, I am sure that the central bank did not push itself to the forefront to take over that role, but it was the only person standing, so barring a change to the treaties it was the only viable option. You could take the easy way out and argue that there are many good and some bad examples of central banks being the financial markets supervisor. These issues actually follow fashion more than hard analysis. Ten or 15 years back, everyone was insisting on the independent, non-central bank supervisor. The trend has been reversed—inter alia because they pay much better than others, but it is not only that. It is very much power politics that are involved. Whatever the central bank will be doing, I am sure that it will scrupulously try to separate out the monetary policy and financial stability roles. Personally, I am not a friend of central banks being the supervisor because while 99.9% of the time there is no conflict of interest, in the 0.1% of the time when there is, one of the two targets has to suffer. My experience is that it is usually monetary policy that suffers in the bad times; in the good times, it may be the other way around. Therefore it is an excellent second-best solution and I would not exclude it. In one of the coming treaty changes, we could create a new institution by just taking the single supervisor and providing the constitutional grounds for having a separate and totally independent supervisor. Maybe it is simply a stepping stone towards an even better future.

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The Chairman: Again that is very clear.

Q172 Earl of Caithness: Thank you for your comments on the banking union and what you expect can be achieved before our elections next year. Perhaps I may ask you two questions. One is a general question. How do you assess the input of the UK in the discussions on banking union? Has that input been effective and led to changes in the proposal? The second is a detailed one. Are you happy with the delay until 2018—five years away—of the resolution mechanism? Without that, if there is a nasty shock to the relatively calm state of affairs that exists at the moment, what is likely to be the reaction of the Eurogroup to any new crisis? Thomas Wieser: I shall start with the last point. I take it that you are referring to the entry into force of the Bank Recovery and Resolution Directive on 1 January. First, it is not yet a foregone conclusion that it will come into force on 1 January 2018. The European Parliament may bring it forward. Secondly, on the role of recovery and resolution in the framework that we are setting up, including the single supervisor, there will be, at some time next year— depending on the entry into force of the SSM et cetera—an asset quality review, sometimes also known as a balance sheet assessment, the stress test and so on. The results for each and every bank will be published in autumn 2014. Banks with a shortfall of regulatory capital will be ordered by the single supervisor to make up for that shortfall according to agreed rules. The first source, of course, needs to be the private market. If they cannot manage to do that within half a year—in that circumstance we will be able to tell you all this in much greater detail—in spring 2015 the bail-in according to the recovery and resolution directive will set in. This will be done under the umbrella of the new state-aid rules for the financial sector, which have been updated and published on 1 August 2013. They foresee a very similar bail-in regime to the BRRD. The difference will be the possible treatment of senior bondholders, but equity and junior bondholders will be dealt with in a more or less identical manner to that under the BRRD. In reality, and if we assume that the entry into force of the BRRD may be earlier than we currently figure, the state-aid regime will be applicable in operational terms for perhaps a year or a year and a half. It does not really matter if the entry into force is earlier or later because there will be some kind of proxy, very similar instrument at hand. Does that create uncertainty in markets? The banks will have to adapt their behaviour, the expectations of investors, the structure of their liabilities and the like, but that will be part of an ongoing larger adaptation process in the move towards Basel III targets, as they start raising capital in anticipation of what the single supervisor will tell them to do. It is indeed a regime switch, but the phasing-in provisions are manageable for the banks concerned. Has the UK been effective in the wider context of negotiating banking union? Of course, the UK is always extremely effective in Brussels—I would say that even without the presence of a former Permanent Representative. But you have had an extremely clever Perm Rep here over the past couple of years. Of course, banking union in legal terms is fairly simple, but we need to take care that the coherence of the internal market is not undermined. Many of us have been extremely mindful of this, and the Commission very much so. Even the ECB, which is the ECB for the 18, has been extremely mindful of the necessity, and of the importance for the European Union as a whole, of maintaining the integrity of the internal market, and of the banking area for the 28. Where are the risks that we can identify? One concerns the supervisory practices that will be shaped by the European Banking Authority in London on the one hand and by the single supervisor on the other. The voting modalities that were agreed in the BRRD will ensure

192 of 441 Eurogroup Working Group—Oral evidence (QQ170-178) that there can be no ganging up of the “ins” at the expense of those who are not participating in the euro. Other than that, the vast majority of regulations that are germane to the internal market for financial services land in COREPER and ECOFIN; it will always be the 28 who decide on them. Some may not like the outcome, but it is part of the Brussels- based process, where the vast majority of rules and regulations in this area are decided by QMV. I remember one issue at an ECOFIN in Luxembourg a couple of years ago—I think it was a MiFID regulation—where the UK was outvoted. It produced consternation across the continent, because it was the only time that the UK had ever been outvoted on a financial service dossier. Therefore, you can see that even with QMV, there is a very high likelihood that the UK will be on the winning side of the vote. Is there an assurance that this will always be the case? No, because that is the story of qualified majority voting. If we had not introduced qualified majority voting—I believe that Margaret Thatcher played an enormous role in getting Europe there—we would not be where we are today, but would be lagging considerably further behind emerging markets than we are anyway. So on banking union, in a nutshell the UK has achieved the maximum that it could achieve, because it will retain an above-average influence on supervisory practices, rules and regulations. As far as the internal market is concerned, I am utterly convinced that it will remain coherent, having grown together, and hopefully become even more so than in the past. The Chairman: I often think that Margaret Thatcher must have been surprised to find herself in the vanguard of the development of the single market, as we are sometimes surprised when we look back at her role and influence in this.

Q173 Lord Hamilton of Epsom: Can we turn to the integrated economic policy framework? Do you think that it is robust enough? If not, could other things be added? What do you think about the new rules and obligations? Will they follow down the same path as the stability and growth pact and be broken by Germany and France in succession, with no sanctions being taken against them? Thomas Wieser: I have a question for clarification. I take it that you are referring to the package of new fiscal rules, the macroeconomic imbalance procedure and the country- specific recommendations that have come out of the so-called European semester or a subset thereof. Lord Hamilton of Epsom: Yes, that is roughly what we are talking about. Thomas Wieser: Thank you. I am always mindful that the rules that we have given ourselves or that politicians have given to us are legalistic constructions. Some nasty people would even say that they are bureaucratic constructions that need to respect the retention of sovereignty by individual member states. Let us take, for example, the country-specific recommendations which are addressed to every member state. They are indeed recommendations and you can take them up or not take them up. Frankly, the punishment for not following them is not exorbitant. Indeed, I believe that the punishment is not exorbitant because these are not really political processes. In a slightly different vein, the fiscal policy rules of the stability and growth pact are sub- constitutional rules and therefore there is no domestic political mechanism for ensuring that they are actually enshrined into domestic policy targets. In former times, when a recommendation was addressed to a member state, I would have a vision of the Finance Minister going home to a meeting of ministerial colleagues in his or her capital saying, “We have to change our budget because I really caught it in the neck in Brussels yesterday”.

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Everyone then starts to yawn and asks what is for dinner this evening. It was simply of concern to the Finance Minister, not to many others. It would have been totally different had national parliaments been involved, but that is not the case in any of these processes, and that is why they are non-political processes. Also, the European Parliament is not engaged at all in matters of policy co-ordination and legal legitimacy. Of course not, because the treaty does not foresee the involvement of the European Parliament. Hearings of national Finance Ministers could have a considerably larger effect on the actual quality of policy-making back home than the raised finger of Mr Wieser or anyone else in the Council building which, because the rooms do not have any windows, no one ever sees. The rules address absolutely the right issues, which are those of fiscal rectitude, intelligence, and the growth-oriented structure of public expenditures; namely, policies that prevent the building up of the sort of macroeconomic imbalances that we have seen in recent years in, for example, Spain, Portugal and Greece, and a procedure for addressing the structural policy changes that are necessary to make our economies fit for the 21st century. However, all this remains at the level of secondary law at the very best, and therefore the incentive for national politicians really to integrate it into their national policy-making is extremely limited, especially as there is no audience back home for this kind of advice. That is why I believe that if we had a stronger interaction between parliaments and politicians on all these issues, we would be considerably better off.

Q174 Lord Kerr of Kinlochard: From the way you spoke earlier on, I have formed the faintest of impressions that perhaps you do not think that the fiscal capacity leg of the Commission proposal is likely to be agreed by the end of the year. You seemed to indicate that you expected nothing to happen on that dossier. Is that right and, if that is the case, does it matter? Could you also, having looked at their ideas, tell us what they think the fiscal capacity would be used for; what is their rationale? Is it, as sometimes appears to be the case, to encourage structural reform or is it to reward good behaviour as a sort of positive sanction which could be withdrawn as a negative sanction; is it something to do with deficits, or is it a stabilisation fund—a mini flywheel and the beginnings of a federal equalisation system? Lastly, where is the money coming from? Thomas Wieser: I did not address the fiscal capacity leg on purpose because I do not regard it as having anything to do with fiscal union. I do not know exactly what it is, except that it is fiscal. A fiscal union is something other than a fund which relies on intermediate, stochastic annually-to-be-negotiated and probably comparatively small contributions that are doled out to politically decided—I have to be much more polite than I would actually like to be— targets. A fiscal union is something that could be a small part of national budgets or a large part of national budgets, but in economic, legal and constitutional terms, it would have to follow the logic of a budget; that is, it would have to be based on predictable but variable revenues with a certain tax base, with a preset or defined set of objectives for the expenditure, subject to parliamentary ex-ante control and exposed to other controls. It would probably have to have an element of reactiveness to conjunctural developments. What I see in the proposals for fiscal capacity are more or less as you described: it is a fund that either rewards or incentivises certain behaviour in a closely circumscribed set of policy parameters. What I have heard about the raison d’être for these proposals is that the degree of national ownership for national reforms is a small one. By engaging in a more political debate that could possibly begin at the level of Heads of State coupled with monetary rewards and then subsequent debates in national Parliaments, you could thereby incentivise member states to do the right thing. They would be more free than they are at present to choose their own path towards bliss and happiness and the like. That is what those who

194 of 441 Eurogroup Working Group—Oral evidence (QQ170-178) have proposed these fiscal capacities are propagating, and that is why I do not even think about the heading of “fiscal union”. If a note was not being taken, I would be more outspoken. Lord Kerr of Kinlochard: Thank you. I do not think that we need to ask you any more about fiscal union. Thomas Wieser: That will come after the next crisis.

Q175 Lord Vallance of Tummel: You have mentioned the next crisis. I was reading my Financial Times today, looking at the headline about what is going on in the US and the budget upset, along with the possibility—remote but greater than it was a few days ago—that come 18 October there could be trouble which might impact on financial systems around the world. There could be another major external shock that might result in a freezing of the wholesale markets, something that can happen quite quickly. I wonder whether the Eurogroup has any view as to how the current structure of the banking union and the progress that has been made with it would withstand a further major external shock, or perhaps one that is internal—perhaps in a particular country like Italy. Are there any contingency plans for dealing with that and what would be the priorities of the Eurogroup Working Group should such an occasion arise, which obviously one hopes it does not? Thomas Wieser: All forecasts are uncertain, especially if they are about the future. Past crises have shown that there is a degree of co-operation between major and not so major Central Banks which is unprecedented in history and which probably saved us from total disaster. That is the aspect of provision of liquidity, but not of solvency. If a major shock to our financial systems emanated from the United States, it would, no doubt, impact not only on central bank balance sheets but also on other balance sheets. The question you are essentially asking is: what is my view on the balance sheets of the financial actors in the euro area and the state of sovereign balance sheets in the euro area? What you are asking me about the euro area goes, mutatis mutandis, for those outside the euro area, not only within Europe but also in emerging economies. As a footnote, the probability of risks from sequestering is considerably lower than the impact of tapering or of interest rate changes in the medium term because they are sure to happen one way or another, whereas as for the effects of sequestering, by the time you go to Frankfurt you will know much more about to what extent that will happen or not. If you look at the state of bank balance sheets across Europe, considerable progress has been made on cleaning them up, though not enough, which is why the balance sheet assessment of the ECB will be stringent and will focus on telling banks to recognise losses, to clean up these balance sheets and recapitalise if necessary. Will there be a widespread need for recapitalisation? I think not, but we see, for example, that there are very well capitalised banks in the so-called south, and that there are banks in need of recapitalisation in the north. There are good banks in good countries and good banks in less stable countries, but there are bad or challenged banks in more challenged countries and also in very stable northern member states. It depends on the size of the shock. It is impossible to say what the effects will be because we do not know what the size of the shock would be. However, we are at least much better placed than we were two years ago to withstand such a shock, as is the UK banking system, which is also in a much better position to withstand an additional shock, if that were to occur. In terms of what it does to the funding situation of member states, again, we are in a considerably better net position in terms of funding means—the volumes have gone down. This has been partially aided by the low-interest rate environment in which we are, but on average debt levels have

195 of 441 Eurogroup Working Group—Oral evidence (QQ170-178) started to go down. However, if I had the choice between a shock now and one in five years I would definitely opt for a shock in five years. It can come from many things other than sequestering.

Q176 Lord Vallance of Tummel: Thank you, that is helpful. You more or less covered earlier the questions I was going to ask. I was going to ask about the UK’s position in the protection of the single market, but you dealt with that in the context of the banking union. Perhaps as a little addition to the comments you made about the UK’s involvement in the work of the Euro Working Group, you said two things. One was that UK people were involved directly but only if they were employed by the Commission, but that there was a good transparency between the work of the group and the rest. I come from a managerial and business background and I am sometimes a bit naïve about political things. I was looking for a business parallel. It would be that if I were the chairman or the CEO of a group of companies, and a sub-group of that company was engaged in a major project which could have a significant impact on the other companies, I would probably have standing rules, again, that other companies would have a standing invitation to join any meeting of the sub-group. Human nature being what it is, if you do not allow transparency at that level, you are potentially asking for trouble. That is just a passing thought which you might wish to comment on. Thomas Wieser: If it were a wholly owned subsidiary of the 28 then that would be absolutely right. As a matter of fact, with all of the banking union proposals, which we are quite certain that the UK will never join, at least in my lifetime—although there are younger people out there—the UK has always been fully associated with these deliberations. That is not only because the legal basis is in the treaty but because it will have either a homeopathic or a larger impact on the UK, which is why they are in the room. The design of the adjustment programme for Greece is something that is beyond the treaties; it is simply a matter that stems from the fact that there is a higher degree of responsibility and maybe solidarity with Greece, even though some Greeks would probably deny that. Therefore I would say that your picture of the Eurogroup being a wholly owned subsidiary of the EU firm is not quite correct. There are maybe not extremely good reasons for not having the “outs” being part of these deliberations, but I believe that a strong impetus is to not want to expose to the outside world the way we reach decisions. I think that anybody who has been part of these deliberations, negotiations or fights would understand that because—since I am being quoted, I will not say why. You simply do not want to be transparent about the way you get there but you can be fully transparent about the target that you have achieved. Lord Vallance of Tummel: You are quite right of course that there is not a direct parallel with a holding company and a subsidiary group, but I suspect that my interpretation of human nature is correct.

Q177 The Chairman: Just a few concluding round-up questions. I do not know whether you came into the room when the relationship that the United Kingdom has was explained by one of our earlier witnesses from the European Parliament: where it had been a shareholder, the United Kingdom has become a client. That is despite all the kind things you said about the strange contradiction of how interested we are as a Parliament in the United Kingdom in all these matters and the energy put into what is evolving here. First, I wonder whether you have any comment on that.

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We also try to be relatively influential as far as we can with our reports. We have a dilemma as to whether we finish our business relatively soon and publish before Christmas. Again, we could seek your advice about whether that is a good idea or whether it would be more appropriate to delay because of the question of the German elections. Maybe we will not even have a Government formed, so we may be talking to people who then disappear. We would be very grateful for your thoughts on those two points. Thomas Wieser: I think there is a wide recognition on the continent that a European Union without the United Kingdom would be not only contrary to five centuries of British foreign policy but detrimental to the symmetry of powers on the continent. If I understand history correctly, it has always been a clear principle of the United Kingdom to support the second largest on the continent. If that were to disappear, that would not be in the interests of Germany and not in the interests of France or of any continental country, but it would be totally contrary to UK interests. Therefore, I think we would all very much welcome a period of constructive engagement, which would be to everyone’s benefit. We have always very much benefited from the insight and analytical capabilities and the political direction in which the UK has pushed and nudged the European Union. This is a drive which, over the past two or three years, has become less and less pronounced. There is, indeed, among many of my colleagues a feeling that the United Kingdom has become disinterested in Europe, which is possibly even worse than some of the more knee-jerk reactions that you might get from the media. Disinterest is sometimes worse than dislike. It would be really deplorable if this tendency that many of my colleagues detect were true. Anything that generates interest that goes beyond the House of Lords is even better. It is very good if the House of Lords is interested but it would be even better if the other parts of British society were just as interested. We keep up hope.

Q178 Lord Hamilton of Epsom: There has always been a problem in the United Kingdom with deeper integration. As long as the question of deeper integration could somehow be avoided or stepped back from, it was possible to carry on pretending that we were fully engaged members. Now that we have this crisis—and people say that you should never allow a good crisis to go by without taking advantage of it—this has led to serious moves towards much deeper integration. We are now going to see a eurozone which, if all the dreams are realised, is going to have its own budget and its own taxation system and so forth, and there will be a bloc of votes from which the United Kingdom will be excluded. We are never going to join that club in your and my lifetime, and therefore the United Kingdom is inevitably going to get more and more detached as integration continues in the eurozone and we are not part of it. I just do not see how we can have a great role to play in all of this because we are excluded. Thomas Wieser: I will now produce a quote from Woody Allen, which definitely does not refer to you. Approximately the quote is: just because I am paranoid does not mean that everybody is not really persecuting me. There is this attitude that the euro area is ganging up on the “outs”, that it is a bloc of votes and a monolith. I do not find that among Polish, Swedish or Danish colleagues but it is a very prevalent attitude in the United Kingdom. I can assure you that I have participated in every Eurogroup meeting that ever was, and I can assure you that the diversity of views is enormous. There is maybe some ganging up against the people who produce the coffee there—and rightly so—but there is never any monolithic bloc deciding on what should be decided in ECOFIN the next day. That is unthinkable. The diversity of interests, opinions and views between Finland and Portugal or Germany and France is such that the UK is not an outlier; it is somewhere within the spectrum of opinions

197 of 441 Eurogroup Working Group—Oral evidence (QQ170-178) of the euro area member states. This is a myth which for some reason or other has flowered and flourished in the United Kingdom but not anywhere else. But, of course, I understand that as the euro area grows together questions arise that did not exist 10 years ago about the relationship of the “outs” to the “ins”. Apart from the fact that there will never be any euro area taxation system, in 20 years’ time there may well be elements of a fiscal union. But I believe that what we are witnessing here in Brussels may not lead to the optimal arrangement between the “ins” and the “outs”. I would go about it in a completely different manner but I am not British. The Chairman: Thomas Wieser, let us conclude there with the ringing tones of your aphorism that lack of interest may actually be worse than outright dislike. We take that to heart. As ever, on this second witness occasion with you, if I may say so, it has been a joy to engage with you on the subjects themselves and the Committee is very grateful to you for the careful and studied way in which you put these things and replied to us. Your answers were clipped and concise and very helpful. Again, to quote back to you one of your own phrases, whether in time the United Kingdom joins the rest of Europe on the path to bliss and happiness will be left to the future. We shall see, but for today we will send you a copy of our transcript. We would be grateful for any corrections but we look forward eagerly to the next opportunity that we have to hear you comment on the next study which is relevant to your interests. In the mean time, our profound thanks.

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European Commission—Oral evidence (QQ 101-108)

Evidence Session No. 8 Heard in Public Questions 101 - 108

TUESDAY 1 OCTOBER 2013

Members present

Lord Harrison (Chairman) Earl of Caithness Lord Hamilton of Epsom Lord Kerr of Kinlochard Lord Vallance of Tummel ______

Examination of Witness

Olli Rehn, Vice-President, European Commission

Q101 The Chairman: Vice-President Commissioner Olli Rehn, perhaps I may welcome you to your own room. This time last year, Michel Barnier contributed wonderfully to our examination of the banking union proposals, but on this occasion we are dealing with genuine economic and monetary union. Before she sits down, I should like to thank Heidi, who we met in the Parliament earlier this year and who has been so helpful in securing this meeting with you. We are grateful to you for finding the time to speak to us. As usual, when we make these investigations, we send a transcript of what is exchanged between us. I would be grateful if you and your colleagues could look at it and make any corrections. I would also say that if you have thoughts which go beyond what you say today and you can provide us with afterwards, we would be most grateful. Again, thank you for speaking to us today. I wonder whether you want to say a few words before I start the questioning. Olli Rehn: Thank you. I welcome you to the European Commission and to Berlaymont. As always with the House of Lords, I look forward very much to a constructive and productive discussion. I also thank you for the questions that you sent me in advance. In view of the time limitations we might not be able to go through them all, but let us try. I shall say a few words about how I see the current economic situation in the light of the reforms which have been made in Europe. We have seen signs of improvement in both soft and hard data and we are at a potential turning-point for the European economy. We expect growth to become stronger over the course of next year. This year we still see a rather subdued and modest recovery, but next year we expect growth to be on a more solid footing, and then we will also see an improvement in employment. But there is a big “but”, because there is certainly no room for complacency and there are clear risks in this scenario, especially political instability and a slowing-down of economic reforms. On political stability, unfortunately a concrete case in point at the moment: Rome calling. Italy is in a difficult political situation, but it is not only about Italy in the eurozone, but more broadly the European economy, including the United Kingdom. It has a spillover effect on

199 of 441 European Commission—Oral evidence (QQ 101-108) the rest of Europe. The recovery that is beginning to take hold in Europe is still fragile. As I said, there are signs of improvement, with incipient signs of recovery in Italy, which continues to suffer from political instability, posing risks not only to Italy herself but to her European partners and the European economy in its entirety. Italy is the third largest economy in the euro area and the impact of what happens there does not end at her borders; it can spread throughout Europe. That is why Italy’s progress or lack of progress, its achievements or lack of achievements, are also Europe’s. That is why it is very important for Italy to return to political stability as soon as possible in order to be able to take the many important decisions that are necessary for the sake of returning to growth and job creation. One aspect of linking this to economic governance, which I understand is the main concern of your current visit, is that there are reasons why the political turmoil during the first half of this year in Italy, Greece and Portugal did not shake the foundations of the economic recovery across the whole of the eurozone and European economy. The situation is different from 2011 or even 2012. I am referring to the Italian and Spanish crises in August 2011 which continued at least until November. I also refer to the crisis in Greece during the two elections in the spring of 2012 before Mario Draghi’s speech at the Olympic Games in London at the end of July 2012. Since then at least three factors have changed, which I think are fundamental to your mission. The first is that the credibility of fiscal policies and to some extent political reforms has increased since 2011. The second is that the European Central Bank has taken decisive action to stabilise the financial and bond markets, and has removed the risk of any disintegration of the euro. I recall that a year ago, in August 2012, I was in New York on a mission. The talk of the town was of “grexit” or “fixit” (the abbreviations for Greece exit or Finland exit). Last week, the situation was very different and the eurozone is much less interesting today than it was a year ago to the most important financial centre in the world, together with the City of London, of course. The third factor is that we have implemented a reform of economic governance so that we have a reinforced system in place. It is providing a medium-term framework for the consistent consolidation of public finances and for the advancement of structural reforms for the sake of sustainable growth and job creation. In that sense, the situation is different, but we need definitely to stay on the course of reform in Europe on banking union and steps towards a real economic union. Member States should continue a consistent and gradual consolidation of public finances for economic growth through structural reforms.

Q102 The Chairman: I know that my colleagues will be interested to follow up a number of those points. Perhaps I can start by asking you about the timeframe as you see it for implementing the various stages of genuine economic and monetary union. Attached to that is how politically feasible those elements are because we will have to bring together many different parties and get agreement from them on the various elements of GEMU. Olli Rehn: First, I believe that in the immediate and short term, stretching towards the medium term, our challenge is to complete and construct the banking union and, in parallel with that, there is the pragmatic, practical and functional challenge to complete the repair of the European banking system. These are very much interrelated. We need to maintain the momentum of constructing the banking union, as agreed in various EU summits over the past one and a half years. I believe that it is possible, and our view of the legal basis is that Article 114 is sufficient to provide the basis for constructing a credible banking union, involving especially a single supervisory mechanism and a single resolution mechanism.

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As regards further steps towards economic and/or fiscal union, we have legislation inside the Brussels beltway called the “six-pack” and the “two-pack”, of which you are certainly well aware. In these forms, we have pretty much exhausted the room for manoeuvre under the current treaties. In my view—and, more importantly, in the view of the European Commission—possible steps towards increased solidarity and further mutual assessment of economic risk need to be matched by increased responsibility, further pooling of fiscal sovereignty and deeper integration in decision-making. That is why we set up some time ago—it started its work in recent weeks—an expert group on searching for and analysing the pros and cons of partial substitution of national issuance of public debt within the eurozone, focusing especially on a debt redemption fund or pact, and also exploring the legal constraints on these options. This will mean that in order to move further in building an economic union and towards fiscal integration or a fiscal union, we will need at least to consider treaty changes, because, as I said, lawyers at the Commission and the Council are very much of the same view: namely, that taking further steps in this direction would require changes to the EU basic treaty. The Chairman: Can you describe the possible nature of the changes to the treaty? Could you also say a little more about putting all three elements of the original banking union into effect, and whether the gaps and pauses in between might invite market turbulence of a kind that might threaten the pace of the changes that are being made which are thought to be beneficial? Olli Rehn: First, I am a functionalist, and I believe that the European Commission is also functionalist, in the sense that form follows function. At this stage it is not possible to say anything specific about the nature of the treaty changes before we decide what kind of substantive reforms we want to produce. In this sense it is better not to put the cart before the horse. The first step in the coming debate is to see what kind of reforms are needed to economic and monetary union, and then we can come back to the more specific issue of treaty changes. There may be one additional element to the blueprint that we presented in November last year, about 11 months or a year ago. It refers to short-term, medium-term and long-term elements. Short-term refers to six to 18 months, medium-term 18 months to five years, and then there are long-term elements. Certain medium-term and long-term elements would require treaty changes. The blueprint is explicit about the elements that would require treaty change. For instance, a new power of requiring a revision of a national budget in line with European commitments would require the introduction of a new legal base in the treaty. Likewise, as I said, a redemption fund would also call for a new treaty base in order to make it happen. The Chairman: Before I turn to the Earl of Caithness, could you advise us on what we understand in terms of building solidarity? A paper from President Barroso on the social dimension of EMU will be published tomorrow. Are you in a position to let us have a sneak preview of what will be in it? Olli Rehn: As you said, it will be adopted tomorrow. Its basic focus will be on assessing, say, social imbalances and on providing a scoreboard of indicators that will facilitate better monitoring of social imbalances within the economic and monetary union, in order to provide better tools of prevention and, if needed, correction. In some senses it is aimed at mirroring the macroeconomic imbalances procedure in the field of economic governance, but you will find out the details in tomorrow’s proposals.

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Q103 Earl of Caithness: Vice-President, you mentioned in your introduction, which was very helpful, that you wanted to implement the banking union as agreed. The Commission said that there were three parts to banking union: a single supervisory mechanism, a single resolution mechanism and a common deposit insurance scheme. We have work on two of the legs. What has happened to the common deposit scheme? Have you dropped it or do you still think that it is necessary? My second question concerns your wording. Initially, the Commission said that it wanted to “break” the link between sovereign and bank debt, but in a speech earlier this year you said “dilute” the link between the two. In British language there is a huge difference between “dilute” and “break”. Do you still believe that banking union should “break” the link between sovereign debt and bank debt? Olli Rehn: Thank you for these questions concerning the SSM, the SRM and the common deposit guarantee scheme. What has been agreed by the euro area member states, and in fact largely endorsed by EU summits, has been that there will be a move within the agreed timeframe towards the two elements of supervision and resolution that clearly have to go hand in hand. They also have to be at the same political level, so that we can have a meaningful method of decision-making without creating moral hazards or negative incentives for different actors not to meet their responsibilities. Meanwhile, the common deposit guarantee scheme, while it is part of the Commission’s longer-term planning that we referred to in the blueprint for a deep and genuine EMU, is music for tomorrow, or perhaps for the day after tomorrow, not least because we are well aware that there is significant political resistance to it among member states. At the same time, we want to finalise work on a directive that is less ambitious than a common deposit guarantee scheme. That is something that my colleague Monsieur Barnier and the ECOFIN Council are working on. As regards the wording “break” and “dilute”, I respect the very firm distinction the English language makes between these two words. However, in reality the situation is not black and white; maybe the right verb would be something between this. “To break” would mean that it really is zero or 100%, while “dilute” might give too weak an impression of what the objective is. Even if there would one day be concrete action in terms of direct recapitalisation of banks within the eurozone or parts of the European Union covered by the ESM, still the member state concerned would have its skin in the game. Whether it would be 5% or 15% remains to be seen, but even in the context of direct recapitalisation it is important that we avoid moral hazard and free riding and that we ensure that the member state concerned has strong enough incentives to ensure that the recap operation will be a successful one. Earl of Caithness: Can I follow that up? If you are leaving some work for the day after tomorrow, do you not think that that gives an incomplete banking union and enhances the chances of another crisis for Europe? Olli Rehn: I think it is important to seriously explore analytically the issue of a deposit guarantee scheme. I believe in rational argumentation: once we can prove and everyone is convinced that a common deposit guarantee scheme is to the benefit of the European economy and its financial stability, I believe this will see the day, whether it is tomorrow or the day after tomorrow, and that they will tell us clearly about the directions.

Q104 Lord Kerr of Kinlochard: Contracts—Mrs Merkel’s concept. The Commission is seeking convergence in competitiveness through rewards and sanctions—a strengthening of

202 of 441 European Commission—Oral evidence (QQ 101-108) the system compared to the Stability and Growth Pact, which had only sanctions. How do you see these contracts as being enforceable and where do you find the cash for the carrots? If it is going to be carrots as well as sticks, where does the cash for the carrots come from? Olli Rehn: This issue is very much linked to the question of legitimacy and the democratic accountability of the reformed and reinforced economic currents. More specifically, I see that we have a chance in the current construct, which in fact has been decided fully in line with the Community method and which is fully legitimate in the light of the treaty of the European Union. In other words, both the six-pack legislation and the more recent two-pack have been agreed unanimously by all member states in the ECOFIN Council and supported by the vast majority of the European Parliament, initiated by the Commission. So that is a classical result of the Community method. At the same time, while we have been tasked with trying to encourage or ensure that the member states practise what they preach in terms of meeting their European commitments under the Stability and Growth Pact—or in terms of economic reforms, which I see as equally important if not more important—once we express our views and provide encouragement in a spirit of partnership to the member states, we are often criticised for meddling in the internal affairs of the Member States. I could provide a list of numerous examples—I do not even have to refer to the UK, which may be in a class of its own, with due respect. Whether it is France, Italy or sometimes Finland, you feel that the resistance to the stature of the economic governance is not related to a policy advisory system on the basis of that reformed governance structure. So it is a broader issue, which is why we will, in the coming five to 10 years, have to think about what kind of more constitutional reflection we have in order to ensure that this new method is also considered legitimate and not only legal. As regards the idea of contracts, which is in a way related to the and the fiscal compact, we see in the blueprint that these contracts could be agreed between a member state and the Commission, and then under certain conditions an economic reform could be supported financially by a eurozone fiscal authority or by a eurozone budget, which we have analysed in the blueprint. However, you know as well as I do that for the moment there is clearly no agreement on such a eurozone budget. That clearly is a work in progress and will depend on decisions related to the formation of the next Commission and the start of the next Parliament or in the case of decisions to be taken in the coming years. I see that these contracts on reforms on the one hand and France’s report go pretty much hand in hand. This can also be seen as part of the economic partnership and programmes that are already provided by the current recent reform of economic governance. Lord Kerr of Kinlochard: I think you are telling us not to expect rapid progress on this particular part of the dossier. You are talking about the next Commissioner. Is that partly because it is hard to see how such a system could be enforceable under the existing treaty, and there would have to be some treaty change to give credibility to the system of sticks and carrots? Olli Rehn: I think it is fair to say that there is certainly room and a need to reinforce the legitimacy and democratic accountability of the current, reformed system of economic governance in the economic and monetary union. This goes towards possible encouragements—you call them carrots and sticks, I usually call them encouragements, which covers both. In that sense, it is a broader political and constitutional issue, but there is the other side of the coin, which is money. For the moment there is a lack of agreement among member states about providing the eurozone with a separate eurozone budget which would then provide funding for this. Of course, there is a third problem after that: you

203 of 441 European Commission—Oral evidence (QQ 101-108) would have to have clear and sufficiently uniform criteria over selecting the reforms that could be supported from this budget. I believe that could be overcome but it is not a simple task and is something we should not underestimate. We have to be able to agree on sufficiently clear and universally applicable criteria across different countries. Lord Vallance of Tummel: Vice-President, before I move on to medium-term and longer-term things, could I ask you a question about the shorter term and perhaps what we will call contingency planning? Looking at the timetable that you described earlier on, I think that that assumes relatively calm markets. Let us suppose that that assumption does not hold and we were subject to another major external shock. That might come about because of what is happening in the United States at the moment. There could, conceivably, be a default on the world’s most important currency, something that might trigger turbulence here in Europe, possibly even calling the bluff of the European Central Bank, where it was required to use the OMT rather than talk about it. Under those circumstances, what would your priorities be in bringing things forward? Olli Rehn: Obviously we do contingency planning and also we have tried to learn the lessons of the recent past. We have different possibilities for reacting in case the situation becomes more difficult. I would not want to paint those on to the wall at this stage. We will cross that bridge when we get there, or we will see what we will do before we start crossing the bridge. We will come back to that if things turn sour in the US.

Q105 Lord Vallance of Tummel: Perhaps I can move on to the budgetary framework and the medium and longer term, where the blueprint talks about a fiscal capacity and an autonomous euro area budget. What is the function and purpose of such a budget? How might it be funded? How large would it be? Olli Rehn: You are right that we propose in the blueprint the creation of fiscal capacity in the medium term with a view to moving towards an autonomous euro area budget in future in order to support the policy choices resulting from enhanced co-operation with both budget and economic policies, which the blueprint calls for. This fiscal capacity and eurozone budget is related to what we discussed with Lord Kerr a few moments ago. The fiscal capacity would therefore aim to rebalance aggregate demand to allow the integration process linked to the deepening of EMU to deliver more widespread benefits. Over the longer term, the blueprint envisages that the fiscal capacity will take the form of an autonomous euro area budget. There are of course other possibilities for the achievement of this kind of stabilisation but the establishment of an autonomous budget would serve the purpose of stability and transparency in its operation. Lord Vallance of Tummel: How would an autonomous euro area budget interact with the EU budget? Olli Rehn: That would be something that the euro area member states and the non-euro member states would need to discuss. Our view is that while the EU budget has been continuously reformed, its basic structure and legal basis would stay as they are, and the eurozone budget would complement or supplement the EU budget in those specific areas where it would be intended. Lord Vallance of Tummel: Can you give us an idea in broad terms of how large the budget would need to be? Olli Rehn: In fact, we do not go into numbers in the blueprint. That would obviously have to be discussed in case or once such a fiscal capacity in the euro area was created. I recall that in the Delors committee of 1988 or 1990, Jacques Delors and his economic committee

204 of 441 European Commission—Oral evidence (QQ 101-108) concluded that the economic and monetary union would need a budget of around 3% of GDP. That committee was set up with the support of Prime Minister Margaret Thatcher and included Governor Robin Leigh-Pemberton, so it must have had the strongest authority behind that proposal. However I refused to take any stand on any exact number. I am just making the reference: there has been some work done previously in this area, even at the time of the creation of the economic and monetary union. Lord Vallance of Tummel: What tax and revenue basis might be under consideration, assuming that we are talking new own resources, which I think we have seen? Olli Rehn: It would probably be based on new own resources and thus there would be an autonomous fiscal resource base, but so far that has not been specified either in the Commission’s reflections or conclusions. Lord Vallance of Tummel: Is it anticipated that non members of the euro area might participate, and if that is the case, how would it work? Olli Rehn: I see that it is possible. It is institutionally possible and it is also possible to agree on a financing key if there is the political will to do so. That would make sense, for instance, for countries like Greece that might have need of particular economic reforms. They could be part of this arrangement. Again, this is still an opening position, but in principle to my mind it could be open to other countries in pretty much the same way as, for instance, the banking union, even though the two are not strictly comparable. They have different characteristics. Lord Kerr of Kinlochard: Thinking back to 1988, 1989 and 1990, the outcome in Edinburgh was 1.2% of GDP, and since then the level of the budget ceiling has, in practice, gone down. If you are thinking of a fiscal flywheel—a stabilising mechanism, which in the United States is about 27% of GDP—that flywheel would clearly have to be of a certain size to have an equalising effect, as in a federal state like the United States. What sort of money are we talking about? You ducked Lord Vallance’s question by saying that we would have to wait and see, but the concept of a fiscal stabiliser surely requires a considerable and significant proportion of the GDP of the area to be stabilised. That is different from the money that you and I were talking about a minute ago when we discussed cash for carrots. There you have an intervention fund which goes in and does things and then comes out again. Here you are talking about fiscal stabilisation. Is that realistic? Olli Rehn: It is true that the longer-term blueprint provides a range of possible outcomes in terms of the objectives of the final euro area budget, but obviously then the operation and the size of the autonomous budget would depend on the magnitude and a whole range of any possible stabilisation functions. It could offer, for instance, stabilisation in the case of asymmetric shocks across the euro area or it could offer stabilisation in the case of symmetric shocks, but clearly that would be even more demanding. In the latter case, a larger budget would be required for its contribution to stabilisation to be significant. I repeat myself deliberately to avoid taking any stand on the exact size because we think it is pretty much an analytical and perhaps also a political issue.

Q106 Lord Vallance of Tummel: I have just one quick and final question. The blueprint proposes quite ambitious, albeit long-term, ideas about the common issuance of public debt eurobonds. You mentioned earlier that some things could happen before then, such as eurobills rather than eurobonds and a debt redemption fund. Perhaps I missed it, but did you have a timescale on those too?

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Olli Rehn: If I recall correctly, these are characterised under the medium-term objectives— at least in my mind they are medium-term objectives. Why is that? It is because we have made a careful analysis and I have heard personally the views not only of the Commission legal services but of the Council in Parliament legal services in the trilogues. I will just say that it is very clear that any steps towards the further mutualisation of public debt through a redemption fund for Europe would require a treaty change. I do not see such a situation happening overnight and it is not very likely that these alternatives would be policy options to combat the current crisis. They are, frankly, more medium to long-term objectives. Lord Vallance of Tummel: So even a short-term eurobill would require a treaty change. Olli Rehn: So far, at least, that is the analysis of our lawyers. Perhaps I can add that we set up an expert group on a redemption fund and on eurobills. It started its work after the summer break, which ended some time ago, and it is expected to conclude its work by the end of March next year. I trust that we will then have the analytical raw material for policy and political debate before the European elections, building on the programme of the new Commission and the work of the new Parliament. Lord Hamilton of Epsom: Vice-President, the crisis in Greece is still a big problem for the eurozone. Its accumulated debt is, I think, €240 billion, and although that is a small part of the EU as a whole, it is a very serious problem for Greece. Surely its debt has to be reconstructed pretty massively and cut down for the situation in Greece to be sustainable. How do you see this working out? Olli Rehn: You will certainly be aware that the United Kingdom paid back its last tranche of lend lease loans to the United States of America under a Prime Minister, Tony Blair, in 2006. That was 70-odd years after the war. My point is that there are possibilities other than a so-called straight haircut on capital. We will analyse the debt sustainability of Greece in the coming months—in fact, mainly next year because of the agreement of the Eurogroup in November 2012. Once Greece has achieved a primary fiscal surplus, a positive surplus, the eurozone member states are then committed to considering further measures for improving the debt sustainability of Greece. Two examples were mentioned. One was to consider a further reduction in interest rates and to consider revising the co-financing rates of structural funds. I would say that a further prolongation of loan maturities on the ESM/EFSF and loan capacity to Greece could be available as a reasonable option. We can start to work on this effectively, in fact, only after Eurostat has validated the fiscal data of Greece. This always happens with a time lag. For this year, 2013, we will get validated data from Eurostat in late April next year. Then we have to have regulation in Greece. In parallel, we know there will most likely be a financial assessment if there are any further needs. Once we have all this information and we analyse other aspects as well, we can then conclude, with the IMF, what the three of us will propose to the euro area Ministers in terms of improving the deficit sustainability of Greece. So in Greece there will be roughly two states of decision-making. First, in the coming months—I would say towards December and January—how to cover the financing needs of Greece in 2014 and a possible fiscal gap in 2015-16, to be analysed and assessed. Then, once we have all these data and once we have verified that Greece has achieved a primary surplus in public finances, the member states will be ready to take further steps.

Q107 Lord Hamilton of Epsom: Thank you very much. My next question is about integration in terms of the EU institutional arrangements. How do you see this happening

206 of 441 European Commission—Oral evidence (QQ 101-108) vis-à-vis the 28? One can see greater integration taking place in the eurozone, but how will this play into the other members and the wider members of the eurozone? Olli Rehn: In my view, the basic principles are such that we will have, first, to preserve and develop the single market—for instance, in financial services and banking regulation—on the basis of the normal Community method and the EU 28. That is the basic principle, so we will continue to do everything we can within the unified framework of the European Union of 28. At the same time, the eurozone has certain clear needs to go deeper in its economic and policy integration. To paraphrase George Osborne, there is a remorseless logic in the single currency which calls for deeper integration in decision-making. Thus, the eurozone has the right to go further on issues that clearly have to do with stronger and deeper interdependence of the eurozone member states. In my view, it is possible to combine the two, and the latest compromise on the single supervisory mechanism is an example of this. Lord Hamilton of Epsom: Can you see a new treaty for the eurozone which would exclude the members who are not members of the eurozone? Olli Rehn: I very much prefer to work on the basis of the European Union in its entirety of 28 members. We all know, for instance, that the fiscal compact treaty was agreed by a smaller number of member states than there are members of the European Union: the eurozone plus—whatever it was then—eight members, I think, out of the eurozone. From next year onwards, it will be the eurozone plus seven members, because Latvia will join the eurozone and Croatia is in, but Croatia is part of the fiscal compact, I suppose. So 26 are in the eurozone. I by far prefer that. I know what is behind your question, but without knowing you own view precisely, frankly speaking my view is that if I were a UK citizen—and I have two cousins with UK passports—I would by far prefer to have my country as a playmaker in the midfield rather than being on the sidelines. The Chairman: Commissioner, you have shown a deep and profound knowledge of Conservative Party history in our country, for which we are grateful. I wonder if I could turn to Lord Kerr for our final question.

Q108 Lord Kerr of Kinlochard: For me, this is the €64,000 question. It follows directly from what you have been saying. Mr Vice-President, you and the Commission are the guardians of the treaties, responsible for ensuring their non-discriminatory application. Most of the things we have been talking about today, you know the United Kingdom is not going to participate in, and on some it will not be alone in not participating. So you have the problem of ensuring the continuing integrity of the single market while certain member states—probably the majority of member states—go ahead doing those things which other member states are not going to do. You have a problem. How are you going to tackle that problem, and how could the United Kingdom best help you? Do not say, “Change your views on the substance of these dossiers and come into line”. How could the United Kingdom best ensure the continuing integrity of the single market and help you to do so? Olli Rehn: I think you put the right sum on the question—the worth of the question. In fact, as regards the UK, I trust that the United Kingdom will continue its constructive approach in relation to building the single market in Europe. I believe that by reforming the European Union we can together achieve much more than by repatriating competences from the European Union. I, for one, believe that we have much to improve on in terms of better regulation and improving the competitiveness of European industry. That is something where we share an objective and we are trying to do our best in that regard, but certainly we can

207 of 441 European Commission—Oral evidence (QQ 101-108) further improve our work in this field. I would rather seek allies in terms of reforming the European Union than in terms of starting to repatriate powers from the European Union. There are specific issues relating to the eurozone, and I believe that we can solve those with the philosophy of George Osborne, who, to my mind, is right and realises that it is a sheer fact and a reality that the eurozone has certain needs and has to go further in its integration. But at the same time, for instance, the compromise on the EBA and the SSM voting mechanisms showed that we can find practical and reasonable compromises and preserve the single market while recognising the specific needs of the eurozone. The Chairman: Commissioner, to replay one of your phrases today, you have been our music for today. In some of your wise words, I hear and see the long vistas of Finlandia stretch out in front of us. Just as we are examining genuine economic and monetary union, I see that we have to recognise the long vistas of that effort coming to fruition. We are enormously grateful to you for coming today to help us with our first meeting on this matter. We will be publishing a report later this year or early next year. As I said, we will send you a copy of our transcript of this meeting and would be very grateful if you could correct it, but if you have after-thoughts, we would be very grateful for those too. In the mean time, many thanks indeed and good luck in the work that you are doing on behalf of the 28 nations of the European Union and the United Kingdom. We will always welcome you to a Premier League football match if and when you want to come to London. Thank you very much indeed. Olli Rehn: Thank you very much for the very pertinent and substantial questions. We will very much enjoy reading the report at the time of its publication.

208 of 441 European Commission—Supplementary evidence

European Commission—Supplementary evidence

Questions 1 & 2

The European Commission's Blueprint for a deep and genuine economic and monetary union first describes a number of weaknesses in the initial design of EMU and adherence to rules. 17 In response to these challenges, important steps have been taken by strengthening budgetary surveillance, economic policy surveillance and financial regulation and supervision and by instituting crisis resolution mechanisms. The totality of measures taken so far amounts to a strong response to the crisis, particularly when compared with what was considered politically feasible only a few years ago. This overhaul has made EMU much more robust than it was at the onset of the crisis. In addition, the Blueprint identifies the steps and actions required to arrive at a deep and genuine EMU on a permanent basis. It is clear that EMU cannot be completed overnight. The Blueprint therefore distinguishes between steps to be taken in the short, medium and long term. All steps to be taken must build on each other and follow from each other. The way forward needs to be carefully balanced and must be in line with the Treaties. Steps towards more responsibility and economic discipline should be combined with more solidarity and financial support. This balance has to be struck in parallel and in each phase of the development of EMU. The deeper integration of financial regulation, fiscal and economic policy and corresponding instruments must also be accompanied by commensurate political integration, ensuring democratic legitimacy and accountability.

An integrated financial framework (Banking Union) Question 3 The Banking Union is a vital part of the policy measures to put Europe back on the path of economic recovery and growth. It is a consequence of economic and financial integration of the internal market and - whilst of particular relevance for Member States who share a common currency - it is intended to boost financial stability in the whole of the EU. Swift progress towards a Banking Union is necessary to ensure financial stability and growth, not only in the Euro Area and the rest of the EU but also more widely. The Union took swift action to break the vicious circle of debt between sovereign states and banks in their jurisdiction and to re-launch stable cross-border banking activities throughout the EU's single market. Building on the regulatory framework common to all 28 members of the single market (single rulebook), and the European Free Trade Association (EFTA) members of the European Economic Area (EEA) beyond, the European Commission has therefore taken an inclusive approach and proposed a Banking Union with different instruments and steps. The Banking Union will be composed of a Single Supervisory Mechanism (SSM) and a Single Resolution Mechanism (SRM) applying a single EU-wide rulebook of prudential and resolution rules, comprising the Capital Requirements Directive and Regulation (CRD/CRR) and unified rules on resolution based on the proposed Bank Recovery and Resolution Directive (BRRD). The BRRD is based on international standards published by the Financial Stability Board and endorsed by the G20. The UK Government played a prominent role in

17 http://ec.europa.eu/commission_2010-2014/president/news/archives/2012/11/pdf/blueprint_en.pdf

209 of 441 European Commission—Supplementary evidence the development of those international standards, backed by the European Commission and other participating EU countries.

The SSM and the SRM will cover banks in all Euro Area Member States and in those non- Euro Area Member States which choose to join. The enhanced financial stability generated by the Banking Union will boost confidence and the prospects for growth across the EU single market. Uniform application of prudential and resolution rules in the Member States participating in the Banking Union will counter financial fragmentation currently hampering economic activity, ensure fair competition and remove obstacles to the exercise of fundamental freedoms in the single market. On 10 July 2013, the European Commission adopted a proposal for a Regulation of the European Parliament and of the Council establishing uniform rules and a uniform procedure for the resolution of credit institutions and certain investment firms in the framework of an SRM and a Single Bank Resolution Fund. The mechanism would complement the SSM which, once operational in 2014, entrusts the European Central Bank (ECB) together with the national competent authorities with the supervision of banks in the euro area and in other Member States which decide to join the Banking Union. The SRM would ensure that if a bank subject to the SSM - notwithstanding stronger capital, leverage and liquidity requirements and better supervision – faced serious difficulties, its resolution would be managed efficiently at the European level with minimal costs to taxpayers and the real economy. Therefore, the SRM will only apply to banks in those non euro Member States which have also joined the SSM. The SRM proposal provides for the set-up of a Single Resolution Fund, fully financed by the banking industry. The Single Fund would provide an effective funding source for the resolution of banking crises in the euro-area. Since shocks in the banking industry are likely to be concentrated at a specific point in time in some Member States, a common European private backstop mechanism, as opposed to individual national backstops, would be more effective in absorbing such shocks. By pooling resources at the European level, the Single Fund will have stronger “firepower” and will increase the resilience of the financial system in all the countries belonging to the Banking Union and have positive repercussions for the whole Union. Conversely, at this stage it is not envisaged to set up a common European Deposit Guarantee Scheme within the Banking Union. National deposit guarantee schemes (DGSs) will remain in place and the Commission considers that, provided there are appropriate lending arrangements between DGSs this can be consistent with Banking Union at least in a first phase. Before proposing a European DGS, the funding of national DGSs should be improved by concluding current negotiations on the Commission’s proposal for a Deposit Guarantee Schemes Directive. As part of this work, appropriate lending arrangements between adequately prefunded national schemes, as proposed by the Commission, would strengthen the overall protection of depositors across the internal market, help tackle asymmetric banking shocks, and mitigate their cross-border spill-over effects. The objective of the SRM proposal is to restore financial stability and, through the alignment of both supervision and resolution at the same level, European for the Banking Union, national for non-participating countries, a level playing field among all EU banks. For this reason, the legal basis for the proposal is Article 114 of the Treaty on the Functioning of the European Union (TFEU), which provides for the adoption of measures for the approximation of national provisions aiming at the establishment and functioning of the internal market. Article 114 TFEU is also the correct legal basis for levying contributions

210 of 441 European Commission—Supplementary evidence from banks to the Single Bank Resolution Fund. This approach was followed in the DGS and BRR Directives in respect of contributions to national funds. The Regulation on fees paid by credit rating agencies for their supervision provides for the collection of fees by a European body, the European Securities Markets Authority (ESMA). The proposed decision-making process within the SRM does not require a Treaty change. It ensures the appropriate institutional balance and legal underpinning to complement the SSM by creating an efficient framework for bank resolution, in line with the conclusions of the European Council of December 2012 and June 2013. The SRM proposal fully conforms to this imperative, ensuring its decisions respect the legal order, democratic principles and accountability principles of the Union. An integrated economic policy framework Question 4 The European Commission identified the lack of systematic surveillance of macroeconomic imbalances and in particular of uneven competitiveness developments as a major weakness of the pre-crisis surveillance arrangements. Slow or absent implementation of key structural reforms over long periods of time aggravated competitiveness problems and hampered the adjustment capacity of Member States. Against this background, the Macroeconomic Imbalances Procedure (MIP) was set up precisely to prevent and correct such macroeconomic imbalances and to identify and allow the timely correction of any emerging competitiveness divergences. Its effective implementation will reduce the likelihood of the building up of imbalances in the future. A Convergence and Competitiveness Instrument (CCI) would represent an addition to this framework combining a quasi-contractual arrangement, by which a Member State would commit itself to implement a number of key reforms under specific timelines, with a financial support mechanism to help facilitate the implementation of these reforms. The two pillars would combine increased economic responsibility with solidarity in the form of financial support to overcome possible constraints in implementing these reforms. In this sense a CCI will go beyond the MIP by laying down the key measures a Member State commit to put in place, with agreed conditions and timelines, and by providing financial assistance in return. The Commission is nevertheless aware of the challenges faced in setting up this new instrument, notably on the need to avoid moral hazard and on guaranteeing the enforceability of the commitments. In its Communication on the introduction of a CCI of 20 March 2013, the Commission put forward ideas, suggestions and questions to get feedback from the main stakeholders on the key issues underlying this instrument. There are issues that require further discussion, namely: how to avoid moral hazard, what type of reforms that could be part of the CCI, which Member States could make use of the CCI and the details of a financial support mechanism, including the link with the EU budget. In this sense, the June 2013 European Council decided that, despite the convergence around the key principles underpinning the concepts of mutually agreed contracts and associated solidarity mechanisms, further work is required on these issues in the coming months. The Commission will provide further input in the near future to feed the discussion. Question 5 The current EU economic surveillance framework already provides a basis for economic policy coordination. The surveillance of economic, budgetary and structural policies that has been brought together into the European Semester has made EMU more robust than it was at the onset of the crisis and better equipped for the future. As mentioned in the answer to

211 of 441 European Commission—Supplementary evidence the previous question, its scope was broadened to include competitiveness and internal and external imbalances under the MIP. However, the current framework does not provide systematic ex-ante coordination among Member States' plans for major economic policy reforms. Ex-ante discussion and coordination of major reform plans would allow the Commission and Member States to assess the potential spill-over effects of national action and comment on the plans before final decisions are taken at national level. Following the blueprint for a deep and genuine EMU, the European Commission published in March 2013 a Communication on the ex-ante coordination of major economic policies which addresses, inter alia, the reforms that should be included in this coordination exercise. As mentioned in the Communication, and in line with the feedback received from the main stakeholders in the meantime, the reforms to be coordinated should be relevant taking into account the following filters: • Trade and competitiveness, which are among the main channels through which spill- overs are transmitted; this may include product, services, labour market and tax reforms affecting employment and growth in the implementing Member State, and hence the demand for products and services from other Member States; • Financial markets, given the potential spill-over effects of certain reforms that could be spread through the financial sector; and • Political economy considerations, notably coming from possible domestic opposition to reform. The use of these filters will definitely be key when choosing the reforms to be addressed. Nevertheless, in order the improve our understanding of how this new exercise could be implemented in practice – notably with regard to (i) which Member States and which reforms should be assessed; (ii) the contents and expected outcome of the exercise; and (iii) the timeline and consistency with Member States' national decision-making processes –, the EU Economic Policy Committee (EPC) will carry out a pilot exercise on ex-ante coordination during the second half of 2013. The outcome of the pilot exercise should include the lessons to be learned from this exercise, notably in terms of the feasibility of the timeline, consistency with the European Semester. In a longer term perspective, the ex-ante coordination of economic policies may also provide key input to identify the economic policies which will require further integration within the euro area. The Blueprint proposes deeper policy coordination in the fields of taxation and employment policies. Tax policy can indeed support economic policy coordination and contribute to fiscal consolidation and growth. The Commission has tabled several proposals, such as the Common Consolidated Corporate Tax Base (CCCTB), the review of the Savings Directive, the new Energy Tax Directive, which are currently discussed in the Council. Based on the experience to be gained with the structured discussions of tax policy issues which focus on areas where more ambitious activities can be envisaged, one might in future consider in the context of a Treaty change providing scope for legislation on deeper coordination in this field in the euro area. Labour markets are another area where such progress could be considered, given the importance of well-functioning labour markets and in particular labour mobility for adjustment capacity and growth within the euro area. Discussion on concrete avenues for

212 of 441 European Commission—Supplementary evidence reform has not started yet. Further integration of the existing economic governance instruments will surely require an in-depth debate, involving possible changes to the Treaties. An integrated budgetary framework Question 6 The blueprint proposes the creation of fiscal capacity in the medium-term, with a view to moving towards an autonomous euro area budget in the longer term, in order to support the policy choices resulting from enhanced coordination of both budgetary and economic policies which the blueprint calls for. The fiscal capacity will therefore aim to rebalance aggregate demand to allow the integration process linked to the deepening of EMU to deliver widespread benefits. Over the longer term, the blueprint envisages that the fiscal capacity will take the form of an autonomous euro area budget. There are, of course, other possibilities for the achievement of central fiscal stabilisation, but the establishment of an autonomous budget serves the purpose of stability and transparency in its operation. For the longer term, the blueprint offers a range of possible outcomes. The operation and size of the autonomous budget would depend on the magnitude or range of stabilisation function; it could offer stabilisation in the case of asymmetric shocks across the euro area or it could also offer stabilisation in the case of symmetric shocks. In the latter case, a larger budget is likely to be required, in order for its contribution to stabilisation to be significant. The autonomous budget could be funded in number of ways, but it would need some form of own resources in order to be considered autonomous. As the creation of such a budget is flagged as coming over the longer term – which is defined from in 5 years' time or later – the blueprint is not explicit in what the appropriate structure might be. It is envisaged, however, that a new structure such as EMU Treasury within the Commission would be needed to act as the new budgetary authority and manage the joint resources. The details of how the autonomous EMU budget would interact with the EU budget cannot be determined at present. The blueprint concerns the deepening of EMU and therefore mainly the position of euro area Member States; regarding non-members of the euro area it recalls some basic principles, such as openness for their participation and the destiny of all Member States except the UK and Denmark to become full members of EMU, but it does not elaborate on their position as regards the medium to long term perspective of an EMU fiscal capacity / autonomous budget. The creation of an autonomous budget is very much linked to the particular interdependencies between countries sharing the single currency and the additional risk sharing that would come with it would be counterbalanced by the sharing of responsibilities and sovereignty. It would operate alongside stronger political and economic integration. Question 7 The creation of European government bond (whether it is called a Eurobond or some other name) is identified in the blueprint as the possible final stage of EMU. Debt mutualisation allows the sharing of sovereign risk and would be to the benefit of the euro area as a whole by opening up the market and allowing positive reputation spillovers. It would need to be accompanied by a strong structure ensuring fiscal discipline and can act as an incentive for countries to deliver fiscal discipline in order to partake in the benefits of the mutualisation of risk. Its operation is predicated on strong fiscal and economic integration.

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The issuance of common debt could be introduced in stages and start in the medium-term with the issuance of short-term debt instruments (called Eurobills in the blueprint) with a maturity of 1 to 2 years, with aim of counteracting the fragmentation and short-term volatility in European sovereign debt markets. A debt redemption fund is another possibility – this would allow debt over the 60% of GDP limit to be transferred in under strict conditionality. The blueprint identified the steps needed to reach the discipline and sharing or responsibility needed to allow for the creation of a European government bond, and considers the institutional and political steps that must accompany it. On July 2 2013, the European Commission put together an Expert Group to look into the merits and risks, legal requirements and financial consequences of initiatives for the joint issuance of debt in the form of a redemption fund and Eurobills. The Group will present a report to the Commission in March 2014. Institutional issues Question 9 Some of the instruments described in the Commission's Blueprint can be adopted within the limits of the current Treaties. This includes Banking Union. Others will require modifications of the current Treaties and new competences for the Union. In general, as underlined in the Blueprint, the Commission is of the opinion that moves towards a genuine EMU should primarily be constructed using all the possibilities offered by the Treaties as they stand, e.g. via the adoption of secondary legislation. Amendments to the Treaties should be contemplated only where an action indispensable for improving the functioning of the euro area cannot be constructed within the current framework. Possible changes should be carefully prepared, so as to ensure the political support necessary. As underlined in the Blueprint, the Commission considers it important that the deepening of the EMU should build on the institutional and legal framework of the Treaties for sake of legitimacy between Member States and efficiency. Its deepening should be done within the Treaties, so as to avoid any fragmentation of the legal framework, which would weaken the Union and question the paramount importance of EU law for the dynamics of integration. EU decision-making rules provide full efficiency, resting on qualified majority instead of unanimity requirements and on a robust democratic framework. Intergovernmental solutions should therefore only be considered on an exceptional and transitional basis where an EU solution would necessitate a Treaty change, and until that Treaty change is in place. They must also be carefully designed so as to respect EU law and governance, and not raise new accountability problems. Question 10

The Commission's Blueprint puts it that any work on democratic legitimacy as a cornerstone of a genuine EMU needs to be based on two basic principles. First, in multilevel governance systems, accountability should be ensured at the level where the respective executive decision is taken, whilst taking due account of the level where the decision has an impact. Second, the level of democratic legitimacy always needs to remain commensurate with the degree of transfer of sovereignty from Member States to the European level. It follows from the first principle that it is the European Parliament that primarily needs to ensure democratic accountability for any decisions taken at EU level, in particular by the Commission. A further strengthened role of EU institutions will therefore have to be accompanied with a commensurate involvement of the European Parliament in the EU procedures.

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The Lisbon Treaty has perfected the EU's unique model of supranational democracy, and in principle set an appropriate level of democratic legitimacy in regard of today's EU competences. Hence, as long as EMU can be further developed on this Treaty basis, there would not be insurmountable accountability problems. Conversely, discussions on medium and long-term Treaty amendments will need to include reflections on adaptations to the EU's model of democratic legitimacy. For example, a "euro committee" established within the European Parliament could also be granted certain special decision-making powers beyond those assigned to other committees, e.g. a greater weight in the preparatory parliamentary stages or even a possibility to perform certain functions or take certain acts in lieu of the plenary.

Whatever the final design of EMU, the role of national parliaments will always remain crucial in ensuring legitimacy of Member States' action in the European Council and the Council but especially of the conduct of national budgetary and economic policies even if more closely coordinated by the EU. Given the interdependencies of the decisions of Parliaments in the EU, inter-parliamentary co-operation is a useful element. One example is the European Semester. The Commission supports efforts to reinforce the democratic legitimacy of the European Semester process and the ownership of national Parliaments in that respect. However, it is ultimately up to national Parliaments and the European Parliament to determine jointly the precise organisation and modalities of inter-parliamentary cooperation.

Impact on the UK and the Single Market As concerns Banking Union, the integrity of the single market will be safeguarded by common substantive rules at EU level (the single rule book), by the specific provisions for non-participating Member States and by the principle of non-discrimination, which is clearly and unambiguously established in EU law by the Treaties and the Regulation establishing the SSM and the proposal for the SRM contain a non-discriminations clause. It is also to be noted that other horizontal tools such as the application of state aid discipline to the banking sector will continue to apply consistently and without distinction to all Member States. The SSM package, including the regulation conferring supervisory tasks to the European Central Bank (ECB) (SSM regulation) and the regulation amending the regulation establishing the European Banking Authority (EBA regulation), provides for extensive safeguards for non- euro area Member States in order to preserve the Single Market. For those non-euro area Member States who decide to participate in the SSM, the SSM regulation provides for safeguards which go as far as legally possible to counterbalance the fact that those Member States are not represented in the Governing Council of the ECB. In particular, non-euro area Member States participating in the SSM, may, on an equal footing with euro-area Member States, participate in the activities of the newly created Supervisory Board which is in charge of planning and executing the supervisory tasks conferred upon the ECB.

In respect of relations with non-euro area Member States which will not participate in the SSM, the SSM regulation provides that the ECB will apply the single rulebook applicable to all Member States. In particular, existing home/host supervisor coordination procedures and colleges of supervisors will continue to exist as they do today, as far as coordination with supervisors in non-euro area Member States is concerned. Non-euro area Member States will retain all their existing powers and prerogatives. The SSM regulation also provides for the conclusion of memoranda of understanding between the ECB and the competent

215 of 441 European Commission—Supplementary evidence authorities of non-participating Member States on the way they will cooperate in the performance of their supervisory tasks.

In addition, the creation of the SSM preserves EBA’s prerogatives in the development of the single rulebook and its role in promoting consistency of supervisory practices in the whole EU. In particular, the single rulebook will be complemented by a European supervisory handbook drawn up by the EBA in consultation with national competent authorities. Moreover, voting modalities have been adjusted to ensure that the interests of all Member States are adequately taken into account and to allow for the proper functioning of the EBA after the establishment of the SSM. Finally, the ECB will be subject to the same procedure of binding mediation as any other supervisor

The SRM proposal also offers a series of safeguards to non-euro area Member States. First and foremost, the same EU-wide single rulebook of prudential requirements made up of the Capital Requirements Directive and Regulation (CRD/CRR) and rules on bank resolution, (the BRRD), will apply in all Member States. As mentioned earlier, the SRM is the mechanism which allows for the consistent application of the BRRD in the banking union through a unified decision making process and with the support of financial resources raised at Union level. This is necessary within the euro area because of the strong economic interdependencies of the countries who share the common currency. The EU-wide single rulebook and BRRD will prevent differences of treatment among banks of the whole Union and preserve the integrity of the internal market.

As the BRRD provisions will be taken over within the SRM, the rules governing the establishment and functioning of resolution colleges among national resolution authorities will continue to apply for dealing with banking groups that operate both in participating and the non-participating Member States. The EBA will continue to have a mediation role, pursuant to the BRRD and the EBA Regulation, where home and host national resolution authorities are in disagreement on the preparation of resolution plans and on the resolution itself. However, where participating Member States are involved, the Single Resolution Board will replace the national resolution authorities concerned in their resolution functions in the resolution colleges.

Moreover, the proposal contains a clause on non-discrimination, on the same basis as the principle established in the Treaties. To ensure an objective and fair resolution process, any discrimination by the Commission, the Resolution Board and the national resolution authorities against banks, their depositors, creditors or shareholders on grounds of nationality or place of business is therefore forbidden. Insofar as any support from the fund constitutes state aid, the state aid framework for banking will apply as it would to any support provided to banks by non-participating Member States. Should support not constitute state aid according to the Treaty, the Commission will apply mutatis mutandis the same rules as laid down in the state aid framework to ensure parity of treatment within the single market.

Furthermore, the proposal takes into account the situation of non-participating Member States by providing for additional principles aimed at ensuring that their interests are taken into account in the resolution process as regards banks with operations in both participating and non-participating Member States. Pursuant to the principle of cooperation, the Single Resolution Board is required to cooperate with the resolution authorities of non- participating Member States at different stages of the recovery and resolution process: for

216 of 441 European Commission—Supplementary evidence the drafting of group recovery and resolution plans, for the assessment of such plans, for addressing or removing impediments to resolvability in case of groups and for taking concrete resolution decisions for groups. The proposal also comprises provisions on the interaction between the Single Resolution Fund and national resolution funds of non- participating Member States (mutualisation and voluntary borrowing).

5.11.13

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European Policy Centre and Professor André Sapir—Oral evidence (QQ 134-147)

Evidence Session No. 11 Heard in Public Questions 134 - 147

WEDNESDAY 2 OCTOBER 2013

Members present

Lord Harrison (Chairman) Earl of Caithness Lord Hamilton of Epsom Lord Kerr of Kinlochard Lord Vallance of Tummel ______

Examination of Witnesses

Fabian Zuleeg, Chief Executive and Chief Economist, European Policy Centre, and André Sapir, Professor, Free University of Brussels

Q134 The Chairman: Good morning. When you receive the transcript, we would be most grateful if you would look over it and correct it. I say to witnesses that if they have any wonderful thoughts when they leave the room and say, “I wish I had told them that”, please do tell us that. Sometimes the best thoughts come afterwards. We are all ears as regards having updates of anything that we pursue. We are here for two days talking about genuine economic and monetary union. You may be aware that we published our thoughts on banking union at the end of last year. I hope and believe that it had some influence on the British Government and hope that it contributed to the debate here. We hope to do the same with this discussion. We have taken extensive soundings. You may like to know—in fact, you may have some advice for us on this—that we will be going to Germany in November. We will be going to Frankfurt to talk to Mr Constâncio in the ECB who has contributed in the past to the banking report. We are hoping to find a political leadership in Berlin by the time we get there. We rather think that Berlin is going to be crucial in all these developments and maybe that is something you will both comment on. Perhaps I can invite both of you to say a little about yourselves and then I will ask the first question. Fabian Zuleeg: I am the chief executive and chief economist of the European Policy Centre—the chief executive since yesterday. The Chairman: Congratulations. Fabian Zuleeg: Thank you. I am originally German. I have been working on European economic issues for a long time, particularly with an emphasis on political economy. We have done a lot of work on the crisis with the main focus on our side being on the governance questions and on the impact on the real economy, so we have looked at questions of growth and employment.

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André Sapir: I am an economics professor at the Free University of Brussels—the francophone part of the Free University of Brussels, since we have two. I am also a senior fellow at Bruegel, another think tank in Brussels. I also serve currently as the chair of the advisory scientific committee to the ESRB—the European Systemic Risk Board—and I am a member of the general board. Like Fabian and most economists in Brussels, I have been working on European integration issues for a long time, particularly since the start of the crisis, both from the real side and from the monetary macro side. The Chairman: We spotted your ESRB responsibilities. I know that Lord Vallance will be interested in that and will wish to ask you about it. As a starter, could you both give us an overview of GEMU and say what elements of it you think are necessary, and therefore highly desirable, and what elements are perhaps less necessary, or even perhaps can be posted down the line a bit, because I think there are questions of timetabling to achieve the full ambition of GEMU? Dr Zuleeg, will you offer a thought or two on that? Fabian Zuleeg: As an economist, I first question the question. For me, the question is: what do you mean by “necessary”? You could say that some of the issues being addressed are necessary from an economic point of view, some are necessary from a political point of view and some are necessary from a legitimacy point of view. While these do not necessarily have to happen all at the same time, if we ignore any of these aspects, we will have a problem further down the line. From the economic point of view, clearly the banking union is something we have to make progress on. It is mainly about managing risk and the question is not only how quickly it will be established but how quickly it will work effectively once it is established. That is one of the big issues. It is as yet untested. Yes, we have used the ECB because at least there is an institution there, but I think it will be some time before it works effectively. On the economic governance side, a lot has happened. In my view there is uncertainty about how the different elements are going to work. Will they function particularly well together? I think there is a question about rationalising the framework. Throughout the crisis we have tried to patch up the holes as they have appeared so what we have now is quite a complex and not always coherent system which has emerged. To a large extent we still have not really explored how all the instruments are going to work. The whole European semester process is still in its infancy. It seems to have some effect but the question is whether it will have an effect on the countries which are not in immediate crisis. Will it have an effect on the big powerful countries both economically and politically? There are still some questions there. What has been largely missing—I am happy to come back to this—is a genuine growth element to monetary union. We have had some action to try to stimulate growth but so far it has not been very convincing and in my view has not been targeted enough at the crisis countries and at addressing the economic problems which arise directly from the crisis such as the lack of lending for SMEs or the lack of private sector investment.

Q135 The Chairman: Is there any element that might be redundant and does not need to be followed through with quite the same enthusiasm? Fabian Zuleeg: The problem is that, like everything else at the European level, this is a delicate political compromise, so while you might say that from an economic perspective certain elements might not be strictly necessary—I think, for example, the Financial Transaction Tax is not a necessary element—for political reasons a number of countries consider it very important to have something like the FTT. Therefore, it is difficult to ask whether this is strictly necessary. It is probably not, but politically it might be a very important element of moving forward. However, what we also have missing at the moment is a rational mutualisation of debt. I would contend that what the ECB is doing is a form of

219 of 441 European Policy Centre and Professor André Sapir—Oral evidence (QQ 134-147) mutualisation of debt in that at least there is an implied liability if something goes wrong, but it is not the most effective way of dealing with the issue. Of course, we know that elements in particular countries are certainly against eurobonds and have also said that they are not very happy with any other form of mutualisation of debt, but we will see whether that will change. The Chairman: Let me ask the same question of Professor Sapir. The two of you should know that we have just come hotfoot from Mr Heinz Zourek at DG Taxation talking about the FTT, so if my colleagues stray into the field of FTT you will understand our interest. As regards GEMU, we have the bits that are necessary and the bits that are perhaps less necessary. Is anything missing? André Sapir: What has been put forward in the proposals, on the whole, is about right as a first step, with different blocs, and looking at some equilibrium between those issues and bringing an economic and political dimension that makes it very clear what one cannot do. What one also hears from Germany is in a sense a corrector. Provided that there is genuine discussion, it is correct to say that if one does make further, important steps in integration, they must be accompanied by elements on the political side. It is a very complicated debate, but the issue of legitimacy is very important, so it is correct to advance on both sides. Obviously I agree that first and foremost this is a banking issue. As one looks back to the process of monetary integration, one is struck, unfortunately, by one’s inability to see earlier—I include myself in this—that there was a missing element in monetary union. It is all the more strange when one considers that the origins of monetary union were linked to financial flaws within Europe; the liberalisation of capital movement was a key element in the origins of the monetary union project. Once one had free capital movement, potentially a number of things needed to change, so it was very much at the heart of the debate, and yet not all the consequences were considered, for whatever reason. So this response in terms of banking union was long overdue. One can return later to the details of how it will work and the different elements, but one can see now that that chapter is definitely long overdue. The other two chapters—the economic chapters, the fiscal issue and economic union—are a bit more complicated in the sense that once one goes into the banking union itself, there are different views of what it means—one hears that in the debate today—and of the links between a banking union and other elements, including a fiscal element. Does that imply some element of mutualisation in the banking union itself? Once one person talks about mutualisation, another one talks about the fiscal chapter. Once you enter that territory, it is impossible to do without the politics: the institutions and the legitimacy. There one needs to have a serious discussion that will be much more political than economic on what kind of monetary union one needs. In a sense, we are going back to the old debate on the link between political and monetary union. Is it possible to have sustained monetary union without a political union? To me that is the fundamental point when one looks at genuine economic and monetary union; how far does one go?

Q136 The Chairman: I know that we will come to that with other colleagues. Do you share Dr Zuleeg’s worry about the absence of concern about growth? André Sapir: Yes and no. There are two questions: the long term and the short term. There is demand management: how one deals with macroeconomic policy. Then there is growth from a more long-term perspective. As far as the latter is concerned, in all of Europe we have an instrument to deal with that which is unused: the single market. It is the single most important tool for a growth policy among the instruments that we have in Europe. It needs to be complemented by a number of other things, some of which are at the level of member

220 of 441 European Policy Centre and Professor André Sapir—Oral evidence (QQ 134-147) states and sometimes in conjunction with the Community, such as R&D policy and innovation. If we had a genuine single market, we would have a genuine growth policy for the Union as a whole. That is a different issue from the situation we are in right now, which is also of a macroeconomic nature. There is a gap between potential and realised output. There is a shortfall. That is an issue not of the EU in general but of monetary union. Do countries that have a single monetary policy also need some management of fiscal policy and of demand, as well as monetary policy? My view is, yes. We are not able to do that at the moment. We have a fiscal policy for each country; we do not have the political capacity to take a view on the fiscal stance of the group of countries within the euro area as a whole, and somehow to deal with that. The instruments for that are not there, and nor are the politics—and we are paying a price at the moment.

Q137 The Chairman: You have struck a rich seam on which my colleagues will want to follow through. Speaking as a fanatic for the single market for the past 20 or 30 years, I could not agree more. Dr Zuleeg, you mentioned the European Central Bank. I would like to ask the two of you to reflect on whether it has received attention from academics, politicians and so on for its burgeoning role, which is beginning to burst out of the T-shirt of Superman. Perhaps you could comment on that, and also, in passing, on whether the ECB— which we will visit in November—and the Commission are sufficiently resourced to take on the tasks that are gradually accruing to them. Fabian Zuleeg: I could not agree more with what André said, including about the single market. The other side of that, of course, is external markets, including the Transatlantic Trade & Investment Partnership is equally important to advance a long-term growth agenda. On the role of the ECB, a certain amount of pragmatism is necessary. Probably there are a number of things that have happened which have made it necessary for the ECB to act in a particular way. It is stretching what was originally envisaged for the ECB, but I do not see that there were many choices on the table at the time. We are talking about a period when speculation about a Greek exit or even the collapse of monetary union was rife. We had a number of summits when things went very close to the wire. What the ECB did at that moment, in the constellation that was there, was probably the only thing that could have been done. While some countries had concerns, and we heard from some institutions such as the Bundesbank, which said very clearly that it had concerns about this, by and large it was accepted, by governments in particular; there was no real challenge to this role of the ECB. For me it is a question of whether this should be a long-term role for the ECB, as I have already hinted in terms of debt mutualisation, to continue with a programme of buying debt on secondary markets. That is an inefficient way of looking at it, but if we go towards real debt mutualisation we also have to look at political union and moral hazard issues. It opens up a much bigger political debate. It is easier at the moment just to let the ECB continue what it is doing. The other question for me is the policy stance of the ECB. There has been a lot of discussion about whether the ECB should be more growth and employment focused rather than simply focused on monetary policy. I find it surprising that we have exactly the same targets for inflation as we had before the crisis. As a German this is difficult to say, especially in public, but I do not think inflation is the crucial problem we face in Europe at the moment. Of course I am not talking about having hyper or double-digit inflation, but to be quite relaxed in terms of vigilance on inflation is the right thing in this macroeconomic climate. To some extent, this is exactly what the ECB is doing. They are not talking about it in that way but if you are looking at keeping interest rates at the level they are, signalling

221 of 441 European Policy Centre and Professor André Sapir—Oral evidence (QQ 134-147) quite strongly that they are not going to deviate from loose monetary policy is the right thing. It is the only pragmatic thing. If we wanted to change this, it would mean treaty change and a huge political issue in Germany and some other countries. It is simply not feasible to even go down that route.

Q138 The Chairman: On my point about the ECB and the Commission and their capacity, do you have a comment on that before I turn to Professor Sapir? Fabian Zuleeg: There are two elements to it. There is a general capacity: whether you have the right amount of staff and so on. The key issue is redistributing some of the resources in the system, and we have already seen that. Parts of the Commission, for example, which deal far more with the elements of the crisis have grown rapidly over the past years. The other side is more the crucial issue of expertise. It is a more difficult one to address. It is not something you can simply create very quickly. There is a question over whether these institutions can attract people of the right calibre to lead this kind of work. The Chairman: Do you agree, Professor? André Sapir: In terms of numbers and capacity, I see no major problems in either institution. Obviously, the ECB is clearly a highly professional central bank compared to the best central banks in the world. There is no doubt that it is on a par with the Bank of England and the Fed. It is respected as such for the quality of its people. It is definitely going to be, and is already being, stretched now with the crisis and especially with the new mission: banking union. As one knows, the ECB will get 700 or 800 people to deal with the SSM side. There is going to be a crunch now in terms of resources. Lots of things are being asked, with the asset quality review and other things to be done over a short period with high expectations. There is a crunch coming right now. If I look back, since the creation of monetary union, there is definitely professionalism. On the Commission side, I agree in a sense with what Fabian said, in a slightly different manner, but I very much agree on the substance. By its nature, the Commission is much bigger than the ECB and much more varied in the quality of its services, which goes from the best to the less good. I usually tend to think that departments that do not spend money are much better than those that spend money. I did a little study on this that has remained confidential, but I think that shows up very well. When you do not spend the money in those circumstances, you really have to compete with your ideas: you have to be competitive. If you have money, you do not have to be competitive. You have a big wallet. That does not help. If I look at the services which deal with monetary union, ECFIN is an excellent department and has received extra resources in the crisis. Those guys are stretched. After Greece, there was Ireland, Portugal, Spain and Cyprus. Are we going to have Italy or God knows what? They are stretched, there is no doubt. They are definitely high-quality people. On the Commission side the real issue is not so much the services, it is more the political side. Is the Commission as an institution—not as individuals—now well equipped to deal with some of those matters, not in terms of the quality of people but rather the way the institution functions and the kind of institution it is? Is it a technical institution? Is it a political institution? It is obviously an executive to an extent. It is a legislature to an extent. Is it well equipped to deal with those different missions? The great advantage of the ECB is that it has a clear mission and mandate. It is a technical institution that has been given a primary mission: price stability. Obviously, it has done a number of other things. It is much easier to deal with the Commission. They cannot be compared at all. The Chairman: I do not know whether it is mention of your confidential private paper on an extremely interesting subject that has excited Lord Hamilton.

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Lord Hamilton of Epsom: I am interested in the 700 to 800 people the ECB will have to recruit for supervision. Where do you think that they are going to come from? Are they going to come from central banks? André Sapir: They will come mainly from national supervisors. It will depend on their countries whether they come from central banks, because central banks are the supervisors. They could come from other institutions, but they will come mainly from national institutions, at least originally—as was the case for the ECB itself. For its monetary task, people came mostly from national central banks. Little by little they recruited young people and graduates. I expect exactly the same thing. They have to be hired quite fast. Where are they? In the national institutions. Fabian Zuleeg: Could I add something? There is a potential issue here. We still have a role for the national supervisors. The question is how far all of the national supervisors will be able to continue in their role effectively if they lose some of their best people to the ECB. I am thinking in particular of the smaller countries, which have less money and are less able to attract good people: some of the new member states, for example. There is potentially an issue. Over time it will work itself out, but in the immediate future there could be a shortfall.

Q139 Lord Vallance of Tummel: As we are on institutional issues, let me ask you another institutional question first, and then move on to the financial markets. Perhaps I may address this to you, Professor Sapir, for fairly obvious reasons. Has the role of the ESRB and the European Banking Authority been properly thought through in the GEMU proposals, or is there a risk of too many players with overlapping agendas? André Sapir: I do not know if it has been thought through and through, but it has definitely been talked about. There is no doubt about that. Within all the institutions there have been discussions about this. People who sit around the table in one are sitting around the table in the other, so they are very much the same kind of people. However, I think it is fair to look at how it will work in practice. It is one thing to think about it in the abstract. After all, the ESRB and the EBA are themselves relatively new institutions. We are talking about only two or three years, so they are still new. No one had expected the developments that are taking place with the banking union, so they were not incorporated into this. Also, these institutions have probably not yet reached their steady state, and then along comes this major element. I would say that no one really knows how they will work together. There has been reflection upon this because, as you know, for the ESRB, the EBA and the other institutions it was mandated in the original legislation that there needs to be a review, and that process is being undertaken. The European Parliament is conducting its own review of the institutions, as are the institutions themselves. The Commission will possibly then have to make proposals for all the institutions in the light of the banking union. Our own committee has just brought out a short report on this which has been posted on the ESRB website. It asks the precise question: how will the role of the ESRB change or not in the light of the supervisory mechanism in terms of the main mission of the ESRB, which is macro- prudential? It is hard to tell, but it is clear that the ESRB and the EBA are EU institutions while the other institution applies only to those countries which join the banking union. Therefore, one is not going to supersede the other. Neither the ESRB nor the EBA is going to disappear so the question is how will they work together. That, I think, will depend very much not just on what there is in the texts, which gives a lot of leeway; it is about how individuals will work and what kind of commitment they will make to ensuring that the two institutions work in a complementary manner. That is needed. In the review next year we shall see how it is working as well as what changes in the design need to be made. There will be an opportunity for that and we have some ideas that we have put forward. People are

223 of 441 European Policy Centre and Professor André Sapir—Oral evidence (QQ 134-147) aware both of the necessity to keep them and of the potential conflict that could arise. There is an awareness of this, but how it will be dealt is something that we shall see.

Q140 Lord Vallance of Tummel: It is a case of, “Watch this space”. Can I move on to the financial markets? Do the GEMU proposals do enough to make sure that market pressures on sovereigns are more effective than they have been in the past so that you have an appropriate measurement of sovereign risk and its pricing? Do you think that that is likely to come about? If not, what specific changes would you advocate? Let us assume that the markets remain reasonably calm. I shall come back to less calm markets in a moment. Let us come back to Dr Zuleeg. Fabian Zuleeg: Given that the markets are relatively calm at the moment, we can start to think about the long term. However, it is difficult to forget the experience we have had. In a sense, while there were political shortcomings—clearly, we had problems in some countries and the markets did not function—I am not sure that I am confident that they will function better in the future because of governance changes, but I think that they will function in terms of recognising these kinds of risks better because they now have experience of it. The question is whether they will let a country get away with accumulating levels of debt that are clearly unsustainable in the long run. They will be far less likely to do that because of that experience. There is still a risk in the future that we will see this kind of crisis getting out of hand, where the spreads reach levels that reflect increasingly not just the sovereign risk, but a high degree of speculation on the political future of the countries involved. If we create a genuine economic and monetary union, that should kill off at least the political element of that risk. Of course, there is also the question of debt mutualisation. Any form of debt mutualisation should reduce in some way the spread between different countries. There are some proposals on the table which would retain a certain element of that rather than having full eurobonds—you would have coverage of a certain part of the debt for the countries concerned. But, overall, we are living in a quite different world. There are still some economic elements which, no matter what we do on the governance side, we still have to address. Whatever we do on that, we will also have to look at the debt level in Greece again. For countries like Greece, the question of exposing them fully to the market is still a long way off into the future. So there are still cases where we will have to continue with our support—away from the international financial markets.

Q141 Lord Vallance of Tummel: Professor Sapir, do you have anything to add to that? André Sapir: Yes, several things. I will come to the sovereign in my response, which is a genuine issue, but I would like to start with the Basel rules. I shall look at the crisis, what we are now calling the euro area sovereign debt crisis—for myself, I prefer to talk about a debt crisis with an important sovereign component—and why I want to broaden the issue a little. When you have a debt crisis, be it a sovereign or a broader debt crisis, as we have, obviously the banking sector is the intermediary. The deeper you get into a debt crisis, the deeper you get into a banking crisis. To an extent we have a banking crisis with some specific euro area components, given how the institutions are set up, so one has to go back to the weaknesses in the Basel rules. We still have to see how the new Basel rules work and to what extent they are sufficient to respond to the problems of not being sufficiently prudent about the build-up of debt in general and the role of the banks in that build-up. One of the key components of Basel has been risk weights. Within that discussion, there is a specific issue that relates to the treatment of sovereigns, both the treatment of sovereigns in

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Basel and how in Europe, given the Basel rules and the CRD, we have adapted our own regulatory environment to be compliant with Basel. We have used a system where sovereign debt attracts zero risk. You will have seen the article by Jens Weidmann in yesterday’s Financial Times which discusses this issue. So today there is a discussion about the treatment by sovereigns of the regulation that applies to sovereign debt and the holding of sovereign debt by banks. It is an issue that we will have to discuss. Now may not be the right moment to open this discussion. It is the right moment for supervisors to start thinking about this, not to implement this, because we are still in deep difficulty inside the euro area on this link between banks and the sovereign. None the less, this issue needs to be addressed. This is one of the complications I foresee we will have, because, as you know very well, financial rules in the EU—like the CRD—are EU rules because we have integrated financial markets at the EU level. This is a single market. And yet, here you have some issues where there are sudden specificities of the euro area. I predict some difficulty in dealing with that, because not all countries are inside the euro area. We will repeat a bit of the discussion of the banking union. Yes, we need this, but do we need it for everyone? This dividing line is not always comfortable. I predict that this will be one area where we will see it. People will say, “Yes, we need to change certain rules”, but then the question will be whether those rules should be EU-wide or only for the countries in the banking union. This will be a dimension, which is in a sense a bit unfortunate but inevitable given the reality. Lord Vallance of Tummel: That is very useful. Can I take you on to relax this constraint that the financial markets are fairly calm at the moment? François Hollande said a while ago that the crisis is already over, which is always a risky thing to do. The television screens come up with Italy and the political crisis there, or today’s Financial Times talks about the danger that the US budget woes will trigger a global crisis, so we may have another asymmetric shock from one area or another. Given banking union and EMU as it has been implemented so far, how far do you think that structure will be capable of dealing with a further asymmetric shock, which might freeze the wholesale markets, or whatever? If there are deficiencies in the current structure, what would be your priorities and your contingency plan if you were the Commission or anyone else trying to deal with it when it happened? It could happen some time after October 19, who knows? Andre Sapir: Look, in principle the euro area is perfectly capable of dealing with problems, even with more difficult problems to come, were they to come, provided that there is the political will. It is a question of the assessment of the political will. When one looks at what the ECB has been doing, sometimes one underestimates or does not know, including me obviously, the political back-up behind what it has been doing. I do not think that the ECB could have taken such bold steps, which we could not have imagined before, without at least implicit political backing. There was also an explicit element of this, which is the banking union itself. I observed what happened in 2012, a crucial year. We started the year in a difficult manner. The ECB had intervened in December 2011 and provided a lot of liquidity, and soon enough, in the spring of 2012, the effect of that had evaporated. So it had provided relief but it was becoming obvious that it was very short-term relief. The problem is that we are still there. A crucial element is whether there is a political commitment, not just Mario Draghi saying, “We will do everything that is necessary”, to take a number of steps on the political side. The banking union was a manifestation of that. How does one judge your political commitment? Yes, you are doing something that you were not able to do before, which is crucial in this crisis, and it has demonstrated this political will, and it then allows the ECB to do a number of things. My view is that we have the capacity to deal with the issues. I agree that there could be bad news in a month or six months’ time, so we are obviously not out of

225 of 441 European Policy Centre and Professor André Sapir—Oral evidence (QQ 134-147) difficulty—there are lots of fragilities there. As long as there is the political will, the problems are managerial. The Chairman: Before I bring Lord Caithness in I am anxious to hear from Dr Zuleeg on this. Fabian Zuleeg: I will keep it very brief because I largely agree that political will is absolutely crucial. One difficulty, which is why I put so much emphasis on the real economic and social situation, is that there is a certain level of political feasibility which we also have to keep in mind. How long are the populations, particularly in the crisis countries, willing to continue down the path along which we have been going so far? This would be aggravated if they have external shocks. In a sense, the crisis is not over yet, and if we have another asymmetric shock on top of that, which might create more unemployment in the crisis countries and which might create a lower growth level, we may well be in a situation where one of the countries simply says, “We are no longer doing this”. That might not be a rational response, but in the end it could well be the political response. Perhaps I am too optimistic, but I believe that the Italian situation will resolve itself because Berlusconi has gone a step too far. But this is the kind of warning signal that we need to look out for. At some point in time we will get an election result somewhere that is far less supportive of the route that we have gone down. That would be a major issue, because we do not have the governance mechanisms in the eurozone or in the EU to deal with a blockage by a country if a country says, “That’s the end”. For me, addressing the real economic situation and the social and employment situation is not only important in its own right but is also important to maintain the political feasibility, especially if we get more shocks to the system.

Q142 Earl of Caithness: I should like to explore a bit more about the banking union. Both of you said that it was important. As the economic and debt crisis has eased, so the progress seems to have slowed on this. The Commission designed a three-legged stool, but it looks like we might get a one and a half-legged, wobbly stool by the time we have our elections next year. What do you think of the recent proposals for the single resolution mechanism? Do you think that a deposit insurance proposal is ever going to come about, and if so, what shape ought it to take? Bearing in mind your comment, Dr Zuleeg, when you made your introduction that those problems could create problems further down the line, will the lack of progress cause problems down the line? Fabian Zuleeg: The first question is whether it is a permanent or temporary lack of progress. There is the whole issue of the German election. We know that Germany has particular issues with some of the elements, but we are going to have a different Government in Germany. We know that already, although we are not yet 100% certain what it is going to look like. When you hear some of the things that the Social Democrats said in the run-up to the election, there seems to be a greater willingness to go to the three-legged stool rather than the one and a half-legged stool. The big question is how this will work out in the negotiations. I am not quite so optimistic that you will find a functioning Government in Berlin by the time you get there, because it looks like it is going to be protracted and difficult to get to some of these issues. That is at the heart of the coalition negotiations. Of course there are a lot of domestic issues as well, so we will see how much emphasis is put by the different sides on the different elements. We are certainly going to see movement on the resolution mechanism. The deposit guarantee scheme is possible but politically tricky, so it would have to be called something different and look a bit different, but it is possible. We shall see. I do not think that that would happen immediately; it will take more time to put into place. With those caveats it is

226 of 441 European Policy Centre and Professor André Sapir—Oral evidence (QQ 134-147) like a lot of European solutions—it is probably not ideal—and if I were to design an optimal banking union it would look very different from the one we are likely to get. However, if we go a bit further, not necessarily the whole way, and if we have that long-term development, it could be sufficient to achieve the kind of stability we want. We have to be realistic: it will take time anyway before the whole system works effectively. It will not happen overnight. The Chairman: Professor Sapir, do you have anything to add to that? André Sapir: Yes. Clearly, we are facing a conundrum, in that we needed the banking union, those three legs. I have been a strong defender of the US FDIC model; I think that that is the right approach. The conundrum is that we needed that before the crisis; one needed the crisis in order to be able to do that; but the crisis is also a bad time to implement it because of the legacy. This is the difficulty and that is why one is not able now to create the full shebang: all the elements. Any economist can see that the three elements are complementary; you need all three to have a genuine mechanism of financial stability, at least for those countries inside the euro area, working together with the central bank. To have genuine stability, one needs all of those three legs, but as we are thinking of putting this in place, everyone is looking at the distributional element. In a sense, we do not have the advantage of the veil of ignorance. You are creating an insurance mechanism when you already know who is damaged at the moment and what are the distributional elements. That is not a convenient time. That is what has allowed the political will to do this, but at the same time it is the difficulty. You cannot ignore that reality. I think that we need the three legs. We absolutely need the single resolution mechanism as soon as possible. I and my colleagues in our committee at the ESRB immediately wrote and published an opinion on the banking union. We said that the banking union, right from the start, must comprise a resolution mechanism together with the supervision mechanism. The reason to do this now is to clean up the mess, which means the resolution element, but there is the problem of the legacy. That is a great difficulty. Absolutely one needs that. There is a legitimate legal question—I am not a lawyer—to put in Germany: if you have a genuine resolution mechanism, can you do that within the current treaty, or are you going beyond it? I cannot express an opinion, but that is an issue which I should very much like to hear about. It is a legal question and a political question how far you can go. If you have a real resolution authority, it takes charge of your banks from the centre. This is how it works: if you have a single resolution authority in the mechanism, which is what I want, if that authority says that banking country A has a problem, as the FDIC does, it takes charge of it—it revamps it, sells it, closes it down, it uses the deposit insurance—but it must be able to do that not in an intergovernmental manner but in a supranational manner. That authority, which is a European authority of the banking union, takes charge over banking in that country. That is a strong power, but one needs it. The Chairman: Let us find out from Lord Kerr two more steps on the road.

Q143 Lord Kerr of Kinlochard: Picking up exactly from Professor Sapir, that is precisely the reason why it is not going to happen in the short term, why we are going to get Schäuble’s wooden house rather than a real single central resolution authority, I guess. André Sapir: I guess that too. Lord Kerr of Kinlochard: Fiscal firepower also seems to me to be somewhere down the line. Can you say a word about whether you think that the Commission is right to want an autonomous euro budget? What will it be used for: firefighting the next crisis or incentivising

227 of 441 European Policy Centre and Professor André Sapir—Oral evidence (QQ 134-147) structural reform? Is it the replacement of the sanctions and to fines, which President Prodi dismissed as the stupid element in the Stability Pact—when he was no doubt being advised by the best possible advisers in Brussels? How big would this fiscal capacity need to be, depending on which of those tasks it is designed to do, and how would it interact with the existing European budget? Would you need some new institution to run it? Fabian Zuleeg: It is a difficult question because it is wonderfully vague. People have mentioned it and some people have even put some numbers on it, but they have been extremely vague, and it has also been extremely vague in terms of the function. The most concrete figure that people have talked about is about €30 billion and that it would be there to incentivise structural reform. I find that a bit problematic: what do you mean by incentivising structural reform? Would this be something that you pay out to countries ex ante? Who would make the decision on which country gets access to the money? There is a whole political governance mechanism that you would have to put into place. On the general principle of should there be a eurozone budget, in my view, yes. One of the elements that we are missing in the economic and monetary union is a formal transfer mechanism to deal with divergence in economic performance between different countries. There have been suggestions that it might be linked to unemployment as a way to measure that divergence. This is a difficult political discussion, but the reality is that for the foreseeable future we are talking about transfer from northern countries to southern countries. Whatever way you design it, whichever way you go about it, at least for the foreseeable future, that will be the flow of money. Personally, I think it is a good idea and we should have it, but politically you have to sell it, particularly in Germany, which will have to take on the bulk of this. Referring back to my answer on the coalition negotiations, I think that is part of them. I would not be surprised if we see faster progress than that, because there might be a lot of pressure to at least state the political will to go in that direction. Merkel, for example in her youth employment summit before the election, was clearly setting a marker that there is an intention to do something. It is difficult to see what else it would be if not fiscal capacity. In reality, you could do it through different institutional frameworks, but in the end it is a question of what the eurozone countries agree, and then you find the most convenient way of channelling that money. Fundamentally, on whether it is a part of the EU budget, if all 28 agree, I do not see why you could not have something like this, but you could also set it outside and do it separately.

Q144 The Chairman: Professor Sapir, I am anxious to conclude with Lord Hamilton in a moment. Is there anything that you would like to add to what Dr Zuleeg has said? André Sapir: At the moment, the EU budget—not the monetary union—has an element of transfer. Most of the budget, for example the structural fund and agricultural policy, is about transfers—80% of EU budget today. I do not find it credible when people talk about transfer unions and so on. We are today in a transfer union. A very tiny one— Lord Kerr of Kinlochard: Countries such as Britain busily transfer to ourselves. Your 80% is just cross-border transfers. André Sapir: That is right, but there is also an element of net transfers to poorer countries or regions. Before I would personally consider enlarging the transfer element, I would entirely revamp the way the current transfer system works. I am not ready to consider that because it is not working today. We do not need more of the same. On the other hand, what I am willing to consider, which is not there now, in relation to monetary union

228 of 441 European Policy Centre and Professor André Sapir—Oral evidence (QQ 134-147) countries only, is whether one should have some form of automatic stabilisation mechanism. This is what has been put forward, and there are different ideas about it. One has been described based on unemployment issues. There are a host of problems there. That is why I go back to what I said earlier: in Europe, we are missing a fiscal capacity to deal with the cyclical element. Sure, we have lots of automatic stabilisers at the country level. What we are missing is automatic stabilisers between countries in the monetary union. It is really a question about the different formulas that exist and which would be the best one. Is it linked to unemployment benefits, as some have proposed, or are there other options? I am very much in favour of exploring this further and trying to find a pragmatic formula. The Chairman: Professor Sapir, we would be fascinated if you wrote a paper on the existing distribution and how we might replace it. Fabian Zuleeg: I just want to add one thing. I fully agree, and the reason I did not mention it is because, unfortunately, we missed that chance because of the very narrow national interests in a number of countries. When we had the possibility of reforming the budget, we did not do it and ended up with a budget that takes extremely little account of the crisis or the changed circumstances. That is a real pity because there is an instrument there. However, at least as far as I can see, we have locked ourselves into something for the next seven years that is not going to be very different. The Chairman: The senior Select Committee, on which I and several Members sit, has looked at this. We had some ideas about that kind of reform, which were rather dashed on the rocks. Lord Hamilton, would you conclude with our last two questions?

Q145 Lord Hamilton of Epsom: I am encouraged by Dr Zuleeg saying that the new coalition Government in Germany may go in for really quite significant transfers from rich countries to poor ones, because that means that the Alternative für Deutschland party may well break though the 5% limit, which it failed to breach in the last election, when it comes to the next election in Germany. I think this will go down like a lead balloon in Germany, if I know anything about the Germans at all. Perhaps I may talk about Britain’s role in all this. Inevitably, if the eurozone wants to hold the euro together, which seems to be something of an imperative for so many members, it has to integrate more and more tightly. You talked about having a budget for it, taxes and so forth, but inevitably the United Kingdom is going to be outside this, as there is no way that we could join the euro without a referendum. We have a referendum coming up in 2017, which I think, in the general election, will be backed by all political parties even though the other ones have not committed themselves to it yet. Nobody can say what the result of that referendum will be, but I think one can say with certainty that there will be a very substantial vote for pulling out—whether it will be a majority or not I could not possibly say, and nobody knows this far ahead. However, there is no way in the foreseeable future that a referendum will be won for us to join the euro. We are going to be permanently outside it. If the eurozone integrates more and more tightly, where on earth does the United Kingdom go? If we do not vote to pull out in 2017, is it not inevitable that we will just drift away anyway sometime in the next 10 years? The Chairman: Give us some comfort, Professor Sapir. André Sapir: To be honest, I cannot. This is an issue for you to deal with. I am serious—it is not an issue where I or anybody else can lay anything down. You have put forward the question perfectly well, and I think you are right that one is likely to see more integration. That will certainly be the case with the banking union. One does not know where it will go

229 of 441 European Policy Centre and Professor André Sapir—Oral evidence (QQ 134-147) from that point, but more integration seems to be there. I also agree with you that it is most unlikely, as one can see when one listens to the news coming from the UK, that the UK will join. Therefore, as was the case during the crisis, one will see a euro group forming on a number of occasions. I understand the frustration of British Ministers: a euro group meets and the next day there is a meeting of ECOFIN, where all countries are present, including the UK. There is frustration among some countries that maybe some of the decisions are taken in a sort of caucus where, although they are not taken formally, there is a feeling that the UK is on the sidelines. You have described it very well. I cannot say what Britain’s interests are. When I look at the economic relationship, the UK has a very strong relationship with the countries in the euro area. Its strongest economic relationship is with those countries, so I would have thought that it is in the interests of the UK to ensure that the relationship remains strong. One of the manifestations of this strong relationship is via the single market. The choice there for you—it is also an issue for other countries—is to see your interest in the single market, which should be a shared interest of all the 28 countries. I repeat what I said before: in terms of growth, this is the main asset that we have in Europe to foster our competitiveness for global challenges. We have to see how this single market, which we all cherish, can be reconciled with a number of countries that are going forward in their process of integration. My view is that it can be done. It is the common interest. But whether there is the political will and whether at some stage the UK will say, “We are too much on the margin of this”, is something you have to judge.

Q146 The Chairman: Can we just take the view of Mr Zuleeg? There is one more question that I want to put. Fabian Zuleeg: I will answer in a slightly roundabout way, because I have to react to the AfD point as well. The AfD will get over 5% in the European election—it needs only 3% anyway in Germany. It will definitely get in, so that is not dependent on whether the new coalition Government puts anything on the table. This is a foregone conclusion, because people will make a protest vote who would not have done so in the general election, because they wanted Merkel as Chancellor. They have a “safe” protest vote in the European Parliament election. The difficulty for me is that, when you are in a crisis like this, someone who comes with simplistic and populist answers will get votes. So the question is how others react to that, whether they will try to copy those answers or whether they will show genuine leadership. I have criticised the German Government for a lot of things in the past, but Merkel has shown that what people care about, much more than the specifics about particular parts of the solution, is whether they have trust in a particular leader to actually tackle the crisis in an effective way. They have that trust in Merkel, even though she has put a lot of things on the table which people said would be politically disastrous in Germany— they were not. Merkel was re-elected very convincingly. There is a lesson in that for the UK. The situation is messy and complicated. I fully agree with André that there are implications for what is happening in the eurozone which will affect the other countries. But the question that the UK has to ask itself is, “What is the alternative? What is the option of saying we are not going to do this?” For me, the real alternative is being outside the single market. For me, that has to be the big question for the UK. Is it worth politically going outside, if you lose access to the single market? That is a big question in the referendum which, I agree, will inevitably come. The Chairman: One final question is to do with UK influence. Those of you who are observers of Premiership football in the United Kingdom will know that we are now full of Belgians in the top league; they contribute enormously. Arsenal is, of course, wonderfully

230 of 441 European Policy Centre and Professor André Sapir—Oral evidence (QQ 134-147) supported by German players. There is now an anxiety on behalf of the Foreign Secretary, William Hague, about British influence here in the Commission and in the ECB, the EBA and other areas, because of our monolingualism and our inability to participate as effectively. Do you two observers—and I free you from the constraints of being mere nationals as a Belgian and a German—observe that there is a weakening influence? Do you think that, although we now have an English-speaking union, which is the European Union, paradoxically, the English or the Brits are losing influence? These can be very short answers. Fabian Zuleeg: Yes, but the key issue is not language but political choices. If you want to have influence, achieve reforms and push forward the kind of things that the UK in the past has seen as in its national interests, such as the single market and the transatlantic trade agreement, you have to be engaged. The biggest problem at the moment is that it is not a good way of engaging to say, “Either you change or we might pull out”. That is a way of putting the question that does not engender a lot of co-operation. The Chairman: Professor Sapir, we are in the land of Bosman.

Q147 Lord Hamilton of Epsom: Does the EU survive if the UK votes to come out in 2017? Fabian Zuleeg: In my view, yes. It would be a tremendous loss for the EU, and it would have a negative impact in a variety of areas, not least in some areas of economic reform that are very important for the EU, such as the drive towards the single market. But the cost to the EU would be much less than the cost to the UK. André Sapir: I very much agree with what Fabian said. I have heard for many years ideas put forward by the UK or by UK economists, which are very much seen positively rather than negatively. So, on the substance, everybody recognises the excellent contribution that the UK is making to debates and to issues of common interest. The discussions in the UK, including your own reports, are always viewed as being of very high quality and as an excellent contribution. People read them—they do not ignore them. But when it is being done in an official manner there is not the degree of engagement for it to translate into the political process. That is what I am observing. People take note of the arguments, but whether that translates into decisions in the political process I am much less sure. In that sense, your political weight is clearly diminished; there is no doubt. I took an example because it is the one that I know better, in the circle of the Ministers of Finance, in the Eurogroup, which has assumed so much power. I understand the frustration for British Ministers, who sometimes do not come to Brussels because they feel that things have already been done. So there is a frustration—it is too bad, when people are very much reading, listening and hearing the economic arguments that have been made, including on how to have a better functioning euro area. It is all very welcome. People understand that there are high quality personnel in the UK at all levels, whether they are civil servants or politicians or in the universities. Everyone is making an excellent contribution, but to be listened to by other politicians you have to engage. The Chairman: All the answers you two have given this morning have been wonderfully received and passionately expressed; they give us a lot of food for thought. You might like to know that our last meeting is with Thomas Wieser from Eurogroup this afternoon. We look forward to that. I thank you both on behalf of the Committee for your contribution to what I hope will be another report that is read in Brussels, and in London as well, when we get to write and complete it. Again, please examine the transcript and add to it or correct it; indeed, if you have further thoughts or any private papers, as Professor Sapir mentioned,

231 of 441 European Policy Centre and Professor André Sapir—Oral evidence (QQ 134-147) please pass them on. Many thanks for your attendance here this morning; it has been a vigorous hour and a quarter. Fabian Zuleeg: Thank you. André Sapir: Thank you.

232 of 441 Mr Nigel Farage MEP—Written Evidence

Mr Nigel Farage MEP—Written Evidence

Executive Summary

Prospectus for Genuine Economic and Monetary Union (GEMU) There is little realistic chance of restoring long-term confidence in the solvency of Eurozone (EZ) banks and sovereigns because the EU's plans: • fail to cut the link between sovereign debt and bank failures; the actions of the EU have, in a number of respects, actually increased the co-dependency between banks and sovereigns as well as the magnitude and likelihood of another crisis; • fail to generate growth in the economies of the EZ periphery; the limited attempts to generate growth depend on spending public money raised by government borrowing - which will suffocate the EU economy by increasing the debt repayment burden which is at the heart of the Euro crisis; and • fail to balance the competitiveness of the EZ core with that of the periphery; the existing single currency requires a combination of internal devaluations and/or constitutional and cultural changes that are beyond the capabilities of EU institutions to deliver, the alternative is a division of the Euro area into at least two currency blocks. Until these failings are addressed, or a country exits the Euro, GEMU will condemn many millions of ordinary people in the periphery to increasing, and permanent, economic hardship.

Implications for the UK generally UK taxpayers will be expected to pay increasing amounts for Cohesion, Infrastructure, Regional and Solidarity Funds (as well as, potentially, Convergence and Competitiveness Instruments and Financial Transaction Taxes) to subsidise the EZ periphery to make up for its chronic lack of competitiveness. It is therefore unsurprising that, even if the EU's Multi- annual Financial Framework for the next 7 years is reduced, the UK's contribution to the EU budget will continue to increase year on year. As the EZ consolidates into a more coherent body the UK will find itself increasingly marginalised: so much so in fact, that the UK would have more influence over EU policy by leaving the EU. Leaving the EU would free domestic business from the burden of EU regulation and provide export businesses in the UK with WTO remedies against EU protectionism - in place of weak political defences afforded by the UK's 8% share of the vote in the Council of Ministers.

Implications for the City of London The EU's rush towards Banking Union has removed the ability of the UK to appropriately nurture, govern and oversee the UK's financial services industry. After a financial crisis, which was in part caused by regulators missing the woods for the trees, we are to be left with regulators less accountable to the public than they were before. Having avoided the dangers and destructiveness of the Euro and bailed out our own banks, the UK government has surrendered regulatory control to largely unaccountable EU bureaucrats who know even less about financial services than the Eurozone governments and banks who got themselves into the mess in the first place.

233 of 441 Mr Nigel Farage MEP—Written Evidence

Questions and Answers:

Genuine Economic and Monetary Union (GEMU)

1. How realistic are the plans for Genuine Economic and Monetary Union?

1.1 However GEMU happens, it is not realistic to expect it to succeed in restoring confidence in the solvency of EZ banks and sovereigns.

1.2 Those behind GEMU refuse to recognise in their planning that political and economic realities are diverging at both national and EU levels.

1.3 For example in political terms, there is a divergence between the governed and the governing: although recent polls in 6 countries (including France and Germany) show only minority support for the EU, 18 the President of the Commission is still talking about the inevitability of a federal Europe. 19

1.4 In economic terms the gap in bond spreads and competitiveness resolutely continues even between France and Germany, let alone between the German "core" and the EZ periphery.

1.5 The politicians at national and EZ levels have invested so much political capital in the EU "project" (of which the Euro is the most tangible feature) that, because they cannot afford to admit failure, they have little political choice but to accept the premise of GEMU that requires deeper integration of the EZ, just to buy themselves time during which to blame a scapegoat. That time is, incidentally, bought with EU taxpayers' money (not just with EZ taxpayers' money) and the scapegoat is the City of London.

2. Do the plans go far enough to correct the flaws in EMU revealed by the Euro area crisis?

2.1 No. The plans do not go far enough to correct the structural imbalances between the "core" and the "periphery" of the EZ.

2.2 The plans fail to address competitiveness, or to permit transfer payments from the core to the periphery, or to discourage banks from holding sovereign debt, or to bailout banks directly, or to let some countries and banks default, or to establish a climate favourable to venture capital facilitating economic growth.

3. Do the plans go too far to be palatable to Member States?

3.1 This depends on whether one regards "Member State" as the political class or the wider population.

3.2 The plans do not go too far for the political elite in the EZ - in fact for many politicians, whose political career has been intimately entwined with the EU "project",

18 http://www.guardian.co.uk/world/2013/apr/24/trust-eu-falls-record-low 19 http://www.telegraph.co.uk/news/worldnews/europe/eu/10041817/Federal-Europe-will-be-a-reality-in-a-few-years-says- Jose-Manuel-Barroso.html

234 of 441 Mr Nigel Farage MEP—Written Evidence

the plans do not go far enough and in their opinion should include Debt Union, Transfer Union and Fiscal Union (see the answer to the question below).

3.3 Ordinary people in the periphery will be condemned to increased and permanent hardship because (in the absence of a Transfer Union, economic growth or free- floating national currencies) the only policy tool available to regain their competitiveness is internal devaluation of their national economies. 20 This permanent hardship means that the plans already go too far for the swelling ranks of the millions of unemployed 21, near-destitute and their families in the EZ.

3.4 The larger question that needs to be answered is, therefore, whether democracy will survive the Troika's policy of internal devaluation imposed on countries like Spain and Greece amongst whom youth unemployment is around the 60% mark and rising. 22 The remaining political support for the Euro and the EU amongst the population of these countries is rooted first in their historical experience of inflation, political corruption and dictatorship in the 1970s (before their accession to the EEC) and secondly in their misguided belief that the EZ core countries will pay. 23 It is an indictment of the current political class that their deficiencies are only tolerated because they are slightly less worse than the failings of those who came before.

3.5 We may continue to be impressed by the stoicism of the Irish, but if we look further across the water to the renaissance of the Icelandic economy we can see that default and devaluation would also have been a better option for Ireland.

3.6 How long the contradiction between political will and economic reality in the EZ can be held in equilibrium is debatable but a tipping point will be reached once the periphery loses hope of economic recovery. In the meantime, in the absence of Transfer Union, it will be the role of increasingly expensive Cohesion, Infrastructure, Regional and Solidarity Funds to maintain "hope" in the periphery for as long as possible (note that these are all paid for by taxpayers in the EU rather than merely the EZ).

3.7 There are also significant constitutional and financial concerns in the core EZ countries, and Germany in particular. 24

4. Will the proposals work, and if not, what other steps need to be taken?

4.1 The proposals will: • buy time (at the expense of EU and UK taxpayers); • bluff the markets (for a while); • give some measure of hope to the periphery (but not deliver positive change); and

20 http://www.project-syndicate.org/commentary/should-germany-exit-the-euro-by-hans-werner-sinn 21 http://www.bbc.co.uk/news/business-22727373 22http://www.theatlantic.com/business/archive/2013/05/europes-record-youth-unemployment-the-scariest-graph-in-the- world-just-got-scarier/276423/ http://en.mercopress.com/2013/06/01/europe-unable-to-counter-increasing-youth-unemployment 23 http://blogs.telegraph.co.uk/news/danielhannan/100220209/like-a-battered-wife-spain-clings-to-the-euro/ 24http://www.telegraph.co.uk/finance/financialcrisis/10108010/German-court-case-could-force-euro-exit-warns-key- judge.html

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• avoid confronting taxpayers in the "core" (for so long as the need to ratify any new treaty can be avoided).

4.2 The proposals, however, do not directly address the most significant flaws in the single currency because (ignoring the fact that the EZ is not an optimal currency area) they fail to include: • "eurobonds" or any other kind of debt mutualisation (Debt Union); • "transfer payments" within the EZ (Transfer Union); or • enforceable central EZ control over national budgets (Fiscal Union).

4.3 All three of the above measures were effectively taken off the EU agenda by the September 2012 ruling of the German Constitutional Court, which prohibited the Bundestag from "accepting liability for decisions by other states" and warned that the Bundestag could not lawfully transfer its tax and spending powers to EU institutions. 25

4.4 Instead (in an attempt to avoid the constitutional objections in Germany) the EU is attempting to force the "square pegs" of Debt Union, Transfer Union and Fiscal Union into the existing "round holes" of EU treaty architecture in the following way: • Debt Union - indirectly via Troika bailouts, the ESM and the ECB's Outright Monetary Transactions (the OMT, which has also found itself subject to legal, constitutional, challenge in Germany) 26; • Transfer Union - indirectly via State Aid, Cohesion, Infrastructure, Regional and Solidarity Funds (as well as, potentially, Convergence and Competitiveness Instruments, the Financial Transaction Tax and Common Deposit Insurance) - effectively spreading the cost of Euro failure from the EZ to the wider EU and UK taxpayer; and • Fiscal Union - indirectly via the Treaty on Stability, Coordination and Governance in the European and Monetary Union and the European Semester (which attempt to influence national budgets and include the Six Pack 27, the Two Pack 28, the Stability Pact, the Fiscal Compact, the Broad Economic Policy Guidelines, the Employment Guidelines, the Stability and Convergence Programmes, the National Reform Programmes, the Annual Growth Survey, and the Alert Mechanism Report).

4.5 However, in the absence of explicit Debt Union, Transfer Union and Fiscal Union, the only policy tool available to permanently correct imbalances in competitiveness (which is at the root of the trade imbalances between the core and the periphery) is internal devaluation of the periphery.

25http://www.telegraph.co.uk/finance/financialcrisis/10108010/German-court-case-could-force-euro-exit-warns-key- judge.html 26 http://www.spiegel.de/international/europe/german-high-court-considers-challenge-to-ecb-bond-purchases-a-904745.html http://www.spiegel.de/international/europe/german-high-court-skeptical-of-ecb-bond-buying-a-905246.html 27 Three Regulations strengthening the European budgetary surveillance framework (the Stability and Growth Pact), two Regulations introducing a new surveillance procedure for macroeconomic imbalances (MIP) and a Directive imposing minimum standards for Member States' national budgetary frameworks. 28 Two Regulations detailing surveillance of EZ member states' budgets (before and after bailouts).

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4.6 Economists calculate that to restore external-debt sustainability Spain, Portugal and Greece need internal devaluations of at least 20% 29 and Goldman Sachs Economic Research are reported to have calculated this year that France also needs a similar internal devaluation relative to the EZ average (and 35% relative to Germany). 30 The populations of modern democracies will simply not tolerate the sacrifices necessary for such internal devaluation and, even if they did, the dislocation to the economy would be fatal to stable government.

4.7 Without adequate internal devaluation, Debt Union, Transfer Union and Fiscal Union, the only remaining solution is to sever the core from the periphery (in effect creating two Euros: one an inheritor of the hard D-mark, the other of the soft Lire) - I understand that this is also the view of Lord Flight 31 and George Soros 32 but in Brussels it is seen as heretical. It is, however, the only realistic solution. It should be accompanied by efforts to encourage global venture capital investments via the City of London once the EZ periphery has regained its competitiveness post Euro-exit.

Integrated Financial Framework (Banking Union)

5. Will the proposals for banking union decisively break the link between bank and sovereign debt, and if not, what more needs to be done?

5.1 The Commission itself admits that the proposals for banking union will only "dilute" the link between banks and sovereign debt (implicitly accepting that they fall short of cutting it completely). 33

5.2 Correcting the flaws in EMU is not enough and, without more, can only be described as shutting the stable door after the horse has bolted. The plans for GEMU do not begin to address other difficulties that have arisen as a consequence of the crisis spreading from banks to sovereigns.

5.3 In targeting large depositors (of over 100k Euros) for "bail-ins", forcing capital controls onto Cyprus and haircuts onto private (but not public) holders of Greek debt, and reneging on promises to bail-out Spanish banks directly (rather than via the Spanish State), the EU has actually made the next bank and sovereign debt crisis more likely, more volatile and more expensive.

5.4 The OMT programme (designed to help sovereigns survive a liquidity crisis which is actually a solvency crisis) and LTRO have structurally impaired the ECB itself. By the end of January this year the ECB had already provided in excess of 900bn Euros of refinancing credit in return for dubious collateral. 34

29 Professor Hans-Werner Sinn at p35 of his report to the European Parliament's Inter-parliamentary Committee Meeting of 29th January 2013 titled "Is the Semester Hardwired for Austerity or Growth?" But NB: the professor went on to explain that the true figures are even worse because the 20% is calculated on the basis of a herculean assumption of 2% annual growth in those economies. 30 http://www.project-syndicate.org/commentary/the-long-term-costs-of-europe-s-rescue-policy-by-hans-werner-sinn 31 http://conservativehome.blogs.com/platform/2013/05/lord-flight.html 32 http://www.guardian.co.uk/business/blog/2013/apr/30/eurobonds-euro-germany-george-soros 33 http://europa.eu/rapid/press-release_SPEECH-13-389_en.htm Peter Spiegel, Financial Times 20th June 2013 "EU fights to unlink states and banks" 34http://www.project-syndicate.org/commentary/the-long-term-costs-of-europe-s-rescue-policy-by-hans-werner-sinn http://www.euromoney.com/Article/3113206/Spanish-potential-loan-error-highlights-ECBs-policy.html

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5.5 At 500bn Euros the European Stability Mechanism (ESM) is still not large enough for the purposes for which it is intended. 35

5.6 Although the ESM is also expected to be able to recapitalise banks directly it will demand "burden-sharing" from the ESM Member State seeking the bailout for its banks. 36

5.7 EZ banks are in need of significant re-capitalisation (admitted non-performing loans are in the order of 500bn on their own ignoring other losses) 37 but the ESM direct bank re-capitalisation instrument is limited to just 60bn Euros. 38

5.8 There are significant structural problems with the ESM: it was originally designed as a means by which to rescue countries and, as a result, its capital structure is not well suited to running the risk of equity investment in banks 39 and so it will have to invest via subsidiaries into which it hopes (vainly) to draw private co-investment. 40

5.9 Moreover, the ESM is heavily leveraged 41 and dependent on guarantees from countries which would be unable to fund their liabilities if called upon: increasing the debt burden on those remaining and pushing them closer to insolvency too. For these reasons the ESM could be described as a death-spiral-debt-tontine, it is arguably less of a firewall than a tinder box.

5.10 Basle III (as implemented by the Capital Requirements Regulation) encourages banks to increase their holdings of government debt by rating it at zero (or low) risk for capital adequacy purposes: which (when combined with the use of sovereign debt as collateral for the ECB's LTRO) re-enforces a trend that makes sovereigns and banks ever-more dependent on each other's solvency. 42 If the EU were serious about breaking this co-dependency it would, amongst other things, have required banks to attach different (realistic) risk-weightings to different government bonds, instead the EU maintains the fiction that sovereigns will not go bust and seeks to curtail the ability of rating agencies to publish "unsolicited" sovereign credit ratings to just three times a year. 43

5.11 It is relatively easy to state what needs to be done to break the link between banks and sovereigns: banks need to go bust (or to be properly recapitalised) and sovereigns need to disengage from the Euro default on their debt and devalue their national currencies.

35 Prof Hans-Werner Sinn and Harald Hau, Financial Times January 28th 2013 "Eurozone banking union is deeply flawed" 36 http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ecofin/137569.pdf Peter Spiegel, Financial Times 20th June 2013 "EU fights to unlink states and banks" 37http://www.zerohedge.com/news/2013-06-15/plight-europes-banking-sector-its-%E2%82%AC650-billion-state-guarantee- and-urgent-need-recap 38 http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ecofin/137569.pdf 39 , Bundestag Spokesman on Finance for Germany's Social , Financial Times 18th June 2013 "Europe remains open to bankers' blackmail" 40 http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ecofin/137569.pdf 41 As at the end of 2012 the ESM had paid in capital of just 48bn http://www.esm.europa.eu/pdf/ESM_Annual_Report_2012.pdf 42http://www.banque- france.fr/fileadmin/user_upload/banque_de_france/publications/Revue_de_la_stabilite_financiere/2012/rsf-avril-2012/FSR16- article-09.pdf 43 Europolitics 20th June 2013 "Stricter rules for credit rating agencies"

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6. Is the three-pronged model of a single supervisory mechanism, a common resolution mechanism and a common deposit insurance scheme realistically achievable?

6.1 There are significant problems in attempting to reach political compromise and then implement the three-pronged model: • the ECB has until the middle of 2014 to establish the Single Supervisory Mechanism (SSM) but this hugely underestimates the logistical task required; 44 • in permitting different countries to apply different capital weightings to assets (for the purposes of capital adequacy under the Capital Requirements Directive IV), the EU has made it much more difficult to agree a credible Common Resolution Mechanism to wind-up EZ banks; 45 and • it is difficult to imagine the Germans agreeing to a Common Deposit Insurance Scheme 46 - and they are correct to object on the grounds of "moral hazard".

6.4 The Germans are also of the view that the establishment of a new EU-wide bank resolution authority would require a new treaty. 47 However, to avoid the need for treaty change, it has been suggested that the EU Commission fulfil the role of bank resolution authority (and delegate tasks to banking experts and national authorities). 48 It is typical of the EU system of government that, when faced with the prospect of a decision that morally and legally requires a democratic mandate, the EU lawyers are called in to save the political elite from an embarrassing outbreak of democracy.

7. How long will it take to create such "banking union" and what are the risks of delay?

7.1 The Eurozone is in a very difficult position. If it acts too quickly the Banking Union will be full of holes and failure will be built in to the system. If it seeks democratic legitimacy it risks the proposals being rejected by electors in the "core". Meanwhile, the relative success of OMT in buying time (although at great cost) has made the politicians so complacent that they risk unravelling the deal that financial markets thought was agreed in principle last year.

7.2 One easily identifiable "pinch-point" in the continuing credit crunch will arrive when the 3 year term of the first LTROs matures in December of next year. The second tranche of LTROs will mature just a couple of months later. In contrast to banks in other countries, many Italian 49 and Spanish 50 banks (who between them were responsible for taking advantage of the vast majority of ECB loans under the LTRO)

44 Yves Mersch (ECB Board Member) and Sabine Lautenschlaeger (Bundesbank VP) as reported in Reuters News 26th May 2013 "Single bank watchdog becomes mammoth project for ECB", so much so in fact that the timetable is rumoured to have been now put back to September 2014 - Reuters News 18th June 2013 "Eurozone single supervisory launch may face 3-month delay". 45 http://www.ceps.eu/book/bank-bonus-compromise-bodes-ill-single-supervisory-mechanism and Schauble is reported (by Dow Jones 20th June 2013) to have stated that a Common Resolution Mechanism would breach the German constitution and he would take the matter up with the ECJ if need be. 46 The Wall Street Journal Europe, 5th June 2013 "ECB faces resistance on Bank Union", Reuters News 5th June 2013 "Europe considers new agency to shut failing banks". 47 Reuters News 10th June 2013 "Bundesbank calls for EU-wide bank resolution authority" http://www.independent.co.uk/news/business/news/eu-treaty-changes-needed-for-banking-union-8635327.html 48 Dow Jones Global News Select 4th June 2013 "EU to Propose Single Bank Resolution Authority", and Europolitics, 5th June 2013 "Bank resolution: Barnier suggests transfer of powers to Commission" and Financial Times 5th June 2013 "A somewhat predictable bank bailout authority". 49http://www.euromoney.com/Article/3040202/LTRO-3-or-bust-Italian-bank-deleveraging-edition.html 50 http://www.euromoney.com/Article/3113206/Spanish-potential-loan-error-highlights-ECBs-policy.html

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have failed to repay all their LTROs early, presumably because they are reliant upon them. 51 Therefore, before the end of next year, the ECB needs to be ready to cope with the fallout of zombie banks in the EZ periphery being unable to repay their LTROs. If the Single Supervisory Mechanism is in place by the middle of next year (which is a tall order in itself) that gives the ECB just six months to prepare. It isn't long enough in my view.

Integrated Economic Policy Framework

8. Binding contracts (Convergence and Competitiveness Instruments) have been proposed to encourage structural reforms through rewards and sanctions. Is such a proposal credible, would it be effective, and how could it be enforced?

8.1 The credibility of Convergence and Competitiveness Instruments depends largely on the prospects for their enforcement. Unfortunately the EU faces a credibility gap in enforcement, not least because of: • the experience of countries breaching the Stability and Growth Pact with impunity; • the Commission's continued indulgence of Eurozone members who fail to control deficits; • the dominance of statist and corporatist thinking in Eurozone countries, • Europhiles identifying "Anglo-Saxon Capitalism" as a scapegoat for the financial crisis; • the veneration of the "European Social Model"; • the shear size of the structural reforms necessary to achieve an "internal devaluation"; • the demographics of an ageing population (and shrinking workforce); and • the habit of EU politicians, the ECB and the ECJ to change the rules when it suits them.

8.2 The proposed "enhanced convergence process" (incentivised by financial allocations of the Convergence and Competitiveness Instruments) is intended to bind all 27 Member States and as such is another attempt to force non-Euro Member States to subsidise the functioning of the EZ.

8.3 Given the experience of the means by which various countries met the convergence criteria of the Maastricht Treaty, countries in the EZ periphery will no doubt cook their books again in order to share in rewards paid out of the Convergence and Competitiveness Instruments to which non-Euro Member States will be expected to contribute.

9. There are indications that, in the longer term, there could be deeper economic policy coordination amongst euro area countries, particularly in the areas of taxation and employment policy. Which areas of economic policy would you regard as appropriate for deeper integration?

51 http://www.efinancialnews.com/story/2013-06-05/ltro-repayments-drain-liquidity-surplus

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9.1 No further EZ integration of economic policy is appropriate. Bi-lateral inter- governmental arrangements are preferable because they retain more democratic accountability and are considered to be more efficient than EU procedures. 52

Integrated Budgetary Framework (Euro-budget)

10. In relation to the Commission's proposal of the creation of "fiscal capacity" in the medium term and the creation of an autonomous euro area budget in the longer term, why is such a budget necessary?

10.1 Euro-area budgets are not necessary. Europhiles argue for euro-area (EZ) budgets to advance "ever closer union" by funding an EZ treasury (to back the Euro currency and for use as collateral for euro-bonds), and channelling "own resources" into an EZ budget (which they will use as patronage to consolidate their powerbase). Their purpose in doing so is to free EU institutions from the control of governments and national parliaments, and to cement the Commission as the government of an EU with all the attributes of statehood according to the criteria in Article 1 of the Montevideo Convention of 1933 53 (and generally accepted in customary international law) with a view to being recognised as such in the United Nations.

10.2 For these reasons the UK should refuse to facilitate any euro-area budget.

11. What would the purpose of a Euro-budget be?

11.1 Aside from their suggestions that a Euro-area budget should cover EZ-wide unemployment benefit, the macro-politics are such that Europhiles consider it as an opportunity to argue for the EU to have its "own resources".

11.2 A taxation system independent of nation states, which funnels money directly into EU coffers, would enable the EU to disengage from its reliance on national parliaments for levying taxes and in the process to remove itself from democratic control.

11.3 By developing the EU's attributes of statehood their purpose is to usurp the role of Member States (including the UK) on the UN Security Council, the G8 and G20 etc.

11.4 For these reasons, again, the UK should refuse to facilitate any euro-budget.

12. How would it be funded, and how large would such funding need to be?

12.1 The estimates range from 30-150 billion Euros but we do not accept that a euro- budget is either necessary or desirable.

13. Would it require new institutions?

13.1 We do not accept that a euro-budget is necessary or desirable.

52 Reuters News 22nd May 2013 "Germany takes bi-lateral paths to tackle EU jobs crisis". 53 http://www.jus.uio.no/english/services/library/treaties/01/1-02/rights-duties-states.xml

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14. How would it interact with the EU budget?

14.1 We do not accept that a euro-budget is necessary or desirable.

15. How might non-members of the euro area participate (voluntarily) in such a mechanism?

15.1 We think it inappropriate for the UK to participate at all, and we should not be encouraging our neighbours to plunge further into an anti-democratic experiment.

16. What is your view of common debt mutualisation of euro area government bonds?

16.1 Debt Union would require treaty change, not least because there are significant constitutional objections in Germany, but also to provide democratic legitimacy.

16.2 Debt Union without treaty change would amount to the same type of arbitrary act that we saw the EU approve of in Ireland, Greece and Cyprus: it would be theft on a scale not seen since the Second World War. It would confirm once again that the EU cannot be trusted to look after private property rights: who in their right minds would lend to, or invest in, such an organisation?

16.3 Debt Union without treaty change would therefore destabilise confidence not just in political institutions but also in commerce and would, as a result, be self-defeating.

16.4 The politicians realised, even at the first proposal of GEMU, that they can't mutualise debt without treaty change, and they know the electorate in the German "core" of the EZ won't take kindly to the idea, so it seems off the table for the moment.

17. How plausible is a European government bond?

17.1 Not plausible, or credible to the markets, without treaty change.

17.2 Only if the EZ had a single government with a treasury, tax base, budget and a solvent ECB would markets regard debt issued by the EZ as credible, but even then the use of Eurobonds would be counter-productive. 54

17.3 For these reasons, and those given above in respect of euro-budgets, the UK should refuse to facilitate any Euro bond (or its short-term equivalent, Eurobill).

18. Do the varying levels of competitiveness and the presence of persistent imbalances across Member States make a system of permanent fiscal transfers inevitable if the euro area is to survive?

18.1 Yes. Internal devaluation is not sufficient, or quick enough, to restore a balance of competitiveness between the core and the periphery.

19. Could the goals of fiscal union (or integration) be attained without transfers?

19.1 Only if popular objections to austerity measures were to be crushed by means that are not suited to democratic government, or mitigated by the use of State Aid,

54 http://www.project-syndicate.org/commentary/should-germany-exit-the-euro-by-hans-werner-sinn

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Cohesion, Infrastructure, Regional and Solidarity Funds (together with possibly Convergence and Competitiveness Instruments, Common Deposit Insurance… and Financial Transaction Taxes) as a substitute for overt Transfer Union.

19.2 It is not appropriate for the UK to encourage either of these solutions as one is anti- democratic and the other involves the UK subsidising the EZ periphery.

Institutional Issues (Treaty Change)

20. Does the current treaty framework allow the euro area to go as far as is necessary in terms of integration within the current treaty framework, or will GEMU inevitably require treaty change?

20.1 President Barroso acknowledged in the Commission's paper "A blueprint for deep and genuine monetary union" that treaty change will be necessary for some aspects of GEMU 55 and this is also the reported view of the German Courts in respect of Debt Union and the Bundesbank in respect of Banking Union. 56

21. Should other mechanisms, such as further inter-governmental arrangements or enhanced co- operation, be considered?

21.1 It would be difficult for HMG to argue against inter-governmental arrangements. The Enhanced Co-operation Procedure under Article 20 of TEU, on the other hand, is not appropriate because it would tend to breach Article 326 of TFEU. Despite Articles 332 and 334 of TFEU it is inequitable for the Eurogroup to hijack EU institutions to damage further the European economy by a continuation of the single currency for any longer than is necessary to put in place alternative arrangements (such as a split between the core and the periphery).

21.2 The use of the Enhanced Co-operation Procedure for EZ matters (as with the Financial Transaction Tax) encourages only one solution: Non-Euro Member States subsidising the EZ periphery. The Commission's drafting of the Financial Transaction Tax has shown how the Article 20 TEU Enhanced Co-operation Procedure will be used against the UK economy.

21.3 It is not appropriate for the UK to be encouraging deeper integration. Non-Euro Member States must have a much looser relationship with the EU if they are to avoid having to pay for the folly of the single currency.

22. How will EU institutional arrangements need to change in order to accommodate deeper integration?

22.1 If the UK remains a member of the EU, then the relationship should be confined to trade and access to the single market within a concomitant structure - to do otherwise would involve the UK permanently subsidising the EZ periphery via EU Cohesion, Infrastructure, Regional and Solidarity Funds (as well as, potentially, via

55 For example, in respect of Fiscal Union: "setting up a European right to require a revision of national budgets in line with European commitments, would require a Treaty change" http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:52012DC0777:EN:NOT 56http://www.independent.co.uk/news/business/news/eu-treaty-changes-needed-for-banking-union-8635327.html

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Convergence and Competitiveness Instruments and/or the Financial Transaction Tax).

23. In the event that not all Member States chose to participate, would the need to ensure democratic legitimacy for contentious GEMU decisions require reform to the decision-making process, either in the European Parliament (eg through differential voting and Committee arrangements) or the Council?

23.1 Yes. This would be the case regardless of whether or not other Member States chose to participate.

24. What are the implications of GEMU for the role of national parliaments?

24.1 The roles of EZ national parliaments in deciding and approving national budgets are being eroded by GEMU, with control being drawn to EU institutions which are further removed from the citizen and have accordingly less democratic legitimacy.

Impact on the UK and the Single Market

25. How can interests of all Member States be taken into account in regard to the Single Market?

25.1 They cannot: Qualified Majority Voting (QMV) is an integral part of the Single Market and has left the UK isolated and largely friendless in the Council of Ministers.

26. Are there alternative "models" for banking union which the UK would find more consistent with its preferences?

26.1 Yes, but only if we leave the EU.

26.2 My preference would be for a system that permits the UK to have financial services regulation that is appropriate for the City of London and the people of Britain, arrangements which permit proper parliamentary scrutiny of regulators, and enforcement of the common law against wrong-doers.

26.3 These modest aims are unobtainable because, despite not being part of the EZ, the UK has no veto in financial services and is already being subjected to Banking Union via EU Regulations (which of course have direct effect into national law without any meaningful involvement of Parliament in Westminster).

26.4 It is ironic that the EU system of regulation and regulators presents, by virtue of its complexity, its own systemic risk.

27. Since the majority of non-euro area Members States are likely to participate in many components of GEMU, are there particular risks for the UK finding itself in a small minority of non- participating Member States?

27.1 The risks are already materialising. Despite David Cameron's treaty "veto" in December 2011, and without raising any further objection (because it would have shown how toothless it has become) the UK government has lost domestic control over the regulation of the UK's largest industry. We are being drawn into Banking

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Union by EU Regulations, a few examples serve to show the scope of this capitulation: • the Single Rule Book; 57 • capital adequacy requirements under Basle III (as implemented by Capital Requirements Regulation) in which the EU effectively forces banks to buy EU government debt and to rate it at zero (or low) risk for purposes of bank capital adequacy; 58 • the restrictions on employees' private contractual rights (eg limits on bankers' bonuses and financial services remuneration); 59 • liquidity requirements for banks; 60 • permitted leverage ratios for banks (post 2018); 61 • the ESMA's ability to ban short selling of securities in London; 62 • the ECB's ability to prevent Euros from being cleared in London; 63 and • although the UK government has re-branded the FSA as the FCA, and given the Bank of England a wider remit, a more important change is that the City watchdogs now report and are responsible to regulators in the EU - including the European Systemic Risk Board, the European Banking Authority, the European Securities and Markets Authority and the European Insurance and Occupational Pensions Authority.

27.2 When politicians want regulators to account for their actions at the highest level it will only be possible via EU institutions - UK regulators are "just following orders" and EU regulators could justifiably claim that it would be unfair to answer questions of one national parliament and not all 27 - but the opportunities for such scrutiny in Brussels are meagre at best, and come nowhere near the sophistication of scrutiny in Westminster, particularly on financial services. How can it be that a consequence of the financial crisis is a loss of public accountability for regulators?

27.3 One might also ask: are these losses of autonomy and accountability worth the access to EU markets that banks are supposed to have, but which in reality is often denied them by the bureaucracy of local regulators? 64 Will the EU, in the middle of a recession and banking crisis, want to risk banning UK banks from facilitating and financing businesses and investments in the EU if the UK were to leave? Given the chronic problems that EZ banks, governments and businesses are facing, and the EU's demonstrable incompetence in financial matters, would it not perhaps be a good thing if the EU prevented UK banks from getting too deeply involved in the EZ?

27.4 In respect of the European Banking Authority (EBA) it should be remembered that the double voting lock is only permitted to exist for as long as there are at least 4 Member States outside of the Euro - only Denmark and the UK have permanent opt- outs, other Member States are required to join the Euro.

57http://www.europarl.europa.eu/news/en/pressroom/content/20130412BKG07195/html/EU-Bank-Capital-Requirements- Regulation-and-Directive 58http://www.europarl.europa.eu/news/en/pressroom/content/20130412BKG07195/html/EU-Bank-Capital-Requirements- Regulation-and-Directive 59 ibid 60 ibid 61 ibid 62http://www.bloomberg.com/news/2013-06-17/u-k-clashes-with-eu-over-bid-to-boost-market-regulator-s-powers.html 63 http://uk.reuters.com/article/2013/04/22/g20-derivatives-idUSL5N0D91LV20130422 64 http://regulation.fidessa.com/2013/01/21/dude-where-is-my-level-playing-field/

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27.5 An example of what we can expect from the new institutional architecture is the turf-war that the Paris-based ESMA recently began over control of the London Inter- Bank Offered Rate - a British institution of global stature linked to transactions worth in excess of USD 300 trillion. Knowing that it has no blocking minority, the UK government gives every outward appearance of being unconcerned that, despite most mortgages in the UK depending on LIBOR as a benchmark, and despite the vast majority of Europe's inter-bank lending taking place in London, the rate could be set in a foreign country (France) which uses a different currency, a different law, and has different priorities to those of the British economy - it's a betrayal of every household in Britain to put their finances at the mercy of foreign bureaucrats over whom the British Parliament can exercise no real scrutiny, but the UK government is powerless to prevent it. 65

28. How can the UK ensure that the voice of this minority continues to be heard?

28.1 Is it sufficient merely to be heard when there is so little chance of being heeded? Is that the limit of our ambition for the UK as the world's sixth largest economy and leading financial services centre?

28.2 Whilst the UK remains in the EU it will continue to have only a marginal influence over matters governed by QMV. Vainly exercising its 8% share of the vote in the Council and occasionally developing ad hoc alliances with non-euro Member States, the UK will never be able to muster a blocking minority against the EZ, let alone a qualified majority in favour of something that the UK wants but the EZ does not (eg clearance of Euros in London, Westminster scrutiny of the chief regulators of London's financial services, or risk-weighting of government debt for capital adequacy requirements).

28.3 Inserting, into recitals in documents from the Council of Ministers, platitudes that proclaim there will be no discrimination within the single market, are not legally enforceable and will be ignored by the European Court of Justice in favour of principles of "ever closer union".

28.4 The UK would have more influence over EU policy by leaving the EU and leading by example: effectively "showing them how it's done". Leaving the EU would provide export businesses in the UK with the legal protection of the WTO against EU protectionism (in place of the weak political protection afforded by the UK's 8% share of the vote in the Council of Ministers).

29. Do you anticipate any institutional changes that would prove problematic for the UK?

29.1 The EZ will become increasingly well-organised as a single body. Speaking at a joint press conference last month President Hollande said he and Chancellor Merkel "are in agreement that there should be more eurozone summits, with a full-time Eurogroup

65 http://www.cityam.com/article/eu-plots-grab-control-libor-london

246 of 441 Mr Nigel Farage MEP—Written Evidence

president with strengthened powers." Chancellor Merkel added that "We need more economic policy coordination, especially in the Eurogroup". 66

29.2 The continued progress of the once improbable Financial Transaction Tax 67 is a good example of how increased use of the Enhanced Co-operation Procedure and EZ "pre-meetings" will demonstrate the old adage of EU politics that "if you're not in the meeting, you're on the menu".

29.3 The political machinations behind closed doors in the Council of Ministers have always been dominated by those who have met privately beforehand to agree a common position. The most important of these pre-meetings continues to be the Franco-German Axis, and the clear intention is that this Axis will now formally use the EZ meetings to decide matters in advance between themselves. The EZ meetings will consequently become the engine for "ever closer union" and we must recognise that the UK will never be invited - but we will be on the menu.

29.3 In such circumstances the legal provisions of the WTO are a better, more open and reliable mechanism to provide UK export businesses with a level playing field than the back-room politics and secretive horse-trading of the Council of Ministers in which we have only an 8% vote. Our membership of the EU denies us our seat at the WTO and remedies thereunder: recourse to the WTO against the EU is only possible once we leave the EU.

30. What is the likely impact of non-participation on the UK's ability to attract inward investment?

30.1 Provided that the UK leaves the EU, the impact of non-participation in GEMU will ultimately be positive. The EU routinely and deliberately usurps the rule of law, is statist and corporatist in outlook, has a shrinking share of global trade and GDP, is anti-democratic, authoritarian, and protectionist. Investors who are comfortable with such structurally inherent risks prefer to place their bets in emerging markets where the returns are potentially much greater than those available in the stagnant EZ economies.

30.2 Non-participation, if combined with exit from the EU, will enhance business opportunities in the UK not least because it will enable the UK to reduce tariff barriers and focus on growing markets outside of the EU (with whom free trade agreements can be much more easily agreed in the absence of the UK having to appease and accommodate EU protectionism).

31. What is the likely impact of non-participation on the position of the UK financial sector?

31.1 The UK is never going to join the Euro, and so participation in GEMU is unsupportable. Joining the Euro would have been a disaster 68 and the impact of non-

66Associated Press, Thursday 30th May 2013

67http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/9979950/Financial-Transaction-Tax-will-shackle- investors-and-harm-economy.html 68 http://blogs.telegraph.co.uk/finance/jeremywarner/100024801/what-if-britain-had-joined-the-euro/

247 of 441 Mr Nigel Farage MEP—Written Evidence

participation in GEMU is therefore always going to be better than that of being in the EZ.

31.2 It is already clear, however, that the EU will do all it can to get the UK to subsidise the failing economies of the EZ periphery. 69 The EU calls it "solidarity" others might more accurately call it "obtaining property by deception".

31.3 It also suits the EU's narrative of the Euro crisis for the Franco-German Axis to go out of its way to attack the City of London 70 and, for as long as we remain in the EU, we have no defence against this because we cannot muster a blocking minority in the Council of Ministers.

31.4 The City of London is today facing a threat from the EU of a similar magnitude to that which the fishing industry faced in the 1970s. Back in the 1970s we trusted the government to protect our interests via the Council of Ministers, that was a huge mistake then, and we have even less influence in the Council of Ministers now.

31.5 This is one of the reasons why we see, from a survey of London firms, that a majority believe staying in the EU under the current terms is not desirable. 71 The Germans have made it very clear that no other terms are available. 72

24.06.13

69 http://www.express.co.uk/news/uk/389776/Britain-faces-6bn-bill-to-help-others-join-euro A quarter of the losses incurred by RBS were actually losses of its subsidiary operating in the Irish Republic - the deposits of which were guaranteed by the Irish government - had the UK government decided only to bail out the parent (RBS) then the Irish taxpayer (rather than the British taxpayer) would have been left with a bill for over £10bn (seehttp://www.thetimes.co.uk/tto/business/industries/banking/article3787033.ece and http://www.dailymail.co.uk/news/article-2338795/British-taxpayers-paid-extra-10bn-backdoor-bailout-Irish-economy-2008- MPs-discuss-breakup-RBS.html?ito=feeds-newsxml). 70http://www.telegraph.co.uk/finance/financialcrisis/9904586/Is-Europe-tearing-apart-the-City.html http://www.telegraph.co.uk/finance/comment/kamal-ahmed/9904823/Make-no-mistake-the-EU-is-at-war-with-the-City.html http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/9985673/Tobin-Tax-is-madness-for-Europe-and- economic-war-against-Britain.html#mm_hash 71http://www.cityam.com/article/half-london-firms-say-no-unreformed-eu 72http://www.telegraph.co.uk/news/worldnews/europe/eu/9821136/Cherry-picking-EU-benefits-not-an-option-Germany- warns-David-Cameron.html

248 of 441 Elisa Ferreira MEP and Liêm Hoang Ngoc MEP—Oral evidence (QQ 157-169)

Elisa Ferreira MEP and Liêm Hoang Ngoc MEP—Oral evidence (QQ 157-169)

Evidence Session No. 13 Heard in Public Questions 157 - 169

WEDNESDAY 2 OCTOBER 2013

Members present

Lord Harrison (Chairman) Earl of Caithness Lord Hamilton of Epsom Lord Kerr of Kinlochard Lord Vallance of Tummel ______

Examination of Witnesses

Elisa Ferreira MEP and Liêm Hoang Ngoc MEP

Q157 The Chairman: Welcome to you, Liêm, and to you, Elisa. Please do not apologise for being late. I, too, have had the pleasure of getting lost in this building for over 30 years. I was just thanking Liêm for coming to see us today and I thank you as well. I think that my Portuguese reaches only to “bom dia”, but thank you for coming along, as you have in the past, to help us. We have interpreters with us today and I am grateful for their assistance.

We are doing this examination in an effort to try to understand the issues involved in GEMU and to make the sort of contribution that the House of Lords always tries to make to these matters. But, necessarily, towards the end we will focus some of our questions on how GEMU will affect the United Kingdom. In the course of our discussion it would be useful if you, as parliamentarians, give us a bit of a feel about how the United Kingdom is viewed in the Parliament. We would ask you to be as broad and forthright as you wish so that we have a better understanding of the position. Perhaps you would first like to introduce yourselves, and then I shall put some opening questions to you. Elisa Ferreira: Thank you for this meeting. I find it interesting to depart from the short and very controlled discussions that mark how we exchange points of view in Parliament. We have a little room to discuss more openly some of the critical issues that we are facing in the European Union, and in particular around the single currency. Along with Liêm Hoang Ngoc, I serve on the Economic and Monetary Affairs Committee. I am Portuguese, so of course I will say “bom dia”. I am an economist and a university teacher, as is Liêm. For a period I was a Member of the Portuguese Government and this is my second mandate here in the European Parliament. I am the Co-ordinator of the Socialists and Democrats for economic and monetary affairs, acting as a kind of spokesperson. I have also been working on a series of economic issues. I worked on the report into the recovery of the eurozone and in particular of Europe. I drafted an opinion and the initiative report for Parliament on how to resolve the issue of cross-border banks. An initiative report is

249 of 441 Elisa Ferreira MEP and Liêm Hoang Ngoc MEP—Oral evidence (QQ 157-169) produced to discuss issues and call for reactions. Later I was one of the rapporteurs on the six-pack report and a shadow rapporteur on the two-pack report. I am the shadow rapporteur on the recovery and resolution framework for banks and the rapporteur on the single resolution mechanism. I do not know if this is a positive CV, but it shows that I have worked on these issues. I am very interested in this discussion, but it is a very broad one, so I would appreciate it if you could help us by organising the kind of issues we should address. I would like to ask Liêm to introduce himself because he is a very important member of our political group in the macroeconomic area. He is a specialist. Some of his proposals and comments have been of paramount importance to the development of the thinking of the Socialists and Democrats on the way out of and reasons for the crisis. It is now his turn to introduce himself.

Q158 The Chairman: I would be very grateful if Liêm could. I should perhaps explain that I am a socialist and I used to be a socialist in the European Parliament but I understand that you have now become democratic. I was very pleased to learn about that. My other colleagues are Conservatives, and Lord Kerr is a crossbencher. My colleague Lord Vallance is a Liberal Democrat. You may like to know that in November we are going to Germany to talk to our colleagues there. We are particularly interested in garnering the views of our French and Portuguese colleagues, of which you are one. I should say that Sharon Bowles is unable to come today, but she has agreed along with Arlene McCarthy, Syed Kamall and possibly Nigel Farage—we do not know—to come to the House of Lords when we reconvene on 25 October. This is a huge opportunity for us to talk to you about the struts or otherwise of the GEMU but also to get your views on France and Germany. Liêm, would you like to say a few words? Liêm Hoang Ngoc (in translation): I will start by presenting myself and then I am looking forward to hearing your questions, of course. Good afternoon, everyone. I used to be an economist at the Paris 1 University, the Sorbonne. I do not know if you have worked very much as economists. I was particularly involved in looking into the Phillips' curve in my research. After that, I worked with the Chair of the Committee of Economic Affairs at the National Assembly, who was a former Chair of the . He got me involved in the work of the Socialist Party and gave me a certain number of responsibilities. I was deputy secretary responsible for the economy. Then, he handed me his place within the Socialist Party national board after that. I had the honour to be elected to the European Parliament at the last election and my co-ordinator had great confidence in me. She allowed me to work on a certain number of very sensitive files. I have been rapporteur or shadow rapporteur on a series of files relating to public debt. I have worked on files such as fiscal harmonisation, which I know is a very sensitive file for you in particular. I have also worked on issues such as the future of the economic and monetary union from the point of view of economic governance and we have also taken rather ambitious positions to try and shake-up the Commission, which has a rather dogmatic approach. We have launched debates with colleagues in ECOFIN, with Olli Rehn, on multipliers, which you know is an important issue. We wanted to know if these were more than one or whether they were lower. There were debates within the Commission about whether they are closer to 1.5. We are discussing in the Parliament and the Council the approach that should be taken on deficits and we managed to get the Commission to agree to a renegotiation of the calendar for deficit reduction, which was an important progression. François Hollande has been trying to renegotiate the rhythm and timeframe since his election. France has played an important role, that is true, in these negotiations but Elisa and I are working within this Parliament to really take a European approach and have a European logic to what we are doing, separate

250 of 441 Elisa Ferreira MEP and Liêm Hoang Ngoc MEP—Oral evidence (QQ 157-169) from the intergovernmental approach. That is in the spirit of the work of the socialists and democrats group. Our approach is a federalist one. There are variations between the different delegations, of course, but broadly speaking we think we need to raise awareness throughout Europe of the risks of national egoism. That is why we have been working on debt mutualisation. We are calling for a significant European budget with its own resources, not just contributions from member states. Looking at the eurozone, we believe that the reforms that have thus far been undertaken are not enough to guarantee growth. We need different reforms. The structural reforms being carried out are simply not enough. There needs to be a new approach to budgetary policy. On the UK, we are open. We do not have an approach that says that there are eurozone countries and then others. No, we have a community approach. We want to preserve the unity of a Europe of 28 and we remain open to the idea of new members to the eurozone. Of course, that is not a very popular idea with many in the UK but we nonetheless recognise that we have a common destiny. We believe that would be something very positive for us.

Q159 The Chairman: Thank you very much for that. My wife is a graduate of the Sorbonne. I send her best wishes to you on that. Our meeting yesterday was with Commissioner Rehn. We tried to réveiller Commissioner Rehn to see whether we could get him a little more animated about this subject. I will start with you, Elisa. Because so many issues were raised, could you give a bit of an analysis of the European Parliament’s committee on the question of GEMU? What did you think was good about it and what needs to be done about the current practice? What is missing? Liêm talked about the growth strategy in particular, which I know will have been of interest. Even though Liêm says that we look at this as a whole of the EU 28, we would nevertheless benefit from knowing how it is seen from a national point of view in Portugal—I believe there is going to be a visit shortly to Portugal from a House of Lords friendship committee—and France. Liêm, you mentioned the role of François Hollande, especially with Madame Merkel. It would be useful to the committee not only to get a feel of whether you think the framework needs to be added to, and perhaps the way suggested to do that, but also if you could give us aperçu a little idea of how it is seen from Lisbon and Paris. Elisa Ferreira: As you know, Lord Harrison, when we politically decided to create a single currency some of us economists knew that it would be a challenge to create the same currency area with very different levels of productivity and competitiveness inside that area. Since the beginning, everybody suspected that the external exchange rate would be more adequate for certain countries than others. Why did we join? I recall that when I started studying European affairs—although I am very young I stared doing that in 1979—the question raised was “What will happen to Portugal if, ever, we join not the single currency but the European Union?”. The decision to apply was taken on political grounds because we were moving away from a non-democratic regime. We were waiting for democracy to be installed and then we joined. When I started as an economist making calculations of gains and losses from accession, I went to the UK and it was there that I studied European affairs for the first time in my life. It was very interesting because in the UK I could get a detached and logical perspective on what was working and not working. This developed a critical approach in me. For us in Portugal, Europe was always a political project. We did not want to have a free ride but we felt that by joining we would guarantee the most essential thing, which was democratic certainty, have the prospect of developing close friendships inside Europe and would be given the chance to catch up in terms of development. When we joined the single currency this political dimension was also present because we trusted that things that were missing in the picture and the architecture would be filled in as need be as the political cohesion of Europe would never be a problem. However, the truth is that for

251 of 441 Elisa Ferreira MEP and Liêm Hoang Ngoc MEP—Oral evidence (QQ 157-169) several reasons, some of which could not be foreseen such as the reunification of Germany, the enlargement for political reasons that followed and globalisation, the interface between the exchange rate and the outside world became much more important given the sharing of gains and losses inside the area. For all these reasons the Europe in which all these processes started is no more. In a certain dimension and to a certain extent some issues that were never questioned are now questioned openly. In particular, the explanation of the crisis prevailing in certain member states has created a serious split, detachment and disenchantment on the part of citizens in the winning countries and the losing countries, including England. We now have a serious political problem as a natural consequence of an architecture that is not complete because we have the single currency but we do not have any mechanisms for self-recalibrating the economy. Some countries—the most competitive ones—benefit from a lower than national exchange rate vis-à-vis the external world whereas countries that are less competitive have an exchange rate that is too high. This creates a permanent accumulation of surpluses in certain member states and a permanent loss of competitiveness in others. There are solutions to this but you have to have the political will to discuss them.

Q160 The Chairman: As Elisa says, Germany has experienced a noticeable growth in its capacity to withstand the buffeting of the financial crisis. Has that in turn changed the relationship with France and what François Hollande is doing to try to re-equilibrate, if you like, the partnership that Germany and France enjoyed in the past, which was recognised as being in many ways the engine of the developing European Union? Liêm Hoang Ngoc (in translation): I will try to give you the French position as objectively as I can, taking into account the latest policy initiatives of Mr Hollande. The most symbolic episode, I would say, and the UK is involved in this, was the budget debate. That was the most significant recent episode—the European Community budget. You are aware of the UK position. It wanted its rebate. Germany, for its part, wants the UK to remain in the EU and France was put forward as the country which wanted to increase the budget, and there was this conflict between France and the UK. France wanted to increase the budget. Now if you look at the results of the negotiations, things were much more complicated than that. There was a compromise reached and in this compromise everybody saw their position reflected. They did not say that officially to the press, of course, but the UK got its rebate, Germany modelled the compromise and France got what it always wanted, which was to keep the CAP. Once this compromise was reached, the intergovernmental agreement was then sold to us in the member states and to this Parliament. That is how I see it. Now the intergovernmental approach, I have to say—and this is what it was—was not necessarily welcome in the European Parliament because the European Parliament was more ambitious as regards the budget. It supported the Commission which proposed a much higher budget in terms of commitments. So that is the context in which I would see the way France behaved. What France was trying to do, just as the UK was trying to do, was to safeguard its national interests. The way negotiations take place is basically on an intergovernmental basis even on the other issues: for example, economic governance in Europe. When François Hollande talks in terms of economic governance, he is talking in terms of intergovernmental governance, excluding the European Parliament. There is no federal approach here at all and Delors condemned this, saying that this economic governance approach was truly intergovernmental, not a European Union approach— that is a democratic approach involving the European Parliament. So the French position these days is very intergovernmental in its approach to negotiations. As regards the substance, in the UK you were having this debate between old Labour and new Labour. If you look at the situation in France now—a similar situation—François Hollande’s position tends to be rather new

252 of 441 Elisa Ferreira MEP and Liêm Hoang Ngoc MEP—Oral evidence (QQ 157-169)

Labour. If you look at the present European situation and if you look at national budget policies, first of all we do not have an overall European budget policy to bring about a relaunch of the European economy. The European economy is still suffering from an asymmetric shock and the individual governments are obviously keenly running their own budgets. And France, when it comes to the automatic stabilisers, wants to negotiate reducing the period during which budget deficits have to be brought down to 3% to two years, whereas if you look at the substance of the Hollande strategy what he wants to do is to put in place structural reforms. It is very new Labour in nature. It really is supply-side economics. He is bending his knee to companies, reducing corporation tax, which is going to reduce tax revenue by 1% of GDP. He is trying to reform the labour markets, introducing flexi- security—he is trying to anyway—and then we have this budgetary discipline seeking to reduce taxes for future generations even if in the short term there are going to have to be some rather painful adjustments. So you see, to explain to you the position of France—the position of the French government—that is the context that I have just described. One could debate the substance of their policies further but that is basically for me the present context and framework. The Chairman: I am grateful to both of you for painting those pictures of France and Portugal. It helps the Committee enormously. To return to genuine economic and monetary union, which you touched on, I am going to ask the Earl of Caithness to explore a certain part of what we have been investigating over the past few days. We very much value your own opinion. I know that this is very difficult to do, but I wonder whether you could reflect on the absent members of your committee who would perhaps have shared views or different views, because we want to try to get a rounded approach. We will pick that up when we talk shortly to the British MEPs, who come from all parties, but that would be very helpful.

Q161 Earl of Caithness: Good afternoon. I should like to get your opinion on the banking union. I have two experts in front of me, so I look forward to your replies. It seems that as the crisis has eased so the political will to get a banking union has eased. Do you think that is a problem? More specifically, on the single resolution mechanism, the British, as you know, are concerned about its legal base and the powers of the Commission. Do you share those concerns? My third question is whether you are happy with the delay to 2018 of the resolution mechanism. Elisa Ferreira: On banking union, we in Europe cannot have an internal market for financial services with 27 or 28 different supervisors, different rules and industry playing in differences of application and rules. In a way, it comes from the internal market and is something that this Parliament had been asking for; that is, the European authorities, or ESAs as we call them. The follow-up of this, particularly in the euro area, is that we created such an unbalanced regime that we ended up in this present architecture of the single currency. We ended up with the crisis creating a kind of vicious circle between banks and sovereigns. As Liêm mentioned, there is no mechanism to catch up after a crisis exists, so countries were asked to make their own effort during 2008 and half of 2009. The weakest ones got into debt. It was not anything that serious, because now we talk of past debt, but in 2007 the public debt of Portugal was 63.6% of GDP so it is not a scandal. When we decided that it would be for lack of an instrument of catching up at the eurozone level that each country would need to trigger some sort of relaunching of their economy, a lot of countries became indebted, for this reason and because they had to support the consequent real economic crisis, with unemployment and with less income from taxes. After mid-2009, when certain creditors looked at certain countries and said, “OK, they won’t be able to pay back what

253 of 441 Elisa Ferreira MEP and Liêm Hoang Ngoc MEP—Oral evidence (QQ 157-169) they are borrowing, and having the same currency doesn’t mean that they will all be together to pay back”, this doubt created the problem of speculation on the Greek debt, on the Portuguese debt and on the Irish debt for other reasons. After this period, the link between banks and sovereigns inside the single currency became a kind of fatal spiral. Governments were downgraded and could not borrow. They asked their banks to buy their debt but then banks became fragilised and were helped by the same Governments, so this was absolutely impossible and we ended up with very strange things such as the management of the Cypriot crisis, in which even the deposits were put at risk. Everybody was suspicious that deposits would probably not be that safe, particularly in these critical countries, because, as you know, the backing of the deposit guarantee scheme is the national budget. So after a while, when the national budget is fragilised, you do not trust that you will be safe. This kind of lack of trust created the need for the three objectives that I recognise in the banking union project. One of them is to cut the link between the debt of sovereigns and of banks and to reinforce the supervision and accountability of the whole system, eventually redirecting the banking system to refinance the real economy and to guarantee deposits. These three elements—not to go to taxpayers for critical problems, to safeguard deposits and to make the system more robust—are, I think, the reason behind banking union, and I agree with it. You asked some very detailed questions. The legal basis is like the treaty change and the Meroni argument. If there is a political will to solve problems, we always find ways to solve them. We ended up with specific changes in the big treaty of Europe just to accommodate the fiscal compact. If there is a will, problems are solved; if there is not, you pay huge bills to lawyers because the argument is endless. On entering into force, we have to make sure that the whole system gets together. We have something that I think makes sense: it is the bail-in ability of creditors according to a hierarchy that starts with the shareholders and ends up we do not know where. I would like the bail-in to end at the limit of deposits. Then we have the resolution fund, which will have to be operational very soon if we want to have a single supervisor, and we are building it. We cannot have a single strong supervisor with teeth that then brings a bank to the limit of resolution and puts it into the hands of the national resolution authority with a national resolution fund. That does not make sense. In order to have single supervision inside the eurozone and the adherent countries, we will have to have the other leg, which is the single resolution mechanism. The timing has to be adjusted. To have this, we need a single resolution fund. This resolution fund is absolutely critical to cut away the backstop for a failing bank going into the hands of taxpayers. That is our main concern. It has got to be fed by banks according to their risk. The whole structure seems to be okay. We are working in the Parliament on the single resolution mechanism and will vote on it. We have until December to finalise the position of the Parliament, so that in this mandate everything is finished. The SSM is finished and is implemented. We will have to make sure that the whole system works. You asked about political will. Political will in the Parliament exists, and here there is a convergence in principle. The different political groups will have to discuss details, but in general there is a convergence. I do not know about the political will inside the Council, where many member states are creating certain problems. I do not want to address specifically the British case, but, for instance, Germany was very vocal in asking for single supervision when there was a possibility of direct refinancing of Spanish banks only to change position because of Sparkasse one week later. Now we will see how it works with the single fund and the single resolution mechanism. The Chairman: Just before I turn to Liêm, I wonder whether the Earl of Caithness would like to come back and supplement his question. We on the Committee would be very

254 of 441 Elisa Ferreira MEP and Liêm Hoang Ngoc MEP—Oral evidence (QQ 157-169) interested to know whether, politically, you think a resolution mechanism can be established. It is obviously something that requires political will but perhaps— Earl of Caithness: I was going to wait for Liêm and then come back to one question. The Chairman: Perhaps if you put it now, we will ask Liêm to embrace it in his answer.

Q162 Earl of Caithness: You said at the beginning that one of your principles was to cut the link between sovereign and bank debt. Clearly, that is not going to happen, because already the language has changed to “diluting” the link between the sovereign and bank debt. Are we not therefore creating a banking union that has inherent flaws in it? Are you happy with the structure? Can you comment on the third leg, deposit insurance, which seems to have dropped off the agenda completely, again leading to a rather weaker banking union than was originally envisaged? The Chairman: Shall we ask Liêm that? Then, Elisa, if you could follow that up, that would be helpful. Incidentally, we have had advice from another witness that the Meroni principle has itself been queried. I do not know whether that changes the approach, but Liêm, perhaps you have some answers for the Earl of Caithness. Liêm Hoang Ngoc (in translation): For those who favour European integration, banking union was obviously a step forward that was more than just symbolic. Should we try to achieve that quickly? The interests of the member states are sort of telescoping the European general interest, which is a shame. How did this debate arise? I will just run through what I see as the important points. The starting point was the situation of the Spanish banks, which was causing concern throughout Europe. The bailout was regarded as inadequate and, at that point in time, Germany accepted going a little further by envisaging the so-called “bail-in”. The banking union started to be set up with the idea of assisting banks in difficulty without excessive contributions from public finance in the future. In many countries, the underlying cause of public deficits was that member states had been paying off private bank debts or helping private banks that had been indulging in lending policies that were far too risky. This is why the idea of a single supervisor arose—a department within the European Central Bank and an office which would be under the supervision and control of the European Parliament. That is important because the head of this unit would have to report to the European Parliament. Then we had the idea for two other mechanisms. First, there were deposit guarantees, which were supposed to be an integral part of the whole system. When you start trying to do things in practice, you come up against the member states. For example, Germany does not want a deposit guarantee fund—it wants a system of national mechanisms rather than a single system for a deposit guarantee scheme, because the Germans do not want to finance banks that are too indebted in other countries. Some people say now that there is no need for a crisis resolution mechanism because if we have a real crisis, it will be so big that we will have to use government funded bail-outs again. Are these excuses or are people being realistic when they put these arguments forward? We had the impression that Germany was holding back on all these things ahead of its elections. There is always the feeling that the single supervisor is not going to exercise control over regional banks and the question is whether the single supervisor would be giving instructions to national supervisors. Germany held back on all these points prior to its elections and when we have the new German coalition Government, things should move along a little more quickly. This is highly desirable—a lot of us in the European Parliament want it. However, I repeat, it does not seem that national interests are going to disappear in all this.

255 of 441 Elisa Ferreira MEP and Liêm Hoang Ngoc MEP—Oral evidence (QQ 157-169)

The Chairman: Before I bring in Lord Kerr, since you are both in the Socialists and Democrats Group, do you think that the influence of the SPD in Germany will modify Madame Merkel’s approach? If you could be quite brief about that. Liêm Hoang Ngoc (in translation): I am not sure about that. Elisa Ferreira: Neither am I.

Q163 Lord Kerr of Kinlochard: Perhaps we ought to ask your advice on how you think the economic co-ordination of GEMU will go. After the six-pack, the two-pack and all the work you have been doing with the European semester developing, we see a proposal from the Commission for binding contracts that sounds a bit like Mrs Merkel’s previous proposal. How does it work? How do you enforce such sanctions? The Stability and Growth Pact had fines attached, but when the France of President Chirac, and Germany, broke the Stability and Growth Pact, Romano Prodi said that fines were a silly idea and everybody forgot about the fine. How do you enforce binding contracts? How do you make them binding? And do you, as senior parliamentarians, think that this is the best way to go or will the Parliament produce an alternative version? Elisa Ferreira: That is a crucial question because lots of things changed during the crisis. Your question is whether we changed what needed to be changed. We changed a lot of things under political pressure created with a special interpretation of the reason for the crisis. According to the mainstream—this is not our political position, unfortunately for us— there was a lack of control over public finances. However, we forgot to analyse why, all of a sudden, there was such a lack of control of public finances. It was because the individual countries had to react to stimulate the economy after the crisis. The explanation and the narrative should have started a few steps back, but it did not. There was an overconcentration by political option on control of the public accounts. There are some important elements within the six-pack, for instance. I benefited a lot as rapporteur from the support of my group. We worked on macroeconomic imbalances: trying to understand what is in the real economy behind the lack of competitiveness, trade balances and wage productivity, to understand the functioning of the common currency. We did not take all our conclusions from that, but in the mean time we went on with the Commission increasing its control over individual public finances. The question is: okay, we control in order to co-ordinate. This year, for the first time, in country-specific recommendations, the Commission started saying to surplus countries that they would have to join the effort to get out of the crisis. There were no sanctions, just recommendations that they could expand internal demand a bit or invest a little bit. All the effort of readjustment was based on squeezing down, on recessionary policies in the weakest countries, putting downward pressure on wages to catch up with low productivity. That is endless, because the imbalances go on and on and there is no mechanism to help those countries to improve their productivity so that wages and internal demand can go up. At the same time, we had a recommendation that fostered recession simultaneously in all countries. In surplus countries, they did it just for the sake of keeping up their advantage, and the others were forced in. In an internal market in which 75% of exchanges are internal, everyone was in synchrony in recessionary policies, which created the multiplier effect of recession that Liêm referred to. I question the quality of those recommendations. Now there is a new element, what we call CCI, which has been mentioned. The danger is that we will end up with countries that do not comply. Portugal has been following to the limit the recommendations forced on it. They did not work. Please let us analyse why that did not work, because it was an experiment. On Greece, we had the excuse that Greece had not

256 of 441 Elisa Ferreira MEP and Liêm Hoang Ngoc MEP—Oral evidence (QQ 157-169) followed the recommendations. Portugal followed them to the letter. Why did they not work? Why are they not working? It is basic economics that you cannot export when everyone is closing their doors, so of course you do not import because you are in a recession and you do not invest. What is the medium-term consequence of this? When things do not work, there is no political room to discuss openly why not and to adjust the recipe. I fear that under CCI we are discussing another innovation. Sanctioned countries that, independent of having followed or not followed the recommendations, did not reach the targets will have extra sanctions. This would apply only to the weakest countries. That will be the cutting of cohesion or structural funds. That was supposed to help them to catch up and was something we owed to Britain with your accession to the regional fund. So one element is extra sanctioning. There is an extra element that can be used in a positive or negative sense under the CCI: that is, to use some of the funds to make what are called structural reforms. In practical terms, structural reform has been limited to reducing wages and support for labour in terms of trade union power, and so on. There are important structural reforms that could help this country, such as in justice or public administration, and these cost money. We will see what the CCI does. We stated clearly in the Parliament that we do not want it on an intergovernmental basis, because then a country can force on another country things that are not demanded. Can we rely on democratic accountability and a more reasonable way to implement this, or is this an extra third level of sanctions on countries that cannot comply? Where are we going from here? That is the political question behind that. The Chairman: Before I ask Liêm to reply, I call Lord Kerr again.

Q164 Lord Kerr of Kinlochard: The perfect answer to your question must be a fully integrated economic policy with an Economic Finance Minister attached in some way to a part of the Commission. The problems you describe seem to me to be endemic to the situation you are in, where you are co-ordinating. I think we will only be co-ordinating national policies rather than having a single policy for quite a long time. The difficulty in what you describe is that the Germans will decide to reflate or not to reflate for entirely German reasons—what happens in the negotiation now on the formation of a coalition. A recommendation emerging, even in the form of a binding contract on Germany to reflate, would make not the slightest difference to the discussion in Berlin. Portugal really needs some assistance with growth. How is it going to be helped by a binding contract that would have a sanction, assuming the deficit rose again in Portugal? We would be back to the Romano Prodi problem. I do not see how that works. Liêm Hoang Ngoc (in translation): We are in favour of the integration that you have just discussed, with a Minister of Finance and an executive. That is a long-term goal, bearing in mind the Van Rompuy road map, but the first step is the co-ordination of national budgets. In this context, the six-pack and the two-pack are symbols of this co-ordination. We are not against such co-ordination. Indeed, we have to do everything to guarantee that countries can do something about their public debt and that budgetary discipline is imposed. Furthermore, looking towards the federal future, we must avoid a situation where a country sees its debts being carried by other countries to a greater extent, even if we are in favour of debt mutualisation. Member states have to be fiscally responsible within a federal structure. That is what we have already achieved. The problem is now how to reconcile budgetary discipline with the need, which I underscored earlier, to have a budgetary policy at European level available alongside structural and other policies. Here, we have proposals which our Conservative and Liberal colleagues do not support. We have said that the Community

257 of 441 Elisa Ferreira MEP and Liêm Hoang Ngoc MEP—Oral evidence (QQ 157-169) budget is not sufficient. As long as you do not have a sufficient Community budget, you do not have enough money for a federal approach. As a result, the member states have to make use of their national budgets in the current circumstances. With budgetary discipline being imposed, their margin for manoeuvre is very limited. Either we introduce automatic stabilisers or we go further, and in a recession we make use of countercyclical policies. We have made proposals within the six-pack and the two-pack, but we did not find a majority. Our first proposal was to change the calculation for structural deficit. We wanted to exclude certain investments, which is something that the United Kingdom has done for a long time with the “golden rule”, based on Keynesian policy.The structural deficits in many countries are low. Our second proposal, which I think was listened to by the Commission, was to modify the pace applied to the reduction of budget deficits in line with the economic situation. That was a proposal by François Hollande at a time we were having in the Parliament a very important discussion on the rate: should it be 0.5% or 1% per year? The debt reduction rate of each member state is about 0.5%, so within the rules set by the six-pack, but the level of indebtedness is a problem because the six-pack is not respected. We have a problem as economists. People are not aware of this, but as deficits are currently reduced at a rate 0.5%, public debt is still increasing. There are consequences to that. I hope that we can loosen the convergence and competitiveness instruments in future. All the countries of the eurozone are implementing these structural policies. The Chairman: Colleagues, I am conscious that we may lose the interpreters soon. I have Lord Hamilton, who would like to offer a view, and Lord Vallance. I know that the Earl of Caithness would like to come back to this. Could I ask Lord Hamilton to be fairly brief, then I will turn to Lord Vallance.

Q165 Lord Hamilton of Epsom: Following on from the last question, the Commission has this proposal for fiscal capacity and a budget within the eurozone. How do you see that mapping out? Where will the money come from? What new taxes would be brought in? Surely we are talking here about a new treaty. As we know, the Commission has been avoiding a treaty like the plague for a long time now for the simple reason that it does not think it can get one through. There are great problems with the referenda that have to happen in France, Ireland and other countries within the eurozone. If you are blocked by needing a new treaty, and you cannot get the treaty through, how does anything happen? The Chairman: Lord Vallance, tack on the question that you are interested in. Lord Vallance of Tummel: The UK Government’s position has been fairly clear that they want to be party to most of the elements of the union but they are very concerned to preserve the interests of the single market. There are two questions. First, do you think that that UK Government position is tenable and sensible? Secondly, one thing missing from the blueprint for economic and monetary union is completion of the single market, particularly in services. One would think that if one was looking for growth opportunities that would be an obvious thing to do. We took evidence earlier today from BUSINESSEUROPE that reaffirmed that all the business entities throughout Europe would be in favour of getting on with that. Do you think there is a political appetite for that as well? Elisa Ferreira: I will give you a personal opinion on the situation of the UK. I understand that the UK is interested only in the single market. In a way, that is very different from the position that I should like to see the UK playing. For a long time, since the UK joined the EU, I have got used to seeing it as a very active, intelligent shareholder in the project. Now, particularly after the speech by Mr Cameron—I do not know all the details that justified it—

258 of 441 Elisa Ferreira MEP and Liêm Hoang Ngoc MEP—Oral evidence (QQ 157-169) it is as if you are no longer a shareholder and have become a client. I am sorry; I do not want to offend anybody. We miss a strong presence from the UK, and all the contributions and the richness of the debate that make a more balanced agenda. I really miss the UK’s active and constructive presence. I recognise that presence in the single market and financial market regulation, where the UK is absolutely active. But then there is a kind of resentment from everybody else, saying, “Okay, there is no burden sharing and a lot of blocking of progress in areas where it is difficult to get out”. Looking at it from the outside, probably, you analyse the common currency as an experiment. It will work or not, let us bet on that. But for people inside, it is a critical situation in which you do not have many ways out apart from trying to fill in the gaps that remain. Coming out and destroying the common currency would be impossible, even politically, throughout the whole of Europe. This is a matter not just for the eurozone. So I hope this is a phase. I know that the old UK, the leader of the industrial policies, is no more while the UK is now the leader of the financial markets. Nevertheless, I hope that time will bring the UK back to being an active and constructive partner of the European project. Of course, I understand that completing the single market is very interesting and important but do not forget that when we look, in economic jargon, to the welfare triangles, we have to understand how we share the gains from an internal market. That has to do with where you play and how you set the level playing field. It cannot be all the most relevant partners being very active in setting a common level playing field that fits their interests and not understanding that wherever you put that level playing field is where the sharing of gains tends to be. This is a very interesting debate but we cannot go on with asymmetric gains and losses, and without addressing the other elements of the coin. How do you foster competitiveness in the weakest members that cannot be permanent suppliers of manpower for lack of capacity to compete, according to the new rules that are, again, even more stressed after we started living in a globalised economy where the outside world determines a lot of what happens inside Europe? It is a complex question. Personally, I think that the internal market together with a lot of other issues has got to come back to the agenda and not be kept outside. The Chairman: Elisa, your position was so well put: that you perceive the UK to be, or that it was, a shareholder, that it was intimately involved, and that it has now become a client. Before I ask Liêm himself to reply to that and to Lord Hamilton’s point about whether there will be the need for treaty change, I will invite Lord Kerr back, who might take some credit for forming British policy in the past when perhaps we were engaged shareholders.

Q166 Lord Kerr of Kinlochard: That is a very interesting critique, Elisa. Thank you very much. However, you began by saying that you knew that the United Kingdom was now interested only in the single market. I cannot let that pass. I am no longer a practitioner but just an observer from outside. Don’t forget that a lot of the encouragement to the European Union to remain the world’s biggest aid donor has come from London, at a time of austerity in London; the Government reducing public expenditure; don’t forget their willingness to hold to the 0.7% of GDP target—one of the very few countries in the world doing that— and their encouragement to the European Union to live up to it. You are our oldest ally. You are a trading country, just like us, and interested in Africa like us. Elisa Ferreira: We did textiles, you did wine.

Q167 Lord Kerr of Kinlochard: You know that the United Kingdom is an outward- looking country, like Portugal. The United Kingdom tries to make the European Union look out and to be big in the outside world. So does France. On defence, the European defence dossier is at heart an Anglo-French dossier. Because we take a different view on what is, I

259 of 441 Elisa Ferreira MEP and Liêm Hoang Ngoc MEP—Oral evidence (QQ 157-169) agree, the most important task of the European Union at the moment—on saving and maintaining the economic and monetary union and the euro, and the British view on that is different—let us not allow that to pollute the whole picture of what the British are in Europe for and I hope what the British will remain in Europe for. Elisa Ferreira: I hope so too. The Chairman: Liêm, would you like to reply to that? Then I will give Elisa the very last word. Liêm Hoang Ngoc (in translation): I will be very brief. I understand the British position. The euro as a currency is a political project, and in the present situation British public opinion is not in favour of this political project. One can well put oneself in the British position and understand it. In the present circumstances, if we want the UK to remain in the EU—and we want them to, because we set up the EU for political reasons after the Second World War, which you are all familiar with—it is important for us to continue the dialogue with you. I can understand your position, and it is true to say that the UK is doing very well in the single market. As Elisa said, the UK in the mean time can devalue its currency and still have access to the single market in which we have a currency that some economists would say is overvalued. So the UK is not necessarily losing out here at all in the present circumstances. Now, with respect to budgetary capacity, we in the eurozone cannot devalue, so given the presence of macroeconomic disequilibria we now have to resort to structural reform. But we cannot reduce labour costs to the extent required, so all that remains is budgetary policy: transfers. That is why the budgetary capacity of the eurozone is crucial. Unfortunately, this requires a treaty change. Obviously, in our present circumstances, the contributions from the member states are not enough for an adequate budgetary capacity in the EU—the member states do not want to contribute more—so we will have to face this question of setting up a budgetary capacity financed by own resources rather than by member states’ direct contributions, as I said. We will have to move to an own-resources based EU budget, maybe via some sort of uniform or harmonised, tax system within the eurozone. There are initiative reports on this within the European Parliament. I am talking about the FTT and the proposals of the Parliament on the reform of corporation tax in the eurozone. The Council has these documents from the European Parliament, so an own- resources system is something that we could envisage. The blueprint and the roadmap after 2019 envisages putting in place this new budgetary capacity, but if we are going to do that and devise a new own-resources system, we will have to change the treaty. In the mean time, when we have a new Parliament, in which there will be a stronger Eurosceptic component, it will be very difficult to approach the problem of changing the treaty.

Q168 The Chairman: Thanks ever so much, Liêm. I promised to give the last word to Elisa. Elisa, in summing up, could you tackle the question of treaty change, which I know Liêm touched on. The Committee is very interested to know whether much can be achieved without treaty change or whether down the line we will have more treaty change. Elisa Ferreira: I join Liêm in saying that it is difficult at this moment to make any treaty change for all the reasons that were mentioned, so there is a disappointment from member states. The winning member states think that they could win even more if they did not have to pay for the laziness of the southern ones. The southern countries think that they are under a kind of overprotectorate that is really squeezing them and forcing them to sell public assets, while they are losing the most qualified generation through emigration. This is not the moment to go for a referendum. That is the issue.

260 of 441 Elisa Ferreira MEP and Liêm Hoang Ngoc MEP—Oral evidence (QQ 157-169)

Of course we can do a lot of things within the present treaty. For instance, one of the elements that was also in our agenda when we discussed six-pack to two-pack was okay, but there must be some sort of global European stimulus for growth through investment. We mentioned the ideas, the projects—all these elements that could stimulate a bit of growth if it did not come from inside the budget. However, we did the EIB, and we could even develop an external development agenda. I do not want to mention the Marshall plan, but we could do something like that that would help us to create some sort of stimulus from the demand side. We do not have this capacity. Going back to the other issue, I did not mean to offend, and I was careful with my words, but of course it is not my native language, so even my sensitivity to certain words is not fantastic. I understand that Britain plays a relevant role and I wanted it to play a stronger role. In a way I am glad that this stimulated from you the kind of listing of the other elements where you can help. I am sure that that is seen from the outside: understanding that the common currency is the common interest of the whole European Union and not only for the eurozone. I am sure Lord Hamilton understands clearly that this cannot function with some sort of extra budget. You do not have any common mechanism substitutes for the lack of automatic stabilisers in the different member states. So we need it, and of course there are several elements that we can discuss, such as own resources. This debate is going on. However, I sincerely miss the presence of the UK in this debate from a positive side and not just saying, “Okay, we do not want to pay more into the common budget and we will pay as much as we receive”. That is logical. You can even help us to build up the missing elements in the architecture even if you do not join the euro. At least you can contribute to the solution of the problem. Being your oldest ally I would really welcome that because that is the way that together we also managed not to be absorbed by the centre of Europe. For this broad discussion we have to feel that the UK is again a very active shareholder in the project. That is what I meant to say.

Q169 The Chairman: Let me conclude this exchange, first, as any good Chairman does, by thanking the interpreters. To illustrate the point about the United Kingdom being a shareholder, I remember the frustration when I was a Member of Parliament and we used to get to the end of long three and a half hour sessions. The interpreters used to glare at us through the darkened glass since, if we had started the meeting early, we would have completed the business. Commissioner Kinnock in those days started meetings at 9 am and 3 pm, and of course nobody was there. That was an innovation from the UK that did not quite work. I thought I would thank them. We have one more session but I also want to put on record my thanks to Belinda, who has been patiently involving and immersing herself in many of these very complex ideas. She will produce the transcript, which we will send to you. We would ask you to correct it and supplement it with any further ideas you have. I thank the two of you for coming today. We will meet your colleagues on 25 October so that we get a wider perspective other than the Socialist and Democratic one. You may have noticed that I was nodding at a lot of things that you said. In conclusion, we strongly take on board that notion of the shareholder idea. We recognise that European parliamentary elections will take place very soon and I would also mention the election which grips the whole of Europe every year, the Eurovision Song Contest, and the influential part it played in Portuguese history when, I think, in April 1974 it blew the whistle for the start of the Portuguese revolution and for you coming on the long trail to join us in the European Union. You remain our oldest ally, even if France is always our closest and most engaging, if I can put it like that. It has been an exhilarating exchange and

261 of 441 Elisa Ferreira MEP and Liêm Hoang Ngoc MEP—Oral evidence (QQ 157-169) thank you ever so much for doing it. We conclude there. I thank you, the interpreters and Belinda as well. Many thanks.

262 of 441 Dr Clemens Fuest—Oral evidence (QQ 89-100)

Dr Clemens Fuest—Oral evidence (QQ 89-100)

Evidence Session No. 7 Heard in Public Questions 89 - 100

TUESDAY 16 JULY 2013

Members present

Lord Harrison (Chairman) Viscount Brookeborough Earl of Caithness Lord Carter of Coles Lord Davies of Stamford Lord Dear Lord Flight Lord Hamilton of Epsom Lord Kerr of Kinlochard Baroness Maddock Lord Marlesford Lord Vallance of Tummel

______

Examination of Witness

Dr Clemens Fuest, President, Centre for European Economic Research (ZEW)

Q89 The Chairman: My name is Lyndon Harrison. It is my pleasure to welcome you to the Committee, Clemens Fuest. We are most grateful for your coming before us today to talk about genuine economic and monetary union. If I may explain to you, we will make a transcript of the conversation and we will send it to you. We would be most grateful, Herr Fuest, if you would correct it or indeed add to it if you have any further thoughts following the conversation we have today about GEMU.

I wonder if you would be good enough to say who you are and the position you hold, in answer to my first question. Could you say what you think are the necessary elements of genuine economic and monetary union proposed by the Commission of Herman Van Rompuy, and what are the elements that you regard as perhaps unnecessary? Dr Fuest: By way of introduction, my name is Clemens Fuest. I am Professor of Economics at the University of Mannheim, and I am president of the Centre for European Economic Research in Mannheim. I am also a member of the academic advisory board of the German Ministry of Finance. Now, which elements are necessary to address the problems in the euro area? I would like to start by saying that I think there is more than one way of addressing the problems of the euro area, and the Van Rompuy paper takes one particular route. I would say the logic behind the Van Rompuy paper is to increase co-ordination and, as it were, control over fiscal policy at the central level in Europe, and at the same time,

263 of 441 Dr Clemens Fuest—Oral evidence (QQ 89-100) introduce and extend elements of joint liability of government debt. I would say that this is the logic behind the Van Rompuy paper. The alternative to that, in my view, would be an approach that would rely more on market pressures as an instrument to control public debt, and to make sure that there is no excessive public debt. How could that work? The monetary union, as it was created in 1999, very much relied on this market pressure by stipulating the no-bailout rule, and I think the shortcoming of that no-bailout rule was that it was not credible. A concept relying on market pressures and no bailout needs a framework where Governments that accumulate excessive debt can go into restructuring, rather than getting help from the outside. I think both concepts are possible, but in order to have a eurozone that is based on the no-bailout clause, I think we would need a different type of financial sector: a financial sector that would be robust enough to absorb restructuring of government debt. As I see it, the Van Rompuy paper pursues a different concept. It emphasises the idea of centralised control of government debt, and centralised liability for government debt. I think here the key difficulty is that, as far as I can see, co-ordination, fiscal rules and monitoring of national fiscal policies is too weak as an instrument to control the incentives to issue more public debt in cases where there is joint liability of government debt. I do not think that the combination of mere monitoring and supervision of the fiscal policies of sovereign states are enough to control the tremendous incentives to increase public debt in a situation where there is joint liability for government debt. I think that this is the key difficulty.

Q90 The Chairman: Mr Fuest, it is so interesting that you should say that we should almost return to the market-pressure model that was introduced in 1999; some would say it has failed. How would you ensure, for instance, that a no-bailout clause was actually implemented, and that true and proper market pressure was allowed the freedom to express itself in the light of what has happened in the intervening years? Dr Fuest: I think that two elements would be required. The first element, as I said, would be a different regulation and set-up of the financial sector. Our financial sector regulation is currently based on the assumption that government debt—at least the nominal value of government debt—is safe. This makes sense in a unitary state where the central government has its own central bank, and the central bank acts as a lender of last resort. In the eurozone the situation is fundamentally different. Here the ECB is a central bank of many states, and I think what would be required to maintain a set-up where the no-bailout clause holds would be two things. First, banks cannot hold government debt to the extent that they do now without providing equity for that as a basis. The second element is that we would need some sort of crisis mechanism along the lines of the ESM. Let us take the case of Greece, for instance. What would have happened in Greece if we had had this kind of set-up? In that case, Greece would have been restructured immediately. There would not have been the crisis and the danger of a run on the banks, because the banks would not have held so much government debt. At the same time, in a programme for Greece, the ESM would have made sure that the basic functions of government can be financed. I do think we need some sort of crisis mechanism, some sort of safety net in the case of restructuring, but the purpose of that safety net would not be to prevent the restructuring; it would actually be to make it possible. The Chairman: Would that have introduced moral hazard? Dr Fuest: This would inevitably introduce moral hazard to a certain degree, but I think the degree of moral hazard would be a lot smaller than the moral hazard that would be created

264 of 441 Dr Clemens Fuest—Oral evidence (QQ 89-100) by joint liability for government debt: extensive joint liability of government debt in the eurozone. The ESM can be seen as a very limited form of joint liability.

Q91 Lord Dear: Good morning. My question is in three parts. I wonder if you could help us, please, by identifying any elements of the GEMU proposals that you think are either completely unacceptable, or perhaps might become more acceptable with some modification. Secondly, are there any reforms outside GEMU that you think should be undertaken to try to resolve the difficulties we are seeing in the euro area? Could you stitch into those two points a view on whether your answer is dependent upon the outcome of the German elections in September? Dr Fuest: Let me perhaps start with the last point. I do not think that the German position will shift significantly after the elections. I know that many people expect that, but I think that the German policy and position is actually quite independent of who wins the election, and I do not think that the German Government are holding things back just because we have these elections now. I think that from a German perspective, the long-term perspectives in GEMU regarding the joint liability of government debt are not unacceptable, but they are not acceptable in their current form. I think they would need to be amended. I think that the German position would be that if there is joint liability for government debt in the eurozone, there has to be effective control—effectively a centralisation of the right to issue debt. Eurozone member states would have to give up the right to independently issue government debt. I think that would be a condition for the German Government, whoever, it is, and it would also be a condition for the German constitutional court to accept that. There are other elements of the GEMU report, in particular the short-term measures, which are quite compatible with the German views and positions: a deeper co-ordination of fiscal policy and of other policies. I think that these elements would be perfectly in line with German views.

Q92 Lord Flight: Do you feel that the role of the ECB has been given sufficient attention, and would you agree that it has been a fundamental initiative so far? To me at least, it has been the engine that appears to have resolved issues where Germany has had reluctance. Do you think that the outright monetary transactions should become a permanent element in a new economic governance framework? Dr Fuest: I agree that the ECB has been extremely important in our crisis management during the last two years. At the same time, I would say it is extremely important to understand that the role of the ECB in the eurozone is fundamentally different from the role of the Bank of England in the UK, or of the Federal Reserve in the United States, because the ECB is a central bank for several sovereign countries. A direct implication of that is that the ECB cannot act as a lender of last resort for national Governments. Its mandate is to conduct monetary policy and to preserve price stability only, and it is very clear that there is currently a danger that the ECB is increasingly dominated by concerns about fiscal and financial stability issues. The ECB is very aware of that, and I think that the OMT programme is a reaction to that. It is a very unusual programme. It conditions monetary policy measures on fiscal policy conducted by individual member states. This is highly unusual, and in doing so the ECB takes over a function that is more similar to that of what the ESM should do, or what the IMF does for countries in difficulties. The trouble is that the ECB, in my view, is no longer within its mandate in doing this. This raises two issues. There is the issue of legitimacy, and whether this is compatible with democratic control. The second issue is an economic one. Does it make sense to stabilise the eurozone by having this combination of providing credit to countries in difficulties and

265 of 441 Dr Clemens Fuest—Oral evidence (QQ 89-100) imposing conditions on them? I think the difficulty with conditionality is that it is never credible, because it basically means that if countries do not comply with the programmes, we will stop helping them. However, if we could stop helping them we would not have needed to help them in the first place. There is a fundamental contradiction between the announcement to stop helping if conditions are not met and the statement that it is necessary to help to maintain financial stability. The ECB is now in this very difficult situation. For that reason, I think that the OMT should not become a feature of the long-term framework. Stabilising countries and imposing conditions on fiscal policy is very clearly a task for fiscal policy, and if the central bank does that there is the danger that its independence is undermined and the credibility of the central bank suffers. This is something that should not happen. The Chairman: Given that the Fed has a responsibility not only for price control but also for the economic well-being of the country, and indeed for employment, do you think that too should be added to the responsibilities of the ECB, especially in light of the concern for youth unemployment throughout the European Union? Dr Fuest: Currently the mandate of the ECB does include the obligation to support the general economic policy of the member states of the eurozone, provided that this is compatible with price stability. Essentially, I think that this allows the ECB to conduct monetary policy depending on the current economic situation of the eurozone. The key point is that this should be a monetary policy taking into account the situation of the eurozone as a whole. It is true that the eurozone as a whole is in a very difficult situation. Unemployment is high, and in this situation it is perfectly reasonable and within the mandate of the ECB to reduce interest rates to near zero, and to do all the other things monetary policy can do. However, this is very different from taking measures that address individual Governments and their fiscal situation. I think that is where the difference lies.

Q93 Lord Vallance of Tummel: Dr Fuest, the Commission has recently published its proposal for a single resolution mechanism, which puts the Commission very much in pole position. That is at variance with the Franco-German paper on the subject, and indeed Germany has reacted strongly against it, on the grounds that it could put the German taxpayer at undue risk, and that the Commission could be operating ultra vires. However, the alternative of leaving resolution to national supervisors and tackling cross-border issues by some form of co-ordination between them surely guarantees irresolution, or at least some risky delay, which could be even worse for the German taxpayer. Should Germany not simply accept the Commission’s position in its own interests and try to make it work, rather than standing in its way? Dr Fuest: There are various issues here. Essentially, I agree; there is a strong German interest in stabilising the eurozone. I agree that stabilising the eurozone does require breaking the link between national Governments and their finances, on the one hand, and the situation of their banks on the other hand. I think to achieve that it is inevitable to address the issue of legacy assets. I am not saying that this element is totally missing from the Commission proposal, but currently it does not play a very big role. It is, if you like, the elephant in the room. It should be a prime concern. How do we address legacy assets? Although this is very difficult, I think the way to do this would be to try to estimate what the legacy assets are, and discuss openly how this burden will be distributed. If that was done I think that it would be possible to come to an agreement. Of course, discussing this would be difficult for any politician in any country, but ignoring it will lead to zero progress.

266 of 441 Dr Clemens Fuest—Oral evidence (QQ 89-100)

Lord Vallance of Tummel: But is there not a problem there? If you address the legacy assets in an honest way, then that may lead to some very unpleasant truths coming out, at which point you will need a resolution authority in place. Dr Fuest: That is probably true. That is why I suppose one would have to address the burden distribution rule in some way before identifying the banks with the problems. On the other hand, we have to see that currently financial markets have views about where the legacy assets are, and it is not that financial markets are currently assuming that they do not exist. I think what financial markets are currently assuming is that national Governments would pick them up, and that then the national Governments would be bailed-out by the European Central Bank. The situation is not so fragile that these things could not be investigated. However, I agree that if the asset quality test currently planned is really carried out, we should have a plan regarding the consequences. Lord Vallance of Tummel: Can I ask you a slightly different question? Some of our witnesses have suggested that for banking union to work, all three elements—supervision, resolution and deposit insurance—need to be in place. Do you agree with that? Dr Fuest: I would agree with that, but that does not mean they all have to be introduced simultaneously. I would say that there is a sequence that would be harmful, but there is also a sequence that would not be harmful. I think the reasonable sequence would be to establish banking supervision, and indeed give the competence to the European Central Bank to, for instance, order a restructuring of banks, but ideally also have common rules about how this restructuring will be carried out, but then let the national Governments pick up the bill, so giving the fiscal backstop. This is not the completion of the banking union, but it could be a first step towards banking union, so I do not think we necessarily need a common resolution fund from the start. It is possible. It is not ideal, but it is possible to start with supervision only.

Q94 Earl of Caithness: Can I follow up your reply to Lord Vallance? You said the stability of the eurozone is very important to Germany, which is quite understandable. We have received evidence that the only way that one is going to stabilise the eurozone is that Germany will have to be prepared to write off quite a lot of the debt, or other countries will have to write off debt. Do you agree with that? My second question relates to the recovery and resolution directive in ECOFIN. What do you see as the dangers in implementing that, and what are the pitfalls ahead of us? Dr Fuest: Regarding the first issue, can the eurozone survive this crisis without debt restructuring, so sovereign debt restructuring? In the case of Greece, the likelihood that the country can re-pay its debt is close to zero. It is not exactly zero, but it is probably close to zero. Most people would probably agree on that. Now, here the situation is a special one, because these are mostly public sector creditors. The more interesting candidates are countries such as Portugal and Spain. I think it is very difficult to say with certainty that some restructuring will be required, but my view is that there is a likelihood, which is probably more than 50%, that some restructuring will be required in Portugal. There are risks that restructuring will be necessary in other countries as well. However, if you look at the research being conducted in this area, what is typically being done in simulations, as you can imagine, is that you work with probability distributions about future growth. The result is that, with some probability, you expect restructuring. The question is: how large is that restructuring probability, or that insolvency probability? As I said, I think in Portugal it is higher than 50%. It is certainly significant in the cases of the other periphery countries as well. Regarding the resolution directive, I think there are various issues. First

267 of 441 Dr Clemens Fuest—Oral evidence (QQ 89-100) of all, there are issues of transition. I think that the basic principles are appropriate: the principles being a bail-in of private creditors of banks, not the taxpayer, the order starting with shareholders and then junior debt, and so on. These principles are fine as well. I think there are currently issues of transition. The draft directive says that this bail-in should only take place in 2018. I think that is far too late. Having this kind of deadline is very bad, because this sets the wrong incentives, in many ways, for the years before, so that is an issue. A fundamental issue is that if we want the bail-in of private creditors to be credible, we have to make sure that these assets are held by actors in financial markets that can absorb losses. We do not want to create another financial crisis, so if a bail in triggers such a crisis, we will not bail-in private creditors. That is the experience of the past, and that makes perfect sense. That is why I think ideas like the concept of the Liikanen report are very important. The Liikanen report has said that we need a form of regulation forcing banks to demonstrate that they have bail-in-able debts, meaning debts held by institutions that are not banks—pension funds, for instance—and this debt would be bailed-in in the case of restructuring. The Chairman: What is actually happening with Liikanen? Dr Fuest: I think it has had a certain influence. If you look at the proposal by Michel Barnier on the common resolution mechanism, there you find elements of this Liikanen report. The proposal actually says that we should make sure that banks do have certain forms of bail-in-able debt, so this aspect of the Liikanen report has had influence. I think regarding the other ideas in the report like the separation of investment banking and other parts of the banking system, I do not know whether they have a lot of influence. However, I think the report has had some impact.

Q95 Lord Kerr of Kinlochard: I want to come back to macroeconomic conditionality as an element in the policy toolkit. This may be slightly unfair, because you have said quite clearly that, in your view, imposing conditionality is never credible. Against that background, could you explain to us the German proposal for binding contracts, a proposal that now seems, judging by the 30 May paper, to have some French support? How would such contracts be enforced? Dr Fuest: This really depends on the consequence of non-compliance. I think that if the consequence of non-compliance is that some form of aid does not take place, and the consequence is that the country receiving the help does not collapse financially, and it just forgoes a transfer, then conditionality can work. Where conditionality does not work is in cases where entire countries depend financially on support, as is the case in the EFSF or ESM programmes, and as is the case in Portugal currently. Even in these cases, I think that conditionality is not completely useless. It does help national politicians to implement reform programmes. It does give them some leverage, or it gives them an argument in the domestic debates. If they want to implement it, it does help, but it does not help in cases where countries do not want to follow the programme. Lord Kerr of Kinlochard: If it is carrots and sticks, the withdrawal of the carrot is in fact the only stick that would be possible under the present treaty. If you were to have a penalty, under the present treaty there is no provision for doing so. You could, if you reached a political judgment, condemn a country like Portugal by withdrawing support. Is that the concept of the contract? If so, I have to say it does not seem very credible to me. Dr Fuest: I agree. I really think it depends on the situation where help is provided, and where the contract is written. If the withdrawal of help has drastic economic consequences, it is typically not credible, but there is this idea of rewarding countries for complying with

268 of 441 Dr Clemens Fuest—Oral evidence (QQ 89-100) reforms, or for pushing forward reforms and really offering them some form of carrot, some form of transfer or some form of help, possibly through a fiscal capacity. In these cases, where the withdrawal of help does not lead to very drastic and immediate consequences, it is more credible.

Q96 Viscount Brookeborough: Would you like to tell us your thoughts on the proposal for fiscal capacity and for an autonomous euro-area budget, in terms of timescale and how you think it should be funded, and how it might operate? Dr Fuest: I think that these proposals, or these concepts, are useful in that, if implemented, they would contribute to stabilising the eurozone, the idea being that, if a country is hit by an adverse shock, the country would receive some money, so this would provide some insurance. I would just say we should not expect too much from it. If we think about the amount of money that could be mobilised—as long as we stick to the current institutional framework, where the EU budget and this fiscal capacity would be financed through contributions from the member states—I think that its size would be very limited. Some people say it should be financed in the framework of the current budget. This is probably impossible. An alternative would be to set up something new, but if you think about what is politically feasible in terms of contributions, I would say that a fiscal capacity like that could be effective in the case of small countries, maybe, if the transfers granted are large enough. They would probably not, however, be large enough, because the principles for transfers would have to apply to all countries. My overall view on this is that maybe the symbolic value is higher than the real effects, just because of the size. Under the current institutional framework, I cannot see that this fiscal capacity will have a very large size. If I may add one aspect, if this fiscal capacity takes the form of insurance, one difficult issue is what we use as the reference situation. We need a reference situation, where nobody gets anything from this insurance. If the reference situation is the current situation in Europe— let us say current per-capita GDP—what could happen is that, if the peripheral countries recover a little, they have to pay transfers to Germany. I think that is not what is intended, so there is a certain conflict between providing insurance, which only distributes in the future and where the flows of funds are unknown ex ante, and currently the view that there should be some redistribution from countries that are better off, like Germany, for instance, to the periphery. Viscount Brookeborough: Do you think that there would be any place for non-euro countries to support it voluntarily or go within it? Dr Fuest: I would expect that this will be offered, but I do not know why a country would really want to do that—maybe for political reasons; I do not know. I do not think that there are economic reasons to do that for a country that is outside the eurozone and for a country that does not intend to join soon. As long as a country can devalue, I do not see an economic motivation to participate. There could be a political one, I guess. The Chairman: Could its form take a corporate income tax, and would that help in generally promoting stabilisation? Dr Fuest: This would be a huge step. I think that there is nothing inherent in corporate income tax that qualifies it for this role. On the other hand, there is a case for more coordination in corporate income taxation. We know that corporate income taxation in a highly integrated world does not work very well when it is run at the national level. From that perspective, corporate income tax would be a natural candidate for a European tax. I

269 of 441 Dr Clemens Fuest—Oral evidence (QQ 89-100) suppose the trouble is that centralising corporate income tax while maintaining personal income tax at the national level is very difficult. Many countries tax a large part of their corporations in the framework of personal income tax, not corporate income tax, so I do not think this would work in practice.

Q97 Lord Marlesford: Could we go back to debt mutualisation, which you have really rather indicated does not find much favour, certainly in its full form. One can understand that, in the case of Germany, there is probably neither the political appetite nor maybe the economic capability of having full debt mutualisation for sovereign debt. Up to now, the ad hoc approach which you referred to a moment ago seems to have been more favoured, but do you see any form of debt mutualisation emerging under the struggle to try to achieve GEMU? Dr Fuest: I do not see it emerging at the moment. A year or two ago, the main motivation to discuss that mutualisation was the huge differences in risk premiums across countries. If you look at the current situation as a consequence of ECB action, these risk premiums have almost disappeared. They still exist but 10-year Spanish government debt has a yield of 4.6%. This is something like 3% higher than the German yield, so I do not think that these differences are problematic currently, so I do not really see this strong motivation for debt mutualisation. Any form of debt mutualisation would only be acceptable if it was somehow limited, and there have been various proposals. For instance, one proposal—the eurobond, or red/blue bond proposal—said, “Let us mutualise the debt only up to a level of 60% of GDP per country”. The trouble with these concepts is that the question is: what happens to the rest of the debt? If mutualised debt is senior debt, all risks are focused on the rest. In the case of Italy, therefore, we would have 60% of senior debt and then the rest would be junior debt. I sometimes have the impression that people forget that the junior status of the remaining debt would create huge uncertainty in financial markets, so maybe the potential of debt mutualisation to help with regard to stabilising financial markets is sometimes overestimated.

Q98 Lord Carter of Coles: A few moments ago, you touched on the matter of fiscal transfers. Do you think, because of the differing levels of competitiveness in member states and the presence of these persistent imbalances, that the euro area really can survive, or will we need these permanent fiscal transfers to take place? Really, can it survive without these and, if that is the case, what would the German reaction be? Dr Fuest: I personally think that it can survive without permanent transfers. I think it cannot survive without some deal on debt restructuring—some solution for the debt overhang— but I think it can survive in the long term. In the area of competitiveness, however, this really requires much more flexible labour markets than we currently have. I think that there are two ways of addressing a shock hitting a member country. One is to live with the fact that wages are rather inflexible and pay transfers, and this is not a concept that would work. I do not see the political support, and I also think that, economically, it does not make very much sense to try to stabilise the eurozone through transfers like that. If there is a future for the eurozone, it has to become some form of, let us call it “adjustment union”: a union where the shocks to individual countries are absorbed by very flexible labour markets. I think that the future for the eurozone is very bleak if we do not achieve that. Lord Carter of Coles: Do you think that the political instability that may follow that in certain of these peripheral countries is sustainable?

270 of 441 Dr Clemens Fuest—Oral evidence (QQ 89-100)

Dr Fuest: I do not think it is inevitable that this leads to massive instability. I just think that we have to reform labour-market institutions in these countries. It is true that if shocks lead to massive youth unemployment, this certainly is unsustainable. The current situation clearly is unsustainable, so something has to be done about it. However, I think that one can conceive labour-market institutions with more flexibility—institutions that can address shocks without creating this mass unemployment. Of course, this does require reform. Unfortunately, there is the view in continental Europe that it is a particularity of, let us say, the European social model that not so much flexibility is needed. I think the truth is, because we have this common currency and because we simply cannot absorb all shocks by paying transfers, we need more flexibility in labour markets than other countries. Lord Carter of Coles: Do you think that there is a German appetite for some sort of transitional transfers as these things pass through? How long do you think the German appetite would last for this? Dr Fuest: I do not think there is a lot of appetite; on the other hand, there is no appetite for a disintegration of the eurozone in Germany. If we put these two elements together, my prediction would be that the solution will somehow be sought through monetary policy. I think that there will be mounting pressure in the future on the European Central Bank to engage in more intervention and in more purchases of government bonds and things like that. I think it would be very difficult politically to sell massive, even transitional redistribution in Germany. I think some transitory redistribution scheme could be sold to voters in Germany, provided that there is some sort of deal—let us say progress in economic reforms. If that was visible, I think it would be possible to come to some transitory agreement, but I do not think it would be large enough to deal with the huge debt overhang, so I think more elements have to be added: debt restructuring and some form of monetary policy that would absorb part of the debt overhang.

Q99 Lord Davies of Stamford: Professor Fuest, your model of a flexible eurozone that does not require long-term structural transfers is a very attractive one. Can I just ask you whether or not you expect, at some point, within Germany, to be able to dispense entirely with such transfers—for example, the transfers to Mecklenburg-Vorpommern? Dr Fuest: You are completely right in pointing out that the German economic model itself is not entirely compatible with this vision of Europe. In integrating eastern Germany, we have done exactly that: zero or very low wage flexibility and massive fiscal transfers. This is all based on the tradition of German fiscal federalism, which does rely on transfers and which does rely on what have been called uniform living conditions. I have to say I am not sure to what extent the German public itself would endorse labour-market institutions with huge flexibility. I think there is some degree of flexibility nowadays after the Schröder reforms of the early 2000s, but the domestic economic model is certainly a different one, I agree. Germany is, however, a nation state and not a monetary union of sovereign states. The Chairman: Dr Fuest, I am going to ask you to respond to three of my colleagues who have a particular interest in the German view of the United Kingdom view of all this, and I am going to ask them to put their questions seriatim, and I would be grateful if you could reply in a portmanteau answer that might embrace those thoughts that you have.

Q100 Lord Hamilton of Epsom: Dr Fuest, the United Kingdom puts great importance on the single market, of which, of course, we are members, but we are not members of the eurozone. The big question is whether this is realistic with regard to the future of the United Kingdom in Europe. Surely, the decisions will be taken by the eurozone members,

271 of 441 Dr Clemens Fuest—Oral evidence (QQ 89-100) and we will be somewhat marginalised. Is it not inevitable that the single market will be harmed in terms of the UK’s interest as we look into the future? Lord Vallance of Tummel: Looking to growth as well as austerity, is the time not right for Germany to lift its objections to the completion of the single services market? This might show those countries taking severe doses of austerity that Germany was prepared to take some potentially distasteful medicine itself for the common good. Lord Kerr of Kinlochard: The UK has made it very clear that we will not participate in fiscal union, we will not participate in banking union, we will not contribute to anybody’s bailout and we do not want any part of any new integrated fiscal capacity. How does all this affect the view in Germany of the United Kingdom? What effect do you think it has on our influence on the single market? Dr Fuest: Regarding the first question as to whether it is realistic for the UK to just participate in the single market, I think that there are risks—in particular, risks to London, obviously, as Europe’s financial centre. I think that the view in continental Europe and in Germany is widespread that it is unnatural that London, as a place outside the eurozone, is Europe’s financial centre. In this context, if you consider the proposal by Michel Barnier about the resolution mechanism, one motivation is maintaining a level playing field for the banking sector in Europe, and the idea that there is no such level playing field is that some banks are backed by strong and solvent Governments and other banks are not. The question is: how does the UK fit into this picture? The answer would probably be that there cannot be a level playing field as long as, for instance, the UK did not agree to at least the rules for the restructuring of banks. It is just an example of issues that might arise regarding the UK’s access to the common market if it stays outside the institutions reformed in the context of the eurozone crisis. How about Germany itself—for instance, the liberalisation of services? I fully agree that there is a lot Germany itself could do by liberalising sectors, and one sector certainly is the service sector. I think the view that things are in order in Germany and that there is no need for reform in Germany, or that Germany is an example in terms of economic reform for other European countries, is misguided. There is a need for reform in Germany; there is no doubt about that, and this should not be neglected. The final question asked how UK non-participation in all these elements of European monetary union is viewed in Germany and whether it leads to a loss of influence. First of all, I think there is some understanding for the UK in Germany that the UK does not participate in certain things, because it is not a member of the currency union. At the same time, the view is widespread that there is a loss of British influence, and it is very badly looked upon if the public gets the impression that the UK is blocking certain proposals like the fiscal compact, for strategic reasons or with the objective of achieving special rules for the UK, or opt-out rules for the UK. There is a lot of critique about this in Germany. There is also the view in Germany that the position of the UK regarding proposals like debt mutualisation within the eurozone is biased because of particular UK interests. The UK would benefit, at least in the short term, from debt mutualisation as a creditor, or with its financial institutions being creditors, but it would not bear any of the costs and risks. The Chairman: Dr Clemens Fuest, we are most grateful to you. We shall be sending a transcript of the conversation this morning, and we would like you to correct that but also to add any further thoughts you have on the conversation. We would have liked to have asked you a little more about Jean-Claude Trichet’s recent comments that the ECB’s role in financial stability is unclear, or Hans-Werner Sinn’s worries about the TARGET2 balances,

272 of 441 Dr Clemens Fuest—Oral evidence (QQ 89-100) or indeed to explore a little further with you the question of how you deal with moral hazard that we talked of at the top of the conversation. I speak on behalf of the whole Committee: this has been an intriguing 45 minutes. You have filled our minds with many thoughts, which we will go away with and test into the conversations that we have about the report that we will write, but I hope this morning you understand, Dr Fuest, you have enormously helped the Committee in its big task of trying to understand better the problems and the opportunities of the European Union with respect to genuine economic and monetary union. Vielen Dank. Guten Tag. Dr Fuest: Thank you very much. It has been a pleasure. Thank you.

273 of 441 Professor Luis Garicano—Oral evidence (QQ189-196)

Professor Luis Garicano—Oral evidence (QQ189-196)

Evidence Session No. 16 Heard in Public Questions 189 - 196

TUESDAY 8 OCTOBER 2013

Members present

Lord Harrison (Chairman) Viscount Brookeborough Lord Dear Earl of Caithness Lord Carter of Coles Lord Davies of Stamford Lord Flight Lord Kerr of Kinlochard Lord Marlesford ______

Examination of Witness

Professor Luis Garicano, Head of the Managerial Economics and Strategy Group, London School of Economics

Q189 The Chairman: Colleagues, we resume our inquiry, with Professor Luis Garicano, who I very warmly welcome here today. We are all ears to hear his replies to our questions. You may have heard me say that we produce a transcript. We would be very grateful if you could scrutinise and correct that, as well as improve on it and add any further writings you might have in addition to the ones you have already given us. Perhaps I could invite you just to introduce yourself and mention the interests and the role that you have. I will begin with a question about the proposals from the Commission and the President for genuine economic and monetary union. Would you be kind enough to identify those elements that you think are essential and imperative and those that are perhaps inessential or even, perhaps, worrying in their possible implications, were they to be implemented. We are most grateful for having you here today. Luis Garicano: Thank you. I am extremely grateful and honoured as a Spanish citizen to be in the Houses of Parliament, which are really impressive. I am a professor at the London School of Economics, in the economics and management department. In a previous life, I was a Eurocrat, sometime in 1992 or something. I know that is not very good here. I worked for the Commission, and studied in the College of Europe in 1992. Then I went to Chicago, where I did my PhD. I was a professor at the University of Chicago for nine years and have been at the London School of Economics for five. I have been involved in the changes in response to the crisis in three areas. In Spain, I have been a very active participant in a group that pushed for reform efforts in the labour, financial and goods markets and other institutions as part of the Fundación de Estudios de Economía Aplicada, a foundation sponsored by the Bank of Spain and several large companies. I have also been involved in the

274 of 441 Professor Luis Garicano—Oral evidence (QQ189-196) process of rethinking the design of European institutions with a group called Euro-nomics, a group of professors from different countries in Europe. We pushed the proposal, which I will be happy to discuss with you later, of a European safe asset without joint liability, which is the European safe bond. Thirdly, I have been involved with another group of economists under the aegis of INET, which last year produced a document on breaking the deadlock and the path out of the crisis. I am very interested in all of this and very pleased to be of any help that I can give you. Please correct any protocol mistake I make; I am not as fluent with the rules as I might be, given that I am not a British citizen. What of the proposals from the Commission? The Commission is always liable to go for the “Full Monty”, if you will pardon my French in this case. I think they go too far. We are throwing the kitchen sink again, saying, “We are in a crisis. Let’s just use the moment to put a lot of things on the table”. They include things such as the joint representation of the eurozone and political union in many aspects. The crisis has shown that the institutional design is imperfect, which suggests that we need to make important changes. But in my view the changes should not go as far as the Commission proposes. I would suggest we should look at Arizona, or one of the other states such as New Mexico, when they had a gigantic housing and financial crisis in the United States, and think why there was no doom loop there or a sovereign banking loop. Essentially, there were two institutions that helped avoid contagion between the state of Arizona, or the Government, and the banks there. One is that the banks were insured at a federal level, through the Federal Deposit Insurance Corporation. That meant that when several banks in Arizona got into trouble, the repercussions were not felt by the state of Arizona. The second is that social security cheques for unemployment insurance come out of the US federal Government. Those two elements are necessary and sufficient. Some element of banking union that goes further than the one proposed to a joint deposit insurance—I would argue that that does not need a lot of fiscal union—and an element of social insurance that involves some minimal element of transfers for unemployment and labour market issues. The unemployment insurance transfers and the changes in the labour market reform could be tied together so that they make themselves less necessary. The kind of budget I am talking about would be very small. The federal deposit insurance would be paid by the banks. It would be paid first by the member states to make sure that the incentives were correct. The European Union would have the role only of dealing with catastrophic insurance, where the problems are sufficiently large in order to lack other incentives. If you think about unemployment insurance, the worst case by far is Spain, which right now is spending 4% of GDP on unemployment insurance, and I do not expect any country to have 25% unemployment if we get the policies anywhere near properly in place. The budget we are talking about would be a small fraction of that—maybe 1% of GDP, the kind of money that is now being spent on agricultural policies, which I do not think are the right way to spend European money. The kind of transfers we would be talking about are not very large, nor are the kind of institutional changes that are needed. I am happy to elaborate but I do not want to bore you. I am happy to go in whatever direction you want to push me.

Q190 Viscount Brookeborough: Professor, to what extent have the difficulties that have affected the Spanish economy arisen out of it joining the euro? Would it be where it is now if it had been separate from that? Luis Garicano: That is always a great question. There was clearly a financial crisis in many places where there was no euro. We are all mindful of that and I do not want to say that the euro was responsible. But both on the way up and the way down, the constraints mattered. On the way up, during the boom period, you had excessive convergence. Spain would have

275 of 441 Professor Luis Garicano—Oral evidence (QQ189-196) had a wall of money. That is not unique, as other countries saw a lot of money coming in. Risk was mis-priced—as you know, economists and financial markets are not very good at pricing risk. We are very good, given that price, at figuring out all the other prices, but you have to start with that price. The price of risk was wrong and you got a big wall of money. But we got an extra big wall of money because we had extra insurance: Spain had the ability to raise funding in the world markets, with the implicit guarantee that this money was being lent to these European countries jointly. Of course, at some period in the 2000s, Greece was paying as much as Germany, such that you think, “Who are the guys who are lending this money?”. The market was really convinced that this was okay. So what were the bad consequences? You would say, “That’s great news”—if somebody is willing to lend you money cheaply, that should be great and you should be very happy. At the first approximation it is, but as with oil and gas, and all these natural resource problems, when you get a wall of money it messes up a lot of things. With what happened to Spain, two things were crucial in the longer run. One is that institutions got messed up—with all this money coming in, why do you want good governance? If you are a good caja, or savings bank, everybody is just yelling at you, saying “Why don’t you just make more money? It’s easy, just go ahead and make it”. I am sure that you have confronted this problem in some of the institutions you have advised or been present in. A risk director for a big bank told me: “We were being yelled at on the way up by too many people saying we were stopping too many good loans and we are now being yelled at on the way down by people saying we did not stop enough bad loans. Whatever way we did it, it was wrong”. Institutions became bad: institutions that were doing the right thing got kind of defeated and the ones that were doing the wrong thing looked fantastic. You get a lot of bad selection, a lot of bad incentives and a lot of bad people. Viscount Brookeborough: Can you define what those loans were used for? Luis Garicano: Largely real estate. Loans worth around 40% of GDP went to real estate developers and builders, perhaps 43%. New loans worth around 60% of GDP went to mortgage holders. That is not gigantic, but if you put it together you have 100% of the country bet on real estate. It happens in the UK and everybody thinks this is a safe asset because bricks and mortar are always there. But look at Detroit: you do not have a safe asset if you have the most beautiful house in Detroit. It happened in Spain. There were a lot of loans to real estate developers and a lot to dodgy public works-type things, such as the City of Science in Valencia. There were lots of buildings where they did not pay anything to the professors or the researchers, so they are never going to fill them with anybody. Viscount Brookeborough: Similar to the Republic of Ireland? Luis Garicano: Similar. It is the exact same problem. The supervisory mechanisms of the Union did not pick it up because Spain was in a big surplus. Spain was paying back debt and public debt was very low at 40% of GDP. The problem was private. With this implicit guarantee, the savings banks, which were semi-public, all the institutions and all the local governments suddenly saw this wall of money coming in. The Chairman: Let us just follow that up. First, Lord Carter, and then Lord Flight has a supplementary question. Lord Carter of Coles: I think you have partly answered this. Why did people not foresee some of these policy mistakes and, for example, increase the reserve requirements for the banks? Secondly, why did the EU surveillance system not work? A little bit of hindsight might be valuable here. The Chairman: Lord Flight, did you want to come in with your supplementary?

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Lord Flight: It was really that first point. Luis Garicano: The Queen asked me the same exact question four years ago. In November 2008, she came to LSE when I was giving a presentation on the crisis. She asked me why, if all these things are so big, nobody noticed them before. I thought, “Wow, that is a good question”, and I guess I have to answer the same thing now. Everybody from the outside saw that there was something wrong. The governor of the Bank of Spain during the crisis, before he was the governor, wrote a lot of articles in El Pais et cetera saying that there was a real estate bubble. The person who would become the main economic adviser to Prime Minister Zapatero was actually fired as BBVA’s chief economist for claiming that this was all a bubble. In 2002 or 2003, there was a big sense in Spain that this was all going too far. This is four or five years before it all actually burst—nothing really happened in Spain in 2007. People looking at it were really worried, much more than in the US and Ireland. It did not get picked up because it is in no one’s interest to pick it up. It is interesting that these two people who were really important policymakers during the whole time of the bubble did not do anything when they got into positions of power in 2004. Why is that? Because you can either build a new hospital, a new highway and a new high-speed train or say, “I don’t have any money because all this money is fictitious”. What would you do? The money is rolling in and everybody is telling you to do these things. I know of only one case when that did not happen: Andrés Valesco, Chilean Finance Minister during the copper boom. He had demonstrations in front of his house every day saying, “Copper money for the poor”. He said, “No, this is a boom, this is not sustainable and we are going to put it in a little pot and hide it away”. When Chile had a crisis in 2008, they had the biggest countercyclical budget of any country in the world. I wonder how easy that is for a politician—I do not know, I have not been one, and some of you will have a lot more experience, obviously. It is difficult to say, “All this money is fictitious and I will not spend it”. The tendency is to spend it.

Q191 Lord Flight: One fact you have not touched on, which is common with Ireland, is that the euro’s interest rate is heavily dominated by Germany and German levels of inflation. Levels of inflation were higher, which meant that the real cost of money was cheap. It is the cheap real of cost money that leads to booms. Earlier, you said something crucial: you were comparing the situation in the United States and made the point that a currency union need transfer payments. Luis Garicano: Not much. Lord Flight: Not much but some, which is something seen as absolutely anathema in Germany in particular. Luis Garicano: On the first question, I agree. I said that those were the problems on the way up; on the way down, the problem was that the crisis response was very hard indeed. You had the wrong monetary policy, which is not designed for your own country, and you cannot devalue, given the big shock that comes with devaluation. Think of it as the natural recourse, as the Dutch disease as we had gas. The prices went up and now we have to get them down and the only way to do it is to through real price cuts—you cannot devalue. You also cannot finance a budget with a rollover of the debt. The UK had no problems refinancing itself but Spain did because nobody knew if the money was there, given that Spain did not have its own central bank. There was the wrong monetary policy, the wrong exchange rate and the wrong fiscal policy, which is hard to correct in this framework. I would not want to take responsibility away from Spain, as I said in my first statement. Your second question was about the level of fiscal transfers and the politics of it. The politics of transfer payments are horrendous: we all know that. I have complete respect for the

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Germans. If you want to see how much respect Spaniards have for the German perspective, just look at Catalonia. Catalonia is fed up with making transfers and it wants out of Spain. If even inside Spain people do not want to make permanent transfers, how do you expect other countries to want to make transfers to you? I do not expect permanent transfers. We need a construction. This is the crucial point, where the UK can be very helpful to Europe in getting the distinction clear between the legacy problem and the future construction. The legacy problem is a mess. We built a system that did not work and it needs to be patched up. It is basically the opposite of what the German and Dutch Finance Ministers said. The legacy problem needs some sharing. I am sorry to say that but there is no way out of it. However, in the future, we can minimise the transfers. The banking union needs minimal transfers—only for catastrophic insurance—and the actual unemployment insurance fund will be in the tenths of 1%. It will amount to very limited transfers.

Q192 Lord Dear: I want to focus really on the two problems of bank debt and sovereign debt, something that Spain is obviously caught up in. Do you think that the proposals for banking union, the integrated financial framework, will actually separate those two and allow them to be managed to the advantage of Spain, for example, and of other countries in the same position? If you do not agree with that, have you got a better plan? Luis Garicano: I am a bit afraid of the banking union as it is being put up right now. Let me state from the start that I am in favour of a minimal Europe, but I do think that a banking union on the cheap is unlikely to work. You are going to need to acknowledge this. It is nice to think of legacy assets as something that is in a little barrel, which you put the word “Legacy—Toxic” on and put in a corner and forget about. It is not in a barrel: legacy assets are being created today as the economy contracts and people cannot pay their loans. Lord Dear: It is how you deal with it, is it not? Luis Garicano: There is a way to deal with it, in my opinion. The idea, which is in the European Commission proposals, put forward by the German expert council of economic advisers—of a redemption fund, a kind of sinking fund for previous debt that does not cover future debt—is a good one. It could maintain the right incentives. Of course, any proposal you make that involves transfers and has the problem that Lord Flight rightly identified, which is that nobody wants permanent transfers. You need to say, “This is legacy and we are going to assume the legacy losses incurred up to today together. From then on there will be no more legacy losses and we will have a two-tier system where the states absorb the first hit and catastrophic insurance is provided by the Union”. Of course, you will all be thinking like any shopkeeper who says, “Well, if you cover my debts up to today, then tomorrow I will be very solvent and careful”. It is absolutely necessary that the institutions from then on are put together properly. That requires a single supervisory mechanism and a single resolution mechanism, which does not have the conflict between the central bank and the regulators that I think the system on the table now has. Lord Kerr of Kinlochard: Do you think that the single resolution mechanism as proposed by the Commission is likely to come into effect? Do you think that the problem of the Spanish regional banks, with their difficulties in recent years, would have been better handled had that mechanism, or framework mechanism, been in existence? Luis Garicano: It is a great question because it gets to the point of Germany’s objections that have been wrong-headed in this particular context. The cajas—the savings banks of Spain—were small, but they were all doing the same thing. Why? There is the usual regulatory contagion where people say, “If those guys are doing this and are not in trouble, I will do the same thing and not be in trouble”. So they all end up doing the same thing. It is

278 of 441 Professor Luis Garicano—Oral evidence (QQ189-196) not “too big to fail” but “too many to fail”. It is like when people build their houses on the beach in a hurricane zone, thinking, “Everybody else is there, so we will get bailed out”. It is risky to exclude from a single supervisory mechanism and a single regulatory mechanism—as it appears we will, from the September discussions at a European level—all the banks except maybe 250, including all the savings banks and all the smaller banks. As Lord Kerr points out, you would not have caught all these small savings banks, which were at the root of all Spain’s troubles. I would want a more all-encompassing mechanism that would allow us to supervise the entire banking system, but at the moment that is not in place. Lord Kerr of Kinlochard: Could it be done within the existing treaty? Would it not require treaty amendment, which nobody is ready to do? Luis Garicano: I am very mindful of that objection. I am not a professor of law, although I did study law in Spain many years ago. I agree that the Commission probably pushed things as far as they could be pushed and think it is better to have some regulatory mechanism right now, especially given what is going to happen in the first three months of next year with the asset quality review. It is better to have some mechanism now than to not have it. It would obviously be preferable to try to confront a situation. You know better than me that there is a treaty process that does not involve the convention, as long as the Commission or the European Union does not get bigger powers. Obviously this does seem to involve greater powers: it is a great objection and I do not have an answer to it. You would probably need some treaty revision, which would be very hard. The Chairman: You gave us your thoughts on the single supervisory mechanism. What about on the single resolution mechanism? I was not quite clear what you thought about that. Luis Garicano: My biggest concern with the single resolution mechanism is this. First, to recap, the European Central Bank signals something is going on, there is a single resolutionary board by bank, the Commission decides whether the bank goes into resolution and then the national authorities execute. The national authorities’ execution of a European Central Bank decision always has the same problem, which is that there is a completely different set of incentives. The European Central Bank, the Commission and the European- level authorities are going to want to deal with things quickly and deal with problems big time and not have them spill over. On the other hand, the national authorities always want to pretend that nothing is wrong. What was the problem in Spain when it came to the crisis? For too long the Bank of Spain had too big a reputation and wanted to defend it. The bank wanted to continue saying that the banks in Spain were all right. In fact, many of them were all right, but it painted all of them with this pretence. It will happen in the same way in the single resolution mechanism as set up, because the European Central Bank will signal while the country and national authorities will have to execute. The fear is that there will be a big incentive conflict: the SRB can give orders to the bank, which I find a little tricky to be honest. The banks are going to be hearing from the central bank, “We feel you guys are fine” but then hearing from the central resolution board, “You guys are in trouble and have to do this and that”. I am a little afraid and do not know how well the current proposals will deal with that kind of conflict when the situation becomes complicated. The Chairman: Before I bring in the Earl of Caithness, I must apologise to Lord Marlesford, who was going to come in on my first question. Do you want to do so now?

Q193 Lord Marlesford: Particularly since the professor highlighted the unemployment problem of 27% and the 4% of GDP which is used to pay unemployment benefit, one of the things I do not understand is why Spain is, I think, the only country in the EU which has no

279 of 441 Professor Luis Garicano—Oral evidence (QQ189-196) threshold for registration of VAT. In Britain, the threshold is £79,000, which means that small businesses provide services to the non-business sector with wonderful competition and providing a very large number of jobs. Why does Spain, with its current unemployment level, not have a threshold at least as high as Britain or maybe even higher? Luis Garicano: I have done some research with Professor John Van Reenen from the LSE and Claire LeLarge, who is based in France, in which we address this issue of thresholds. We basically show that when you look at the situation in France, when you get to 50 you suddenly get a big drop. Firms in France grow nicely, then they get to 50 employees and suddenly you do not have any more firms: you have a big hole in the distribution. Where are these firms? The problem is that in France there is a big threshold for many of these social regulations, labour laws, the comité d’entreprise and these kinds of things. In France, you have too many small firms. In Spain, it is even worse: there is a gigantic proportion of microenterprises. Why? A microenterprise in Spain essentially operates as if the threshold was there: they are basically under the radar. As you know the grey economy is large in Spain. When you go to a restaurant or a bar in Spain—to Marbella or somewhere else on holiday—you will see many people do not give you a receipt. One of the most shocking things I remember is that when my mother bought a house, I had to walk through the street with a bag. We sold the house and went to buy another house. We had to walk through the street with the equivalent of her entire lifetime savings in a little plastic bag. That is kind of amazing but houses were paid for, even now, as part of the grey economy. It means that small businesses essentially operate under the threshold. They just kind of ignore things. The big businesses know how to deal with the system. You do not get medium businesses in Spain. Because they get hit by these rules, they prefer not to grow but to be able to say, as they say in France “débrouiller”—I do not know how to say it in English; I am not sure it is even an English concept—to find your way through the system. They prefer to do that and, as a result, you do not get firm growth. The biggest productivity problem Spain has, if you compare Spanish firms by size with American or German firms, is that Spain’s small firms are as productive as US small firms. Medium firms in Spain are as productive as US medium forms. Even large firms are as productive as US large firms. How can they be as productive? Because the proportion of small firms is gigantic. You get them both: the entrepreneur who is good can do things but does not want to grow because it is a big headache. You are right in identifying a big problem for Spain, which is that the rules constraining growth are very extensive. I think the way to tackle them is not so much to include new thresholds but to find new ways to grow by not having all these burdens

Q194 Earl of Caithness: I want to take you on to the integrated budgetary framework. Do you support the Commission’s plans to have its own euro budget? Luis Garicano: No, I do not think it is realistic. As I argued initially, “realistic” is a political concept that you are much more able to consider, but I do not even think it is economically necessary. What is economically necessary is a limited set of transfers to cushion some of the social hits and catastrophic insurance for systemic institutions that avoids this new contagion. Plus, and I do think that this is very important, you need a safe asset that is Europe-wide. But a safe asset does not mean that it has joint and several liability. We do not need to all borrow together and guarantee each others’ loans. With independent parliaments and independent countries, one of us will always borrow too much and then say, “We are all in this together, right?”, and you will end up having to bail this country out. There is a way to avoid it. The Euro-nomics proposal I was talking about at the start on European safe bonds addresses that. If you want, I will tell you why it has no political support. The European safe bonds proposal says, “Let’s all borrow together. Let’s have a

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European agency in the following way”. The European agency will buy the debt of individual countries in the secondary market, so that countries will still have to go to the market. It will sell two bonds: a senior tranche, which is a senior bond, and a junior tranche, which is a junior bond. The senior tranche is not insured but it is in some sense some loss of social mechanism provided by the junior bond, which absorbs. That allows all the banks, instead of having in their vaults now, as all the country banks do, to have the safe asset, which is a joint asset. The flight to liquidity will not happen towards Germany, it will happen towards this safe instrument. We would have market discipline, which is what we need. We are not going to have discipline through the Commission telling the country to do certain things. At the end of the day, countries are sovereign and they can always ignore the orders. One thing we see in Spain, which is sad, is that a lot of reforms come from above and there is perfunctory compliance. People say. “I will do this. You want independent fiscal authority? Sure, here it is”—and then you start your fiscal authority with your friends and family. Is that going to do any good? At the end of the day, the market discipline has to be there. Yes, the markets made a massive mistake in the previous run-up, but we still need to rely on market discipline because that is the best way to ensure that the countries are in line. Countries are not liable for each other’s European safe bonds, but European agencies buying debt in fixed proportions from each country will accomplish that. Earl of Caithness: Can I ask you a bit more about that? What support do you have for your idea of a European safe bond, and is your idea, which was very good in September 2011, still relevant given ECB statements and how it has reacted since? Luis Garicano: The ECB has promised to do something and nobody has tested it. I do not think it is extremely believable. Happily the markets do not want to test it, and I do not want to be the one asking them to do so. If you wanted to do the OMT in big numbers, that would require substantial intervention. I do not think that the ECB’s decision does anything to solve the long-term problem. They solve the liquidity crisis today, but not long-term. Here is the problem with the politics of this. Who is the constituency for the European safe bonds? Actually, the southern countries like the captive banks because they have a cheap buyer of the debt. They can just call the bank and say, “Now you guys have bigger credit you have to buy this debt”, and the banks will buy it. With European safe bonds that stops, because the European banks in all countries are going to be buying the European safe asset. That will be the only one that has zero-risk weight. So suddenly they are afraid that they will have to borrow in the market, and they do not like that. Nor does the Commission. It thinks, “This is the opportunity to create it”. They look at the US, see what works, and want to do the same thing. True, the US works, but is European public opinion ready to go that way? No, so the Commission is not a constituency for it. The northern countries want no commitment whatever, so in the end the only people who endorse it are the IMF. They did a whole review, compared the four proposals and said, “This is realistic, it is doable, it can get us out of the liquidity issue, and it creates a safe asset, so it is a good proposal”. Apart from them, the politics of it are not great. I represented the treasury of a large southern European country—not Spain. They said, “That is very good, but who will buy our debt?”. I said, “Okay, good question”. “If the banks are not forced to buy our debt, who will?”. That is the question. The Chairman: We are a bit pressed for time. I am going to ask Lord Carter to come in.

Q195 Lord Carter of Coles: Thank you, Lord Chairman. This is really about the UK’s position in relation to GEMU. How is it seen in Spain?

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Luis Garicano: Spaniards seem to be pretty obsessed with matters concerning a big rock when they think of the UK. I would not know how public opinion generally in Spain sees it, but the way I see it is that the UK is essential in this whole process, because the single market has been the UK’s construct and it is the best achievement of Europe. The UK is the necessary counterbalance to the infatuations of grandeur that sometimes come from southern countries. You need to be able to say, “Is this really necessary?”. The UK is always asking that question. We need to be coldly realistic, do a cost-benefit calculation, figure out what we really need, and do no more than that. The UK will always ask that question. The Netherlands, Sweden and Germany will also want that question asked. Many in Spain want that question asked too, because we realise that Spain’s problem is a problem of institutions. The institutions are weak. The UK has institutions, such as this one, that have lasted for hundreds of years without changes, and those strong institutions are the guarantee that the European project is still under the control of the citizens. It will be the largest struggle for every right-thinking European if the UK abandons its effort to help on these matters. The UK is badly needed and its position has always been recognised and considered thus far. It is always sensible, and I think we need sensible decisions. Lord Davies of Stamford: Professor, how do you assess the progress made in Spain so far in addressing competitiveness problems, rigidities in the labour market and the banking problems? What sort of things need to be done, how much has been achieved, and do you think that the Rajoy Government is on the right lines? Luis Garicano: On banking, competitiveness and labour, I would give different judgments. The problem with banking has been, as you know, that Spain has gone down the Irish route of saying, “Everybody is good, so we are going to guarantee everybody and essentially comingle private and public debt”, which is inimical to the free market system that we all operate. You take the risks, you take the losses. We do not do bailouts as a capitalist economy, but that is what ends up happening. Once this happened, Spain found itself with this big undigested problem. It exploded it, as you all know, with the Bankia crisis in May last year, when suddenly the Spanish Government found that they had this big bank and needed to resolve the problem but did not have the money. That came to a head at the whole June 2012 summit, where things really started to happen. Since then, I would say that the Government have made very important efforts to clean up the governance of the caja sector. Basically all the institutions now have proper professional management to take out all their bad assets, and the bad bank has made a big effort to clean up the consequences of the real estate bubble that I hinted at before. A lot of provisioning has been taken on by the banks themselves, so I would say about banking that if the first three, four or five months next year of the asset quality review are successfully executed— there is a huge execution risk, because we have all these new institutions and they are making a big commitment—I would expect Spain’s banking problem to have disappeared from the radar by July or August next year. The situation with competitiveness and labour is a bit different. There was labour reform in Spain. In Spain, as well as in the UK, wage costs dropped. I know that is seen as a crisis in the UK, but the UK’s big advantage is that prices adjusted during the crisis so quantitative easing had to adjust. The wages have also dropped, which means that the labour market has done its job and jobs are preserved. In Spain, wages increased big time in real terms in 2008, 2009 and 2010, because there were collective bargaining agreements from the past. We had a huge shock in the labour market and had even bigger wages. Now that has improved. What kind of market is that? Nobody wants oranges, so let us raise their price. That is going to get a lot of oranges sold. We had a shock, and the collective bargaining system was not designed

282 of 441 Professor Luis Garicano—Oral evidence (QQ189-196) to deal with it. Now that has improved. The part that has not improved is the contracting framework, which is a complete mess and still has a lot of duality, a lot of kids on the outside of the market who managed to get a permanent job, a lot of permanent people who are quasi civil servants, and a job market that is dysfunctional and with very low training and very few opportunities for the youth. Here in the UK and everywhere else, the youth end up paying the bill, but in Spain they do to a much bigger degree. The Chairman: The final question goes to Lord Kerr.

Q196 Lord Kerr of Kinlochard: Supposing the Commission’s idea of binding contracts, which was originally Merkel’s idea I think, had been enforced, would Spanish policy have changed in time? I am getting at whether macroeconomic conditionality can be made to work. The stability and growth pact is a failure. Any regime with fines, I would have thought, is implausible: a country in trouble put in greater trouble. Luis Garicano: Exactly. Lord Kerr of Kinlochard: Can it be made to work unless the Government of the country in question wants the change in its economic policy? It sells it for domestic reasons to its domestic public. Luis Garicano: I was arguing indeed that a lot of cosmetic reform is possible in which you pretend to take measures but actually do not. The fear is very much there. I like the instrument, however, and the ability to link a specific instrument. Imagine a small unemployment insurance fund in Spain that says, “We are going to help all these unemployed people in Spain”, but the contractual and training frameworks in Spain have not changed and all the active labour market policies are catastrophically bad. There are good practices in Sweden, the UK and Denmark that could be used. This unemployed man is going to go there if these practices are adopted. It could make a substantial difference. Would it have mattered in 2006 or 2007? No, because many people thought in 2006 and 2007 that everything was fine in Spain. Many other people were warning that everything was not fine. The previous political party in government in Spain carried out a big labour reform in 2002. The Secretary of State was the current Minister, Mr de Guindos, and it was pulled because of a demonstration at the time. The biggest problem for Europe—and I will finish on this point—is that this fictitious prosperity prevented any big policies being adopted. Why would you reform the labour market? Why would you change the education system? You are growing faster than the US: 3.6% per year. Why would you go to the trouble of having the unions and the people unhappy if you can just rest on your laurels, be rich and be happy? Many of the good policies that had been adopted in 1994 to 2000 stopped being adopted. On crucial human capital issues, the drop-out rate in Spain fell. People were going more to school, to college et cetera. In 2000, that reversed. People did not want to go to school because they could earn a lot of money laying bricks. In a way, at the time, there was a misconception about the permanency of this world of low risk and that probably would not have changed. However, I do believe that it would help right now if there were some conditionality on the structural reforms attached to some financial instruments. The Chairman: Professor Garicano, let us wrap it up there. Thank you very much for your views on GEMU, for your explanation of ESBs and for your insights, which I think the Committee have found fascinating, into the question of Spain, your home country. Believe me, you are as understandable in English as I am sure you are in Spanish. We are most grateful to you for coming before the Committee today. Please look at the transcript,

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correct it and send it to us. We would be grateful if you could keep an interest in our inquiry, and if there is anything else that you want to add we would be very thankful for it. Luis Garicano: My pleasure. The Chairman: In the mean time, thanks very much indeed.

284 of 441 Megan Greene, Graham Bishop and Hugo Dixon—Oral evidence (QQ 19-38)

Megan Greene, Graham Bishop and Hugo Dixon—Oral evidence (QQ 19-38)

Transcript can be found under Graham Bishop, Hugo Dixon and Megan Greene

285 of 441 Anton La Guardia—Oral evidence (QQ 121-133)

Anton La Guardia—Oral evidence (QQ 121-133)

Evidence Session No. 10 Heard in Public Questions 121 - 133

TUESDAY 1 OCTOBER 2013

Members present

Lord Harrison (Chairman) Earl of Caithness Lord Hamilton of Epsom Lord Kerr of Kinlochard Lord Vallance of Tummel ______

Examination of Witness

Anton La Guardia, the Economist

Q121 The Chairman: Thank you Anton La Guardia for coming. We have had an interesting day so far. Just to put you in the picture on the Genuine Economic and Monetary Union, we have seen Olli Rehn and the Bruegel Director, Guntram Wolff—who was very good. We are seeing Sir Jon Cunliffe. We have an array of colleagues tomorrow. We are focusing on GEMU but also have had something on the Financial Transaction Tax, so we are always open to asides on that as well. Just to make it formal: thanks for coming. We will make a transcript of our conversation and send it to you. Please correct it and add any further thoughts which you think the committee might find useful. We are always very open to that. We are doing GEMU now, having published on banking union at the back-end of last year. We hope to finish before Christmas and present our findings to the Government. We have dug up some very interesting information so far, but our final away visit will be to Germany, to the ECB in Frankfurt. We are seeing Mr Constâncio there and hope to see members of the new Government as they come in. Anton La Guardia: They may not be in place yet. The latest news today is that they are talking about January. The Chairman: We are telling everyone to hurry up because our committee cannot wait. Lord Hamilton of Epsom: What are the chances of another election, do you think? Anton La Guardia: German politics tends to be quite consensual so I expect they will reach a deal eventually but it could take time. It is also very legalistic. They have very long government agreements that have to be lawyerised. The Chairman: I think our own coalition Government are struggling hard with the intricacies of having elections without clear outcomes. Lord Hamilton of Epsom: We have quite short coalition agreements and partners do not agree to things.

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The Chairman: You will discover our political allegiances as we go along. Can I invite you first of all to say who you are and your very outstanding background, which we are hoping to employ? Let us start from there and I will ask an opening question. Anton La Guardia: My name is Anton La Guardia. I work for the Economist and write a political column called “Charlemagne” about European politics. That appears weekly in the magazine—or the paper, as we call it. I have been here since 2010, so not from the beginning of the Greek crisis or the first bail-out. I arrived in August 2010, so in time for Deauville. Lord Hamilton of Epsom: Were you with the Economist before that? Anton La Guardia: I was there for four years as defence correspondent. Lord Hamilton of Epsom: In London? Anton La Guardia: Yes. I should say two things, particularly because we are on the record. First, I speak in a personal capacity so what I say does not necessarily reflect the views of my paper. Secondly, although I work for the Economist I am not an economist. I am essentially a political journalist.

Q122 The Chairman: It is for that reason that we have asked you to come along. We are hoping you will draw on that experience and supplement all the economic and financial stuff we are getting from other witnesses. To start with an economic question on GEMU, having looked at it, what elements remain essential for the European Union to achieve financial stability? Are there any elements that are inessential or that may either be a waste of time or negative to contributing to the ambition to achieve that stability? Anton La Guardia: Your question presupposes that we know what the GEMU proposal is. That has changed. If you read the various iterations of Van Rompuy’s report, it evolved from mid-2012 to December, at which point it was more or less torn to pieces by the European Council and very little was left of it. So the question is: at what point in those proposals are we talking about? They were most ambitious at the beginning and then they were reduced as we went along. I think Van Rompuy’s fundamental framework was sound. First, when he says a genuine economic and monetary union, he presupposes that the one we are in is a fake one. Secondly, dividing it into four pillars makes sense. There had been a lot of talk about a comprehensive solution. I think he helped the thinking about what the elements are of that fundamental solution. I do not have a problem with that. The one he least developed was the political union because he did not quite know what to say about it and the one he most developed was the banking union because that was already in the works and being developed. Then he had what he called a common fiscal framework, which was basically his road to eurobonds, which was killed off quite quickly. Then he had economic policy co- ordination—economic union. That is essentially how you develop all that stuff which is not strictly financial and banking, so economic policy, labour markets and so on—stuff that had gone into the Euro Plus Pact, which turned out to be quite weak and no one really talks about it any more. Things come and go in the City. The Chairman: You might like to know that we were talking about that on the train coming over. Anton La Guardia: There is supposed to be an annual summit of the Euro Plus Pact. The Chairman: That is right. Interestingly, the political union or accountability side is not in our remit. Maybe that is to the good if your observation is right that that is the one that we have adopted quickly. But we are interested in the integrity of the other three elements. I think my colleagues will want to explore parts of that. We want to ask you about François

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Hollande, who has said that the problem is over and we are all okay now. Given the two points of view, do you also identify, as I think many members of this committee do, that these fits and starts are characteristic of action in the European Union—especially about GEMU? We wait for the next crisis to come along before there is a fit and something is done about it, and then there is a period when we wait for the next bus of financial disturbance to come along. I also want to take advantage of mentioning the French President to ask whether you think the French have the right view of the developments there. We are very conscious that the former axis of Germany and France has rather declined over the years. We would be grateful for your thoughts on that as well. Anton La Guardia: Is it over? Again, it depends on how you define it. The financial part of it is in abeyance. The sense that the euro is about to break up has receded. We are left with an awful economic mess. Southern Europe is still in recession and you have mass unemployment. In a sense we have gone from an acute disease to a chronic one, but the chronic disease can still kill you: it can turn acute again. There are any number of things that could make it worsen. It is being held in abeyance in large part because of Mario Draghi’s “We will do whatever it takes”, but it is untested. No one knows how solid that commitment is. Is there really an unlimited amount of money behind it? I think not, but no one is willing to test the proposition. Secondly, it requires countries to sign up to some kind of programme, which they have been very reluctant to do. Thirdly, by signing up to a programme, it requires the Bundestag to vote knowing in the back of its mind that when it votes it is unchaining the ECB. All that stuff is quite complicated and we do not know how it would play out if it were ever called in. There is a lot of political uncertainty. Economic growth is not going to rise to the level needed to bring down unemployment very quickly. Therefore you have very fragile politics, as we have seen in Italy this weekend. The grand coalition in Austria has only just got in and the Portuguese Government are taking a hammering at local elections. The uncertainty is political and it can come from anywhere. It is not over. Yes, it moves in fits and starts. It would be nice to think that they would adhere to the principle of a stitch in time, but they tend to do only a stitch at a time and only just in time, when the thing is about to fall apart. At the moment, given the lack of pressure from markets, I do not think that things are going to move very quickly. For the French, exports are still declining—certainly, their share of world exports is declining, so they still have a severe competitiveness problem. They seem to be reforming very slowly. One of the issues in the City is the degree to which the Commission or the Brussels system can turn the screws on the French and say, “You really must reform”. We have had a couple of skirmishes in which recommendations from Brussels have not gone down well. Last week we had , who brought the French budget here before he presented it to the National Assembly, which was a moment. How the National Assembly will take to the Commission’s views when it reports back in November I have no idea, but it is one of the things to watch.

Q123 The Chairman: Stepping back to that first question—if we say that political union is not within our remit—of the first three which you outlined, which ones do you think are really important to do? Banking union? The supervisory mechanism? Anton La Guardia: It makes sense to start with banking union, partly because they have started with it so they might as well finish it. Secondly, as a result of Draghi’s intervention, yields on sovereign bonds have come down but borrowing costs for small and medium-sized firms for banks have not, particularly in southern Europe. So the ECB’s intervention has

288 of 441 Anton La Guardia—Oral evidence (QQ 121-133) exposed the fact that in the real economy there are still real problems of credit. That is a very good reason for solving it. The other reason is that there is a suspicion that there are still a lot of problems in the banking sector that need to be dealt with, which are being hidden because of the fear of the impact they would have on sovereign balance sheets and are therefore not being dealt with, and restraining credit. If you can realise the losses, clean up the mess and move on through banking union, that should help get some normal activity going in the economy.

Q124 Lord Hamilton of Epsom: Can I pick up on the politics of where this is all going? Do you see this ever—by which I mean “in the next five years”—arriving at a point where some political party might get in in the Club Med, which wanted to pull out of the eurozone? Anton La Guardia: I would not say never. If Golden Dawn came to power, things might change in Greece. Lord Hamilton of Epsom: Communists are more likely to come to power before that, though, are they not? Anton La Guardia: The point is that the politics is fragile, and it could therefore change. On current performance, nobody wants to leave. Even the Greeks have chosen to stay in, despite the pain they have gone through. The Cypriots have endured many of the disadvantages of leaving—they have capital controls on—but they have stayed in, and countries want to join. The Latvians are joining next year. The Estonians have come in. The Lithuanians want to come in, perhaps just for strategic reasons, but nevertheless there is still a queue of people at the door. I do not see anyone leaving. Perhaps the country most likely to leave, not the eurozone but the EU, is Britain. The Chairman: Perhaps we will come to that. Lord Hamilton of Epsom: On the question of Germany, they are pretty pivotal on this. Do you see the German elections making any difference to Angela Merkel’s position, particularly on mutualisation? Do you think she might get pushed into something like that with the next crisis? Anton La Guardia: The logic of banking takes you to mutualisation because, essentially, you are mutualising the banking risk, which is why it is going to get harder. Supervision was the easy part because that is control and we can do control centrally, but the wallet is national and therefore very hard to pool. One of the reasons for going down the road of banking union is that in a technical world that people do not understand so well, it might be easier to do some of this mutualisation. But we have seen all those small banks in Germany say no to banking union, or at least “Carve us out of it”. Does the election in Germany make a difference? Only at the margins. Any German Government will function between two rails. One is, do not let it collapse. Therefore, when it looks like it is about to go over the brink, they will intervene in some fashion. The other end of it is to limit liabilities on the German taxpayer. You have seen the SPD, which came out fairly strongly in favour of eurobonds at one point, retreating from that position. If I am not mistaken, they are now left with only a vague commitment to talk about redemption bonds. Lord Hamilton of Epsom: They would not be part of a coalition agreement? Anton La Guardia: I sit here and not there, so maybe when you go to Germany you will get a clearer answer to this. I doubt that any form of mutualised bonds is going to be part of it. There are a lot of red lines that Germany has crossed over the years in relation to what has happened in the markets and how bad the crisis has seemed. After all, the debt redemption proposal was made by Angela Merkel’s council of economic advisers, so it is there. It is

289 of 441 Anton La Guardia—Oral evidence (QQ 121-133) something that I presume one could come back to should the need arise but, at the moment, I do not think that they feel the need to go there.

Q125 Lord Kerr of Kinlochard: What is your prediction of the outcome on this dossier of the December European Council? Will any more be done before the Parliament is off to get re-elected? Anton La Guardia: They will get the single supervisory mechanism wrapped up. They will probably get something called a single resolution mechanism. Will it be any good? Will it be worth its name? Will it matter? Will it be the loose network that Wolfgang Schäuble speaks about or will it be a truly integrated authority in which there are no national vetoes and which has free use of their resolution fund? I doubt it. Schäuble has this image where he says, “We will start with a timber-built frame and then we will have a steel one”. I think it will be a wooden one for quite some time, but something that they will sell as a resolution mechanism will be there. Incidentally, time is running out, especially if you do not get a fully functioning German Government until next year. The window to get it all finished is quite small, and then it depends to some extent on whether the European Parliament wants to play games with it. Of the other elements, nothing is going to happen on the eurobond front. There is little more that can be done on the fiscal discipline front. The two-pack is just about to kick in, and we will see how that plays out. We have the fiscal compact. I do not think anyone is in the market for more legal change on the discipline side. On economic co-ordination, the people really doing this stuff are those under troika control; they are having to reform labour markets, taxation systems and so on. But for those outside the programmes, not much will happen on that front. On political union, nobody really wants to talk about that. The only dimension is whether the European Parliament has a Spitzenkandidat, a leading candidate with which they can then campaign and say, “Oh, the President of the European Commission has greater democratic legitimacy”. That is all that is envisioned, and even that may prove difficult. The Chairman: Do you think this could happen by December or by the time of the parliamentary elections? Anton La Guardia: By the time of the parliamentary elections. That was the timescale I was talking about. I may have misunderstood you. Lord Kerr of Kinlochard: No, I think you understood correctly. Lord Hamilton of Epsom: Do you think that the troika is developing a useful template for other countries that might find themselves in trouble? Anton La Guardia: It is deeply unpleasant to be supervised by the troika, and there have been internal tensions. Typically, when you call in the IMF, the Prime Minister, the Finance Minister and the governor of the central bank are in front of him or her, on the other side of the table. In this case he has the Government, represented in part by the Commission on one side and the central bank on the other side, next to him, so he cannot impose the full range of requirements that are needed. That has made management of the crisis much more difficult. You have seen hints of that in the post mortem that the IMF did on the first Greek programme. Lord Hamilton of Epsom: What you are saying is that it would have been better if it had been only the IMF—it had been diluted.

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Anton La Guardia: The original thought when the Greek crisis broke out was that there should be a European monetary fund to deal with this. That did not happen; the Germans wanted the IMF to come in to provide credibility and act as an enforcer. They did not trust the Commission because they thought it was weak. Therefore they were brought in. Increasingly, as the crisis has gone on, you have seen the IMF turn from being the enforcer of discipline on bailout countries to sometimes being chief advocate. The people who have most pushed for Greece to be given a break, to have its targets extended and to be given a debt write-off, have been the IMF. It has become perhaps the most powerful critic of the way the eurozone has acted. It did a lot of the work on fiscal multipliers, saying, “Austerity has gone too far too fast”; it has just produced a paper on the need for a budget to provide asymmetric rebalancing in case of shocks—asymmetric shock absorption. It has basically tended to push them to have higher firewalls. The IMF has wanted the eurozone to do more. It is a really interesting process, in part because the fund itself is under pressure from some of its members to say, “You’ve got your hand far too deep into the mangle of the eurozone; you’ve got to get out and you have to restore some responsibility”.

Q126 Earl of Caithness: I want to take you back to banking union. Do you reckon that there is a fair chance that there will be something on the single resolution mechanism by the time the Parliament goes? Do you think that is likely given the legal questions that have been raised and also what the involvement of the Commission should be? That seems to be quite a bone of contention. If you have not got that and you also have not got anything on the third prong of banking union, which is the common deposit insurance, have we really got a banking union that is worth anything? Anton La Guardia: We will have to see what the Germans say. They raise treaty change for two reasons, either because they want something—more fiscal discipline—or sometimes because they do not want something and say, “I can’t do that because it goes against the treaties”. The informal word in this town is that they have dropped their objection on the legal base for the single resolution mechanism. It has not been said in public—the Germans I have spoken to have said, “You can do something under the single market article”—so that suggests an opening. You might want to look at a Reuters report of a leak after the Vilnius informal ECOFIN. You have the other problems of the scope, which perhaps would be included. There is a hint that they would like to carve their small banks out of a single resolution mechanism. That, by definition, limits the liability of Germany, because you have only one big bank. As I said, something called the single resolution mechanism will probably be there, not least because the European Central Bank demands it. As part of its assuming its supervisory role, it does not want to be left holding the baby. So they will have to find a way of giving the central bank something because it is about to start its asset quality review. On the assumption that there are still problems with the banking sector and you reveal them all, and you do not have a means of dealing except to unload it back on the shoulders of the sovereign, you then have a difficulty. They will want to avoid that if they possibly can. Will there be an appeal to the Karlsruhe on the legal basis? Probably. Will it be dealt with in time? Who knows? Karlsruhe has tended to let things run and then come back and said, “It’s okay, but only so far”. It is a break in the system. Deposit guarantee is not talked about by anyone in the City, although I think it makes eminent sense. Even the people at Bruegel will say, “Well, it’s of secondary importance”. I think if you want the thing to be coherent it is better to build things that are solid so that you then do not need to do some of the other things you were going to do outside the banking domain. A single deposit guarantee makes sense. It so happens that the Germans

291 of 441 Anton La Guardia—Oral evidence (QQ 121-133) have not one but four different systems. They say, “We do not have a single one, so why should we have a single one for Europe?”. The agreement has been not to talk about it—it was dropped out of the Commission’s proposals. There was a vague mention of it last year in a draft of the Commission communication, and then it was dropped. Can it still be called a banking union? Yes, of sorts. As I say, it is a wooden one, or maybe a Japanese paper house one.

Q127 Earl of Caithness: Just two quick questions on that. Will the proposal, which you think might get through, break or dilute the link between sovereign and ordinary banks, and what will be the first thing to be done if there is another banking crisis next year? Anton La Guardia: I think “dilute” rather than “break”. For example, on the question of legacy assets, the creditor states are saying, “These are the results of decisions taken by national supervisors. Why should we pay for it?”. It will dilute in the future. The thing about legacy assets is that if you take one logical extreme it means that you cannot mutualise anything. You can only mutualise things such as a new bank and new loans in future, which is plainly an absurd position to take. There is now a sort of sliding scale, so the first hit has to be taken by the bank itself through bailing, the second hit is taken by the sovereign, then if the sovereign gets into trouble maybe the ESM can intervene. The sovereign is still in the line of fire so it does not break the link. It may have some benefit if it resolves the problem of supervisors turning a blind eye to problems in their national banks—they are not supervising them but protecting them. One of the problems has been that banks have feared being recapitalised by the Government and being bailed out because of the fear that they will then run into problems with competition law and Armenia would come in and force them to divest themselves of assets. Supervisors have tended to say, “Our banks are okay; you don’t need to do anything”. I think that as with everything else, it will be a half-built thing. Lord Kerr of Kinlochard: I just want to check that I have this right. You think that the Parliament and the Commission, before the Parliament goes away, will settle for an SRM conclusion that is not a single resolution mechanism but a network of resolution mechanisms, with no firepower and no fund but simply national funding of resolutions and individual banks, possibly with a German carve-out again, to make sure that the little banks, where the problem is most likely to start, are exempt? Anton La Guardia: Not quite. I think the cursor will be somewhere between the loose network and a single authority. It will depend very much on voting weights and arrangements and who votes when, so it will be muddy. Then there will be an initially small fund because it will have to be filled by the private sector over time. There will be a shell called the fund. It will not have very much in it but over time it should be filled. The question is: what happens in the interim period when the fund does not have much money? If you read the ECB statements, they all say that there needs to be a national backstop. There has to be a backstop of some sort behind this because it will take 10 or 20 years for the fund to be at full power. Even then, it may not be big enough to deal with a really serious debt report.

Q128 Lord Vallance of Tummel: Can I come back to asymmetric shocks? Let us suppose that there is another one. Let us suppose even that the current mess-up on the US budget gets sufficiently nasty for the financial markets to take fright and for the wholesale markets to freeze up quite quickly. What do you think the impact would be? Is this Japanese paper house capable of dealing with the freezing of the wholesale markets? What would be the political reaction and the priorities?

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Anton La Guardia: I have not pondered the problem, partly because one assumes that it will not go on for ever. What would happen if there was a serious shock? As matters stand now, there is not very much from the single supervisor but everything is still national. It would be like 2007-08. There is a famous Sarkozy quote from 2008 when he was trying to get some joint action and said to Merkel, “Let’s do it together”. She said no and used a German expression which means that everyone must wipe their own front doorstep. He turned around and, for those of you who understand French, said, “[French quote unclear.16:08:00]”. I think that will be the first reaction. Then, if the system does look as though it is about to fall apart, they will say, “Okay, let’s get the ESM to do something”. Lord Vallance of Tummel: If you look at the timetable for all these things, some of it does not get in until 2018. It is quite possible that we may have something within a matter of weeks but certainly within a matter of years. With your ear to the ground in the City, do you think that the Commission has any contingency plans? Anton La Guardia: Specifically on the US shutdown? Lord Vallance of Tummel: An asymmetric shock of that type which, let us say, froze the wholesale markets. Anton La Guardia: The only contingency plan is a national exchequer and the only thing the Commission does not have is money. It would urge a reaction that said, “We must act together. We must at least act in the spirit of all these things that we are creating”, but it will still be the taxpayer and the national leaders who decide how to use the money. Now that there is an ESM, I think that would be deployed—there is a pot of money there—in some way if there was a seriously big shock. If the ESM is not enough, replenish it or move faster. I certainly think that big bank bailouts are a lot more difficult. I think there will certainly be an attempt to bail in, so the contingency will be to bring forward bail-in proposals, as they did in the case of Cyprus.

Q129 Lord Vallance of Tummel: Can we move on to an integrated budgetary framework? How likely do you think it is that there will be some kind of euro area budget proposal next year? Anton La Guardia: The proposal started in the French finance ministry, which came up with it. The idea was to use it to pay short-term unemployment benefit. That is the way you get the asymmetry: you do not deal with the underlying unemployment, so France chooses to live with 10% unemployed. You deal with the shock of the sudden spike in unemployment but only for six months. Van Rompuy ran with it and pushed it quite hard but was eventually shot down in December 2012. Lord Vallance of Tummel: So it is dead? Anton La Guardia: That was dead. The French wanted an automatic system that just works. You create it and it operates by itself. It somehow magically evens out in the end. There is no net transfer over time. There are transfers as cycles move up and down but, over time— Germany would have been the beneficiary when it was the sick man of Europe. The Germans say, “If it’s such a good idea, why don’t you guys, France and Italy, do it together?” The French said no. They are willing to consider something small, conditional and discretionary that, for example, helps with structural reforms. This is where these contracts came in. The idea is that you sign a contract and the eurozone helps you because it is expensive to set up a new apprenticeship scheme. However, it is very small-scale and very difficult.

293 of 441 Anton La Guardia—Oral evidence (QQ 121-133)

Lord Vallance of Tummel: The other question I was going to ask you has been partly answered. You do not think that debt mutualisation will be a runner in the foreseeable future? Anton La Guardia: No, I do not see it for some years. It would make sense for two reasons. First, it is a declaration of intent—a sort of political act. Secondly, it provides safe assets for the banks to hold. That is one way of breaking the cycle between banks and sovereigns. I do not need to hold Greek bonds; I can hold eurobonds. I think you can use it as an incentive. You do not say, “We’ll do it now”. You can say, “In 10 years’ time, we will move down this road and here is a whole series of hurdles that you countries have to jump over to get there”. That is more sustainable in the long term; it gives incentives. Italy and other countries had a spur for reform to get into the euro. They did not want to be left out. If we assume that the crisis will fade away, how do you sustain pressure for countries to reform? A strong incentive for that long road could be quite useful. Lord Vallance of Tummel: Is that what you meant when you said earlier that the logic of banking union leads to debt mutualisation? Anton La Guardia: No, I said that it leads to mutualisation of banking risk. Germany thinks that about debt mutualisation of liabilities of all sorts. So the initial debate with Juncker was, “Let’s mutualise debt”. They said no and have come back to banking union through the resolution mechanism and the resolution fund, through which you are mutualising banking risk. That is why they are very cautious about it. The logical consequence of banking union with three pillars—supervision, resolution and the deposit guarantee—is to have a safe asset. The Chairman: Would a big asymmetric shock hasten debt mutualisation? Anton La Guardia: So much political capital has been invested in saying no to it that it will be the last thing that is done. It is more likely to move faster down the banking track.

Q130 Lord Hamilton of Epsom: Can I question the incentive for the Italians to go for eurobonds? Basically, the Italians would want to do that if eurobonds were much cheaper than their own. Their bonds would be very expensive because the Italian economy was in trouble, so they would not be allowed to issue eurobonds. The only time they would be allowed to issue eurobonds is when their rates had come down and the incentive was not there any more. Anton La Guardia: Yes. There is a liquidity effect, which you could argue about. You could create a bigger, deeper and more liquid market, and then everyone benefits. You could set the conditions for joining Europe and taking part in eurobonds to be that, when you have reformed so far that you have become a Finn, then you can have eurobonds. Tramonte was saying, “Let’s have eurobonds now to try to save us from these exorbitant costs”. The ECB has stepped in and brought down the yield. If you listen to Hans-Werner Sinn, he is saying that mutualisation has taken place through the Target 2 imbalances, through the central banks, unseen, which is politically more palatable. Lord Kerr of Kinlochard: Tell us about us, please. Our policy seems to be that we do not want to obstruct banking union but it must take place in ways that in no way affect the integrity of the single market. Is that an achievable aim? The momentum of the single market seems already to have faded away because most of the key states are playing another game at the moment. They have to save the euro and develop banking, fiscal and economic union. Is our position sustainable over time as we, with a diminishing number of friends, say that what really matters is the integrity of the single market and that the job of the Commission

294 of 441 Anton La Guardia—Oral evidence (QQ 121-133) is to ensure that that is maintained? We are asking quite a lot of Mr Barnier, are we not? Will it work? Anton La Guardia: There are many threads to that conversation. Britain would have been in a much better position had it said in 2011 that they were champions of the single market. Instead it came out with stuff about the City and financial regulation, which sort of queered the waters and made it very difficult for people who really liked the single market to ally themselves with Britain. There was always the sense that the Brits are not really after the single market any more. Secondly, more single market actually means more European Commission, more enforcement powers and so on. How would that go down in the current climate? You almost feel that the Brits are not pushing the single market that hard any more. In any case, many people do not really want to be associated with them. People who should be natural allies will tell the Brits, “Can you get the Germans to sign up, and when the Germans have signed up we’ll sign too. We cannot really do it just with you”. From the Italians, Letta was in London trying to say, “Let’s do more single market—we want an energy and a telecoms single market. We are ready to work with you on this”. Then there is the difficult position of saying, “We want more single market but we want less Europe and to repatriate powers and so on”. Really on that debate there are not a lot of people willing to play that game. They may be willing to do stuff in secondary legislation—I know this is not the question that you asked me, but I may as well complete it. Nobody wants to talk about competences. You might want to ask Jon Cunliffe about the interesting moment yesterday. Apparently David Lidington was at the talking about the balance of competences. The Dutch were cited, and the Dutch permanent representative stood up and said, “Our exercise is different from yours. Ours is about setting a line and saying that we have gone as far as we can in certain areas. It is not about repatriation. We don’t want a treaty negotiation”. I am paraphrasing. If even the closest ally of Britain on this question is saying, “We’re not like you”, that is significant.

Q131 Lord Kerr of Kinlochard: Would it help if, as you were saying about 2011, there was a positive British development of the single market agenda on the table? I agree that for the Government it would have the downside of more commissioners. But one problem is that, on the very good first bit of Prime Minister’s Bloomberg speech—the part which people in northern Europe tend to agree with and which can all be done without treaty reform and by votes in the Council—we have not actually put forward any proposals. So people are wondering whether we really meant all that, because we are not doing anything about it. Instead, we keep talking about the need for treaty reform, and that must be about something else because none of that stuff needs treaty reform. Is that right? Anton La Guardia: Everything that the British are saying in Europe at the moment is now flavoured by the question of treaty renegotiation. What are the Brits trying to repatriate and undo? The real question is whether anyone would listen any more. The Chairman: They think that Merkel is going to listen. Anton La Guardia: Nobody wants the Brits to leave. Everybody would rather have the British there. The French do not want to be left with the Germans on their own, and the Germans do not want to be left with the French on their own. The smaller countries do not want to be left with the French and the Germans on their own. So everyone wants Britain in order to be able to triangulate and so on, but that does not mean that they will give Britain everything that it wants. There is space for negotiation, but it is at the margins, and I am just not sure that it is sellable back home. No one really wants to undo the big compromises of the past. That is what it comes down to. The tone of the debate in Britain is, “We never

295 of 441 Anton La Guardia—Oral evidence (QQ 121-133) liked this and we want to undo it—get us out”. For everybody else, the point is that they know what the compromises were and that there were good reasons why they were made. It is not perfect for anyone, but on balance it serves their purpose.

Q132 Lord Vallance of Tummel: I come back to the business of completion of the single market. I find it quite surprising that the Commission document that purported to be a blueprint for genuine economic and monetary union did not even mention the completion of the single market. That is a very strange thing. So here we are negotiating with the United States in the most important trade negotiations between the EU and the US, and we do not even have an open market in services in our own back yard, which is going to make it more difficult. Does this not seem to you a good time for a demarche on the completion of the single market? Anton La Guardia: There is a deal to be struck. What can we give Britain to keep it in? Well, let us deepen the single market, and have a deeper EMU and a deeper single market. Made to a country that wants to stay in and still wants to embrace the European concept, that could be an attractive proposition. My sense sitting here is that Britain has moved beyond that. It has moved to the point where we are now questioning the free movement of workers. It is very hard to have a deeper services market if you do not want the Polish plumber to turn up. So this is difficult. Services bring people here. You do not want the Bulgarian hairdresser. It is part of the whole package. If Cameron got the integration of the telecoms market, would that solve the problem for Britain? Lord Vallance of Tummel: If you do get a deepening of the single market in services, it would undoubtedly help. It would also help growth. We are looking at this thing, which is meant to be some kind of growth agenda as well as a fiscal agenda, and it seems very foolish not to be going for it. Anton La Guardia: I agree that one of the things that Europe can do to promote growth is to deepen the single market. The thing about the single market is that it is a bit like a garden: regulation keeps cropping up, which gums up the system. The Chairman: It has to. The market always changes, so you have to change with it. Anton La Guardia: Sorry, can I make one further point? You mentioned TTIP. The equation is almost the other way around. We can get different services, and that forces Europe to create a single market in services. It actually has a good effect on Europe. Lord Hamilton of Epsom: As you know, there is a great dialogue among Government Ministers who say that they will renegotiate treaties and bring back great powers from Europe. On the face of it, that plays well with the Tory party in Parliament. However, anybody who knows anything about this—you have really confirmed this—knows that it is for the birds. It is never going to happen. There is not going to be a renegotiated treaty, because you need unanimity, and once you start down that road, you will dismantle the whole structure. So can this pretence be maintained until 2015? Anton La Guardia: The discussion about treaty change comes and goes constantly. One reason why it tends to come back is that Germany at some point feels that it needs treaty change to give itself a copper-bottomed assurance against Karlsruhe. However, it also realises how difficult Lisbon was. Therefore, it has tended to go for small treaty changes. One was to accelerate the simplified revision procedure to create the ESM, and the second was an intergovernmental treaty. If you are sitting in Merkel’s office, you will think, “Why can we not just keep doing this? We will just keep doing small treaty changes that allow us to evolve progressively”. Most of the others do not want to go down that route. The British

296 of 441 Anton La Guardia—Oral evidence (QQ 121-133) position is premised on the fact that there must be a treaty change because the Germans want it to reinforce the Euro Plus Pact, to clean up banking union and for any number of reasons, and therefore sooner or later there must be treaty change. But I think that unless there is a crisis it will not come. Lord Hamilton of Epsom: Does that effectively mean a new treaty rather than changing an old one? Anton La Guardia: The Germans have always been in favour of incremental change to the old treaty, as small and easy as possible, preferably with rules that mean that you do not need unanimity. The fiscal compact had all kinds of interesting innovations. It came into force before anybody had signed it, not everybody needed to sign it for it to come into force, and so on. However, the British debate has evolved a little bit and is no longer about just the treaty, although that is the most obvious way to repatriate powers because the British hold a veto. It is to say, “Let us reform the EU as a whole. Let us do more, for example, to get the Commission out of dealing with the sizes of nuts and bolts, or soil quality”—for some reason soil quality is something that really irritates Germans. But this is small stuff. It is less even than Wilson came back with. People will be willing to negotiate and strike a deal. I just do not think that the substance of it will be enough to satisfy the huge expectation that has been created. That is my point. One thing to watch is that there is a line in the most recent Franco-German agreement that states that they reserve the right to bring the ESM closer to the resolution mechanism. That is, quite consciously, a back door to a treaty change in which you say, “Okay, forget about putting this stuff to the Commission, we will put it in the ESM. The ESM is an intergovernmental treaty, so we do not need the British. It is a eurozone-only treaty, so it will involve a smaller number of countries, we do not need the British, and if you create an obstacle, we can sidestep you”.

Q133 The Chairman: I have one final question before I wrap this up. Tomorrow we meet Thomas Wieser from the Eurogroup. We have asked Greg Clark in the past whether he has meetings with the Eurogroup. I think that he meets colleagues at various European meetings. How important is that? Is it a trick that the UK is missing out on by not having better relations by the Eurogroup and Eurogroup Working Group? Anton La Guardia: The Eurogroup Working Group tends to work in the background. A lot of business gets prepared there. It basically prepares for the various councils. The Eurogroup Working Group prepares work for Eurogroup meetings of Ministers. Should Britain have a relationship with it? It is very hard to argue that the British should be in the Eurogroup Working Group, given that they are not in the euro. Should they have a close working relationship? Yes, in the same way that British finance Ministers should have a close working relationship with their eurozone colleagues. At ECOFIN meetings, the Eurogroup reports back to ECOFIN and says, “This is what we have done”. But it is at one remove. I do not think that that solves the fundamental problem. The Chairman: Mr La Guardia, you misled the Committee. You claimed that you were not an economist, which was like Maynard Keynes writing in his passport that he was chairman of the Arts Council. If I may use unparliamentary language, you have been absolutely superb and terrific. The Committee will think about the quality of all your answers, and the sharpness with which you gave your opinions. Your have been vital in helping us make up our minds on the subject of GEMU, and perhaps a few other items as well, over the coming months. We are eternally grateful. As I said, we have put one further burden on you. We will send a transcript of what you have said today, and will ask you to correct it and improve

297 of 441 Anton La Guardia—Oral evidence (QQ 121-133) on it if you can, adding any further thoughts that you have. In the mean time, a million thanks. Anton La Guardia: Thank you very much for listening to me.

298 of 441 Professor Mark Hallerberg—Oral evidence (QQ 248-262)

Professor Mark Hallerberg—Oral evidence (QQ 248-262)

Evidence Session No. 21 Heard in Public Questions 248 - 262

WEDNESDAY 6 NOVEMBER 2013

Members present

Lord Harrison (The Chairman) Viscount Brookeborough Lord Davies of Stamford Lord Flight Baroness Maddock Lord Marlesford ______

Examination of Witness

Professor Mark Hallerberg, Hertie School of Governance

Q248 The Chairman: Mark Wallenberg, thanks ever so much. Professor Mark Hallerberg: Hallerberg. The Chairman: Hallerberg? I have had the habit of changing the names of distinguished Treasury officials in the past, so forgive me if I make that mistake. Mark Hallerberg, you are very welcome to come before the Committee to discuss genuine economic and monetary union. Perhaps I could invite you to say a little bit about yourself, having discussed where we have previously met and the roles that you have performed. It is the habit that, at the end of this exchange, we will record what we have said and send you a transcript. I ask you to correct it and, better still, when you suddenly realise that you have forgotten to say this, that or the other, just to improve on it and send any fresh ideas that you have which have been stimulated by this discussion. Could you say a little bit about yourself? Perhaps I may tag on to that the kind of lead question that we have had, which is: in looking at the construct of genuine economic and monetary union, what do you think is absolutely necessary? Which bits of the structure are absolutely necessary? Which bits are perhaps unnecessary and even harmful? Then I shall ask you a little further down the line what your perception is of what might be called the German red lines in terms of whether we can really achieve genuine economic and monetary union. We will go on to try to get your advice about what it actually means. Professor Mark Hallerberg: Some of you may wonder why you are meeting an American professor in Berlin. I have done work on economic and monetary union; I have written some books looking specifically at fiscal policy. I look at what is often referred to as fiscal governance. I am interested in how Governments make budgets and with what sort of rules and institutions they regulate and govern the way they make those budgets. I had a book where I went to the then 15 member states. I was in London, at the Treasury and other places, in the early 2000s to understand how budgets were made in the then EU 15. I was

299 of 441 Professor Mark Hallerberg—Oral evidence (QQ 248-262) then a professor based in the US. I kept flying back and forth all the time because my research interests were here. A position became available at the Hertie School of Governance, which is a private school—which is very rare in Germany—but I was coming from Emory University, which is also private in the US. It has similar goals and is a public policy school that is only at the graduate level. I have become in some senses if not a bit of a gadfly then someone who is more or less an academic—keep that in mind—and an observer of some of the things that happen here. When you ask me questions about what the Germans think, just keep in mind that you are asking a non-German what that is. There are advantages to that. I do not have a stake in these goals. There are sometimes disadvantages; there are certain conversations that I may not have been privy to. That is my introduction. What is necessary and what do you need? The phrase “genuine economic and monetary union” dates back of course to the four presidents’ report. You already know what I think about financially integrated budgets and economic and democratic legitimacy. We met because we were at a seminar before talking about the democratic legitimacy bit and the concern that there has not been much oversight of some of the things that have been happening. I will get to that point. That is important, and it is probably even necessary, but the bits that I am very concerned about are a little further up—but I will get to democratic legitimacy. The Chairman: We can take them one by one. On democratic legitimacy, strangely, this Committee is purposed for the first three. We have an interest in the fourth one. Professor Mark Hallerberg: But that is not your concern. The Chairman: It is not our major concern. Nevertheless, we are gadflies as well, so we would be interested. Professor Mark Hallerberg: I shall give you the two-minute version of that. We did interviews and asked the European affairs and finance or budget committees of the EU 27— we did not get to Croatia—what they were doing in terms of the European semester. What sort of oversight is there at the debates? You often think of the House of Commons and the House of Lords as being weak relative to the powers of other Parliaments in the European Union, but you perform much more oversight. The Hungarians, the Danes and the Czechs all have very active committees and you begin to wonder why that is. Well, one of our arguments is that these countries are not only euro-outs but want to be euro-outs, and they are concerned with the things that are happening and are much active in oversight. The euro-ins, the ones that you would think would be even more focused because some of the measures apply especially to them, are much less likely to have their Parliaments involved and seem to have less interest in having their Parliaments involved. I would think that, because they are the ones who are going to face some of these governance structures, they should be the ones coming to the table more often and being more active in these debates. That is the democratic legitimacy point. It is based on a research paper which, if you are interested, I can send to the Committee. What is necessary? I am concerned and I am delighted to see some movement on banking union, which is crucial. We say that it is necessary; I think there has to be something. I am repeating some things that you have presumably heard before; I did not come up with this. You have somehow to sever the financial sector or banking crisis from the sovereign debt, because that often warps into a sovereign debt crisis. There are 27 countries. If you think about what happened in Cyprus earlier this year, you will see that this was a case where local authorities did not provide adequate supervision of the banking sector in Cyprus. They were very concerned about non- Cypriots who were major shareholders—the Russians, but others were very interested— and they were concerned about their little part of the world. Because they did not do a

300 of 441 Professor Mark Hallerberg—Oral evidence (QQ 248-262) good job of supervision, it spread to be a concern of the whole Union; it was not a concern just of Cyprus. This could happen in other places that are bigger. If you have a systematically important bank that gets into trouble, the primary domestic actor that gets involved in most of these countries will be the finance ministry. That is very much focused on the politics. Steps have already been taken in terms of supervision; the discussion is now what to do in terms of resolution. The common rulebook is there, too. I think there are sometimes clashes between what is nationally important and interesting and what is important for the Union. When I say the Union, I mean also the Union taxpayer. I would make the argument that if some steps had been taken earlier in places like Cyprus there would not have been the necessity to involve the European Union in the first place. Some of you may be sceptical about EU institutional involvement. I think that, to make things work well in an economic and monetary union, you need some sort of financial supervision and some sort of resolution at the European level. The other reason why I think that that is important is that it connects then to the arguments about the budget. One issue that you have now is that it is very difficult to allow a member state to “fail”. I think that it is not just me saying this; I think that it is a German concern—that is, you want to be able to have a situation where, if somebody gets in trouble, you can say, “No, you haven’t fulfilled the terms of a programme or you haven’t fulfilled the terms of the Union and you don’t deserve funds”. Then they have to go to the banks. So that it does not then lead to a bank failure, it spreads to the other member states and then it catches fire. So the financial side is important for the banking side.

Q249 Lord Davies of Stamford: This is a question about the legal position in Germany—I think that you are expert on that. How far could the Germans go, in your interpretation of constitutional law and so forth, in signing up to banking union without a new European treaty? What degree of mutualisation could be involved in a common resolution system without the need for a new treaty? Another way of putting this question is: what is the difference between the so-called timber-framed version of a resolution mechanism, which Schäuble has said will be possible without a treaty, and a steel-framed mechanism? What are the concrete differences? We need to look at the political difficulties of having a new treaty as against what the additional strength of the banking resolution system and the whole banking supervisory system in the Union might be. Professor Mark Hallerberg: I am not a lawyer or a legal expert, so I can only give you my interpretation of the debates. To the extent that you are asking me to make a ruling on what the court would say or what the legal interpretation is, that I cannot do. Lord Davies of Stamford: Well, I cannot ask the court. It is a terribly important question and you are a very intelligent observer who is independent of the German political system. Within the German political system you get controversies, so you do not get a very objective answer. That is why I am putting the question to you. Professor Mark Hallerberg: I just think that on the legal merits I cannot say; I can say the politics. You mentioned Mr Schäuble. His legal team has said that it had these concerns. Lord Davies of Stamford: Where is that threshold beyond which you have to go for another treaty? I have never quite understood. You talk about timber frames and steel frames. Can you describe the specifics of each model, or the differences between them? Professor Mark Hallerberg: On the legal issues, my understanding is that the Chancellery is more open to the idea that most things are possible. The Finance Ministry has been saying that it is less flexible. I think that the big issue is more a political one, which is who bears the legacy cost; that is, who pays for this? To the extent that you could say that it is a legal issue

301 of 441 Professor Mark Hallerberg—Oral evidence (QQ 248-262) requiring all these treaties and this complicated stuff and that we should not do it, it reinforces the position that they would not like to get involved. Lord Davies of Stamford: The resolution is by definition about inherited liabilities and therefore the legacy cost. Professor Mark Hallerberg: Yes, but the current position is that the goal would be, “We did not supervise these other banks. Why should we have to resolve them?” Lord Davies of Stamford: So the individual member states have to take account of the legacy costs, which basically means that they have to do the resolution because all the liabilities are historic. Professor Mark Hallerberg: Yes. Lord Flight: It defeats the object. Lord Davies of Stamford: So there is going to be no banking resolution system worthy of the name. It will not add anything at all. Professor Mark Hallerberg: I think that goes too far. It depends on what they do. You have some other questions that I was given in advance about other ways to try to solve this. The first step would be to have this review. The hope would be that you have a clean bill of health and then you would have a new fund. If you could say, “No, the problems came after; we kind of had a clean slate”, then you could have some sort of framework like this. The political issue, which I think is sensitive in any country, is the idea that “Somebody else supervised these banks. Now those banks come to us and we pay for them”. That is very unpopular and very difficult. What they are trying to do is say, “No, we start over”. Lord Davies of Stamford: It is a very useful insight for us. What you are really saying is that this whole idea about having a common bank resolution system only makes sense going forward. It is not relevant to the present weaknesses, if there are weaknesses, of European banks. It is not relevant to any systemic crisis that might be threatened by the asset and stress reviews which are going to be undertaken in the next few months. Professor Mark Hallerberg: I half agree. The Germans have a wonderful phrase, “Yein”, which means yes and no. You stated that it is not relevant to the current crisis. I disagree with that. This is the big issue. A lot of banks are not lending right now because they have a lot of insolvent things and things hidden off the books. How you deal with that is the huge question and I do not have an easy answer for you. What will be the design of the resolution fund? This is the idea of the timber and the steel. To give you positive spin on what Schäuble says, he does want the steel version at some point. The question is when. If you get that steel, you have a sense that everybody in the zone has a similar sort of risk in such a scheme—it is not a bailout scheme. There is some chance that one of us gets sick and we need help, but we have a common supervisor that is always checking to make sure that you are all healthy. That kind of system makes some sense. Lord Davies of Stamford: So a kind of stunde null at some point, when the asset test has been completed? Professor Mark Hallerberg: I think that that is the goal, yes.

Q250 Lord Marlesford: So are you really saying that the reason for having all these stress tests at all is that the banks are so frightened of lending, because of their fragile balance sheets, that it is necessary to resolve that problem to get them lending again? Has that been the motive force for the ECB examination of debt?

302 of 441 Professor Mark Hallerberg—Oral evidence (QQ 248-262)

Professor Mark Hallerberg: I do not think that it is just an information issue. Some of them have bad debts on their books, and are not lending for that reason. I do not know how to resolve those bad debts. I have done some research on bad banks and if you score off the bad part and keep the good part—it now looks like you are doing that with RBS but you did not decide to do that originally. You did something else. But then the question is who owns them? Who bears the liability or the risks? Imagine the European Commission having liability for the bad banks. That does not make sense. The thing that is unresolved or stuck in my opinion is about what to do with the bad stuff in Spain, for example, and some other places. Spain is at least beginning to pick up and get better but there is concern and this gets to the idea of having a common framework. The rules vary significantly across countries. There is a common set of rules to determine whether somebody is insolvent. The rules are much laxer in a country like Italy, for example, but you are not sure if they are resolved. That is when you talk about not lending. There is a little bit of risk but if I can have a clean bill of health on the ones that are okay, maybe we can move forward. Lord Marlesford: The ECB has a dual role. It is trying to set up a position whereby it can be an effective supervisor, which means that it has to know the situation as it is. Equally, it is responsible as the monetary authority for keeping the show on the road. Therefore, even though they may be separated inside the ECB, if we lose confidence there could be another crisis. So one must ask whether they are going to look for the proof or whether they want to say that all is well and Draghi can continue and do all it takes, but will not take any at the moment. Professor Mark Hallerberg: You are mentioning two things. You are arguing whether these should be together. Two academics a couple of years ago were arguing whether you get higher inflation if you combine monetary policy and banking supervision under one bank umbrella. You may know that the Bundesbank president has the same concern, and would somehow like to separate these. I share a similar concern. There are some advantages to having supervision at least at the ECB. The question is if you get more inflation who else would you give it to? Should it go to the Commission or who else would have the authority? They do not have the competence yet—they are hiring lots of people. They are the most likely suspect. I do not know who else we would give it to.

Q251 Lord Davies of Stamford: The Germans have accepted that there are cases when it is necessary to have a bail-out as well as a bail-in. That has happened in Greece, and so on. They have resisted, as a matter of principle, the idea of any permanent fiscal stabilisation system. Do you think that the eurozone or even the EU can survive without a permanent fiscal stabilisation system, such as happens in the United States, for example, or internally in Germany through its system? Professor Mark Hallerberg: That is a very good question. I do not think that it is politically possible. It would be too much money. A colleague of mine proposed this. There are some interesting schemes which are worth exploring. It does not have to be there for Europe to survive. It can survive without that sort of fund. Politically it is very difficult to set up that sort of fund. It does not work effortlessly in the German case. You mentioned the US. Some funds are distributed. Keep in mind that roughly 90% of unemployment is funded by the states, not the federal Government. A state such as Michigan, for example, is always screaming that it has high unemployment and has to pay high costs. Somehow the common currency of the dollar works. There are more transfers in the United States. I have heard schemes about which they always say they are like the United States, but actually they are not. The US does not have some of them redistributed. There are other ways. The defence

303 of 441 Professor Mark Hallerberg—Oral evidence (QQ 248-262) industry is there and money is always coming from the federal Government, or something like that. That often helps to stabilise things. But keep in mind that Americans move a lot. When Massachusetts gets in trouble a lot of people flee. Will Europe ever get to that level? Maybe not. But efforts to work on labour mobility and other things can at least be a start. I think the premise is too strong. It can survive without that. If you could design one that would be politically acceptable it could make some difference, but on the amount of money we are talking about, it is on the margins. I do not think that it is necessary. Lord Davies of Stamford: I just add in parenthesis that the degree of labour mobility in Europe has been shown to be much greater than was expected, as a result of the crisis that we have been going through in the past few years. Do you think that the German attitude to debt and mutualisation generally will change over time, or with the constitution of a potential CDU/CSU/SPD coalition? Professor Mark Hallerberg: I do not think that the coalition will make a difference. There is a pretty consensual view. For now the answer is no. You asked whether it could shift over time. There may be ways. The ESM is one way; German money goes in and is then paid out. Is that debt mutualisation? Well, not really if the ESM works like the IMF—the IMF has never lost money. That organisation has never lost money that it lent. Is it mutualisation when it lends to Argentina? It makes sure it is always the first to get the money out. If you could design a fund—and this gets to these proposals for the European Monetary Fund with which I have some sympathy but the Germans would say that it is too far right now—that gets to a stage where it works. German money is involved but they do not see it as being mutualised. You could do things. Lord Davies of Stamford: Thank you. Those are some very straight answers to my questions.

Q252 Viscount Brookeborough: What about the idea of a Marshall plan? Professor Mark Hallerberg: If you go back to what the Marshall plan was—it was liquidity because people did not have US dollars to buy US tractors. That is mostly what it was. It was food aid from the US for stuff they could not sell anyway. There was a bit of grant, but it was very small. I guess the question I have with the idea of a Marshall plan or fund for southern Europe is that some of it is there to some extent. The liquidity support comes from the ECB. As a member of the eurozone that is one of the things that the ECB does positively. It helps to provide liquidity. In terms of loans, the ECB has also made sure that the bonds do not get too expensive. What does it really mean? Viscount Brookeborough: It is support from the north to the south. It is lent. It is straightforward finance.

Q253 Lord Flight: Can we just return to banking union, which we are looking at in depth? The first question is what are the objectives, and a point was made about making it easier for banks to lend. But surely it is the other way round; it is to increase confidence in the banks and the thousand odd billion of bank deposits to banks in the problem countries that fled. There is a desire to regenerate confidence so that money will flow into banks in those countries, so that they can lend it out. In that context, it is important economically. Having better common regulation is obviously a positive and a stress test of their transparency, and so on, but the second and third parts are pretty important as well. Unless there is a resolution scheme that will not just dump more liability on Governments, part of the objective is lost. It is no good if the stress test shows that Spanish banks need another hundred billion and the poor old Spanish Government has to increase its debt. So I think

304 of 441 Professor Mark Hallerberg—Oral evidence (QQ 248-262) that it is actually in Germany’s interests to be supportive with some degree of collective resolution fund, if only to relieve the Bundesbank. That does not look as if it will happen. Is therefore the banking union of that much importance in terms of objectives if it does not deal with the resolution issue? Professor Mark Hallerberg: Resolution has to be part of it. I agree with that. Lord Flight: Well, real resolution. Forget the future; who cares about that? An Italian bank might be bust and want to know if there is a decent fund to bail it out. Professor Mark Hallerberg: The idea is that the banking industry itself will be paying into this fund, so there is the question of how long it will take. In the early days the answer is no. To get lending as you are describing, you need to clean out the problems, and that is not being done right now. What do you do with the debt? I get concerned when I hear, “Why don’t the Germans just pay for it?” The debt is now above 80%. In 2020 the demographic issue will hit. The projections are that the growth rate will be less than 1% per year. If you are thinking at home and look at what will be happening in five or 10 years, you should be saving: “Where is the money going to come from?” You can do some bail-outs. You can do a little at the margins, but Germany is not big enough. That is the other concern that I have. It is like putting everything on their shoulders but there is only so much money. Lord Davies of Stamford: Is the financial transaction tax the answer? Professor Mark Hallerberg: No. Lord Flight: If you only get a third of the banking union, will it really make much difference? Professor Mark Hallerberg: If things stay as they are I am concerned that it will not make enough difference. I am sympathetic to that. But, it is at EU level and we should bring these things together because, ultimately, the German taxpayer may get stuck with other things that look like bail-outs if we do not resolve the banks. Lord Flight: You could increase the ESM fund, requiring all countries to contribute, so it is not just Germany. You could have a larger collective EU pot that will not do all the bailing out, but it could be a catalyst. Professor Mark Hallerberg: But again I would want that through the sovereigns. The IMF does not lend to individual banks. The sovereigns are responsible. I would like to see something similar. I have heard plans about the ESM doing the bail-out. The other thing that is proposed is to allow countries to grow deficits above 3% one time only, so if there is a little bit of a mess it can be cleaned up now. But it depends on how bad the banks are.

Q254 Baroness Maddock: The European Central Bank will be the single supervisor in the future and will be conducting a review of assets next year. There are questions about how credible that might be—history shows that. Do you think that there is any danger that that could undermine confidence in the banking sector? If there are problems, how will they be financed? Professor Mark Hallerberg: On the second part of your question, as I have already indicated, I do not know. On the first part, Dexia was supposedly in good shape but then it quickly was not. It was busted. I can tell you that if a similar thing happens and a major bank fails a few months after the review, it will undermine credibility. I know from personal experience—I was at the ECB a few weeks ago—that there are people who know this. They will say that they want to be “tough”. What does that mean in practice? There are people who have those motivations. Is that what ultimately comes out? It is difficult to say. It is

305 of 441 Professor Mark Hallerberg—Oral evidence (QQ 248-262) more likely this time than last time. My guess is that there will be some things found that we did not all know. Somebody will be a little hurt, some country will be a little bloody, but that will not include the whole banking system. If it turns out that things are much worse than everybody thinks, that will be difficult. Will it cause panic? How will it be financed? If it is really big there will be nothing we can do. I think that the expectation is that they will find one or a couple, and hopefully nobody goes bust in the following couple of years, except the ones they identified. They will then have credibility and carry on.

Q255 The Chairman: Where does the Bundesbank stand in all this? They are sitting there, and they have the ECB, a great big bank, next door. What do they think about it all? Have you been to the Bundesbank and what did you pick up there? Professor Mark Hallerberg: I can answer about a particular bit of the Bundesbank but they have lots of opinions. In terms of these sorts of things, they are very concerned. The idea or line that somebody else was the supervisor, and so somebody else cleans it up, comes right out of the Bundesbank. They cannot imagine any scenario where the German taxpayer would be involved in paying for anything that the German authorities did not supervise, full stop. The next sentence would be, “But you may have to bail out the sovereign rather than the bank and how would you deal with that?” That is what we are responsible for and what we talk about. They have also indicated their operational concerns, which I think are actually quite reasonable. They mentioned that not enough people at the Bundesbank speak English. There is going to be a new authority at the ECB. Where are the supervisory people going to come from? They are going to come from the national banks and are all going to have to speak a common language. That will be English, which is the language of finance. These are common problems in Brussels anyway. If you think about a crisis, you have hours to deal with certain things and the Bundesbank has set off. Where are we going to train all these people so that they can speak to each other? They are worried not just about big-picture things but operational issues. That is my main point. The Chairman: Before bringing in Lord Marlesford, I will just pursue the Bundesbank element. Are they still influential and who with? Or should that be with whom—I am speaking to an American colleague? Professor Mark Hallerberg: They are influential but not as much as they used to be. In some sense I would almost say that they used to be almost a moral authority. If the Bundesbank objected to something, that changed the discussion. The Bundesbank president was on TV all the time in the 1980s. They are not as present as they used to be but have simply declined in influence in the press and other sorts of places. That is clear. That does not mean that they are not influential in terms of, “This is their speciality, in which they have expertise”. I think that they are well respected. If you ask who listens to them, that is a good question. Lord Davies of Stamford: To what extent are their positions influenced by sour grapes in that they regret the loss of their previous position and resent the ECB running monetary policy? Professor Mark Hallerberg: There could be some of that but they really are concerned about the German perspective and the German taxpayer. There is a genuine public-spirited side: that is what they stand for. Lord Flight: They are the protector of the German faith, basically. Professor Mark Hallerberg: That could be one way of looking at it.

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Lord Davies of Stamford: They never believed in the euro project and it is always nice to turn round and say, “We were right all along, the whole thing has collapsed”. Are they hoping for that?

Q256 Lord Marlesford: It appears that the US Treasury has stepped into the whole argument and been critical of the Germans for not doing more to stimulate their own economy in order to help other countries. I am unclear whether what they have in mind is a sort of quantitative easing on Fed lines or something else. I do not know whether you feel in some way that a country with a surplus, such as Germany, has an obligation to try to bail out other countries through domestic economic activity and whether this could spread. What do you see as the implications of this US intervention? More important, perhaps, what has been the reaction here to it? Professor Mark Hallerberg: The reaction has been that the US has other things to worry about and that it has been a bit defensive, probably too much so. As to the merits of it, keep in mind who said this: the US Treasury has its own political interests. Right now, the country with the largest current account surplus is Germany, and the US would certainly prefer to have people buying more American cars than German cars. There is a political dimension, which one should not forget. In terms of the criticism itself, I often wonder what people really want the Germans to do. Okay, they have surpluses. Do you want them to become less competitive, or to raise wages? Does having a less competitive Germany help the eurozone? Lord Flight: They want them to consume more basically. Professor Mark Hallerberg: But are they going to buy things from China or from Portugal? Lord Flight: From everywhere. Professor Mark Hallerberg: In terms of helping other euro countries, or even the European Union more generally, I do not see how spending an additional 1% or even maybe 0.5% of GDP in some sort of giveaway so that German consumers buy certain things is going to help Spain or Greece enough to get them out of their crises. Maybe I sound German, but I find those sorts of criticisms of surpluses strange. Germany implemented reforms in the early 2000s to become more competitive, and I do not see how it helps Europe if you undo them. However, the criticism is right when it comes to the investment side. Investment has been very low. One of the issues about the current account surplus is that, on the capital account, more capital has been going out than in. That means that there has not been the investment that there should have been here. I told you about the concerns about what German growth will be like in five or 10 years. Lots of investments in Germany are critical. One way you could address this issue about surpluses is on the investment side. That bit, I buy. However, I do not think that the idea of spending a lot of money and having consumers somehow spending a lot of cash would be effective. It would not help America: they would not be buying Chevrolets. Lord Marlesford: You say you buy the investment side. Investment can come from the public sector or private sector. Obviously, the Government is in charge of the public sector but if the private sector—German companies—decide to increase their profits by investing overseas, are you saying that there would be, or could be, some means of persuading them to make those investments inside Germany? Professor Mark Hallerberg: Yes. Lord Marlesford: How would you do it?

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Professor Mark Hallerberg: You could do it through taxes or through public-private partnerships, although that is not going to be big enough to make much difference. Lord Marlesford: Is there any sympathy for that inside the political parties in Germany? The SPD, for instance? Professor Mark Hallerberg: I am not sitting in their coalition negotiations but my understanding is that this is one of the positive things that is going to come from this next Government. There will probably be a lot of money for investment. How it is spent is part of the negotiation. In that sense, the US Treasury has overreacted: I think there is something coming that will have some sort of effect. I should say as well that, on the margins—I do not know if you have followed this—the pay packages have been fairly generous. It just takes time. If you go up 3% or 5%, these things do compound over time, but the quick turn is not going to happen.

Q257 Lord Flight: Whether deliberately or not, Germany and China have both had mercantilist export-led growth policies. China has, in a sense, screwed the rest of the world, which has got to have a deficit, which has created many of the problems. Not surprisingly, the US says to China, “We do not like your false exchange rate, which is encouraging this”. Within an EU context, it is very similar. It may not have been by design, but because Germany has held down pay costs and the rest of it and not everyone has, it has become super-competitive within the eurozone. Going back to your point, what it needs is Germans spending more money going on holiday in Greece and Portugal. Not all extra spending will necessarily happen in the eurozone but Germany, like China, needs to stimulate consumption if some degree of economic balance is going to return worldwide. Professor Mark Hallerberg: Yes, but they are competing worldwide. For that reason, the idea of somehow undermining German competitiveness makes me nervous. Why can those Spaniards not come to Berlin? They are starting to: there is a bakery around the corner from where I live that is only Spaniards. An adjustment could come: if there is a competitive economy in the eurozone, why not have people move there? When they move, that lowers unemployment in Spain, which helps the Spaniards. There might be a brain drain—there are other words for this—but that is the kind of adjustment that would be more productive than simply spending a lot of money. Lord Marlesford: A top political imperative for Germany is survival of the eurozone. I am not clear whether that means survival with all the existing countries or whether, if the price of survival involved one or two countries, such as, say, Greece, having to leave, Germany would be prepared to pay that price. Professor Mark Hallerberg: Your premise is very important. They have made the determination that anybody leaving would mean the end of the eurozone. I am not sure that that is true and I am not sure that they are even sure—it is the uncertainty of it. They have been convinced that it is something that they cannot control and cannot know. It is much cheaper to give Greece yet another package than to risk it. I would not put bets on Greece leaving, let us put it that way.

Q258 Baroness Maddock: I want to ask about the necessity for an integrated economic policy framework, if we are going to see GEMU go forward. How much deeper does it need to be, do you think, if we are going to achieve what is being proposed? Professor Mark Hallerberg: How much deeper does co-operation or co-ordination need to be?

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Lord Flight: Eurozone integration: economic, fiscal and all the rest of it. Professor Mark Hallerberg: It is a big question. There are two issues. One is that you have to come up with some sort of bargain about these legacy debts that we have talked about. As you move forward, they have set up these frameworks on how much they should be spending, what sort of structural reform they should be making and this kind of stuff. There are questions about competitiveness: it is in the German interest to make sure that the Spaniards and others become more competitive. It is not that the Germans then lose money; I am thinking in terms of how this goes worldwide. If there are ways of co-ordinating to help with this, that is good, but I do not think that it has to be deeper or the whole thing collapses. I can see the muddle that you end up with: there were 10 years when people did not seem to think that there were many problems here. We had conferences where we used to celebrate: “It’s been 10 years of the euro, everything’s fine, maybe we should be studying something else”. And then the whole thing fell apart. I think that there is a possibility that things will stabilise and that there will not be much deeper integration.

Q259 The Chairman: Is there the need therefore for a fiscal stabilisation capacity for the EU 28. Does it involve— Professor Mark Hallerberg: You said the EU 28? The Chairman: The 28 of the EU. The eurozone 17, but that as well. It could involve the wider scene, and also the European Treasury and even European tax- raising powers. Will all this help? Given your look of scepticism, I hope you will explain it in great detail. Professor Mark Hallerberg: It could also hurt. I am always nervous about who is accountable to whom and for what. The idea of the Treasury, is this a political animal whose job it is to do what? Is it identified with a party? Some of the debates today are about should the Commission president be directly elected. What exactly is this person going to do? I guess I am being a slippery academic. I am not going to answer yes or no. To me it very much depends on the design of it. My sense—and I guess this would be a response to both of you—is that banking union is going to be the last bit of integration in quite a while. I think things are going to slow, partly because of the elections that are coming in May. Lord Flight: Yes, you are talking about a very hostile environment. Professor Mark Hallerberg: Yes. My personal opinion on that is that there is going to be a pass and a sense that politically you cannot do anything for a time. That is why these negotiations on banking union are pretty important now. They should be settled. They should be based on the merits as opposed to based on the expense. Lord Flight: Even though they will not be of that much import, they have done something? Professor Mark Hallerberg: Yes. Exactly. Lord Marlesford: Schäuble seems to think that the banking union itself requires full treaty change to achieve it. Professor Mark Hallerberg: We have talked about this before. It depends on what exactly that is. Some version of banking union is fine as it is and will not require treaty change. I think even the German perspective is evolving.

Q260 The Chairman: Right at the beginning of this exchange—and thank you so much for it; I apologise that we have rather jumped around, but you have jumped around with us

309 of 441 Professor Mark Hallerberg—Oral evidence (QQ 248-262) with great alacrity—let me take you back to our number four stage, the accountability, which I think is important. Our senior Committee is examining the role of national Parliaments and what they do. In part we see ourselves within the national Parliament in the Palace of Westminster trying to do a bit of a job in these difficult areas. What advice have you got for the Committee on how we should fashion that and talk to our other national Parliaments and our friends in the European Parliament to be effective on the fourth tier of democratic accountability? Professor Mark Hallerberg: Are you referring to Article 13 of the—oh, you are not in the fiscal compact? That is one of those strange bits. I should probably ask you whether you attended anyway because they had this inter-parliamentary meeting. The Chairman: The fiscal compact, we absented ourselves from it. As I understand it we have linked ourselves more in. To explain the relationship with the national Parliaments, my Clerk and I were recently in Vilnius. Professor Mark Hallerberg: You did go to that meeting? That is what I was asking. The Chairman: We were there and people were chipping away at how the 28 member states, the 17 eurozone states and we as national Parliaments might be effected against the European Parliament which has invested the role of holding the ECB to account, certainly on the supervisory function. Professor Mark Hallerberg: We met, I believe, in Copenhagen at a meeting of the different committee chairpersons of the European Affairs Committees. You ask how can you do this. Parts of those discussions, I guess, were followed up in Vilnius. Some of it is truly, I stress, the accountability part of it. The idea is having regular hearings and regular supervision of what it is that the Governments are doing and what is happening at the European level, but having this in the national Parliaments. I had a sense that several national Parliaments were simply not involved, as I have mentioned before. As you probably know, the European Parliament would like a lot more power than it has; it would like a lot more supervision than it has. Its powers are very incomplete. The Chairman: It already has a lot. Professor Mark Hallerberg: I guess. It is a half-empty, half-full situation. They would say that they do not have enough. The Chairman: Well, Mario Draghi is coming for them on a quarterly basis. We are going to the ECB, I am disgressing now, but that will be “huis clos”. We will not have an open meeting. The European Parliament has that statutory power. Lord Davies of Stamford: It has to be. The ECB cannot see 27 or 28 national parliamentary delegations. It is not practical; it is absurd. Professor Mark Hallerberg: Well, I do not think it should be that they see 28 every quarter but you can have a system where you see somebody on occasion. Draghi has come to Berlin and has spoken before the Bundestag. The question I have is: does this rotate? Does he have to go to different places on a more regular basis? His staff will also say that he does not have the time, which brings you to the issue that these are very busy people and how often can they see different things. If you had a procedure, it would not just be him. I am thinking of commissioners and other things. I do not think it would be wrong to have whoever is in charge of economic and monetary affairs given custody. The Chairman: Forgive me if I am wrong, but I think that Draghi addressed the Bundestag behind closed doors in a two-hour session.

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Professor Mark Hallerberg: The Budget Committee is usually secret. I cannot go to it.

Q261 The Chairman: We have had such an interesting discussion, perhaps the last question to ask you, as a good American friend and colleague, is what do you think the UK’s role in all this is? Professor Mark Hallerberg: Do you want me to answer that? The Chairman: Yes, I do. The American Administration have always been supportive of the UK having an active EU role, and no less here than elsewhere. Be a friend and advise us. Professor Mark Hallerberg: But I am only an academic. The Chairman: Not a slippery academic any longer. Professor Mark Hallerberg: I have a very direct view. Being in Germany and being concerned about how some things are done here on the economic front, I would be disappointed, and even sad, if you left the union. I think you play a very important role in terms of the competition policy and in terms of the economics, and debate is always useful. Some of you may have different views. I would be very upset if you left.

Q262 Lord Flight: It seems to me that both when the banking crisis was at its height and in shaping the banking union, the Bank of England did a hell of a lot of work behind the scenes. In a sense, the UK has almost put in the model which Europe is now about to follow to ban European migration. So we may not be part of the European banking union, but what continues to happen behind the scenes is that the Bank of England is almost the most important bank of the lot in terms of shaping what happens with the ECB. Professor Mark Hallerberg: You have state aid issues as well, right? If you give aid to a bank, the European Commission has a say on that. I would not say that you are out as long as you are not in, but the question was what advice would I give your population. You have reasons why you do not want to be in the euro and I would never argue for you to get into the euro. As to if you left the European Union, I think the European Union plays an important role in economics and even in security. I hope you stay. Lord Davies of Stamford: This is an important issue although it is not strictly relevant to our agenda for today. You have just said that you would never suggest that we join the euro. Why is that? Viscount Brookeborough: Do you think we provide a very useful job where we are? Professor Mark Hallerberg: Those are two separate issues. I lived in Lancaster for two years, in the north of England and spent some time getting into this. I do not think that the mentality is right now. I think there is more involved than just economics in terms of joining the eurozone, and you are not in a position right now to do that. Will you be in a position— I have heard Paddy Ashdown argue for this—in 20 or 30 years? Perhaps, but I am going to give you a less economic-based argument as to why I do not think right now would be appropriate. Never? I admit I would not be the person to propose this but if in 20 or 30 years things change, perhaps. I think that you can provide a very useful role without ever being in the eurozone. That is my main message. The Chairman: Colleagues, let us conclude there and thank Professor Mark Hallerberg most sincerely for that exchange. It went down some of the corridors that we least expected but it did so very helpfully, usefully and interestingly. For that we thank you. I will

311 of 441 Professor Mark Hallerberg—Oral evidence (QQ 248-262) close the meeting officially. We will send the transcript; please correct it and add to it. In the mean time thank you for coming this evening, and do share a cup of coffee with us. Professor Mark Hallerberg: Thank you for having me. Thank you for hearing me out.

312 of 441 Roger Helmer MEP, Sharon Bowles MEP and Syed Kamall MEP—Oral evidence (QQ 209- 221) Roger Helmer MEP, Sharon Bowles MEP and Syed Kamall MEP— Oral evidence (QQ 209-221)

Transcript can be found under Sharon Bowles MEP, Roger Helmer MEP and Syed Kamall MEP

313 of 441 HM Treasury, Nicky Morgan, Economic Secretary and Peter Curwen, Director Europe— Oral evidence (QQ 316-331) HM Treasury, Nicky Morgan, Economic Secretary and Peter Curwen, Director Europe—Oral evidence (QQ 316-331)

Evidence Session No. 26 Heard in Public Questions 316 - 331

TUESDAY 19 NOVEMBER 2013

Members present

Lord Harrison (The Chairman) Viscount Brookeborough Earl of Caithness Lord Dear Lord Flight Lord Hamilton of Epsom Lord Kerr of Kinlochard Baroness Maddock Lord Vallance of Tummel ______

Examination of Witnesses

Nicky Morgan MP, Economic Secretary to HM Treasury, and Peter Curwen, Director Europe at HM Treasury

Q316 The Chairman: Nicky Morgan, welcome to your first meeting with Sub- Committee A, our last meeting for the very prolonged report on genuine economic and monetary union. I thank you for seeing me with Lord Boswell yesterday to prepare for this meeting. Nicky Morgan MP: My pleasure.

The Chairman: Also, as I believe the Committee will support, I hope that we will have a fruitful relationship with you and your colleagues. I will ask you to introduce your colleagues in a moment. I remind you that, as is the practice here, we will make a transcript of all that transpires between us. We will then send it to you and ask you to correct it, and then also ask you, when you go out of the room and have some wonderful new ideas which you forgot to mention, please to convey them to us. We will be in the process of writing our report, which we hope to complete and publish in January of next year. This exchange is also being webcast. I am always told that any asides that are made by my Committee Members should be sotto voce, but my own view is that as long as they are good and interesting, I see no reason why we should not hear them more loudly. Did you want to introduce your colleagues and say a few words yourself? Nicky Morgan MP: Thank you Lord Harrison, and thank you to the Committee for inviting me to this evidence session. I introduce my official, Peter Curwen, who I think has appeared before the Committee previously.

314 of 441 HM Treasury, Nicky Morgan, Economic Secretary and Peter Curwen, Director Europe— Oral evidence (QQ 316-331) The Chairman: He has. Nicky Morgan MP: For the benefit of the record, he is the director of the international EU group at the Treasury, in charge of EU policy. I am looking forward to this morning’s exchange of views and questions and answers. I welcome the Committee’s work on this significant area of EU policy, which will certainly prove very valuable in setting both the interests of the EU and, in particular, the UK. I look forward to hearing the outcome of your final report when it is published, and I am pleased to be able to contribute to what I see as a most important inquiry into the plans for genuine economic and monetary union. I also want to say something about the UK’s position generally; I know that we are going to explore that on these plans. Since the onset of the sovereign debt crisis in the euro area, the Government have consistently said that they support closer fiscal integration for the euro area to strengthen the single currency. It is in our interests to see a stable euro area and to support measures to ensure that a similar crisis does not happen again. At the same time, however, we have been clear that the UK will not be part of close integration and will protect the interests of those outside the single currency, especially in the single market. That is the general approach we are taking to these plans. As I say, I am sure that we will go into further detail on this shortly. I want to stress that I cannot say more to you than that my colleagues and I intend to remain closely involved in negotiations on EMU going forward, to protect the national interest. At the October European Council, the UK secured language confirming that closer economic and social surveillance mechanisms should be voluntary for countries not in the single currency. As the Prime Minister said at his post-Council press conference, “Britain isn’t in the single currency. We’re not going to join the single currency, so we do not have to take part in these new pieces of euro co-ordination”. With that opening statement, I look forward to the questions.

Q317 The Chairman: Thank you very much for that. In your close analysis of genuine economic and monetary union, as proposed, what are the elements which you believe are necessary to set the boat right? What, in your view, are the elements that are perhaps less necessary and might even prevent the objective of GEMU, which is to set us right on financial matters? Could you give us a bit of an update on the negotiations as they stand at the moment, which the UK Government are conducting with their friends and colleagues? Nicky Morgan MP: Let me start, and I am sure that Peter will give you the proper answers to your questions. It is helpful, as you say, to start thinking about the situation as setting the boat right, about what has happened to that boat and about the situation with the euro-area crisis. The situation does appear, obviously, to be better. Market sentiment towards the euro area appears to be more positive thanks to steps that have been taken. The most important step, which has been highlighted to the Committee before, was the European Central Bank’s commitment to do “whatever it takes”. That is clearly very important and addressed one of the euro area’s major systematic weaknesses, that of a lender of last resort. Clearly, that commitment has given confidence to the markets that the systemic crisis is less likely. However, there is no doubt, as discussions over the past year or more have shown, that further institutional progress remains necessary, particularly towards banking union—that is certainly a subject of discussion among the EU Council—to address the interdependency between the banks and the sovereigns, which has been a major part of the crisis. The Chancellor has made it very clear that “a remorseless logic”, as he called it, means that the euro area, like any single currency, needs closer economic and fiscal integration to secure its future. Certainly in the UK, I have already mentioned the

315 of 441 HM Treasury, Nicky Morgan, Economic Secretary and Peter Curwen, Director Europe— Oral evidence (QQ 316-331) importance of the single market and doing what we need to do to protect that. We think that a number of further steps need to be taken, and will be if discussions are followed up. The euro-area Governments need to provide common supervision mechanisms and credible back-stop arrangements behind the euro-area banking sector. They also need to work on the broader fiscal and economic integration agreed by the European Council in December last year and on the issues that have been discussed over the past 11 months, such as economic contracts and solidarity mechanisms. You asked how negotiations are unfolding. Obviously, my colleague the Financial Secretary was at ECOFIN on Friday talking about the single resolution mechanism. I think Peter was there, too, and might want to say something about that. I have already mentioned the recent October European Council, where leaders agreed to reach decisions on the “main features”, as they called it, of contracts and solidarity mechanisms, which will be voluntary for the euro-outs. But we do not actually have any legislative proposals yet, so it is probably too early to tell how negotiations are going to unfold. Clearly, there are comments from various countries, but there seems to be broad agreement, both here in the UK and in the euro area, that implementing the single supervisory mechanisms and the next steps on banking union are the priority. I am sure that we will come on to discuss that in more detail. The Chairman: Before I bring on Lord Dear, I will turn to Lord Hamilton, who I know has a particular interest in Japan.

Q318 Lord Hamilton of Epsom: You have not been given notice of this question, for which I apologise. The newspapers have been filled with the parallels between the eurozone and Japan, in that we may go through a decade of very low growth and even deflation. Can you see any serious changes in policy, such as quantitative easing on a massive scale? The other problem, going back to your comments about banking union, was that of course Japan never reconstructed its banks. That was another reason why it failed to grow for 10 years. What do you see happening to take the eurozone out of a period of extended low growth? Of course, we must also bear in mind that Japan started with extremely high employment, and maintained it. The eurozone is starting from a point of extremely low employment and high unemployment, particularly youth unemployment. That is really unsustainable over 10 years. Nicky Morgan MP: Thank you very much for the question. I have to say that it is not something that I have studied in great detail, so if there is anything more that I should have said that occurs to me afterwards I will certainly write to the Committee. Everybody involved in any aspects of government throughout the most recent years and the crisis that has unfolded across the euro area and the world is very conscious of what has happened in Japan and of the “lost decade”, as they call it. When you look at the European Council decisions over the past few months and all the work that has been done on issues like Europe 2020, they are very conscious of youth unemployment and the measures that need to be taken there. The ECB definitely cut interest rates last week. Lord Hamilton of Epsom: To a quarter of 1%. Nicky Morgan MP: Absolutely. That is a cut. I have read through the Council decisions from last October and June. Growth is very much on the agenda among all member states. We know that it is very much on the agenda of the UK Government. The underlying inflation rate is at 0.8%. Everybody will be, and is, working very hard in the Council and the Commission not to have a decade of no growth. However, we have seen that more needs to be done—things like cutting the burden of regulation, which the Government have been very hot on.

316 of 441 HM Treasury, Nicky Morgan, Economic Secretary and Peter Curwen, Director Europe— Oral evidence (QQ 316-331) Lord Flight: I have a short supplementary. The German internal devaluation medicine obviously drives down the economy. The countries cannot have their own monetary policy because they share a currency. That leaves the crucial issue of whether Germany will permit the ECB to follow monetary policy analogous to what Japan is doing right now. The answer at present is that Germany is absolutely not. The Chairman: Minister, would you like Peter Curwen to come in on that? Peter Curwen: It is always best, perhaps, not to second-guess the ECB; it jealously guards it independence, much as the Bank of England does now. I would say that the ECB has been quite active, particularly under Mario Draghi. Nearly two years ago it had a long-term refinancing operation to help banks and liquidity in the euro area. Last July, and then September, it announced the outright monetary transactions programme to which the Minister has already referred, which as the Minister notes has probably been the single biggest thing to help provide reassurance and confidence to the euro area. You make the point that underlying inflation is low. It is positive that there is growth. It is very weak. None the less, the euro area has moved out of recession and that is important. Part of the GEMU discussions that we are about to discuss comes back to your question about how you can make the structural reforms to improve competitiveness across the euro area. A lot of the euro-area governance reforms over the past three to four years have focused on the macroeconomic, as the Minister said: on the sovereign side. On the banking side, a number of the GEMU reforms are more focused on the microeconomics. That probably goes to the heart of improving the competitiveness of the periphery of the euro area, so that the euro area as a whole can become stronger. The Chairman: Minister if you do not want to add to that, I will go to Lord Dear. Lord Dear: Unless you wanted to add to that? Nicky Morgan MP: No. We have probably said all we can say about Japan at this time.

Q319 Lord Dear: Minister, I would like to swing the focus on to the single market and ask you a direct question, which I think will probably be a precursor for much of what you are going to say on other questions later. To go straight to the point: do you think that there are any circumstances at all in which you could envisage the UK taking part in any of the elements of GEMU? That, of course, is against the background of our Government having made it clear over the past two or three years that they will not participate in the majority of these measures. There we are giving a view on GEMU that we are not going to get involved. Do you think that we will? Nicky Morgan MP: Having read through an awful lot of this before coming here today, one issue is that so much is still so uncertain. I go back to the quote I gave at the beginning: the Prime Minister has been very clear that we are not going to sign up to these things. It was made clear in the October Council decisions that these steps were voluntary for the euro- area outs. The single market is incredibly important to the United Kingdom. It is something very much at the forefront of all Ministers’ and officials’ minds when they go to Brussels. It is probably dangerous in any government negotiations to say “never say never”, but the Prime Minister has made the position clear. For those who are part of the euro area, there are things that they will want to do in order to provide a stable euro area, which is important for us, but we as the UK are not going to get involved in them. Lord Dear: At all? Not even giving advice to countries who are themselves participants?

317 of 441 HM Treasury, Nicky Morgan, Economic Secretary and Peter Curwen, Director Europe— Oral evidence (QQ 316-331) Nicky Morgan MP: I think the important point is that the UK has a place at the table in these discussions. I think that we are going to come on to that. Some of the questions talk about the influence of the United Kingdom. Certainly from my experience last week at ECOFIN, and from the Financial Secretary’s experience on Friday, I would say that the UK is very influential and listened to. However, we are not part of the euro area, and those countries will want to do things that we as the UK will not sign up to. That does not mean that we are not influential and giving our opinions on them. Lord Dear: Of course, the obvious question that is bandied around in the media and elsewhere all the time is how you can give advice if you are looking through the window rather than enjoying the party. Nicky Morgan MP: I am not sure that you have to be a part of it in order to give advice. People certainly look to the UK for our view on things, even if we are not signed up to them. Lord Dear: Do you think they will continue to do that even though we are still looking through the window and not taking part in the room? Nicky Morgan MP: It is always very difficult to speculate on what is going to happen. We all know that all the negotiations that we are talking about this morning move very quickly. Certainly, my experience of ECOFIN last week, which I will perhaps come on to discuss in a moment, was that the UK was very much a central part of decision-making at the EU level. The Chairman: One table that we are not at is the Eurogroup. Do you have conversations with Dijsselbloem or anyone there? Do you find your absence from the Eurogroup impeding the ability of the UK to affect the changes that might be desirable? Nicky Morgan MP: Peter has more experience of this than I, so I will let him answer. Peter Curwen: We have conversations with Dijsselbloem. We see him all the time. The Chancellor had lunch with Finance Minister Dijsselbloem in Downing Street last Monday, at which I was present. We have a ready track with the chair of the Eurogroup. We had a very good lunch in both senses. It was a useful set of discussions. On the Eurogroup itself, it is entirely appropriate that it discusses issues that are relevant to the euro area. We have various mechanisms through which we can contribute to that discussion. At the Economic and Financial Committee level, which is the group that prepares ECOFINs, there is now a Eurogroup working group. However, there is always a read-out of the Eurogroup working group’s discussions, normally of the previous night, to the EFC. Indeed, a number of discussions at the EFC, at which I am present, cover euro-area business. Say there is a discussion on the Greek economy. It is not as though that is not discussed openly at the EFC quite regularly. At ministerial level, a breakfast now precedes every ECOFIN meeting, which starts with a read-out from Finance Minister Dijsselbloem on what the Eurogroup discussed the previous night. At the ECOFIN we attended on Friday, they obviously discussed the exit of Ireland and Spain from their programmes. They also discussed with us, and the Commissioner presented, where the euro area was on its latest growth numbers. The Chairman: But that is not the same as being in the room when matters are discussed, is it? Peter Curwen: Matters that are relevant for the 28 are discussed at 28. That is my understanding. Indeed, that is what has happened. That is the experience that we have had. We fully accept that there is a risk, of course. That is why we have a number of safeguards, and we will come on to those. We have built in a number of safeguards. I think the view that

318 of 441 HM Treasury, Nicky Morgan, Economic Secretary and Peter Curwen, Director Europe— Oral evidence (QQ 316-331) the euro area is always and at all times a united body, particularly on financial services issues, is not right.

Q320 Viscount Brookeborough: Minister, I get the feeling that although we all believe in the same things as far as the area goes, our attitude and the impression that we give are quite negative. One of the comments that you made earlier was that we are taking part to protect our national interest. That is absolutely true, but would it not perhaps be a bit more appropriate if we started off by saying that we are taking part to try and make the euro area a better area for us to live in and to co-operate with, that we wish to improve that, and that in doing so we will also protect our national interests? I just get the impression from the way in which our conversation has been going that the result of the impression given to other people, and definitely to other countries within Europe—when we were in Germany, it came over—is their thinking, “Well, if you go on with this impression then, quite frankly, at some stage we are going to cut our losses”. Nicky Morgan MP: All this must depend on who you speak to. Viscount Brookeborough: But Germany is quite important. Nicky Morgan MP: Well, absolutely, and I think that the Prime Minister and Chancellor Merkel have a very good relationship. One of the things underlying all the issues that we have discussed this morning is the formation of the new German Government, which will have a significant impact on everything. Germany is a significant EU player. I am sure that you are right. The Prime Minister has made it very clear that we firmly believe in EU membership. There are benefits for the people of the United Kingdom and we derive great strength for our businesses in the free movement of goods and people. I have no reason to disbelieve that we give that impression. There are of course some people who want to go further and faster. They are part of the euro area. We have made it clear that we are not going to be part of that, but we very much play our full role in other aspects of the EU. I go back to my original point, which is that it would very much depend on who you were to speak to. Lord Kerr of Kinlochard: Minister, I would like to go back to your exchange with Lord Dear and go a little deeper into the tension between what you rightly said in your introductory remarks about their needing closer economic and fiscal integration, and our position as great believers in the single market. The single market operates by qualified majority, thanks to Mrs Thatcher 30 years ago. They are a qualified majority, the eurozone- plus. When they were talking about economic integration, we chose to stand outside with only the Czechs for company. How do you drive the deeper integration of the single market, which is what we want, if you are not involved in the process of economic integration, which is what they want and you, in my view rightly, say that we should want because we want to euro to succeed? Nicky Morgan MP: One example I can give you is the securing of the double-majority voting on the single supervisory mechanism. Lord Kerr of Kinlochard: I am talking about the Council, not the EBA, and voting in the Council, where we now do not have a blocking minority. When I was in the Council, on all financial regulation we were never outvoted, partly because we were thought then to believe quite strongly in the European Union and partly because it was German policy never to vote the British down on anything to do with financial regulation. That seems to have gone. I think you have come to a fascinating job in interesting times, in the Chinese sense. How are you going to manage that tension? Would it help if we appeared to care a little more, to be less

319 of 441 HM Treasury, Nicky Morgan, Economic Secretary and Peter Curwen, Director Europe— Oral evidence (QQ 316-331) concerned about preserving the UK’s position, and to be less defensive? Would it help if we had a more positive agenda about deepening the single market? Nicky Morgan MP: To start at the end, we do have a positive agenda. We are wielding— Lord Kerr of Kinlochard: That is not really what comes across, to be honest. If you travel around the continent, you hear about a very defensive Britain, anxious to protect its position and not to lose out now that we are in this minority position. One does not hear much about positive British proposals. While the Prime Minister made some in that first section of the Bloomberg speech last January, we still have seen no action in the Council to follow up on a single one of the things he mentioned.

Q321 Lord Vallance of Tummel: Minister, you have covered quite a lot of ground that I was going to cover anyway, but let me push it a little bit further. Tactically, it seems to me that we have not got this quite right. Tactically, it might have been better to have agreed to some facets of GEMU, something that was not too bad for us, at least to have got ourselves involved in a positive way. All that I hear from my European colleagues is just what Lord Kerr has just said: that the UK is now seen as being negative, that it is pursuing a prime objective of protecting the national interest and not doing very much else. Even if you had some small ground where you were directly involved, I think that we would gain tactically. Perhaps I can ask you whether there are any specific facets of GEMU that do not have significant negative impacts on the UK which other member states would really wish us to be involved in. Are there any where you are finding some degree of pressure or demand from other member states for us to get directly involved? Nicky Morgan MP: No. Lord Vallance of Tummel: Nothing? Nicky Morgan MP: No. Peter Curwen: I have been present not at European Councils—I have been there, but they are just for heads of Government—but at SHERPA meetings, which help to prepare those European Councils. When we set out our case, as the Minister has done, at no point in the SHERPA meetings is there a demand for us to be part of the GEMU. The Prime Minister has secured language in each of the European Council conclusions. He has obviously had to secure it, but there has not been great pressure against us securing that language: that it is voluntary for all outs. The other aspect, I think, is that rightly, because the Government and Parliament have taken a view, we are not going to be in the room when euro-area programmes are produced and cheques have to be written. At those points it is quite right that we are not in the room. If the euro area is doing a programme for Greece, for example, or for Cyprus, the UK Parliament has taken a decision, collectively, that we do not wish to write cheques for that. In those circumstances, we should not be in the room, and we are not. However, this view that we are never in the room is a slight myth. I am sure that we will come on to this, but the European semester brings together a lot of what we are discussing, and I am sure it will bring in parts of GEMU as well as EU 2020, the annual growth survey and everything else that the Commission produces. It is a very complicated process. We are fully part of that. All 28 discuss that, and we contribute as positively as anybody else in those discussions.

Q322 The Chairman: I will just detail this to you before I bring Lord Vallance back. When we were in Germany two weeks ago, one of our witnesses said to us that Germany is

320 of 441 HM Treasury, Nicky Morgan, Economic Secretary and Peter Curwen, Director Europe— Oral evidence (QQ 316-331) in the Eurogroup meeting, and then comes out and finds again that it is again among like- minded friends, in the case of UK, Sweden and so on. The point is that we were not in there when the decisions were being formed and facilitated. Nicky Morgan MP: I am sure the Committee is well aware of this, but it is worth revisiting the successful budget negotiations and the MFF which the Prime Minister secured working with like-minded nations. I was at the ECOFIN meeting last Monday discussing the 2014 annual budget, working very closely with Germany, France, the Netherlands, the Danes and our Swedish counterparts. It is a mistake to think that somehow the UK is on the outside, not in the room, not at the table, which is the language that I am hearing this morning. That is not the impression that I have gained from my first ECOFIN meeting, and that is not what Peter is saying from his years of experience. As always with these things, to go back to my point to Lord Kerr, it depends who you speak to when you visit various European capitals. If you were to conduct the same evidence sessions in the UK and ask about perceptions of how Germany or other countries in the EU are seen, everybody would have their own perception and see an involvement through their own prism. The budget negotiations, the MFF, the emphasis on youth unemployment and the reallocation of the budget lines show clearly that the UK has been winning the arguments. It goes back to the point about the emphasis on growth. As I say, I was reading through the different Council decisions from June and October this year, and I can clearly see the Prime Minister’s and the UK’s involvement in those decisions. Lord Vallance of Tummel: I have to say that I disagree with you. The reaction that we got on our visit to Brussels before going to Germany was just the same: that the UK is seen as being overly negative, protecting its own back, and not getting involved in as positive a way as our European colleagues would like. I get exactly the same reaction from colleagues on boards of German companies, so it is not just the political class that I am talking about; it occurs elsewhere. That brings me back to the question: is there nothing more that we could do on the positive front? It may well be that in SHERPA meetings nobody is making demands of us, because they know that demands are unlikely to be pursued. But if we were to take a positive stance, is there anything that we could do and become involved in, because an earnest intent would pay huge dividends? Nicky Morgan MP: The UK has made it very clear that we are not part of the euro area and we are not going to be part of the mechanisms that we set up. We very much want there to be a stable euro area. That is good for all EU member states, and generally for the EU’s position in the world. You might have a principle, which is not being involved, but everything is always kept under review. As I said before, it would be foolish of me as a new Minister to sit here and say “never say never”, but I think the UK has made its position very clear, and if you start chipping away it is better to concentrate on the things on which we are focused. I go back to the issues of the EU budget, to youth unemployment, to growth within the EU, and say to those who want to be involved in closer fiscal and economic integration, “We will support you and we will offer advice, but at the end of the day it is very much for those involved in the system to take part in that system”. Peter Curwen: On the point about the European Council that we have just had, a very large part of those conditions—I do not have them with me at the moment—are about better regulation or regulatory fitness. That agenda was driven very much by the Prime Minister. He had a better regulation task force, and he had a breakfast with at least six or seven leaders prior to the second day of the European Council which Mark Bolland, the ex-CEO of Marks & Spencer, addressed. This is an agenda that the UK is leading, obviously with supporting and influential people such as Chancellor Merkel. It is certainly true that where

321 of 441 HM Treasury, Nicky Morgan, Economic Secretary and Peter Curwen, Director Europe— Oral evidence (QQ 316-331) the euro area has specific issues and concerns, and where legislation is agreed that is specific to the euro area and which we have supported, we are not going to be privy to those conversations. Nicky Morgan MP: And that is right. Peter Curwen: We should not feel upset, but where I would agree with Lord Kerr is that we have clearly had to be vigilant, more vigilant perhaps than when he was the ambassador in Brussels, that what the euro group does does not stray into the single market, and we have to be vigilant to ensure that we police that and that we have safeguards—as the Minister said, we have put safeguards into the EBA—and we will continue to do that. It is a different way of operating in Brussels than perhaps in the past. It is not something that we should feel defensive about, because we have supported it. The Chairman: I think that too many of the answers from you, Minister, have pointed to other areas where the UK may or may not have had success, but I remind you of what you reminded us about, which was George Osborne saying that it was imperative for the United Kingdom that we get this right about the euro area. You are before us today to talk about genuine economic and monetary union. I am going to call upon the Earl of Caithness, because he, too, was in Brussels when we took evidence there.

Q323 Earl of Caithness: Minister, what we have just been going on about is, I have to say, nothing new. I remember many of these points being put to me when I was Treasury Minister 20 years ago when it was the question of the ERM; we were not in the room. Jacques Delors said that we were right all along, but it is a bit late. How do we get our point across? You carefully explained what we do at ministerial level, and we all understand that, but what about the City of London? Do you feel that it is being listened to by the Commission? Is there more that industry and the City should be doing to beat the drum for the UK and not just rely on you, or is there more that you as a Minister should be doing to facilitate access to them? I am similarly stirred in our discussions on the financial transaction tax, where it appears that some very sound opinion in the City has not been listened to by the Commission, which is why we have the messy situation now. Nicky Morgan MP: We have taken legal action in relation to the FTT, so proceedings are ongoing, and I think the UK has made its position clear on that. I know that the Committee has looked at that very helpfully, so thank you. There is a tremendous opportunity for the City of London in relation to banking union. We have a fantastic City. I have not discussed it with him, but I think that the Prime Minister, of all Ministers, goes out there and bangs the drum for the City of London at all possible opportunities when discussing issues relating to banking union in the EU. From my experience, having worked in the City for many years, I know that it has its own excellent contacts with the EU, and that is something that we probably need to build on. There are great relations between the Treasury and the City and, as I say, we will raise the opportunities for the City and talk about them at all possible times in EU meetings when issues of banking union are being discussed. Earl of Caithness: Do you think that there is more that certainly you and the City can do to present it as Europe’s financial centre rather than just the UK’s? That has a negative influence too if it looks as though it is just the UK’s. Actually, the City benefits the whole of Europe. Nicky Morgan MP: Very much so. Peter might want to come in here, because he has been at meetings where this has been discussed, but I think that is absolutely right. It has to be presented in a positive light, and you are absolutely right that London is there for the whole

322 of 441 HM Treasury, Nicky Morgan, Economic Secretary and Peter Curwen, Director Europe— Oral evidence (QQ 316-331) of the EU and for member states and is not just the UK’s financial centre, very important though that is in the UK’s economy. Peter Curwen: I have the chance to meet interlocutors regularly not only in the City but in the EU itself. The City is a major financial centre. Its major competitors are still Singapore, New York, Hong Kong and what have you, and it is greatly to Europe’s benefit that there is the City of London within the European Union, but I completely agree with your point that the City is an EU asset, not just a UK one. We should all do more collectively, including the City, to spread that.

Q324 Lord Kerr of Kinlochard: I would like to ask two sets of questions. The first one, I promise you, is a high lob that you can smash. What are the prospects of banking union developing a resolution mechanism and of agreement being reached before the European Parliament election and the break next summer? We have formed the impression as we go about taking evidence that what Schäuble calls a timber-frame resolution mechanism—a sort of loose interlocking network of national resolution authorities—is quite likely to be agreed before the spring, but that a single resolution mechanism is unlikely to be agreed before the spring? Do you agree with that, and will the timber-frame one do? Nicky Morgan MP: I suppose the answer to the latter question is that it is a question for those within the banking union as to whether they feel that it is sufficient or not. The UK continues to believe that a well designed single resolution mechanism is going to support the longer-term stability of the euro area. That is what we want to see. In terms of timing and negotiations, I am new to the EU, but it seems to me that things take quite a long time to get. In December 2012 the various Presidents tabled their proposals, and we are now almost 12 months later. I think the Lithuanian presidency is making good progress. It is clearly putting a lot of effort into many different aspects of the negotiations, and the President has made clear his intention to reach a Council general approach as soon as is feasible. Obviously the December Council meeting is approaching, and we do not have long after that before the European elections are upon us. I have mentioned already that the new German Government are very important in terms of how this whole area is going to develop. My understanding from the Council is that we will not get any proposals until January. Peter Curwen: I have a quick point to make on where we think we will be. It is a good question. The ECOFIN last Friday highlighted that there was quite a gap within the Council on a very large number of issues: scope, financing— Lord Kerr of Kinlochard: Mr Curwen, I think we know that. We are trying to find out what the Minister thinks should happen, and whether what we’d like to happen will happen. Your answer, Minister, was that that was a matter for them, but honestly it is not: it is a matter for us too, because if there is chaos in the European banking system, that is particularly bad for us because of the importance of the City, as you and Mr Curwen have just explained. My second question, which was meant to have a little more spin on it, is about the legal base for the single resolution mechanism proposal. The Commission has proposed a single market legal base, which in some respects might be ideal from our point of view because we have full rights, we are in the room, and there is no question of separate treaties. It is not a eurozone legal base under which we would have sort of honorary membership rights: in the room but below the salt.

323 of 441 HM Treasury, Nicky Morgan, Economic Secretary and Peter Curwen, Director Europe— Oral evidence (QQ 316-331) The Commission propose a single market legal base, which in some sense one would expect us to welcome. I understand the reasons why we are in extreme defensive mode and resisting the legal base; if a resolution authority closes down a European bank and economic operators sue, there could be immense damages. If we were liable for our share of the damages for the action of a resolution authority over which we do not have control. I can see that that would be very risky. Ideally one would find a way through. It seems to me that the single market base is based on that. We do not want the single market to split, but we need safeguards; we need some kind of mechanism or assurance that we would not be liable for the consequences of decisions taken by a resolution authority to which we did not subscribe and that was not responsible for our banks. I would have thought that the Commission would be likely to agree with that because the Commission, too, wants to maintain the integrity of the single market. Is that what we are trying to do? What I hear is that we are being extremely defensive, and of course we see that the Government are contesting the legal base, which means in a way retreating into our shell and saying, “No, it is not to do with the single market, it is to do with the eurozone. It is nothing to do with us”, and back to your first answer Minister, that it is up to them and nothing to do with us. The Chairman: To give a very immediate example, what if a German or French bank based here in London had difficulties? Would you expect the British taxpayer to help to resolve the matter? Lord Flight: Absolutely not. Lord Kerr of Kinlochard: I would argue that that is out of the question. In order to ensure that it is not out of the question, it seems to me that we do not need to contest the legal basis. Am I wrong about that? Nicky Morgan MP: I do not think that we are contesting that. We are keeping it under review. You have just highlighted, Lord Kerr, exactly the issues that surround it and why it is not an easy issue to resolve. My predecessor, the former Financial Secretary Greg Clark, set out in an Explanatory Memorandum to the Committee back in July the issues around the legal base, and that is a helpful memorandum to refer back to. You have set out the difficulties, the reason why it has been kept under review and the reason why I cannot tell you as of today that this is sorted. Lord Kerr of Kinlochard: But what are you trying to do, Minister? What is the aim? I was discouraged when you said that it was nothing to do with us and is up to them. I think we now agree that it is to do with us, because it could go extremely badly for us. Nicky Morgan MP: I am not saying that the single resolution mechanism is nothing to do with us. I can tell you exactly why we want it, and I think you captured that in your question to me: we want there to be the most stable possible euro area and banking union. That is in the UK’s interests and the interests of all member states. When we see proposals on how we get there, that is the time to evaluate them and to decide whether they meet the criteria. You asked me for criteria, and that is the ultimate criterion and objective of the UK. We must have the clearest, strongest possible legal base so that there is no doubt. The questions that Lord Harrison has put about what would happen to an overseas, or German or French, bank based in the UK have to be part of the decision-making. I hear Lord Flight’s immediate reaction, and I think that the British taxpayer would agree.

324 of 441 HM Treasury, Nicky Morgan, Economic Secretary and Peter Curwen, Director Europe— Oral evidence (QQ 316-331)

Q325 The Chairman: Before I turn to Lord Hamilton and Lord Flight, perhaps Peter Curwen could return to the negotiations on banking union. You were giving us a bit of an update. Peter Curwen: Yes. There was discussion. It was one of the major items at ECOFIN on Friday. As I have just described to you, there is quite a distance between member states within the euro area: those who are going to be funding this single resolution mechanism and those who are party to the single supervisory mechanism. As for Lord Kerr’s question, it is always difficult to judge how quickly these negotiations will progress. I still think that the Lithuanian presidency will manage to produce a general approach in time for the European Council. That will be what they will try to do, but we will see. Earl of Caithness: Before December? Peter Curwen: Yes, before December. That is the general approach of the Council, and then it would of course have to go to the European Parliament, and as Lord Kerr rightly says there would then be a timetable until April or about then. But there are a very large number of issues, including the one that Lord Kerr highlights on the budget liability point. On that, as we said in the EM, I completely concur with everything that Lord Kerr has said. It is one of the issues that we are focusing on, as well as on equality of treatment between those who are outside and those who are inside in terms of, for example, the way in which the EBA applies itself, and also ensuring that there are no conflicts of interest for the Commission. I know that you have written a letter to this effect, but one of the issues that we have is if the Commission is both the resolution authority and the state aid policeman, how do you marry those up? That is a complicated question and one that we are thinking about. As the Minister said, on the legal base, it rather depends where this negotiation ends up. The nature of the resolution body, for example, and how financing is done, particularly in the transitional period, what back-stops there are, et cetera, are all very complicated questions. It is almost like a simultaneous equation between that and the legal base. That is why we are keeping it under review and cannot give you an answer. The Chairman: Colleagues, we have less than half an hour with the Minister, so I am going to press on. Lord Hamilton, will you table your comment, and then I want to go immediately to Lord Flight for his question?

Q326 Lord Hamilton of Epsom: I am interested that Draghi has announced that there are going to be stress tests by autumn next year, which seems to me to be necessary but rather late. Are we confident that there will be resolution mechanisms in place? If you have a stress test with no resolution mechanism, you will have everybody queuing up to take their money out of the banks. Nicky Morgan MP: You are absolutely right. The Government are supportive of the stress tests in terms of deciding how any issues are going to be dealt with. I suppose, however, that that does not mean that we should not get on with doing stress tests. It is better to know what the problems are. Viscount Brookeborough: If the stress testing shows that there are problems, in light of the fact that the resolution fund will not be in place by then, how would you expect it to be financed? Peter Curwen: There are two separate things, which get conflated. The ECB is undertaking an asset quality review. The EBA will undertake stress tests. The ECB is just for the banks that are covered by the euro area, and the EBA tests will be EU-wide. The point you make on back-stops is genuine and correct. On that, the easiest thing that we could do, because

325 of 441 HM Treasury, Nicky Morgan, Economic Secretary and Peter Curwen, Director Europe— Oral evidence (QQ 316-331) this is a big issue within the Council, is to agree that Council statement we agreed at ECOFIN on Friday on banks’ asset quality in the view of stress tests, including our back-stop arrangements. Rather than me going through all that—it is pretty comprehensive—maybe the thing for us to do would be to send that Council statement to you, because that then covers that point. Lord Flight: I think we have slightly overtaken my territory. The issue is what sort of banking union may emerge and whether it will be any use. Our impression so far has been that there is no problem with supervision and that there are close relations between the Bank of England and the ECB, and to some extent the Bank of England is designing the ECB’s regulation arrangements. That is good news. In terms of resolution, the Germans made it absolutely clear to us that there is no chance of them putting up any common money. They are terrified of it, partly because of East Germany and all the rest of it. They made it clear that they expect a resolution mechanism where a country that has a bank in trouble, potentially resulting in a stress test, will have to bail it out itself. Therefore, they are completely denying the objective of it, which is to separate banking and sovereign debt problems. If the stress tests do reveal big holes, it is clear that Italy, Spain and France will have to cough up huge amounts themselves to put their banking systems right. I think that is unavoidable to some extent anyway, whether there is banking union or not, but that is the reality of the situation. The various pits of money that already exist could only be used in absolute crisis. On common deposit insurance, again, there may be similar amounts in the same countries, but Germany will insist that the common deposit is the liability of each country. The Chairman: Lord Flight, would you like to ask a question of the Minister?

Q327 Lord Flight: Absolutely. We have got out of sequence, which has caused a problem. The question is: is the banking union that we are likely to get worth having, or is it going to worsen the problem? The second question is that some extremely misguided people have said, in order to sort of cosy up to the EU, “Wouldn’t it be a good idea if the UK participating in banking union?”. To my mind, it would be absolutely crackpot. Down the line, although not now, it could involve us coughing up large amounts of money. The Chairman: Lord Flight, if we could hear the Minister’s views rather than yours? Nicky Morgan MP: I enjoyed listening to Lord Flight’s views. The Chairman: We always enjoy Lord Flight’s views. Lord Flight: I think it is time the Committee is made aware of some fundamental points to be asked. Nicky Morgan MP: Thank you. Your reporting of how the Germans see things was very helpful. It will back-stop what we thought, but it was very helpful to hear. I notice that there was an article yesterday in the Financial Times about the ECB and some comments on Germany’s position on various things. You mentioned the common deposit insurance, which I understand, after being suggested last year, has not got any further. I hear what you say about banking union overall. I go back to my original point, which is the need for a strong and stable euro area, the Chancellor’s remorseless logic, the need to avoid a repeat of the crisis— The Chairman: Minister, let me stop you there. Do you think that a common deposit insurance element is required? That was the view that was taken: that banking union had to

326 of 441 HM Treasury, Nicky Morgan, Economic Secretary and Peter Curwen, Director Europe— Oral evidence (QQ 316-331) have all three prongs to succeed. You rightly identify that that last element is falling off the agenda. What is your view of that? Nicky Morgan MP: The President of the European Council set out the three issues. If the view is that you need three, then if you do not have three that is not as ideal. The Chairman: I am asking you, with George Osborne saying that it is of imperative interest to the United Kingdom that we get this right—almost implying his own version of Mario Draghi’s “We will do what it takes”—what you will do. Nicky Morgan MP: What would I do to—?

Q328 The Chairman: In terms of the deposit insurance, that third element of the banking union, does it worry or concern you that that appears to be falling off the agenda? Nicky Morgan MP: The important point when a bank falls over is to give reassurance to those who have deposited the funds there. If that is deemed to be a critical part of giving banking security, and is not a part of the system, one would have to ask why it is not and whether, in Lord Flight’s words, we have ended up with a banking union that is not what was originally envisaged. That is if we end up with banking union. As we discussed and were exploring earlier, there is still a lot of work to be done at a European level on this. Lord Flight: The point about common insurance is that if people start to get worried about Italy, they will obviously move all their deposits from Italian banks to German banks. It seems to me that that is unavoidable because Germany is not willing to pick up the bill for a common deposit insurance system. Nicky Morgan MP: Yes. The Chairman: Are you happy that the 2018 date for the bail-in is part of the resolution mechanism? Would you like to bring it forward earlier? I do not know whether Peter would like to help us here. Peter Curwen: The language in the BRRD was that the bail-in will occur by 2018 at the latest. That was the language: “at the latest”. It is certainly the case in the context of the discussions that we are having on the SRM, for example, that that bail-in date is very relevant. It comes back to Lord Flight’s point about the German appetite to stand behind aspects of the European resolution mechanism and what have you. If a bank is in difficulty, they want first to go to private sources— Lord Flight: And bail-in second. Peter Curwen: Then you go to national frameworks and, finally in the hierarchy, you go to the European level. Lord Kerr of Kinlochard: We understand that, and your descriptions of other people’s positions are fascinating, but we want to find out about the British position. Let us take a very simple issue. How big should the resolution fund be? The European Parliament says €150 billion, but the talk in the Council is of €47 billion or €48 billion or something. What is the UK prescription? Peter Curwen: That is not something that we can answer at the moment. We are not putting the money into that. Lord Flight: It is none of our business. Peter Curwen: It is a matter for Germany and others. We absolutely want a single resolution mechanism to be credible for the reasons that the Minister has set out. That is

327 of 441 HM Treasury, Nicky Morgan, Economic Secretary and Peter Curwen, Director Europe— Oral evidence (QQ 316-331) clear. However, it is up to those who are going to be party to this—certainly the 17 current members of the euro area—to deal with that themselves. This is a complex negotiation that has a whole series of interlocking issues. It is not one that I am prepared, now, to speculate upon. Lord Kerr of Kinlochard: I entirely agree about complexity. I would just love to know where we are trying to go. Nicky Morgan MP: We have already set out where we are trying to go. We will judge as a United Kingdom whether what we have ended up with has given the stability to the euro area that we are all, across the EU, seeking. However, to ask us to speculate on a number, to go back to an earlier point, would undermine British influence. If we, as the UK, were to sit down at a Council meeting and say, “It must be this number, and if it is more that might be fine but less is not good enough”, that would confirm the view that the UK was trying to be far too—. It would be much better to negotiate and to arrive at a situation. Peter Curwen: My fear is that that would really irritate our partners in the Union. The Chairman: I am going to invite Baroness Maddock to contribute, because she gives an example of when we want to fulfil the ambitions of the United Kingdom for the construction of GEMU. This is a practical example of what we will have to concern ourselves with.

Q329 Baroness Maddock: As part of the plans for GEMU, there have been proposals for convergence and competitive instruments, the idea being that these will encourage structural reforms through rewards and sanctions. What is our attitude to this? Do we think that this is credible? Is it effective? We have tried to do some of these things in the past. Are people going to obey any more than they did in the past? How can we enforce them more than we did in the past? You touched in your very early comments on Europe 2020. How does Europe 2020 fit with all this? Nicky Morgan MP: My understanding is that the convergence and competitiveness instruments are one possibility. They are put forward in particular by President Van Rompuy, but reading my briefing pack I understand that “contract” does not mean contract as we would understand it. The question then is what it does mean, which opens up a number of other questions. The basic idea of having some sort of solidarity mechanisms whereby countries are incentivised to put reforms into place and they get recognised for having done that is potentially the right way to go. It is certainly one of the possibilities, but it is very much out there for discussion. We have not seen any details yet. Contractual arrangements can certainly play their part, but a question arises if they are not legally binding. Your question went on to mention enforcement. If there was enforcement, there would need to be some sort of potential sanctions mechanism. What would happen if you did not follow the thing you had signed up to? What would the sanction mechanism be? All those issues are still very much up for discussion. There seems to be a range of views from different member states as to what they would consider to be a contract, in the loosest sense of the word, that would do the job of what the CCI has been put forward for. Europe 2020 is different from what we have been discussing until now. It is very important and all the EU 28 are very involved in it. The UK has been very involved in it, and it is a combination of co-ordinated efforts to have the greatest impact on growth and jobs. There seem to be some very good headings there. Things have been well thought through and there are things that we need to be doing as the EU. Obviously GEMU is different. We have already talked the euro-area countries being part of that. Europe 2020 is still very much on

328 of 441 HM Treasury, Nicky Morgan, Economic Secretary and Peter Curwen, Director Europe— Oral evidence (QQ 316-331) the agenda and is still very much talked about and pushed forward. The UK is very supportive of it and very much involved in it. Baroness Maddock: I was really asking whether you could indicate for us, because this is what we want to know, how the two go together. How do the proposals in GEMU go with the 2020 strategy? We have talked about some of the issues. Nicky Morgan MP: Peter will correct me if I am wrong, and obviously he has far more experience of this than I have, but it seems to me that they are different things. They might work together ultimately. I suppose what I am getting at is that it has to do with a stable euro area and a good rate of growth. Europe 2020 is already there; it is a programme, it is signed up to by all 28 EU member states, and as we have seen there is some growth in the EU, albeit weak growth. GEMU is very much about institutions and member states working together. We talked about the single resolution mechanism in banking. Perhaps it is better to say that they are two sides of the same coin; they help to get to where we want to get to, which is a strong and stable euro area and a strong and stable Europe with a strong growth rate. The Chairman: But do you agree that the sanction mechanism involves the withdrawal of cash from certain countries? Are you happy with that reprimand? Peter Curwen: I think we are getting slightly ahead of ourselves, because there are no firm proposals for what a contract would be, let alone a solidarity mechanism. When Lord Kerr and I discussed this last time, the stick was the absence of a carrot. That is still potentially where we are. To be frank, we are a very long way from understanding what those who want to be part of the euro area mean by contracts—as the Minister indicates, they will not be legally binding as contracts normally are— Nicky Morgan MP: Which we would understand by the phrase. Peter Curwen: —and what solidarity mechanisms there are. The question of where this fits, again, has not been resolved yet. There is quite a big push from the Commissioner that it should fit into the European semester process, of which we are a part. The euro area, for example, will cover that bit but within the wider EU semester. That is already a very complicated process, and there is no need to make it even more so. I think it is just going to get more complicated. The Chairman: Good news, Minister. This is the final question.

Q330 Lord Kerr of Kinlochard: We need to come back to the dreaded issue of treaty reform. Does this GEMU dossier that we are talking about require treaty reform? The Germans are wobbly from time to time as they look to the Karlsruhe court and wait for its decision. Most other people, very strongly in Paris, seem to think that treaty reform is not going to happen in the short term, so we will get the best GEMU that we can get without amending the treaty. Is that your prediction of what will happen? Nicky Morgan MP: I am afraid to say that it goes back to what is finally on the table. Certainly there is talk in the Commission blueprint of what I think they call “appropriate democratic legitimacy and accountability of decision-making” that would require major treaty reform. I think the question of whether treaty reform was required would depend on the issue of contracts and sanctions. I am not an EU treaty expert, but it seems to me that some of this is very significant and I would expect us probably to end up with some form of treaty reform, but without concrete proposals it is difficult in all areas to work out the extent of that treaty reform.

329 of 441 HM Treasury, Nicky Morgan, Economic Secretary and Peter Curwen, Director Europe— Oral evidence (QQ 316-331) Lord Kerr of Kinlochard: I certainly think that if there were a real single resolution mechanism as distinct from a timber-framed one, it would be very important to embed it at the highest juridical level possible, i.e. in a treaty, but I do not think that it is likely to happen in the short term. If there were an intergovernmental conference to amend the treaty, what would the UK position be? Would we come forward with a quite separate agenda and say, “You cannot have the treaty amendments that you want in order to build your economic and monetary union and safeguard your euro unless you give us the treaty changes that we want to take back powers to the UK”? Nicky Morgan MP: There are an awful lot of “ifs” in that sentence. Lord Kerr of Kinlochard: Then I will simplify it. Would our case be about what is best for GEMU, or would we make a separate case—one could almost say blackmailing—that, “Yes, we agree that you should deepen your closer economic and fiscal integration”, your phrase, “but we are not going to let you do it unless you give us what we want”? Nicky Morgan MP: As a new Minister, I would be a brave Minister if I were to second- guess the Prime Minister and No. 10’s negotiating stance, and as my advice on that has not been sought at this stage I would say that there are so many “ifs” in that sentence in the sense of timing, of where we end up, of where we end up in any other negotiations on wider issues, that I am afraid I will have to retreat to saying that we will have to see how these things go. As I think I have pointed out, there is an element of treaty reform that could be on the table. The Chairman: I am going to take some further comments from the Earl of Caithness, Lord Hamilton, and Lord Dear, and then we will close the session. Earl of Caithness: Given what you have said, Minister, where are the potential downsides for the UK, should the EU agree that form of banking union possibly in December, possibly in March, before the European Parliament is re-elected? Do you see any particular difficulties for the UK and what could be agreed on the table? Nicky Morgan MP: Again, I am a new Minister to all this, but given my years of commercial negotiations I would say that when any party or set of parties agrees one thing, there are always potential benefits but also difficulties for the other parties who are part of the wider grouping. I think we will have to see. I have hopefully made clear this morning that although we are not part of the euro area, the UK is very much part of the discussions. We have a clear objective, which as I said is a strong, stable, growing euro area. I think that all member states want to achieve that, so there will always be opportunities for the UK as well as potential difficulties, but it depends so much at the moment on where we get to at those Councils, as you said. The Chairman: I am going to ask Lord Hamilton to comment and then Lord Dear. Then I will come to a conclusion.

Q331 Lord Hamilton of Epsom: Is it not premature to talk about any form of treaty change, because it is quite clear that President Hollande will veto any question of any major new treaty, for the very simple reason that he has to put it to a referendum in France and he feels that he has almost no chance of winning it? Nicky Morgan MP: Thank you. Lord Dear: You have said all the way through, Minister, and I fully understand, that we want to be part of a vibrant and economically stable Europe. We have problems in Greece and indeed in other countries in southern Europe, and we have the German Council of

330 of 441 HM Treasury, Nicky Morgan, Economic Secretary and Peter Curwen, Director Europe— Oral evidence (QQ 316-331) Economic Experts talking about debt redemption pacts, which are really a sort of Marshall plan. I wonder whether the Government have any emerging views on whether we would applaud that sort of approach, as opposed to going back over the same ground vis-à-vis Greece, for example, and if so, what our position would be in round terms. Nicky Morgan MP: It is not something that I have considered or thought about. If it were to contribute to the strong, stable, growing euro area that I have talked about, then I think all options are to be welcomed. I think we would need to see clearly what happens when a new German Government are formed and where they end up. We have been through a significant euro-area crisis and a significant world economic crisis, and there are big issues still to be tackled within the EU. What goes to the crux of the discussions that we have had this morning is the fact that the matters on the table in front of the European Council and other bodies in Europe and before this Committee are not easy and are not going to be resolved overnight or immediately. But we welcome, as I say, moves towards the creation of a stable euro area, as that must be a good thing for the UK. Lord Dear: Are you saying that the Government welcome what the German Council of Economic Experts has said about looking in detail at some sort of debt redemption pact, or Marshall plan if you like? Are we in that position? The Chairman: I will say to the Minister that we will conclude it there. As I indicated before, I would be grateful if you could look at the transcript, correct it and improve on it. Could I ask you to collude with Peter Curwen and perhaps look back at some of the questions, including the last one offered by Lord Dear, and if you think fit would you be kind enough to write to us to supplement the advice that you give the Committee in this concluding round on genuine economic and monetary union? We know that we have had some tricky questions, and they do need to be thought through, but we would be very grateful if you could just go back over the transcript and not only correct it but indicate where you think you could help the Committee with further thoughts representing the Government’s point of view. We would be extremely grateful. Nicky Morgan MP: I would be very happy to study the transcript, and if there is anything that we can add that would be of use to the Committee we will certainly do so. The Chairman: Where you feel you may not have answered all the questions in full. Minister, thanks ever so much. We look forward to a prosperous relationship with you over the coming months and years. We wish you well in your new position and hope to see you here many times in the future. Nicky Morgan MP: Thank you very much.

331 of 441 Liêm Hoang Ngoc MEP and Elisa Ferreira MEP—Oral evidence (QQ 157-169)

Liêm Hoang Ngoc MEP and Elisa Ferreira MEP—Oral evidence (QQ 157-169)

Transcript can be found under Elisa Ferreira MEP and Liêm Hoang Ngoc MEP

332 of 441 Professor Otmar Issing, Professor Claudia Buch and Professor Jan Pieter Krahnen—Oral evidence (QQ 297-315) Professor Otmar Issing, Professor Claudia Buch and Professor Jan Pieter Krahnen—Oral evidence (QQ 297-315)

Transcript can be found under Professor Claudia Buch, Professor Otmar Issing and Professor Jan Pieter Krahnen

333 of 441 Syed Kamall MEP, Roger Helmer MEP and Sharon Bowles MEP—Oral evidence (QQ 209- 221) Syed Kamall MEP, Roger Helmer MEP and Sharon Bowles MEP— Oral evidence (QQ 209-221)

Transcript can be found under Sharon Bowles MEP, Roger Helmer MEP and Syed Kamall MEP

334 of 441 Professor Jan Pieter Krahnen, Professor Claudia Buch and Professor Otmar Issing—Oral evidence (QQ 297-315) Professor Jan Pieter Krahnen, Professor Claudia Buch and Professor Otmar Issing—Oral evidence (QQ 297-315)

Transcript can be found under Professor Claudia Buch, Professor Otmar Issing and Professor Jan Pieter Krahnen

335 of 441 Bettina Kudla, MdB/MP (CDU), Detlef Seif, MdB/MP (CDU) and Manfred Zöllmer, MdB/MP (SPD)—Oral evidence (QQ 287-296) Bettina Kudla, MdB/MP (CDU), Detlef Seif, MdB/MP (CDU) and Manfred Zöllmer, MdB/MP (SPD)—Oral evidence (QQ 287-296)

Evidence Session No. 24 Heard in Public Questions 287 - 296

THURSDAY 7 NOVEMBER 2013

Members present

Lord Harrison (Chairman) Viscount Brookeborough Lord Davies of Stamford Lord Flight Baroness Maddock Lord Marlesford ______

Examination of Witnesses

Mr Manfred Zöllmer, MdB/MP (SPD), Ms Bettina Kudla, MdB/MP (CDU), and Mr Detlef Seif, MdB/MP (CDU)

Q287 The Chairman: Manfred Zöllmer, Bettina Kudla and Detlef Seif, a very warm welcome in front of this House of Lords Committee researching the question of genuine economic and monetary union. And welcome to your interpreter, too. I hope that you will leap in at the appropriate moments to remind me that you may have to shoo-shoo a little bit to those comments that you want to understand better. I should tell Manfred Zöllmer in particular that Mr Meyer-Rix came before us just before lunch, as one of your back-office boys, to give us his views, so we have a little bit of an insight into the SPD. We have heard now from so many people here in Germany, and tomorrow we go to the European Central Bank and the Bundesbank in Frankfurt to conclude our investigations. We will then write up a report which we hope to publish in the new year. Our ambition is to help not only in the tense discussions that are going on in all the 28 member countries and 17 countries of the eurozone but beyond that. It is also perhaps to underline and explore a United Kingdom view of all this. Towards the end of the period that we have, we would be most grateful for your views. We will come to how we in the United Kingdom and the House of Lords can help aid and abet that particular process. It would be a good idea if the three of you would be kind enough to introduce yourselves and then perhaps I will begin some of the questioning. Bettina Kudla: Thank you, Lord Harrison. I extend a very warm welcome to you all. It is a great honour for us all to be here in the embassy and to talk with you about important topics. I am a member of the Finance Committee and the EU Affairs Committee. Detlef Seif: Hello, my name is Detlef Seif. One hour previously, I took part incognito in your lunchtime meeting. It was very interesting to hear the different points made about Europe and the European crisis.

336 of 441 Bettina Kudla, MdB/MP (CDU), Detlef Seif, MdB/MP (CDU) and Manfred Zöllmer, MdB/MP (SPD)—Oral evidence (QQ 287-296) Manfred Zöllmer: (interpretation) Thank you, Mr Chairman. I am glad that we now have the opportunity to continue the interesting dialogue that we started when a group of our committee visited the UK this year. My name is Manfred Zöllmer. As you know, I have been an MP since 2002 and am the deputy spokesman on financial and political affairs for my parliamentary group.

Q288 The Chairman: Just to add to that, we are most grateful to you for coming in at a time that is very difficult for the three of you, as of course you are having these important coalition discussions. We wish you well in that enterprise and look forward to some resolution perhaps sooner rather than later. We hope that that will prosper and do well. Do you think that the architecture of the genuine economic and monetary union, as it is being proposed, is for the most part a satisfactory architecture? Has it got the right elements to it for us to succeed and stabilise in the euro, or are there bits in the proposals which are perhaps unnecessary or even which might stand in the way and present problems further down the line? Detlef Seif: I shall speak in German, because it is better for the special language. (Interpretation) To answer this question, we have to think about the definition, because we have put the GEMU in reference to the further development of Europe and the crisis. Therefore the question first of all should be: what is this crisis we are talking about? Earlier, I found it quite interesting when Lord Flight spoke, and I was about to speak when Lord Davies came in and said, “Well, the crisis we are talking about really is not a crisis of the euro as such because that currency is pretty much stable; it is rather a crisis of the banking system and is also a crisis related to sovereign debt”. I agree that it is not a “euro crisis”, because the euro as a currency is stable; it is rather a crisis of the eurozone caused by states which, for lack of regulation and regulatory frameworks, were pretty much able to do whatever they wanted, which led to the bubbles, all the imbalances and all the consequences we know. Now the question is, as was proposed, whether some of these countries should be let out of the eurozone. Would that be a solution? Would that be helpful? Would it be possible? Would it be sensible? We have had long discussions on that proposal, and even our Chancellor said at the beginning, “Well, Greece is not really that important, so there would be no greater harm if we just said goodbye to them and did not support them”. However, as we know, the markets responded accordingly. As I indicated, we saw the reaction from the financial markets and we saw that even a country with a small GDP like Greece could lead to a development that could have resulted in a global disaster from a financial point of view, so it is really important for us to stick together reliably so that others can rely on the eurozone and in order to avoid such risks reoccurring. There are two tasks ahead of us right now, the first one being to deal with the crisis and the second being the right and necessary control mechanisms, not only for the eurozone and Europe but preferably worldwide. Things like the six pack and other macroeconomic control mechanisms levers are really important in this aspect. Quite frankly, I never really understood why the UK withdrew from a mechanism like the fiscal compact and other measures in favour of stability, because this stability is exactly what we need. The Chairman: Before I go on to Bettina and Manfred, just answer me this. I understand that the German for “genuine” is echte. Does there come with it the baggage that there is if you say “genuine economic and monetary union”? It sounds as though you did not have it before; that you were really playing around before. Or does it not have that kind of connotation?

337 of 441 Bettina Kudla, MdB/MP (CDU), Detlef Seif, MdB/MP (CDU) and Manfred Zöllmer, MdB/MP (SPD)—Oral evidence (QQ 287-296) Frank Gräf: (interpreter) I can give you a personal answer. If you speak about “genuine” or echte or wahr union, it means more than just “union”; it implies that it goes deeper, that it involves more.

Q289 The Chairman: Bettina, is there anything that you want to add to what Detlef said, because I would like to get a different perspective from Manfred? Bettina Kudla: (interpretation) I think that we are dealing with different kinds of problems here. On the one hand, we have the sovereign debt crisis, as we know, and I believe we also have the tools in place to deal with it. We regretted the fact that the UK was not able to join the fiscal compact. On the other hand, we have the problem of the financial markets, which in part led to the sovereign debt crisis, as we know. One of the key issues that we are discussing right now is the banking union, to enable the ECB to have oversight of the systemic risks and the systemically relevant banks. From our point of view, there are a couple of red lines, because, on the one hand, we do not want the small banks—by small, we mean those of under €30 billion of capitalisation—to be supervised by the ECB. We are also not in favour of a single deposit insurance mechanism. We believe that this should remain under national jurisdiction, but of course there is a need for greater harmonisation—things have already been started but not to the full extent. So the trick is to find the right balance between reliability and security on the one hand and, on the other, not to ruin the regional special characteristics which we want to preserve. The Chairman: Manfred, perhaps you could give us your perspective on that. Manfred Zöllmer: (interpretation) I pretty much agree, at least 95%, with what my colleague said. At the time of the Maastricht treaty, I think that people assumed that if you established legal limits for debt, for example, those limits would automatically be implemented economically, which was not the case, as we realised. First, a single currency of course demands greater integration to limit issues such as that. My colleague mentioned the high amount of sovereign debt in some of the countries, but, in part at least, that came about as a result of those countries having to save the banks, as in the cases of Ireland and Spain— Greece was always a different case. We also saw during the crisis that we did not have the necessary emergency mechanisms to deal with it, like you would have with the IMF framework for example. We were pretty much not prepared for the crisis which happened. I think that we are prepared now, at least to a certain extent. We would also have to verify our European institutions to see whether they were strong enough to withstand any risk in the future. To do that, reforms are necessary. The European Council should be given greater jurisdiction and competence and so should the European Parliament. We also have to recognise that the establishment of the eurozone changed the relations between the countries of the eurozone, which means that you need this greater integration to take into account of these new relations. The Chairman: Manfred, you imply that you are nearly there with 95% of what Bettina said. Manfred Zöllmer: No, what he had said. The Chairman: So you are with Detlef. Manfred Zöllmer: (interpretation) Bettina is not in the coalition with us. We are working on that. The Chairman: But what we can say is perhaps there is a German view of banking union developing. Is it distinct from a French view?

338 of 441 Bettina Kudla, MdB/MP (CDU), Detlef Seif, MdB/MP (CDU) and Manfred Zöllmer, MdB/MP (SPD)—Oral evidence (QQ 287-296) Detlef Seif: What is the French view? Bettina Kudla: (interpretation) I think that the French Government have come to recognise that deficit spending is not a solution to the problem, but that you rather need sound growth and a good economic environment and that you cannot solve the problem simply by raising taxes—so much for being in coalition mode. I know that Germany has been criticised for weak domestic demand and excessive exports, but this economic situation is also the result of a very reasonable wages policy that we have undertaken in the past couple of years. I know that other countries have difficulties because of excessively high wage increases, which resulted in their not being stable and led to economic difficulties. I also do not see how a reduction in German exports would resolve the problem in other countries. The metaphor that I like to use here is that if you have a person who likes to buy fancy cars and is addicted to it, you cannot keep him from doing that simply by banning all the car dealers in the city. You have to start working on him. The Chairman: There is only one thing better than hearing Lord Flight in full flight one time a day and that is having the opportunity, on that very theme, to hear him expatiate for a second time.

Q290 Lord Flight: The problems of Ireland and Spain were largely about property lending, but of southern Europe generally, and as just referred to, about becoming acutely uncompetitive against Germany—something of the order of 30%, that being the result of higher pay, higher inflation and so forth. The euro served just like the gold standard to lock these countries into recession. That has at least in the short term been worsened by the German medicine, worthy though it may be in the long term, which increased youth unemployment to nearly 50%, with economies stagnant and declining. As a further turn of the screw, as their imports have reduced, the whole eurozone is now in a substantial surplus, so not surprisingly the euro has gone up another 10% or 15% in the past year. That in turn has fed back and worsened the problem. At least within the eurozone, there are two things that can address that. One is that Germany could embark on radical measures to increase consumption and investment; secondly, the ECB should be taking a lax monetary policy as soon as possible if it wants to head off the situation getting worse in Italy. What more could Germany reasonably do? It is no good saying, “Well, not much”, because if it does not do something, you may find that you have another major euro crisis on your hands next year with Italy. Detlef Seif: (interpretation) I am a Conservative, just like you are, and I do not believe in the state intervening excessively in what is happening in the markets. I know that there are lots of ideas out there about how to promote economic growth, and ideas to raise taxes. I do not believe that it would be the right way. It would also be wrong to raise wages beyond the point where they match productivity, as that would lead again to distortions and imbalances in the system. What we could do is look at the places where we still find obstacles, be it taxes, fees or other forms of obstacles, and reduce them wherever that is possible. One question that we should ask ourselves is where the euro would be today if Germany had not had the development that it had over the past couple of years. What would the situation look like today? The countries in the EFSF and ESM generally are in quite good condition; we see good economic development in those countries—except for in Greece, maybe. We should refrain from looking at programmes worth billions of euros that should support the market, because it would lead to imbalances. That is a point on which I do not fully agree with my colleague, Mr Zöllmer—but we will hear. The Chairman: I shall bring in Manfred in a minute. Did you want a follow-up to that?

339 of 441 Bettina Kudla, MdB/MP (CDU), Detlef Seif, MdB/MP (CDU) and Manfred Zöllmer, MdB/MP (SPD)—Oral evidence (QQ 287-296) Lord Flight: I have had my say, I think. Manfred Zöllmer: (interpretation) I agree with what you said about Germany’s crisis management having exacerbated the crisis at least in part. That is true, because we did not have the right equilibrium between reform and austerity. The Chancellor, at least in the beginning, focused only on austerity, and we know what happens then; in the end it leads to a recession spiral. The United States had a different approach—but that is on the side. I am also not really in favour of support programmes worth billions of euros that go in the wrong direction. However, we had a lack of structural support programmes, especially in countries like Greece, for example. Let us face it, the situation of the labour market and the high unemployment rates are clearly unacceptable, especially the unemployment rate among young people in those countries. If we fail to solve this problem, we will have to deal with a whole generation that sees Europe as this big terror that is not their own and with which they cannot identify. So that is really difficult. We should develop some programmes, especially in the field of labour markets, to improve the situation there, but also develop specifically geared programmes that could be helpful in certain countries, such as on renewable energy, and the case of Greece. There could be lots of other examples, too. Lord Flight: How sacrosanct is Germany’s view on allowing people to leave the euro? The market economy solution to the whole problem is to allow countries to have their own currency, which automatically adjusts their competitiveness. Bettina Kudla: We have discussed this for quite a while. For the German Government, the position is quite clear: we think that the eurozone should stay together because, if even one country were to leave the eurozone, we believe that it could lead to major distortions and systemic risks in the markets, which would affect all of Europe. One common standpoint is that we rejected mutualisation of debt. There can be programmes such as a proportionate liability scheme (in the form of the EFSF and the ESM) but mutualisation as such would not be helpful. We do not see how it could contribute to improving the economic situation.

Q291 The Chairman: We will come on to that, but, Manfred, could you answer Lord Flight’s question? Is the logic of what you were saying before that Germany should be made to pay more to ensure the integrity of the euro so that the euro is sustained? Manfred Zöllmer: I believe that we already have mutualisation of debt through the ECB and its purchase of bonds, and so on. Of course, Germany benefits from its economic surplus— there is no doubt about that—which means that we are the main beneficiary of the eurozone right now and will continue to be for the time being, because I do not see Greece establishing an automotive industry or other things like that. We will have to deal with that fact, but it means that you have a certain responsibility in times of crisis. That is inevitable with a single currency; we have just recently visited the United States and had talks there, and they too have a single currency, if you will. We were also told that there was no mutualisation of debt, but it turns out that, if a city or a certain state gets in trouble, the others jump in and you have mutualisation of debt. The Chairman: Before I bring in Lord Davies, I should tell you that I used to be a Member of the European Parliament for Crewe; in my constituency, we used to make Rolls-Royce and Bentley motor cars. We had German investment and now there are many jobs, not only in Crewe but also in the south, with Rolls-Royce Motors, because of wise German investment. Lord Davies of Stamford: I do not want to continue my dialogue with Lord Flight for too long but I must make the point that it is just as effective and far more desirable, if it can be

340 of 441 Bettina Kudla, MdB/MP (CDU), Detlef Seif, MdB/MP (CDU) and Manfred Zöllmer, MdB/MP (SPD)—Oral evidence (QQ 287-296) achieved, for competitiveness to be restored by internal devaluation—that is, by a reduction in nominal prices of the factors of production, notably labour—as it is by external devaluation. The reason is that external devaluation has an inflationary impact on the economy and external devaluation, particularly in the present circumstances, has a very negative solvency impact on the economy because people holding debt in euros would find it impossible to repay it if their country left the euro and their domestic currency devalued, as it certainly would do against the euro. That would lead to the insolvency of private sector bodies—of banks, very crucially to the economy of their country—and of governments that adopted that course. The Chairman: Let us ask our German colleagues. Lord Davies of Stamford: I think that Lord Flight is promoting a route that would lead to disaster. I will stop there for the moment. The Chairman: Did you understand most of that? Would you like to press on, Lord Davies?

Q292 Lord Davies of Stamford: My question is directed at Mrs Kudla. Perhaps I did not understand you correctly but I think you said that you were in favour of having a single supervisory mechanism in the European Union for banks, and of having a resolution mechanism, but one that was national, not a single European resolution mechanism, which would depend on national authorities and national arrangements. Is that correct? Did I understand you correctly? Bettina Kudla: (interpretation) No, it was agreed that all EU member states could participate in the banking union but that the single supervisory mechanism should apply only to large systemic banks, not the smaller banks. Lord Davies of Stamford: Yes, we know that; that is perfectly true. That was not my point. I think I heard you say earlier that you were in favour of the agreement, which has already taken place, for a single supervisory mechanism but you did not want a bank resolution system on an EU-wide basis and you thought that bank resolution should depend upon individual national authorities. Is that wrong? Manfred Zöllmer: (interpretation) Maybe I could jump in here. This is an issue that we are discussing in our coalition negotiations right now, as you know. There is no argument that we need a mechanism for the resolution of banks; this is clearly necessary. The question is: do the mechanisms in place, such as Article 114, give us enough instruments for a single resolution mechanism or is this not the case? We Social Democrats believe that a single supervisory mechanism can work only if you have a single resolution mechanism. Our current Finance Minister has proposed a new model that would leave resolution on a national level but sort of intertwined between the different nations. This is currently subject to discussions and I am sure that we will have many arguments about it in our negotiations. The one point that we do agree on right now is that we do not want a single deposit insurance mechanism at this point in time. Lord Davies of Stamford: Can I come back on that one? I have now established what was being said and I want to question it. I think that there are at least three reasons why a bank resolution system on a national basis will not work. The first is that a national bank resolution system would not be responsible to the ECB. The ECB cannot summon it or ask it to take action in the same way that it could a European-based bank resolution system. There is an obvious conflict of interest because the individual country concerned might well not wish to face the cost of resolving a particular bank and might therefore refuse to go

341 of 441 Bettina Kudla, MdB/MP (CDU), Detlef Seif, MdB/MP (CDU) and Manfred Zöllmer, MdB/MP (SPD)—Oral evidence (QQ 287-296) along with the proposal of the ECB. That would be a recipe for chaos and for a serious reduction in confidence in the whole working of the system. The Chairman: Lord Davies, just hold on for a moment. We are here to hear what the witnesses have to say. Lord Davies of Stamford: I know but the witness has said something that I want to challenge. The Chairman: If you could please be very quick because others want to ask questions. While we are waiting for Lord Davies, you may like to know that the European Central Bank has just cut its base rate from 50 base points to 25. Lord Davies of Stamford: The second reason why I think your system will not work, Mrs Kudla, is because the banking markets in the EU are already so integrated. So many of the assets of German, French or Austrian banks are in eastern Europe. Already these banks have such a lot of cross-border assets that you cannot address resolution problems on a single national basis. The third problem that I have with your proposal is that in certain cases you will find that a national resolution system cannot gather the resources required to address the problem. We have had that already in Cyprus so you must be familiar with that problem. We could have it again tomorrow in Slovenia or somewhere else. In those circumstances it would be necessary for other countries to come in and it is extremely messy and dangerous to do that retrospectively after some delay and chaos rather than having the system in place at the beginning. Those are the three problems that I have with your proposal. The Chairman: Let us hear the answer. Bettina Kudla: (interpretation) This is exactly the challenge, is it not? Whether we speak about the national level or the European level, whenever there is bank loss you have to make sure that you have a big enough safety cushion to absorb that bank loss. Even if you had a European deposit insurance scheme, the money for that scheme would still have to come from the national states. This is one of the reasons why we always underline the strong responsibility of the national states and consider it so important. If we relieve national states of their responsibility, we would have the mutualisation of debt, where everyone would have to jump in for everybody else, which is not what we want. Detlef Seif: (interpretation) Again, we have to speak about the definition of a banking union. Many people have a lot of different ideas about what a banking union actually means—some refer to a national level, others to the eurozone, others to the EU or the whole of Europe and what have you—and what steps should be taken; you need the regulations in place first and your supervisory mechanism, then you need your resolution mechanism, and so on and so forth. Actually, we already have a couple of regulatory instruments in place in Europe regarding the financial markets, securities and the insurance system—we have had those for quite a while. The problem was that not all these regulations have been implemented at all times in some of the countries. That is exactly what caused part of the problem. It is essential that we have this single supervisory body. As we know, the plan right now is for the ECB to take on this role. This leads me to questions 4 to 6 of your questionnaire. One of the great challenges for those 1,500 people who are supposed to work there is to actually do this sort of supervision and oversight on 138, or even more, large systemic banks. That will be a major challenge. We have seen in the past, for example, in Greece, where they tried to use Goldman Sachs to muddle around with their financial situation. Of course, the same would be possible for any bank. It would be hard to have a sound and reliable supervisory mechanism in order to

342 of 441 Bettina Kudla, MdB/MP (CDU), Detlef Seif, MdB/MP (CDU) and Manfred Zöllmer, MdB/MP (SPD)—Oral evidence (QQ 287-296) identify such practices. This is what we need. First, we need this effective supervisory body that will actually be able to work. I am usually an optimist, but I find it hard to believe that it will be possible to achieve this by 2015.

Q293 Lord Marlesford: I want to continue with this question of the role of the ECB in the banking crisis. We all know that the power of the ECB to supervise banks has existed ever since Maastricht. It was under Article 127 of the Maastricht treaty. However, as has just been suggested, the ECB has no experience in doing it; it is due to start doing it pretty soon, and the first requirement is to understand the asset situation of the banks that it is trying to supervise. Of course, the banks themselves have never really understood their own asset situation—sometimes deliberately and malevolently; sometimes by mere incompetence; sometimes from mere optimism—but it has been a very unsatisfactory collection of assessments by the banks of their own lending strength. The ECB is to carry out stress tests and is to produce those results in the middle of next year, preparatory to and needed for the future supervisory role. However, not only are there questions over whether the staff to do it exist and whether it is only the major banks or all the banks—but even for the major banks it will be very difficult—but there is a real problem for the ECB because one of its roles as a monetary authority is to keep the show on the road, to keep market confidence. As Mr Draghi has said, the ECB will do “whatever it takes”, because otherwise countries cease to be able to borrow. That is why the great intervention was made. The eurozone is travelling along in a tunnel, quite smoothly at the moment, on the rails, but in the middle of next year it will come out either into the sunlight or into a hurricane, depending on what the ECB finds. Is the ECB going to look for the truth or is it going to be sensitive to market confidence? The Chairman: Manfred, would you like to respond to that? Sunshine or hurricanes? Manfred Zöllmer: (interpretation) I share your generally sceptical analysis of the role of the ECB, my Lord, because we always believed that monetary policy should be kept separate from supervision. We always said that if the two of them are put together that can be only for a transitional period. This is what we believe, because there is always the risk of a conflict of interest. This is why we believe as Social Democrats that the supervisory function for the ECB should be only a temporary measure. I am also a member of the administrative council of the BaFin, the German financial supervisor, so I have an insight into that. The national supervisory bodies will continue to play a role, even if the supervisory role is to go to the ECB, because the ECB will simply not be able to do the work. We need close co-operation between the national and the European levels. That means that we will probably see the formation of bodies with national and European members in order to cover both sides. The national supervisory bodies will send staff to the ECB to assist them in their efforts, but it is an ambitious plan. There is no doubt about that. A lot still needs to happen for the goal to be achieved of a better supervisory mechanism than we have now. Bettina Kudla: (interpretation) Maybe I can find a different kind of wording here when we speak about monetary policy and supervision being combined, if you will. We have had lengthy discussions on that. Despite the fact that the ECB should be given that supervisory function, we always insisted that it be kept separate within the ECB from the part that takes care of monetary policy. To what extent this will be practicable remains to be seen, of course, but it is at least the plan to keep those two units separate within the framework of the ECB.

343 of 441 Bettina Kudla, MdB/MP (CDU), Detlef Seif, MdB/MP (CDU) and Manfred Zöllmer, MdB/MP (SPD)—Oral evidence (QQ 287-296) What worries us is the policy of low interest rates adopted by the ECB, which was initially used as a tool to fight the crisis. We believe that, if those low interest rates are here to stay, the instrument loses its effectiveness and becomes blunt.

Q294 The Chairman: Colleagues, we have just 20 minutes left, so I shall ask Lord Brookeborough to ask one question from his pack; Baroness Maddock to ask a couple of questions; and Lord Marlesford to ask a question about the role of national parliaments, because I want to get on to that question. Then, please feel free to raise anything that you feel that we have not. We would also be interested, in closing, to try to get some understanding about the current negotiations. Detlef Seif: (interpretation) Just to remark on the banking union, I thought that it was unfortunate for the UK not to play a more active role in this entire process but to remain the adviser on the sidelines, if you will, because the problems that we are facing are not problems of the eurozone as such. The objective of the banking union was to avoid bubbles and distortions in the market. Those are problems not limited to the eurozone, as we know; they are not structurally related to the euro. We would have been happy if the UK had taken on a more leading role. We understand the caveats that you just raised with regard to the ECB and its capability to undertake a supervisory function. Had the UK played a more prominent role, maybe we could have come up with a different model, a different solution. I just wanted to make that remark. The Chairman: We are very grateful for that remark. I do not know whether you want to amplify it. One question that we want to ask later is about the role of national Parliaments and what we can do to increase the role of the Bundestag and the Houses of Parliament in London. Perhaps you, as friends of Britain, could advise us how we might be able to help the process which colleagues are performing in the eurozone. Albeit that we are on the sidelines to some degree, we have declared as a coalition Government that the prosperity of the eurozone is integral to the success of the United Kingdom within the wider single market. Bettina Kudla: (interpretation) Just a brief remark. I think that we should not keep up the separation of the 17 versus the 25, under the fiscal compact, or 28 of the European Union, as strictly as we have. We should try to find ways to bring the UK more into the boat, so to speak, especially in areas such as the regulation of the financial markets, which I understand is of great concern to you: the financial transaction tax, common supervisory mechanism, et cetera. The other obstacles that were raised with respect to budgetary policy (such as the refusal to join the fiscal compact) I really cannot understand, because I believe that the UK could be a beneficiary in that respect. I do not understand why you have so far been reluctant to join the European Semester, because I believe that there would be opportunities for the UK. The Chairman: Thanks very much. Perhaps I cannot answer that one, because I take a different view, but I do not think that I want to invite any of my colleagues to at the moment. I wonder, Baroness Maddock, whether you would pursue the interests that the UK has with regard to our German colleagues, because I am conscious that time is running out and I would like to finish off on what we practically can do together as two groups of people.

Q295 Baroness Maddock: I think that you have answered some of the questions that we wanted to ask you about the role of Britain, the United Kingdom. We have been very concerned that some of the things proposed do not prevent the development of the single market, because that has been the prime concern of the United Kingdom, and it has not wanted to get involved with a lot of these things proposed through GEMU.

344 of 441 Bettina Kudla, MdB/MP (CDU), Detlef Seif, MdB/MP (CDU) and Manfred Zöllmer, MdB/MP (SPD)—Oral evidence (QQ 287-296) I was going to ask was whether you think that we are a hindrance or whether we can help. You have indicated how you think that we might be able to help. Is there anything else that you can add that we can take back to do in our role? Bettina Kudla: (interpretation) One thing would be your perspective of the negotiations between the EU, the European Commission and the USA on the T-bill. Manfred Zöllmer: (interpretation) I believe that there is a point where you have to make a decision. If you join a club with lots of different people, with lots of different ideas, you must be aware of the fact that you will not be able to uphold 100% of your ideals and ideas. I am surprised to hear the current discussion as it takes place in the UK. Of course, there were difficulties and problems along the path of European development, as we all know, but for a country now to say that it wants only a single market and does not want to be involved in the rest will not work, because the others will not accept that. So, as I see it, the question is: do you want to be in or out? It will be not be possible to reap only the fruits, the benefits, and ignore all the rest. Baroness Maddock: I am a Liberal Democrat member of the coalition in the UK, so you can understand that I have some sympathy with that view. The Chairman: I have one last question, then I want to invite you to tell us a little about how the discussions are going. The three of you are being very civilised today; we just wonder whether that is an expression of hope for the future. Viscount Brookeborough: We understand that Germany is opposed to mutualisation, especially Eurobonds. I wonder if there are any conditions under which you might accept such a scheme. Manfred Zöllmer: (interpretation) This is actually a debate that is non-existent right now on account of our constitutional court having set very narrow limits with respect to instruments like Eurobonds, et cetera. I believe we should take a different path and the ECB has already taken a position on the instrument of sovereign bonds, for example. We also have to have a debate on how to fund the tools, and what tools we should fund, in order to respond properly should a crisis occur again. But mutualisation of debt is not an issue right now.

Q296 The Chairman: Before I call on Lord Davies to give a vote of thanks, can I ask the three of you what more can we, as a separate Parliament, do to aid and abet all that we have been talking about this afternoon? In the process in which you are now chiselling away to try to get an outcome and produce a Government for Germany for the next four or five years, how is it going and how can we help? Detlef Seif: (interpretation) I believe that in the UK—and I am not referring to the more intellectual layers of your society or to you as politicians—generally speaking the public has a very negative view of Europe, especially the European Union. It would be important for you to carry that differentiation into the public opinion. I know this is difficult. I know about the difficulty of domestic politics and that the Conservatives have to make arrangements in order to get a majority at all. I know it is not easy. But it would be a first step to explain to people that things like a banking union are not one-on-one with the European Union and that even if you do not want to accept the European Union you still have to accept certain mechanisms. I think that would be important. It would be the first step towards making people aware of the differentiation that not everything is EU, full stop. Secondly, it is important for us as colleagues to engage more and more in talks, especially for the next few years because the next few years will be decisive for Europe as a whole and also for the

345 of 441 Bettina Kudla, MdB/MP (CDU), Detlef Seif, MdB/MP (CDU) and Manfred Zöllmer, MdB/MP (SPD)—Oral evidence (QQ 287-296) image of member states. We should really promote and foster this exchange and keep in close contact. Manfred Zöllmer: (interpretation) I would also like to see the debate in the UK become more rational, if you will, and more focused on your own vested interests. Quite frankly, if the UK were to leave Europe, it would be a loss for Europe but it would be an even bigger loss for the UK and would squander all the benefits that you can get from Europe. That would be one issue. Another remark, since we are speaking about Parliaments and the role of Parliaments: during the crisis the German Parliament has gained a lot of competencies as to how to deal with European regulation. Now we are the ones entitling and telling our Government how to deal with certain European regulations. This is just part of the democratisation of the whole system that we have not yet seen on the European scale. Maybe this would be a good idea for the UK, too, so that your Parliament tries to get more influence when it comes to making decisions on European issues. Baroness Maddock: I think that that is part of what we are trying to do on our Committee. Bettina Kudla: (interpretation) What you need to be aware of is that if you choose not to participate in a certain process you basically will be left out. When it came to a decision about the fiscal compact the UK chose not to participate. That means that there will be a negative consequence because you will also not participate in the ensuing process and all the decisions that follow from that and all the deliberations on the air-tight process. When it comes to decisions in the future, maybe one should weigh more carefully the consequences this might entail. I believe there are a couple of areas where we can find better common approaches for economic development for all 28 EU countries in the fields of trade obstacles, taxes on cross-border trade and tax evasion, which could lead to increased revenues for the states, et cetera. Those are areas where we can work in the common interests of all 28 countries. I would also like to see us demand more from the European Commission to come up with proposals that would be more in line with a market economy and not so socialist as they are right now. I think that would be a good idea. The Chairman: Thank you very much indeed. We are most grateful. And a big thanks to our translator.

346 of 441 Professor Rosa M. Lastra—Written Evidence

Professor Rosa M. Lastra—Written Evidence

In response to the call for evidence by the House of Lords’ European Union Committee – EU Economic and Financial Affairs Sub-Committee (Sub-Committee A), chaired by Lord Harrison – with regard to its inquiry into the EU “Genuine Economic and Monetary Union” and its implications for the UK, I respectfully submit this brief memorandum.

The European Commission’s December 2012 report, A Blueprint for a Deep and Genuine Economic and Monetary Union and the report by the President of the European Council, Herman Van Rompuy, in his paper “Towards a Genuine Economic and Monetary Union paper” set out the four building blocks for the future of EMU, namely an integrated financial framework, an integrated budgetary framework, an integrated economic policy framework, and strengthened democratic legitimacy and accountability. The inquiry intends to focus on the first three pillars, which enhance discipline and solidarity. This memorandum addresses some of the key questions posed in the call for evidence.

The United Kingdom should remain engaged in the design of the new stages of European integration since the UK is a full member of the EU, committed to the Single Market program. The inquiry is thus most welcome at a time in which the UK is perceived from other European partners as disengaged from the future of the EU. I for one think the future of the UK lies firmly anchored in Europe. Historically, geographically and economically it is in the UK’s best interests to have a leading role in the future of the EU.

Genuine Economic and Monetary Union

How realistic are the plans for Genuine Economic and Monetary Union (GEMU)? Do they go far enough to correct the flaws in EMU revealed by the euro area crisis, or do they go too far to be palatable for some Member States? Will the proposals work, and if not, what other steps need to be taken?

The remorseless logic of fiscal union in a monetary union (in order to ensure the survival and long term success of the euro) and the inadequacy of the framework for financial supervision and resolution have been evidenced by the twin financial and sovereign debt crises and their aftermath. The fiscal backstop of one of the pillars of the banking union plan – resolution – suggests that a lot of work still remains to be done. The plans for GEMU increase coordination and surveillance of fiscal policies, enhance discipline with the creation of a Finance Minister and the contested ‘federalism by exception’ which would allow a central authority to have powers vis-à-vis Member States which do not comply with the rules (conditionality adds an element of diktat over fiscally ‘irresponsible’ countries), but still fall short of full fiscal union. True fiscal union requires a treaty revision.

The underlying problems of the GEMU plans outlined so far are three: first, a growing disconnection between the intellectual elites that drive European integration and the general public (legitimacy); secondly, fatigue with fiscal austerity policies at a time in which many European countries desperately need growth and employment; and, thirdly, insufficient consideration of how the different degrees of integration – single market and EU, euro area, SSM and EEA – interact with each other.

In particular, we must address the legal and constitutional challenges that stem from the increasing design of a ‘double treaty structure’ - EU treaties on the one hand and

347 of 441 Professor Rosa M. Lastra—Written Evidence intergovernmental treaties, such as the ESM Treaty or the Treaty on Stability, Coordination and Governance, TSCG (Fiscal Compact) on the other hand. EU institutions are relied upon for the effective working of the institutions – such as the ESM – created by such intergovernmental treaties. Though the European Court of Justice is satisfied with the legality of the ESM in the Pringle case, this double treaty structure requires further legal consideration. It is interesting to note that progressively the Commission takes over elements of budgetary discipline covered by the TSCG into genuine EU law.

An integrated financial framework (Banking Union)

Will the proposals for banking union decisively break the link between bank and sovereign debt? If not, what more needs to be done? Is the three-pronged model of a single supervisory mechanism, a common resolution mechanism and a common deposit insurance scheme realistically achievable, how long is likely to be needed to achieve it and what are the risks of long delays?

The vicious link between bank and sovereign debt cannot be fixed simply by advancing towards a banking union. The zero credit weighting assign to sovereign bonds by Basel rules and their implementation under EU law needs to be addressed too. Not only banks, but fund managers, have invested in sovereign bonds under the fallacious assumption that they are risk free. In any case, the key element to break the link between national government debt and national bank debt in euro area Member States is to advance towards European supervision, so that the ESM only recapitalizes institutions that are subject to adequate supervision (which according to the banking union proposals, means supervision by the ECB, given the tendency of national authorities towards forbearance). Of course, all this needs to be tested and, in any case, ESM resources are finite.

Banking union rests upon three pillars: single supervision, resolution and deposit insurance (with an underpinning single rule book), and only the first (i.e., SSM) has been adequately articulated so far. The other two pillars are essential for the banking union to function effectively, since supervision and crisis management are part of a seamless process. However, political difficulties in Germany and elsewhere, the conflicting needs of the single market and banking union and other important legal and constitutional issues (in particular the legal basis of single resolution given the inevitable fiscal backstop), have meant that so far we have no clear plan as to how best to achieve a common resolution and common deposit insurance scheme.

An integrated economic policy framework

Binding contracts, known as “Convergence and Competitiveness Instruments”, have been proposed as part of the plans for GEMU, which would encourage structural reforms through rewards or sanctions. Is such a proposal credible, would it be effective, and how could it be enforced? There are also indications that, in the longer term, there could be deeper economic policy coordination amongst euro area countries, particularly in the areas of taxation and employment policy. Which areas of economic policy would you regard as appropriate for deeper integration?

EMU has rested upon a weak E and a strong [or I’d rather say a relatively strong till 2010] M. Plans to address the weakness of E require a gradual approach on the one hand (one could use the analogy of a ‘flight upgrade’) such as the binding contracts and other efforts in

348 of 441 Professor Rosa M. Lastra—Written Evidence

‘coordination’ as well as a more radical approach on the other hand (one could use the analogy of ‘taking another flight’) that leads EMU to proper fiscal union and economic integration (a step beyond ‘coordination’), with adequate democratic legitimacy (hence the need for a Treaty revision) and coherence.

An integrated budgetary framework (questions 6-10)

In relation to the Commission’s proposal of the creation of a ‘fiscal capacity’ in the medium term and the creation of an autonomous euro area budget in the longer term: Why is such a budget necessary, and what would its purpose be? Are there any alternative models that would achieve central fiscal stabilisation? How would it be funded, and how large would it need to be? Would it require new institutions? How would it interact with the EU budget? How might non-members of the euro area participate (voluntarily) in such a mechanism?

It is clear that economic integration requires a more substantial budget than the current rather minimalist approach. As stated above, fiscal union does require a Treaty amendment.

The creation of a European government bond (‘Eurobond’) jointly issued by euro area Member States has been suggested by a number of academics and commentators. What is your view on debt mutualisation? How plausible is it that such a scheme can be implemented?

Though the requirements of article 125 of TFEU (Treaty for the Functioning of the European Union) and the Pringle judgment may suggest otherwise, depending on how they are structured, the introduction of Eurobonds may not require a Treaty amendment. (See e.g., http://fdv.univ-lyon3.fr/mini_site/cee/dico/b/bei.htm).

Do the varying levels of competitiveness and the presence of persistent imbalances across Member States make a system of permanent fiscal transfers inevitable if the euro area is to survive, or could the goals of fiscal union (or integration) be attained without transfers?

Indeed, a federal system like the USA is able to confront exogenous shocks (the recent example of Hurricane Sandy comes to mind) and regional/state crises because of the existence of automatic fiscal transfers, stabilizers. A strong E for EMU does require such a system of fiscal transfers. Though EU structural and cohesion funds are a form of fiscal transfer (compatible with Article 125 TFEU), an automatic system of fiscal stabilizers requires a Treaty amendment. [The Union also has the possibility of creating its own resources - if there is a political will - albeit following a difficult procedure, according to Article 311, subparagraph 3 TFEU].

Institutional issues

Does the current Treaty framework allow the euro area to go as far as is necessary in terms of integration within the current Treaty framework, or will GEMU inevitably require Treaty change? Should other mechanisms, such as further inter-governmental arrangements or enhanced cooperation, be considered? How will EU institutional arrangements need to change in order to accommodate deeper integration? In the event that not all Member States choose to participate, would the need to ensure democratic legitimacy for contentious GEMU decisions require reform to the decision-making process, either in the

349 of 441 Professor Rosa M. Lastra—Written Evidence

European Parliament (e.g. through differential voting and Committee arrangements) or the Council? What are the implications of GEMU for the role of national parliaments?

True GEMU, namely a fiscal union, with fiscal transfers, taxation powers and others, requires a Treaty change. Whether an intergovernmental treaty – akin to ESM Treaty – could form the basis for such fiscal union is most questionable. There are limits to what an international treaty which is not a revision treaty can do. [Pringle judgement].

However, in some areas a gradual approach is possible on the basis of some existing treaty provisions notably Article 127 (6) and Article 136 TFEU, the legal basis of the SSM regulation and ESM Treaty respectively. [The Pringle decision concluded that the ESM Treaty could enter into force before the entry into force of Article 136, paragraph 3, because it is a field of shared competences of the States and the Union].

In an article published in the Financial Times on 13 May 2013, Wolfgang Schäuble (“Banking Union must be built on firm foundations”) pointed out the developments which do not need in his opinion a Treaty revision, including ‘a resolution mechanism based on effective coordination between national authorities; and effective fiscal backstops, also including the European Stability Mechanism as last resort’.

Impact on the UK and the Single Market

The UK Government have stated that any proposals must take account of the interests of all Member States, in particular with regard to the Single Market. How can this be achieved? The UK Government have made clear that they will not participate in the majority of these measures. Do you think this is the right response or are there specific elements of the proposals for which it would be in the UK’s interest to take part – whether fully or partly? Are there alternative ‘models’ for banking union which the UK would find more consistent with its preferences? Since the majority of non-euro area Member States are likely to participate in many components of GEMU, are there particular risks for the UK finding itself in a small minority of non-participating Member States? How can the UK ensure that the voice of this minority continues to be heard? Do you anticipate any institutional changes that would prove problematic for the UK? What are the likely indirect impacts of non- participation on the UK’s economic prospects, for instance in terms of its ability to attract inward investment and the impact on the position of the UK financial sector?

As I have stated in an article – attached – on the relationship between the Single Market and the Banking Union, theirs will be an uneasy co-existence. The issues of ‘jurisdictional domain’ haunt the current banking union proposals, since two of the four cornerstones of such proposals relate to the EU as a whole (namely a framework for recovery and resolution and a single rule-book), while the other two relate more specifically to the Euro area (the Single Supervisory Mechanism or SSM and a single Deposit Insurance/Resolution Fund). Furthermore, state aid rules are a fundamental component of the Single Market, and are intrinsically related to the area of resolution. The needs of a well functioning single market in financial services cannot be disentangled from the design of the banking union.

The problems of coordination amongst different authorities – in the case of the EU, the ESRB, ESM, EBA and ECB – are real, as the tripartite arrangement in the UK showed during the Northern Rock episode. The issues of jurisdictional domain further haunt the banking union project, since the European Banking Authority (EBA) will remain in charge of the

350 of 441 Professor Rosa M. Lastra—Written Evidence single rule book (i.e. regulations and technical standards) and will be guardian, with the Commission, of the single market (the Commission will retain its key legislative function, level I legislation). But the ECB will be a very powerful institution and this risks making EBA to some extent irrelevant. EBA’s existence and powers (strengthened by the EBA regulation) are justified because of the different jurisdictional domain EU/Euro area, but add a layer of complexity to the supervisory picture. That complexity is further compounded by the need to coordinate with ESMA and EIOPA. And complexity frustrates accountability.

The co-existence of those two concepts, Single Market and Banking Union – with different jurisdictional domains – is another manifestation of the co-existence of two notions of the European Union: one trade and commercially oriented, espoused by many in the United Kingdom, and one politically oriented, in which economic sacrifices are acceptable on the altar of further integration, as advocated by many in Germany. While these two notions can continue to co-exist, the agenda for further integration is moving ahead with or without the UK. Those voluntarily outside cannot impede moves towards a more solid EMU.

22.05.13

351 of 441 Professor Rosa M. Lastra—Supplementary Evidence

Professor Rosa M. Lastra—Supplementary Evidence

Following the publication of the draft Singe Resolution Mechanism Regulation, I was invited to submit supplementary evidence to the House of Lords’ European Union Committee – EU Economic and Financial Affairs Sub-Committee – with regard to its inquiry into the EU “Genuine Economic and Monetary Union” and its implications for the UK.

Single resolution is one of the three pillars of banking union, as envisaged by the European Commission in its September 2012 Communication (the other two are single supervision and single deposit insurance). Single supervision has been entrusted to the ECB according to the Single Supervisory Mechanism (SSM) proposed regulation, while there is no political agreement yet on Single Deposit Insurance, which faces stern opposition in some Member States, notably Germany.

The single resolution mechanism (SRM), as outlined in the proposed Regulation, is part of the EU resolution framework, together with the rules on recovery and resolution (proposed Recovery and Resolution Directive or RRD). However, while the jurisdictional domain of the SRM is the SSM area (Euro area Member States plus others that voluntarily choose to have the ECB as supervisor), the jurisdictional domain of the RRD is the EU area as a whole (plus EEA). The RRD is a fundamental component of the single market (as advocated by many in the United Kingdom), a piece of legislation that needs to be transposed into national law in all EU Member States. Indeed, a single market cannot function effectively without clear rules on cross border crisis management.

The proposed Single Supervisory Mechanism - with the ECB at the helm - cannot succeed in its mission of breaking the vicious link between bank debt and sovereign debt if it is not accompanied by a clear and effective Single Resolution Mechanism.

Article 1 of the SRM proposed regulation states that its rules and procedures will be applied by the Commission together with a Single Resolution Board and the national resolution authorities and that the SRM will be supported by a Single Resolution Fund. Article 2 - in combination with Article 4 - defines the scope of SRM jurisdiction, aligned - of course - with the jurisdictional domain of the SSM regulation (i.e., credit institutions in the SSM area). Article 16 deals with the resolution procedure. The authorities that assess the threshold conditions for resolution are the ECB or a national resolution authority; they shall communicate that assessment without delay to the Single Resolution Board and the Commission. The powers of the Single Resolution Board – made up of representatives from the Commission, the ECB and national resolution authorities – include the centralisation of information received from the ECB and national resolution authorities and powers of recommendation, since the Single Resolution Board recommends to the Commission that a bank or a group be placed under resolution. The resolution framework includes the resolution tools to be applied and the use of the Single Resolution Fund (the content of the resolution plan being specified in Article 7). Once the Commission (which is also responsible for competition and state aid) decides – on its own initiative or upon a recommendation by the Single Resolution Board – to place a bank under resolution, the national authorities shall take all the necessary measures to implement the scheme.

The Single Resolution Fund will be funded by contributions by the banking industry (1% of covered deposits in participating SSM-SRM Member States, according to Article 65, currently amounting to 55 billion Euros) and will have the ability to borrow from financial institutions,

352 of 441 Professor Rosa M. Lastra—Supplementary Evidence third party and public resources. The crucial issue of how to allocate losses to banks is of course the subject of much controversy. The purposes for which the Single Resolution Fund can be used – including guarantees of assets, purchase of assets, capital contributions etc – are spelt out in Article 71.

A number of contentious issues arise from the SRM proposal.

First, is the legal basis adequate?

The legislative basis for the SSM Regulation is Article 127(6) of the Treaty on the Functioning of the European Union (“TFEU”), which allows the Council to confer “specific tasks concerning policies relating to the prudential supervision of credit institutions and other financial institutions with the exception of insurance undertakings” and requires for its adoption unanimity by the Council, after consulting with the Parliament and the ECB.

The legislative basis of the SRM Regulation is Article 114 of TFEU, which was also used in the establishment of the ESAs (European Supervisory Authorities). The issue of the adequacy of the legal basis in the case of single resolution is thorny because Article 127(6) does not in principle allow for the conferral of resolution powers to the ECB (though one can understand supervision in a very broad sense, as I have advocated since 1996; in my opinion, Article 127(6) could arguably provide the basis for single deposit insurance) and because in the absence of fiscal union, it is national governments that are eventually called to recapitalise failing national financial institutions (‘he who pays the piper calls the tune’). In the light of the Meroni doctrine, the Commission cannot delegate powers to an agency if such powers are of a discretionary nature (and resolution decisions involve a degree of discretion). That, together with the fact that the Commission acts as competition/state aid authority, justify the role the Commission will have in resolution according to the July proposal.

While the ECB is and will remain a creature of primary law (proper EU institution), the ESAs and the Special Resolution Board (and Fund) are conceived as creatures of secondary law. It is always easier to amend secondary law than it is to amend primary law. As well, by definition, secondary law is not as democratically accountable as primary law.

In addition to the adequacy of the legal basis, we also need to ensure adequate accountability. Decisions about allocation of losses involve an exercise in distributional justice. Furthermore, resolution requires – like central banking – adequate expertise, thus raising issues of resources and technical competence.

It is at this point questionable whether the political consensus to get the SRM through the legislative approval process will be sufficiently robust. The key question is whether or not it can succeed in the absence of fiscal union (the issue of fiscal backstop). As well, the relationship between an independent ECB and – by definition – more politically motivated national resolution authorities (national governments provide capital of last resort) to ensure a smooth transition from supervision and early intervention to actual crisis management and resolution remains untested. Finally, credibility and adequate resources are fundamental for the success of the SRM.

353 of 441 Professor Rosa M. Lastra—Supplementary Evidence

Impact on the UK and the Single Market

As I have stated in the attached article, the relationship between the Single Market and the Banking Union will be an uneasy co-existence. The issues of ‘jurisdictional domain’ haunt the current banking union proposals, since rules on recovery and resolution and crisis management and a single rule-book relate to the EU as a whole, while the SSM, SRM and single deposit insurance relate more specifically to the Euro area/SSM area. Lender of last resort has hardly been mentioned in the debate (the elephant in the room?).

The Euro area, the SSM area, the EU and the EEA represent concentric circles of integration, subject to differentiation and conditionality.

The problems of coordination amongst different authorities – in the case of the EU, the ESRB, ESM, EBA, and ECB – are real, as the tripartite arrangement in the UK showed during the Northern Rock episode. Complexity is further compounded by the needs to coordinate with ESMA and EIOPA. And complexity frustrates accountability. The European Banking Authority (EBA) will remain in charge of the single rule book (i.e. regulations and technical standards) and will be guardian, with the Commission, of the single market (the Commission will retain its key legislative function, level I legislation). Furthermore, state aid rules are a fundamental component of the Single Market, and are intrinsically related to the area of resolution.

The needs of a well functioning single market in financial services cannot be disentangled from the design of the banking union.

13.09.13

354 of 441 Ruth Lea—Written Evidence

Ruth Lea—Written Evidence

The Commission’s proposals for the Single Resolution Mechanism

1. The European Commission published its proposals for a Single Resolution Mechanism (SRM), the second pillar of Banking Union, on 10 July 2013. 73 The SRM would complement the Single Supervisory Mechanism (SSM), the first pillar, which will be operational in late- 2014. The SRM’s function would be to manage efficiently the resolution of those banks subject to the SSM which faced serious financial difficulties. A Single Resolution Board (SRB) would supervise the national resolution authorities, which would be in charge of the execution of the resolution. A Single Bank Resolution Fund (SBRF) would be set up under the SRB to ensure the availability of medium-term funding support while the bank was restructured. It would be funded by contributions from the banking sector, replacing the national resolution funds of the Eurozone Member States and of Member States participating in the Banking Union, as set up by the highly significant draft Bank Recovery and Resolution Directive (BRRD). Crucially, the Commission would decide whether and when to place a bank into resolution and set out a framework for the use of resolution tools and the fund.

2. At the June 2013 European Council, EU leaders set a target of reaching agreement on the SRM by end-2013 so it can be adopted before the end of the current European Parliament term in 2014. This would enable it to apply from January 2015, together with the BRRD.

3. The proposals seem eminently reasonable and are in line with the Commission’s previous announcements on the SRM. 74 And the SRM, as part of the proposed Banking Union, should spread financial sector risk and be a positive integrationist step in underpinning the Eurozone.

4. However, there have to be doubts as to whether certain Member States, notably Germany, are prepared to make the necessary political commitments. The SRM is facing much opposition, not least of all concerning the shared financial implications for the banks of the Single Bank Resolution Fund. Well-run banks could well object to supporting poorly-run banks in financial trouble, albeit through the SBRF. Moreover, it can be argued that, as banks are strategically vital to a country’s economy, a country cannot be in charge of its own economy if it does not control them. Arguably, therefore, national governments should have the final say in the possible closing down one of its dominant banks – not the Commission.

5. More specifically:

• The current German Government has questioned the legality of the proposed SRM, suggesting that there is a need for changes to the treaties. 75 The Bundesbank has also expressed the need for treaty changes. 76The German authorities are well aware that any such treaty changes would take years to accomplish. The Commission insists however that the legal basis for the proposal is Article 114 of the Treaty on the Functioning of the

73 European Commission, “Proposal for a regulation of the European Parliament and of the Council establishing uniform rules and a uniform procedure for the resolution of credit institutions and certain investment firms in the framework of a Single Resolution Mechanism and a Single Bank Resolution Fund and amending Regulation”, 10 July 2013. 74 European Commission, “A Blueprint for a deep and genuine Economic and Monetary Union: launching a Europe debate”, 28 November 2012. 75 Reuters, “Germany may file complaint against EU banks plan - newspaper”, 25 July 2013. 76 EUObserver, “Bundesbank wants treaty change for banking union”, 23 July 2013.

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European Union (TFEU), which allows “the adoption of measures for the approximation of national provisions aiming at the establishment and functioning of the Single Market”. 77 • A recent Franco-German statement made reference to a rather non-committal Single Resolution Board “involving” national resolution authorities, based on the current treaties. 78 Reading between the lines, there seemed to be some back-tracking on the Commission’s notion of the SRM.

6. Germany’s reluctance to push ahead with the proposed SRM may just be a reflection of political sensitivities ahead of the Federal Elections on 22 September, when any suggestions from the political leaders of further financial support, albeit through the banks, for the Eurozone is deeply unpopular. And after the election whoever leads the next Government will return to the negotiating table with renewed zeal for Eurozone integration, or at least be prepared to agree to the Commission’s proposals for the SRM. (On current polling Angela Merkel seems almost certain to be returned as Chancellor – though possibly as head of a Grand Coalition with the SPD, rather than in coalition with the FDP.) We shall see. But there has to be a fair chance that the Eurozone’s progress towards Banking Union will finish here.

04.09.13

77 European Commission, “Proposal for a Single Resolution Mechanism for the Banking Union – frequently asked questions”, 10 July 2013. 78 “France and Germany – Together for a stronger Europe of Stability and Growth”, 30 May 2013, available from www.bundesregierung.de.

356 of 441 Ulf Meyer-Rix—Oral evidence (QQ 273-286)

Ulf Meyer-Rix—Oral evidence (QQ 273-286)

Evidence Session No. 23 Heard in Public Questions 273 - 286

THURSDAY 7 NOVEMBER 2013

Members present

Lord Harrison (The Chairman) Viscount Brookeborough Lord Davies of Stamford Lord Flight Baroness Maddock Lord Marlesford ______

Examination of Witness

Mr Ulf Meyer-Rix, Deputy Director, Planning Group, SPD Bundestag Group

Q273 The Chairman: Colleagues, I am going to start this session. It is a great pleasure to see Ulf Meyer-Rix in front of us. He is going to help us with this difficult tease of a subject— genuine economic and monetary union. You may know that what happens in the House of Lords is that we have this exchange, we record it and then we send you the transcript. We would be very grateful if you could examine that and improve it and, indeed, if you have further ideas afterwards I would be grateful for them. Until we write it up, all that evidence is there waiting for us to use.

I invite you to say a little about yourself but then, just as a starter question, could you reflect on what you know of the kind of genuine economic and monetary union architecture that is being thought about at the moment? Perhaps you could give us an overview of those elements of it which you regard as essential or absolutely necessary and those elements of it which are less necessary and may even be, to some degree, obstructive and unhelpful to the situation. If we start off on those elements, my colleagues will be very interested to take up various parts of that, so—over to you and thanks very much. Ulf Meyer-Rix: It is a great honour to be here. Thank you for inviting me. As you perhaps saw from the short CV that I gave you, I am working at a small staff unit of our parliamentary group, the SPD. It is a policy planning unit. We are not assigned to those colleagues in the parliamentary group who are working in special committees; we are just a kind of centralised group, working on topics with a broader range. I happen to work on questions of European monetary union and the crisis in that in the last three years. What I will try to give you is my personal view on the positions of our parliamentary group and how I see things as an economist who is devoting his time to those questions. The Chairman: That will be really helpful. Thank you very much. Ulf Meyer-Rix: On the process of genuine economic and monetary union, I think that we had a great kick-off at the start with the quadriga’s report some time ago. On practical policy

357 of 441 Ulf Meyer-Rix—Oral evidence (QQ 273-286) in Brussels, it seems to me that it is boiled down, step by step, to a more pragmatic approach. Obviously, it is at least a smaller approach, so time will show whether its more pragmatic aspects were okay and the start of something new—of consolidating the monetary union and, with it, the EU as a whole. We will see. To go into the different parts of GEMU, I think we see that the part on banking union, which is obviously the focus of debate now, in Brussels as in all the capitals of the member states, is absolutely necessary. That is because what we saw in the summer of last year was that the internal financial market of the European Union was not working any more. The economist Nouriel Roubini, from the United States, spoke of the balkanisation of European financial markets. What happened in a way was that in the eyes of investors, one euro deposited in a Spanish bank was not one euro deposited in a bank in Germany or other surplus countries any more. What happened is that, realising this, the people took their euros out of the accounts that they had in Southern Europe and transferred those into safer havens. If this process had lasted for some more time, the monetary union would have gone kaput—broke. This was interceded by the decision of the European Central Bank to announce this OMT programme, which reversed the impressions of the investors. In a way, they were assured that the euro in the southern account is to be paid back and is guaranteed, in a way, by a central institution so that they have to take everything off. However, in a way the problem is just suspended; it is not solved. I think everybody knows that there will be economic and, even more, political turmoil if we get into a situation where the ECB really would have to buy the sovereign bonds of southern European countries, in a remarkable way. It is one thing to have the ECB saying, “Yes, we would do that if the conditions are met”, and another if it really had to do it in reality. The Chairman: The banking union is obviously crucial. Perhaps we will then explore some of the other elements and questions we have but would you, Lord Flight, just take us into some of those questions?

Q274 Lord Flight: Herr Meyer-Rix, I could not agree more with where you started; the problem is not solved at all yet. However, I make the point that the German medicine for southern Europe is good economic sense but it has the inevitable result of shrinking demand and of raising exports. A new imbalance has come up in Europe, one of the by-products of which is that the euro is far too strong, which is now damaging the economies of the EU, particularly the southern European economies. Logically, if you are expecting the south to contract in that way then Germany has to expand dramatically. It needs to expand demand and consumption to restore some degree of balance, as it were. I think that the Americans have made this point and that it was not altogether well received. What we hear is, "Oh no, it's fine. German consumption is growing a bit and the current account balance is shrinking a little”. But it is nothing in comparison to what is actually needed if we are not to head down the path to another crisis, which would be caused by having too strong a euro and would result in political problems in southern Europe. How are you really going to get German consumption going? Ulf Meyer-Rix: I really agree with you that the problem with the policy that the German Government championed last year, with its idea that perhaps every country in Europe—or at least in the eurozone—should be just like Germany is that there is a misunderstanding of how the German model was working. What has developed is a monetary union that consists of two halves that fit together, in a way, but are completely different. Trying to solve the problems by making every member just like Germany - that is what is happening now. If the whole eurozone is having large surpluses against the rest of the world, of course the euro

358 of 441 Ulf Meyer-Rix—Oral evidence (QQ 273-286) will move. That affects everybody in the zone, so there has to be a rethinking that this is not stable. The problem on a larger scale is that it is not only Germany and the European Union or the eurozone which is following the idea to solve the problems that arose from the financial and economic crisis in 2008-09 by boosting exports. I think that America is doing the same and that the United Kingdom is on the same line. Lord Flight: Consuming too much. Ulf Meyer-Rix: There still surpluses in Asia and China, so the question is: who buys all this stuff? Where, on a world scale, is the aggregate demand needed to balance this out? I think that there is a big difference between the case of Germany and that of China, which seem to merge in the outside view which came out of this Treasury report last week. In China, consumption is really repressed and, on the other side, this leads to a very high percentage of investment in GDP and, of course, an external surplus. Even if we have had a kind of wage repression in Germany over the past 10 years, the development of our private consumption is in line with the development of GDP as a whole. That is not really a good idea because the development of GDP as a whole was not really strong. However, that is not the same pattern as we see, for example, in China. Our problem concerning our external imbalances is, in the first place, not the consumption but the investment. If you look at German gross investment you will see that in 2012, it was just the same as it was in 2000. In real terms, it was down—that is the problem. Of course, there are a lot of reasons why we think that we should try to boost consumption as well. But if you look at the external imbalances as a kind of mirror image of internal imbalances, which they of course are, the real cause of the problem in Germany is especially one of investment. That is where we should look, to see how we could boost it. We have problems with private investment, even though German companies realised huge profits, at least in different parts of the time range between 2000 and 2012. The problem is not that there are no profits to invest but that they do not invest them in Germany, at least not as much as seems to be suggested by those profits. We also have a problem with public investment, especially on the lowest level of our federal system with the communities. They have a lot of budgetary problems and the first thing that they shrink in their budgets is, of course, investment. They decide politically, “Don’t invest”, so this money is saved, at least for a time. That is the problem we have to focus on and it was a point on which we as the SPD were focusing in our electoral manifesto. In our programme, we had the central idea of increasing investment and, of course, trying to support consumption—especially by means of a minimum wage, not only for those economic reasons but as a point of justice because there are parts of the German economy where the wages are scandalously low. However, on the greater scale of the whole economy, our focus was especially on investment and that is what is in line with those larger aggregates.

Q275 Lord Flight: How sacrosanct is Germany’s commitment to the euro? Over the past 40 years, every time Italy has been tied to Germany’s currency, its economy has gone into sharp decline and every time it has exited it has roared ahead. Right now, it has been sharp decline for 10 years and caught in a quite dangerous debt trap. So there is a classic economic argument for Italy to leave the euro. There may be pressures for it so to do politically as well over the next year, unless, to my mind, there is a much broader federal eurozone commitment. Ulf Meyer-Rix: One question may be whether you would like to enter monetary union in the state of diversity that has developed between the member states over the past 10 years. The other question is, since we are in this monetary union and since the developments of

359 of 441 Ulf Meyer-Rix—Oral evidence (QQ 273-286) the past 10 years produced results that are effective for our economy, whether to leave this union just now or to force other members out. Our position is still that we should cling to this monetary union. From our internal perspective, it is clear that we made a lot of not only political but financial commitments to save the euro, not only via the loans, given to Greece and other crisis-ridden countries, but also via the mechanisms of the ECB — those famous target balances. As long as the monetary union is there, those target balances are only in the accounting of the ECB. On the day that some members leave and are unable any more to repay their debts and validate their debts in euros, because the euro is not their currency any more, those balances are realised in real money. Of course, if you look at this amount of hundreds and hundreds— Lord Flight: €700 billion. Ulf Meyer-Rix: Yes. So it is something to consider. It is perfectly sensible to think about what may happen, but politicians who are responsible for the real budget must take into account those problems. The Chairman: Just before I bring in Lord Davies, is it ever realistically possible that Germany would be a net importer? How would that even begin to come about? I take your point about investment being the name of the game, but could it even happen that Germany could find itself in that unusual position? Ulf Meyer-Rix: It is really not easy. Not only have we accumulated those big surpluses on our trade and current accounts, underneath there lies a kind of specialisation in our companies and our whole economic structure that we cannot change from one day to another. Our companies are producing what they produce today, and to say that we would like to switch to other ones this will take time.

Q276 Lord Davies of Stamford: I hope that you would agree with me that in answer to my friend, Howard Flight, who suggests that the answer to all the problems is devaluation, what is important with all prices and price movement is the movement not so much of nominal prices but of real prices. There has been a real internal devaluation, which has been considerable in the southern countries over the past two or three years, which is very encouraging. That is very effective and does not carry with it the dangers and costs of external devaluation, which include a boost to domestic inflation, which would be disastrous, and the solvency problems to which you referred, which would be even more disastrous as both sovereign borrowers and the private sector, including banks, find it impossible to meet liabilities denominated in euros if their income is no longer denominated in the euro. That seems to be the answer to that question. Turning to the whole question of banking union, to what extent do you think it is essential that we have in place all three elements, not merely a common supervisory system, which I think is now agreed, but also a common bank resolution mechanism and a common retail deposit insurance scheme? There seems to be very little progress on the second and none at all on the third, and the second is held up by German concerns about the mutualisation aspects of a bank resolution system. What is the SPD’s view on that? Is it possible that, as a result of the coalition agreement, there will be the basis for unblocking that mechanism? Ulf Meyer-Rix: As I said before, the banking union is a part of this whole parcel of genuine economic and monetary union, which is essential to stop the process of dissolving that we saw last year. That is the picture in which I have to look at the different parts of banking union and ask whether they contribute to the restoration of a single financial market inside the monetary union. Single supervision is of course an important point. What we saw in the first half of the existence of the EMU was, if you look at the numbers, not really the problem

360 of 441 Ulf Meyer-Rix—Oral evidence (QQ 273-286) of too much sovereign borrowing in the periphery—perhaps there was in Greece and a bit in Portugal—but an enormous increase in private borrowing in all the southern, periphery countries and, of course, in Ireland. All European banks were engaged in lending to satisfy that demand for private borrowing, and those national regulators all had incentives to keep the engine in their countries going to boost investment and growth. As always in those financial and real estate bubbles, as long as they work, everybody says, “It is normal, don't be silly, don't be the last one to engage”. All those national regulators had a strong incentive not to be strict with all those supervision of borrowing and lending processes. If we want to stop that, it is important to have a single supervision.

Q277 Lord Davies of Stamford: If I may say so, that is a very clear and good summary of the situation about the single supervisory authority. I think that we are all agreed on that. I think that the whole Union is agreed on that. The Council has taken the decision to have a single supervisory authority. What concerns us are the other two elements, which you said were indispensable but not in place. We could well have a situation in which the single supervisory authority wishes to have a resolution of certain banks, but no resolution mechanism is in place. What is the SPD’s view on that? Do you think that it is an urgent problem? Do you think that you could contribute to solving it? Do you think that, as a result of the coalition Government emerging, it will be easier to solve that and that some of the resistance to solving it from the German side will be reduced? Ulf Meyer-Rix: This was a point of clear difference between the SPD and the former coalition, the CDU/FDP. We are in favour of a common resolution mechanism. In our view, they belong together. If the single supervisor comes to the point of asking for a bank to be resolved, there has to be a mechanism which all stakeholders know will be the same, whether the bank is in Spain, Germany or Portugal. Otherwise, we would just replicate the problem that I talked about before. Lord Davies of Stamford: In what sort of timescale do you think this matter could be resolved? What model do you think would be accepted for a bank resolution mechanism? We had a proposal this morning from one of our academic witnesses to leave the existing bank resolution systems in place and then to have a European authority on top of it. Ulf Meyer-Rix: I am not sure what compromise will be reached in the coalition talks, because there is a huge difference. The CDU is not really convinced about a common system, so I am not sure whether we will have that or whether we try to find a substitute by way of a national resolution system and, on top of that, something to supervise the national processes to make sure that there is common handling of similar problems. I am not sure that this would be enough, but there is great commitment in all parties in the German Parliament that there should and must be an agreement about a resolution mechanism in place when the single supervisory authority comes into effect.

Q278 Lord Davies of Stamford: My final question is: what about the third element, in that case, of a common system for retail deposit insurance? Ulf Meyer-Rix: That is still a bigger problem for Germany in two ways. Lord Davies of Stamford: I think that we know about the present German position, but does the SPD have a different perspective on it from the CDU, and will the coalition agreement results in a difference in German policy on that? Ulf Meyer-Rix: I think that there are differences in a way. But of course everybody in Germany is very slow to suggest mutualising debt, not only in the sphere of the sovereigns but also in that of bank accounts.

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Lord Davies of Stamford: We had gathered that. Thank you very much. The Chairman: Before I bring in Lord Marlesford, do you think that if a taxpayer-backed backstop was required to effect the resolution mechanism, the German people would be amenable to funding it or would they shy away from that? Ulf Meyer-Rix: A credible backstop would be a precondition just to talk about ideas like that in a really political way. Whether it would be enough to convince the people to agree to a system like that, I am not sure. The Chairman: I think that that is our answer.

Q279 Lord Marlesford: I wanted to ask you about your views on the process that the ECB is going through. As I see it, at the moment the eurozone is travelling through a tunnel that is quite quiet and calm. Next summer it will come out of the tunnel either into the sunlight or into a blizzard. Lord Flight: A hurricane. Lord Marlesford: Well, whatever. That will depend on the result of the ECB’s asset quality review—what we commonly call the stress test. There are three things that I would like to ask your view on. First, does the ECB have the skilled personnel to undertake that review within the timescale, given that the banks have shown all too often that they have very little idea of the real value of their own debt? I am talking about the quality of their lending; they have made lending—sometimes deliberately and rationally, sometimes unwisely and even dishonestly, but sometimes just incompetently. Secondly, does the ECB not have a conflict of interest between getting at the truth, whatever it reveals at the end of the tunnel, and keeping the show on the road as the monetary authority maintaining the confidence of the markets and enabling Draghi’s “We will do whatever it takes” to happen. The third question is a follow-up of what Lord Harrison just said. Let us assume it is a blizzard and a big hole in the collective finances of the banks is revealed, how do we fill it? Ulf Meyer-Rix: Concerning the quantity of the personnel of the ECB— Lord Marlesford: Quantity and quality. Ulf Meyer-Rix: As I understand it, it relies not only on its own personnel but has hired consultants; that may be an answer to the quantity part of the question. To the quality question: Banks have lots of possibilities to evaluate their assets and of course they have to have ideas about the future to do those evaluations. It might not be just incompetence or idealistic ideas about the future that mean that, with hindsight, evaluations seem to be completely out of line with real developments. But I think that there will be strong outside pressure for those asset reviews to be done in a very sensitive and even strong way. I also have in mind the problems with those EBA assessments some years ago, when some banks passed and months later they needed large rescue packages. The setting and the outside pressure on the ECB should be large enough for it to be very intensively done, with all the limitations that are there when people are concerned. Of course, in a way the banks that are going to be rescued are the customers of the ECB, even though they try to fence those different departments. The Chairman: What about the particular point that Lord Marlesford made, that it is the responsibility of the ECB to maintain the confidence of the markets but also to be scrupulous about determining the truth about the asset quality of the banks? Ulf Meyer-Rix: That is directly connected with the question of a credible resolution mechanism. If there was a credible mechanism for what to do with banks that do not pass

362 of 441 Ulf Meyer-Rix—Oral evidence (QQ 273-286) the test, you could solve this problem and this conflict of interest. In this case, a very strict test would enhance the credibility of the market as a whole but if there is no credible process of what to do with banks that fail the test, of course it would be a problem for market stability. Therefore, it is necessary to have a credible answer on this part of the banking union process too; otherwise, the question remains that if you do not have a reliable answer, what will happen to a bank which fails the test? Afterwards, if we have a resolution mechanism but no reliable idea of how to fund the resolution process, it will just walk back all the way and then we have a problem with market stability. Lord Davies of Stamford: There is not a cat in hell’s chance of getting those two elements in place in time for the stress test and the asset quality test, is there? It just cannot happen now. Lord Flight: The more the German medicine works in creating a deflationary downward spiral, the worse the problems of the banking sector in those countries as well. Ulf Meyer-Rix: That is true, of course. If you look at the figures, all those countries are gearing up the fault rates. On the other hand, measures have been taken to prevent these problems. We had large rounds of bank recapitalisation in Spain, Greece and Ireland. We had a kind of recapitalisation in Italy that was more below the surface, which consisted of a switch of some accounting reserves into tax credits. We saw a similar measure some weeks ago in Spain, which gives the banks more reserves to get through the tests, although at a cost to the taxpayer in future. The Chairman: To sum up Lord Marlesford’s point, there almost has to be a paradox that some banks will have to be exposed as being faulty in order to give credibility but by doing that, maybe it can survive and the mechanisms can be found to resolve it. Viscount Brookeborough: I accept that it will take somebody like the ECB to expose it but in practical terms, why is it required that the banks know their assets? Why is the ECB the only organisation that can tell them that the quality of their assets is not acceptable? Lord Marlesford: It is going to be the supervisor. Viscount Brookeborough: I accept that but these banks are sitting there, knowing what assets they have, quivering and waiting for the ECB. Lord Flight: They are not going to go public on bad news, are they? The Chairman: Let us go to Lady Maddock. Lord Flight: Tax credits are no longer allowable as capital under the recent ruling so the tax credits trick that Italy has done does not work any more.

Q280 Baroness Maddock: I wanted to talk about an integrated budgetary framework. There is a view that because there is no fiscal stabilisation capacity across the whole of the 28 in Europe, not just the eurozone, this is a problem. I do not know what the German view on this is. If you thought it was a problem, what scale of top-down fiscal stabilisation would you think desirable? Ulf Meyer-Rix: I think that whether there should be a kind of fiscal equalisation capacity depends on how we answer the question of what differences in the standard of living in the different parts of the monetary union we will accept, and what differences the people will accept. In Germany, we tested those questions some years ago. After reunification, we introduced monetary union between economically different parts of our country. Our special point of view, from being in the same country, was that there were very large

363 of 441 Ulf Meyer-Rix—Oral evidence (QQ 273-286) differences that in the longer run would not be politically acceptable. It was clear from the outset that there must be a large amount of transfer. Of course, this question of what differences of standard of living are politically and morally acceptable will not get the same answer in different countries of the European Union as inside one country where those equalisation schemes have to be much larger; for example, in the United States they have very a large, if indirect, equalisation mechanism via the federal budget. Your second question about the amount that is needed to fund a top-down equalisation mechanism cannot be answered correctly without having an idea of what different standards of living will be acceptable, and of what will happen if the people start moving in reaction to those different standards of living. It is not really clear what the answer will be in the end. Of course, our Social Democrat view is that there should be an equalisation mode. But it is not as if there is no transfer at the moment: We have the structural fund and the regional funds of the EU and we may have to look at the possibility of expanding or augmenting them in a proper way; on the other hand, we have to look at the possibility of absorbing the funds in a useful way. It is between those margins where we have to look for an answer to the question. Baroness Maddock: I think in a way you were talking more about redistribution than stabilisation. Perhaps you would like to expand on that. Ulf Meyer-Rix: Stabilisation is – in the short run - more importantly addressed by the question of banking union. If there was a situation in which, in a sustainable manner, there was private capital inflow into all countries that need inflows and can use them to expand their economy and their standard of living, there would be no necessity for publicly funded stabilisation programmes. So, on stabilisation, the banking union project is more important at the moment. As I referred to earlier, the problem of monetary union is not that there is a level playing field and we have to react to asymmetric shocks; it is composed of two very different parts. The situation has to be stabilised, and that is what I am trying to make clear. The main focus is on the banking union process; it cannot be done without that. Lord Flight: What about the politics? If the German medicine grinds the economies down, there is a risk of political reaction. Look at the history of the 19th century and what happened to Germany. I am worried about political extremism developing, especially in Italy. Ulf Meyer-Rix: Of course. It is in a way inevitable that there will be a political reaction to an economic crunch like that. We see that political reaction all over those countries, in different ways and in a very violent and unpleasant way in Greece, of course. Then there is how it plays out in Italy, where there is a populist movement, the Five Star Movement of Beppe Grillo; but it seems to be not that extreme. It is hard to get at it. Of course, there is a political reaction on the other side. In our reactions here in Germany, we saw the “Alternative für Deutschland”, a populist party arguing against the euro. The Chairman: They were interesting, were they not? Although they were against the euro, they did not have the other nexus of being anti-this, that and the other in the European Union. In fact, far from it; they were for a single market and for the European Union. It was the euro that they specifically objected to. I am going to ask Lady Maddock to return to the point that she made before.

Q281 Baroness Maddock: I shall move on slightly. We have had quite a lot of witnesses who have said that Germany has been implacably opposed to debt mutualisation, and in particular eurobonds. Do you think that this position will remain, particularly with what is happening in Germany now, or is it likely to diminish?

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Ulf Meyer-Rix: No, I think that in the short run at least that position will not alter. Our SPD view on this was a different one. In our election manifesto, we clung to the proposition of a special fund, which was proposed by the Council of Economic Experts here in Germany, which would combine the idea of debt mutualisation in the short run but leave the responsibility of paying back with each single member state. It would be mutualisation just for the time being but not for ever; but every single country that used money from the fund would internationalise its own debt, in a way, and would be responsible for paying it back in a very strict way. The Chairman: That is now off the table, is it? Ulf Meyer-Rix: Yes, it seems to be off the table for the moment. I rather do not think that it will be part of the coalition agreement, if it comes into being. For now, you will not see any German initiatives on this point. Baroness Maddock: But do you have a view about any conditions that might be acceptable for mutualisation? Ulf Meyer-Rix: The conditions that belonged to this proposal for a special redemption fund were the strictest that I can imagine. This fund was not a proposal of the SPD or some left- wing institution; it was from the Council of Economic Experts, which from no perspective is tied to our side.

Q282 Viscount Brookeborough: Is there any need for deeper economic policy integration among euro members? How far does this element of GEMU intend to go, and is it practical? Ulf Meyer-Rix: In the situation that we are in now, which, as I said, is characterised by these huge imbalances, it is inevitable, if you want to stay on with monetary union, that you have to have a deeper integration in economic policy. We cannot all be exporters; there has to be a common framework to cope with the question of the economy of the eurozone as a whole —otherwise we cannot cope with these imbalances. The question then is whether it is enough or how far this purpose is served by the kind of thing that is envisaged. Viscount Brookeborough: Do you think that the euro members are happy to go in that direction? Ulf Meyer-Rix: Happy? What we see, at least for now, is that all members want to stay in the Union. I think that they will realise that, if they want to go on this way, they will have to go in that direction. As I said before, the external imbalances are a mirror image of internal imbalances. For instance, as Germans we would deliver into such a common economic policy the commitment to steadily invest more than we did in the past 10 years. It would not be against our own interest to do that. We have large policy discussions here about collapsing bridges or potholes in streets, and infrastructure in general. Here in Berlin, part of our public transport infrastructure is 100 years old, and it has to be renewed step by step. This is under way now but of course there is still a lot to do in that way. If you try to focus not on the first step, on the external side and talking about what you have to harmonise on the European level, and try instead to tackle the problem from the perspective of the individual member states, you can ask what the internal mirror image is of the imbalance. If you ask what it is we want to do here, and deliver as part of a European pact, you can look differently on the question of more economic integration.

Q283 The Chairman: Before Viscount Brookeborough goes on, as politicians all around the continent each and every one of us has his or her own favourite potholes, but can you

365 of 441 Ulf Meyer-Rix—Oral evidence (QQ 273-286) give a precise example of economic policy integration? It would be very useful to have an example of where you think that might be usefully done—and then I want to return to Viscount Brookeborough. I know that it is a difficult question to answer. Ulf Meyer-Rix: There is, for example, the renewal of the energy structure of all our economies. In Germany, we had the decision three years ago to switch from nuclear power to renewables; that is not only a question of abandoning the nuclear plants and trying to install as much as possible wind energy plants—you need a completely new infrastructure. Substantial production will move from the parts where those power plants were formerly to those coastal regions, where the offshore wind is coming. It is a huge programme of investment, which is completely in the interests of our country, and of course we could contribute to it as part of a European programme. The Chairman: Do you remember that they used to be called trans-European networks? I always thought that, in so many areas, they were a very good idea.

Q284 Viscount Brookeborough: We understand that your Chancellor Merkel is keen on binding contracts, known as convergent and competitiveness instruments. Are these credible, effective and possible? Will they work? Ulf Meyer-Rix: Maybe you do not know—a lot of people do not know—that in our inner German fiscal relations between the federal level and the Länder level, we use this instrument. In connection with— Lord Flight: Does it work? Ulf Meyer-Rix: Yes, it does. We had this debt brake introduced into our constitution three or four years ago now, which forces the Länder to refrain from net borrowing from 2020 at all. There will be net borrowing of the Länder; at least in a structural way there will be a component to adapt changes in the cycle, but from a structural perspective there will not be any possibility to be a net borrower. Viscount Brookeborough: So you will not transfer in order to offset this? Ulf Meyer-Rix: What happens now is, to support the poorest of the Länder in this way from heavy structural borrowing at the time when we imposed this debt brake until 2020, they receive some money from the federal level, but in exchange for the commitment to some reforms in their budget structure. They were, in a way, bilateral contracts between those Länder who receive the money and the Bund. The Chairman: I will turn to Lord Marlesford, but I cannot resist the comment, “Neither a Länder nor a borrower be”.

Q285 Lord Marlesford: This Committee has been following closely the financial transaction tax to which the British Government are opposed on the grounds that it has to operate worldwide or not at all and that it would, in the proposed way, risk damaging the City of London. We know what is happening in terms of the enhanced process for getting agreement on it. I would like to ask you, if I may: has it been any part of the coalition negotiations? Secondly, and perhaps most importantly, what other tax measures have been discussed in the coalition negotiations? Ulf Meyer-Rix: The financial transaction tax is important for the Social Democratic Party as a means also of having the banks, as the culprits of the crisis, pay for it. There will again be a kind of reassurance of the common commitment by Social Democrats and the former coalition when enacting the fiscal compact. When enacting it here internally in Germany

366 of 441 Ulf Meyer-Rix—Oral evidence (QQ 273-286) there was a precondition for Social Democrats that there would be a commitment to a financial transaction tax. It will depend on the further path of this proposal in Brussels and what will come out then. However, our joint position will be reassured in this way. On other tax questions, they are not in the centre of the coalition debates now. Lord Davies of Stamford: What would you use the financial transaction tax for? Is that just to finance banking union or for some other purpose? Ulf Meyer-Rix: That question is complicated because there are a lot of ideas of how to use it. Of course, if we had this tax between those member states, the idea would be to use at least a substantial part of it for funding a fund, to have in future crises a backstop that is paid for by the banks themselves and not by the taxpayer. The Chairman: On that point, before I ask the last question, you should know that this Committee came out very strongly against the FTT and that we are currently writing a further report on the enhanced co-operation procedure with the use of the FTT. We are highly sceptical of it, and we wonder whether, with the two parties which have this fixed element in the potential German coalition of the SPD-CDU-CSU, it will just lie on the table and never be enacted in truth. Ulf Meyer-Rix: Of course, what we could do as opposition and what we would be able to do as part of government here is only to try to enhance the process on the European level. We are not the sole decision-makers on this. Politically, it is a very important point for the SPD. If there was no progress on the European level that will be a political problem. That is for sure. Lord Flight: A point was put to us by one of your colleagues that Germany could bring in a kind of stamp duty transaction tax like in the UK, which would be a very neat and easy way of addressing the party politics. Ulf Meyer-Rix: It was the position of the SPD to say that if we cannot get a tax on an international level, we should at least resort to a tax of this British stamp duty-type. Since there has been a drive in the European processes in the past few years, we were not that loud on this part of our position from some years ago because we did not want to take pressure from the European process. However, if it should turn out that it will not be possible to reach agreement on a European or international level, there will again be a question of whether we should not have it at least—but it is only the fall-back position; it is not the idea to promote the stamp duty instead of having this European process. That could be a question which arises if it becomes clear that the process on the European level does not lead to something.

Q286 The Chairman: Let me ask this question. We ask you to be frank as possible because we would like your advice to us as the UK in the first instance about genuine economic and monetary union. What do you think our position should be in terms of helping, aiding, abetting and encouraging what is happening here? What would you say to our coalition Government? As I and Lord Davies are of the opposition party in the United Kingdom, perhaps you would also like to tell us in the Labour Party what should be our position, whether you even differentiate between the Labour Opposition and the current coalition in terms of the presentation of the United Kingdom view. Or is it true in Germany that the United Kingdom is seen as a potential ally that never quite comes up to the mark? Ulf Meyer-Rix: To be frank, it is not a prevalent public view to see the United Kingdom as a potential ally on this question at the moment. Of course, especially with the current Government, it concerns not only the question of monetary union, which is in its own right

367 of 441 Ulf Meyer-Rix—Oral evidence (QQ 273-286) and to be seen in very different directions. We see not only a Eurosceptic position but sceptical positions on everything concerning the European Union. So it is hard, at least on first-glance level, to see a potential ally. On the other hand, if at least those parts of the process of genuine economic and monetary union, which are really necessary to bring this Union into function and flourishing fail, then all of Europe has really big economic problems and this will, of course, concern the United Kingdom. Europe, whether as the European Union or just as all those different economies here on the continent, will be part of the solution of your economic problems as well. At least on this point, there should be an idea of aiding and helping to get through the process which at least allows the stabilisation of the monetary union in the way that allows it to be in the world for the next years and to be the flower bed of a new, flourishing European economy. I think that we all need this. We cannot in a broader political perspective put all our lots in the hope of a revival by China or east Asia in some way. The Chairman: Ulf Meyer-Rix, you have been tremendously helpful to the Committee in the past hour or so. Thanks ever so much for answering all our questions so clearly and cogently. I indicated earlier that we will send a transcript of this exchange. Please correct it and improve on it. We would be most grateful for any further ideas you think might be helpful to the Committee in its deliberations for the final report. In the mean time, thank you for coming to this part of Britain in the middle of Berlin to talk to us. We are very grateful for your frank and full approach. Thank you very much indeed.

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Open Europe, Centre for European Reform and John Peet—Oral evidence (QQ 1-18)

Transcript can be found under Centre for European Reform, Open Europe and John Peet

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Marco Pagano—Oral evidence (QQ 78-88)

Evidence Session No. 6 Heard in Public Questions 78 - 88

TUESDAY 16 JULY 2013

Members present

Lord Harrison (Chairman) Viscount Brookeborough Earl of Caithness Lord Carter of Coles Lord Davies of Stamford Lord Dear Lord Flight Lord Hamilton of Epsom Lord Kerr of Kinlochard Baroness Maddock Lord Marlesford Lord Vallance of Tummel

______

Witness

Marco Pagano, Professor of Economics, University of Naples Federico II

Q78 The Chairman: [Italian.] We hope that you are able to answer our questions. Signor Pagano, we will make a text of your conversation this morning with the Committee. We will send it to you, and I hope you are able to correct it, and indeed to add any points that you feel that you might like to after our conversation. I would be very grateful to you if you could say who you are, and tell the Committee your position. Marco Pagano: I am a Professor of Economics and Finance at the University of Naples Federico II. I am also the president of the Einaudi Institute for Economics and Finance, which is a research institution mainly funded by the Bank of Italy, which partly explains why today I am using the facilities of the Bank of Italy to communicate with you. I am also the vice-chair of the Advisory Scientific Committee of the European Systemic Risk Board. Starting from 1 January next year, I will be the chair of the Advisory Scientific Committee. These are my main affiliations. The Chairman: If the Governor of the Bank of Italy is sitting next to you, we would be very happy to talk to him as well! However, in default of that, perhaps I could ask you the first questions about genuine economic and monetary union, and ask whether you feel that the necessary points are now being laid to ensure the encouragement of the survival of the euro. Please could you offer a critique of what you think is beneficial of the proposals that have come from Herman Van Rompuy and the Commission? What elements do you think are perhaps potentially less successful?

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Marco Pagano: I would say that the main problem with this proposal is that it is coming far too late. It should have been advanced much earlier; as a matter of fact immediately after, or perhaps even before, the introduction of the euro. Even if it had been done in the first five years of the life of the euro, it would largely have avoided the destabilisation of the euro- area financial markets and banks as a result of the crisis across the ocean. It would have spared us lots of trouble. It would have spared lots of trouble to taxpayers and workers in the euro area, and perhaps some worries to you as well. The Chairman: Going back to the time of the creation of economic and monetary union, if we had no troublesome institutions such as the German constitutional court, would there be other elements that you would include in the formation of economic and monetary union that are perhaps absent today, but which would have been useful to have had then and useful to have now? Marco Pagano: Many of the elements of this proposal, and elements that I am going to discuss now, have been quite apparent—for instance, to Jean-Claude Trichet and other people who contributed to the design of the euro—but they have essentially been eliminated by euro-area politicians upon the demands of Governments, at the time of the introduction of the euro. It is not as if we did not know that these things were necessary. We knew it all along, but many countries were not ready to give up this extra degree of sovereignty, and perhaps now they will. Let us hope so. Now, one area that is missing from genuine economic and monetary union, which I think would be important, is the creation of a safe sovereign debt asset in the European Union. There are various proposals on the table, as you certainly know: eurobonds, euro bills and a redemption fund. The one that I think has been least considered, yet could be easily implemented without any treaty change, and would immediately provide European banks and even the European Central Bank with a kind of European bond, is the proposal that the Euro-nomics Group, which I am part of, has advanced. This proposal is essentially the creation of a synthetic European bond by pulling together in pre-determined shares, which are proportional to GDP, the existing sovereign debt—for different maturities of course—issued by euro-area members, and by tranching it through, essentially, a securitisation. The issuance of this synthetic asset would be into two tranches—a senior tranche, which is obviously safer, and a junior tranch that will be less safe, called respectively European safe bonds (ESB) and European junior bonds (EJB). The European safe bonds could then instantly be not only the type of security sovereign debt that the euro-area banks could be safely asked to hold, instead of national government bonds, but could also be used by the European Central Bank for its open market operations, and could be used as collateral to finance European banks. Moreover, this would make available to European households and firms a reference safe asset, which would be comparable to federal debt in the United States.

The Chairman: Before I pass you to my colleague Lord Dear, it would be very useful to have anything you have written about your version of eurobonds, if it was possible for that to be made available to us. Marco Pagano: Yes. All the material describing not only the pros and cons of this proposal but also the exact details of how it should be implemented, or how it could be implemented, is available online, on a site called www.euro-nomics.com. This is a website that has been created by a group of academics. These are European nationals who mostly teach in the United States, plus a few who teach in Europe. I am part of this group. The Chairman: I think Bruegel’s red bond, blue bond idea, and Graham Bishop’s variation on euro bills are maybe similar proposals.

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Marco Pagano: Let me just say one thing. This is different in two senses. First of all, it takes the existing debt and pulls it into a synthetic security. Secondly, in its pure form, it does not imply any form of fiscal solidarity or risk of the fiscal transfers across Governments, unless they choose to guarantee the solvency of the senior tranche by putting up a fund, which would act as a further shock absorber to protect European safe bonds in case of losses that were so large as to wipe out entirely all the European junior bonds. Essentially, by choosing the size of this guarantee, Governments could effectively fine-tune the extent of the transfers across countries—i.e., the degree of fiscal solidarity—that they want to allow for in a crisis. It could be either zero fiscal solidarity, i.e. zero guarantee, or as large as one wishes. In that sense, it is quite different from the other proposals, because by itself, it does not require any degree of fiscal transfers across the euro area. The Chairman: Thank you for drawing our attention to that. That is very helpful indeed.

Q79 Lord Dear: Professor, good morning. My name is Lord Dear. I am a Cross-Bencher, a politically independent member of the House of Lords. To some extent, you have answered the question I was going to put to you. You talked about euro-nomics, the European bond proportionate to GDP, and senior and junior tranches; that is very interesting. I wondered if you could perhaps develop that just a little. Do you have any ideas about further reforms apart from GEMU? Are there any further reforms that you think might be undertaken to resolve some flaws in the system? Do you think the situation will change, for better or worse, following the German elections? Marco Pagano: Let me outline one important point, which, even though it is quite present in the minds of many people in Europe, has not been put on the table, probably for fear of the potentially destabilising consequences. It is the reform of the prudential treatment of European sovereign debt in European banks. This is not part of this genuine economic and monetary union plan. I think we pretty much all agree that the key feature of the current crisis in the euro area is the perverse loop between the fiscal crisis and the bank crisis. One element that is necessary in order to cut this loop is to prevent banks from holding risky government debt, or at least too much of it, or too concentrated in terms of risk characteristics. This is particularly important right now, because if anything, at the current stage, the degree of home bias of euro-area banks in their holdings of sovereign debt has increased to the maximum in the last four or five years. This means that, essentially, if for instance Italian BTP prices or Spanish bonos prices drop because of renewed tensions in the sovereign debt market of these countries, Italian and Spanish banks will be even more exposed to this destabilising drop in the market value of their holdings than they were before, because they simply have more of it. One key thing would be to change prudential regulation to deter banks from concentrating their sovereign holdings, and especially concentrating it by holding too much risky sovereign debt, because that is one element of the current vicious circle that we have had, and we still have, in the euro area. Going back to my proposal, if we had banks holding a well-diversified mix, or a synthetic asset that is a well-diversified mix of sovereign bonds, this problem would automatically disappear. However, this requires a change in bank regulation, relative to the current situation, where essentially banks face a zero-risk weight on all sovereign debt issued by euro-area Governments, irrespective of which Government it is. Therefore, whether it is issued by the Italian, Spanish or German Government, a bond is the same object for bank regulators in Europe right now. This provides a very perverse incentive for banks to engage in the purchase of risky, high-yield sovereign debt: especially banks that are undercapitalised and may wish to bet for resurrection, and have the incentive to engage in buying a lot of high-risk sovereign debt.

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Lord Dear: Do you think things will change after the German elections for any reason? Marco Pagano: I am not a political expert; I am an economist. I honestly do not know. First of all, we do not know what the outcome of the elections will be. There may be a bit more flexibility by Germany in considering reforms such as those outlined in the genuine economic and monetary union plan, which inevitably require a certain degree of further sovereign transfer either to the European Commission or to European central institutions such as the ECB, or a newly created euro-wide resolution authority. It is hard to say, because it is difficult to distinguish between what you may call “the persistent nationalism” that has been plaguing Europe, which is a fundamental constant—or more or less constant— and what may be temporary political concerns.

Q80 Lord Davies of Stamford: Professor Pagano, I think your point about the great dangers of the artificiality of regarding sovereign debt assets in the eurozone as risk-free is very well taken. However, I wonder whether your proposed remedy would not be equally dangerous, because if you change the prudential rules, you would force the banks to unload a large part of their holdings of non-prime sovereign debt in the EU, and that would surely depress the market, put out yields and itself create the kind of crisis we want to avoid. The Chairman: Do you have a brief reply to that? Marco Pagano: This is a very good point, and I realise that there is this kind of transition concern. It is very important to think of this reform as something for the long run, and not something that should be adopted tomorrow, but we should start thinking about ways to go in that direction, without, as you correctly point out, destabilising the markets. The reason why this is not being talked about openly is precisely because of this danger that you just mentioned. Nevertheless, in my view, this should not prevent us from considering this problem, because this is one of the key elements that has determined the perverse feedback loop between banks and Governments. The Chairman: Professor Pagano, if you have any thoughts about the transitional arrangements that might be created to satisfy Lord Davies’s perceptive point, we would be very grateful, but we change our direction of inquiry with Lord Flight.

Q81 Lord Flight: Good morning, Professor. Would you agree that the role of the ECB is fundamental to genuine economic and monetary union, and that it has not been given much attention so far? How would you define its role and the division of territory between the ECB and Governments regarding GEMU? Marco Pagano: I agree that right now, in particular, the European Central Bank is probably the main institution holding things together in the European financial markets in a variety of ways, both by providing liquidity to banks and by holding this kind of off-equilibrium threat, which is the OMT scheme—the outright monetary transactions scheme. However, this is a very particular situation. What should probably be the normal state of affairs is that the ECB, like other central banks, should be in charge of price stability, by which I mean not just keeping inflation low, but also avoiding deflation, which is probably the greatest danger now. Also, as is increasingly being realised, both across the ocean and in England, a key role for the central bank is to look after macroprudential stability, which means preventing situations in which financial markets as a whole may be destabilised. Part of this is because it is good for society, and it is partly because, as the ECB itself has realised, it is almost impossible to do monetary policy if financial markets are in a state of turmoil. For instance, even now it is very hard for the monetary action of the ECB to affect the Italian or the Spanish economy, because the interest rates in these economies do not respond to the normal monetary

373 of 441 Marco Pagano—Oral evidence (QQ 78-88) policy stimuli. Essentially, one key task of the European Central Bank is to promote change right now that will lead the European financial markets away from their current state of fragmentation, and lead them to be integrated again. I would say that these are the main roles. You asked before, “What should the role of the Governments be?” Of course, a large portion of macroprudential actions cannot be taken by the ECB. For instance, if the real estate market in a country starts embarking on a bubble again, the decision to change loan-to-value ratios is something that is not within the powers of the ECB. The Chairman: Signor Pagano, is it the role of the European Systemic Risk Board to intervene at that point? Marco Pagano: Yes. The European Systemic Risk Board should make recommendations at that point to the national Government to intervene—for instance, by changing loan-to-value ratios. However, it is not within the powers of the European Systemic Risk Board to actually change those parameters. It can only make recommendations, so at that point there must be a certain degree of co-ordination with the national Governments, such as the Treasury of that country. Lord Flight: In the situation you describe, surely if the ECB becomes the regulator of the main banks and if its regulatory role is analogous to the PRA in the UK, the ECB is actually going to directly tell large banks what to do in order to head off the property bubble? Marco Pagano: Yes, it can do so. However, suppose that there is a sector imbalance, and that not all banks are lending to the real estate sector. Maybe you do not need to intervene on all banks by, for instance, changing their prudential ratios to induce them to lend less, but you specifically need to intervene on the real estate market. At that point, you may want to have more selective measures that are specific to that sector, and loan-to-value ratios is one example. You may need a multiplicity of macroprudential policy tools. The Chairman: Signor Pagano, we do not have much time. I wonder if you could just say whether the ESRB’s role is clear within the genuine economic and monetary union, before I pass on to Lord Vallance? Is it clear? I have not really been very conscious of it working. Marco Pagano: The European Systemic Risk Board has relatively well-defined tasks. I feel that the problem it has had so far is that it is not very clear how its recommendations can be made to stick with the Governments. It has issued several recommendations lately, although they have had a very limited echo in the press. Apart from issuing recommendations, there is little else that it can do. There is also another important point, which is that it is a somewhat bloated body in its design. Its general board is formed by all the representatives of the European national central banks and the securities regulators, so it amounts to over 50 people in a room. It is very difficult for such a large body to take effective decisions, and I would say it is somewhat hampered by this design and governance.

Q82 Lord Vallance of Tummel: Professor Pagano, the Commission has recently published its proposal for a single resolution mechanism, which puts the Commission in pole position. That is at variance with the Franco-German paper on the subject, and a few questions flow from that. First, in your view, which approach would be more effective, assuming any legal difficulties could be ironed out? Secondly, which is more likely to come about, given the German opposition to the Commission’s approach? I believe the German opposition is based on a feeling that their taxpayers would be at risk, and that the Commission might be operating ultra vires. Marco Pagano: Let me say that some of these concerns are well based, and there should be appropriate safeguards for the German taxpayer in the design of such an institution.

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However, I think it is key to have a single resolution mechanism, with a certain degree of flexibility, which is envisaged even in the proposal by the Commission. There should be a single body such as the FDIC in the United States, when could swiftly intervene in a case of distress, especially with large, systematically relevant institutions with large cross-border operations in Europe. It is essential to have such a body already in place by the time the banking union starts, and I think that failing to envisage this is a shortcoming of the current way the Commission is proceeding in this matter. It is essential to have such a body in place and ready to operate at the very moment in which the single supervisory mechanism—the new bank regulator of the banking union—will actually start operating. It makes absolutely no sense to have a single prudential regulator which, when it recognises a situation of distress that needs intervention in a bank—especially in a systemically important financial institution—cannot immediately either intervene or have another institution intervene in that bank in order to stabilise it, either by restructuring it or by having partial bail-in or partial bail-out of that institution. It is particularly important to have one institution that does this in Europe, because there are huge potential cross-border externalities at the moment, with institutions such as Paribas, UniCredit or Deutsche Bank. These banks operate all of Europe, so it would be a great mess if there were separate national-level resolution authorities that had to co-ordinate at that moment. I realise that this is, again, one further piece of sovereignty that German and French Governments, and other countries’ Governments, are very afraid of losing. However, it is a very important element in the new architecture of financial markets in Europe. If a European single resolution mechanism was not in place at the same time as the single supervisory mechanism, we may end up in a situation that is potentially even worse than the current one. There is no piecemeal approach in this issue. If we do not go all the way, I think that we may end up in a worse position relative to where we are now. The same goes, for instance, for the information flows between the national central banks and the single supervisor in Frankfurt. If these information flows do not work well, and if the powers of the ECB are not strong enough, I think it would be very hard to regulate these institutions. We may end up in a situation that is worse than the current one. Lord Vallance of Tummel: Do you think that to get proper banking union in place at the same time, you need not just the supervisory authority and the resolution authority that you have just mentioned, but also deposit insurance? Marco Pagano: Yes, definitely. If you look at the United States you see that, essentially, it is the same institution that looks after bank resolution and deposit interests: it is the FDIC. Of course, politicians try to stay away from that, because the deposit insurance raises further questions about who pays for what, and therefore they are trying to stay away from that. But, when you have to restructure a bank or shut down a bank, the issue of how to protect depositors of that bank immediately comes up, and it is very hard to actually cut across the line between resolution and how to deal with depositors.

Q83 Lord Kerr of Kinlochard: Professor, the proposal from Michel Barnier seems to be that the Commission should itself become the resolution authority. That seems to me to be very unlikely to fly. The directive that was passed in ECOFIN the other day for the co- ordination of national resolution authorities is not going to come into force until 2018. Therefore, the situation you describe, where the ECB as single supervisor cannot call on a single EU institution to undertake a resolution of a failing bank, is going to happen anyway, at least until 2018, and, if I am right, for some considerable time after then, because the Commission proposal is not going to fly. Am I wrong?

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Marco Pagano: I think that if the creation and the implementation of this resolution authority do not occur simultaneously with the introduction of the single supervisory mechanism, this potentially spells great trouble for the European banking system. Unless the date that you mentioned is brought forward, it would be rather dangerous for the European Central Bank to venture in as a single supervisor. I think it would be at risk of losing a lot of its hard-earned reputation in doing so. Lord Kerr of Kinlochard: I understand your concern about the hiatus. I cannot myself quite see why the co-ordination of national resolution authorities should not be usually sufficient to deal with the more fundamental problem that you are describing. Marco Pagano: It depends on how such co-ordination is effected. If we look back at what we have witnessed in the past in Europe, of the resolution of large cross-border banks such as Dexia, we have to say that such co-ordination has operated very badly.

Q84 Earl of Caithness: Professor, please could you give us your thoughts on the agreement at the ECOFIN Council about the Recovery and Resolution Directive? What are the pluses and minuses, and where do you see difficulties? In particular, do you see a potential that some people have pointed out, that there could be a two-tiered approach to back resolutions in the future between the rich, wealthy states and the smaller periphery states? Marco Pagano: A possible consequence is that similar financial institutions placed in different countries may eventually borrow at different rates, say, on the bond market. However, I think it would be unwise for countries that have the fiscal capacity to bail out their banks to rely excessively on such a possibility. It would be quite a mixed blessing, or potentially a curse. Europe is hugely over-banked and there is a need for a considerable reduction of the size of the banking sector. Potentially there is a need for several closures in the industry in Europe. Extensively bailing out banks in core European countries may eventually be a mixed blessing for these countries, whereas bailing in or shutting down banks in southern European countries or periphery countries may—even though it is regarded as a curse, at the moment when it occurs—eventually turn out to be a much sounder policy. I do not know to what extent politicians in core countries want to surrender to the temptation of bailing out their banks.

Q85 Viscount Brookeborough: Good morning, Professor. Would you like to tell us your views on the proposal for a euro-area budget, and whether you think it is feasible, or whether you think it is too far down the line to worry about how it might be funded? Marco Pagano: I am not an expert on this issue, so I would rather not dwell on the details of how to do this. I think it is quite important for the European Union to develop its own fiscal capacity. Looking at this from the perspective of bank regulations, supervision and so on, it is important for Europe to have a real fiscal backstop for its banks. There is a need to set aside a pot of money that can actually be used in this case. Looking at this from the narrow angle of banks’ stability in Europe, it is important for Europe to develop a minimal fiscal capacity in that sense. I have no clear opinion on whether it should be done through raising taxes directly or realised through contributions by member states. Viscount Brookeborough: Do you think that it is really some way down the line, in the sense that, before we have solved all the problems of the banking union and everything, there simply could not be a European budget like that? Marco Pagano: I have no idea about the political dynamics that may lead to such an outcome or impede it. I am at a bit at a loss when I have to forecast policy decisions in the

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European Union. These decisions are often taken much more swiftly in a situation of crisis than in a situation of relative calm, such as the one that we are witnessing now. Right now, the ECB is doing more and national Governments are doing less, in terms of improving institutions in Europe. If we have another good crisis, maybe we will have a big spurt of activity in this direction.

Q86 Lord Hamilton of Epsom: Professor Pagano, you have touched on the question of debt mutualisation as your solution to the problems of the eurozone at the beginning of the answers you gave. I think your solution was euro state bonds. What I am unclear about is how these differ from eurobonds or euro bills. Surely, at the end of the day, they have to be underwritten by the rich countries of the eurozone, and the Germans are very reluctant, with their constitutional court, to actually do that. Marco Pagano: I realise that Germans are understandably worried about making commitments that would essentially have their taxpayers foot the bill of other countries. It is precisely the knowledge of this concern that led us to propose a form of issuance of a joint form of European debt that would not, in principle at least, require any mutualisation of debt, because it would simply be like putting together existing debt via a giant securitisation of European debt. However, as I said, this scheme would be open to a certain degree of mutualisation, which would be fine-tuned by participating countries, so that, depending on how much they guarantee this debt, with some kind of joint guarantee fund, they can decide to what extent they want to commit some resources from their own taxpayers to this joint debt. However, their commitment would be limited to this fund, so it would not be open-ended, and I think this should be reassuring for German politicians, for instance, or for Finnish or Dutch politicians, because their commitment within the scheme would be limited to the amount of money that has been put forward at the creation of the scheme.

Q87 Lord Marlesford: Professor Pagano, I wondered whether, in the case of Italy, there are any particular problems with GEMU. In particular, I wondered whether you feel that the north of Italy and the south of Italy are moving closer together or drifting further apart, in economic and social terms. Marco Pagano: My impression is that the whole of Italy is not doing well right now. I think that at the very least there has been no further convergence of the two areas of the country in the last few years. I am not very clear about the statistics here, but I think there may have been further divergence between the North and the South in the last few years during the crisis. Maybe not at the beginning of the crisis, but right now I at least have the impression that the two parts of the country are drifting further apart, looking at various indicators such as unemployment and regional GDP.

Q88 The Chairman: [Italian.] We are most grateful to you, Signor Pagano. If you have any further thoughts, please do communicate them to the Committee. We will send a transcript of what we have spoken about this morning. We will look up the website with your very interesting thoughts that you advised us of early on today. Do you have any final closing points you would like to make? Marco Pagano: I have a question for you. First of all, let me tell you that it has been a pleasure for me to answer your questions. Now it is my turn to ask you a question. I would like to know from you collectively why the UK, which has clearly underscored its decision not to take part in this genuine economic and monetary union or any further deepening of federalism in Europe, is so keenly interested in asking these very interesting questions about the process.

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The Chairman: With great embarrassment, I am looking round to my colleagues to provide an answer. The interim one that I will give you is that I think we are united on this Committee that whatever is the case, we do recognise that for the United Kingdom to prosper, we do have to understand what our colleagues in the euro area of 17—soon to be 18—and the European Union, a single market of 28, are doing. We have to understand how we can work, and indeed how we can help the situation, so that the version of the single market and Europe that comes out is one in which prosperity will be found in all countries of the Union for the benefit of all, and especially for the young unemployed at this time. We are most grateful for you asking that very difficult question, and we will have a three-hour conversation amongst ourselves about the right answer to reply to you next time you ask it. When you are next in London, we would be very pleased to see you. Thank you very much. Grazie tante. Marco Pagano: Thank you, and thanks for your eminently reasonable reply.

378 of 441 Marco Pagano—Supplementary Evidence

Marco Pagano—Supplementary Evidence

Please let me try and reply to the two requests from the chairman:

1. Please find attached here a number of documents that I have contributed to write on the European Safe Bonds (our version of Eurobonds, if you wish). The full description of the proposal is contained in the file 06e-Esbies_document.pdf. A comparison with competing proposals is in the document 01d-Alternatives-to-Eurobonds.pdf. The other documents have self-explanatory titles. Almost all of them are also available on the web at the following URL: http://euro-nomics.com/esb/

2. Lord Davies is absolutely right about the crucial importance of transitional arrangements: either raising risk weights on (risky) sovereign bonds or introducing limits to the concentration of sovereign risk (i.e. enforcing greater diversification of Euro-area banks sovereign portfolios) entail considerable risks of destabilization of the Euro-area sovereign debt markets. So it is essential to phase the reform very gradually, and envisage a grandfather clause, by which the old prudential rules continue to apply to existing sovereign debt holdings (until they mature), while the new rules will apply to all future purchases of sovereign debt. Even such an arrangement has its considerable drawback, as it will imply that banks will refrain to trade their existing sovereign debt, which will imply that sovereign debt markets may experience a considerable liquidity dry-out. This problem would be lessened by the introduction of ESBies, as this would make the national sovereign debt markets less and less relevant, and thus also their illiquidity less worrying. Notice that according to our plan the issuer of ESBies (the European Debt Agency) would also act as a market maker in its market, and ensure a minimum level of liquidity for this new type of synthetic Euro-area debt.

Of course, an issue that cannot be sidestepped is the recapitalization of European banks. The ESBies do not change the need for it, but rather make it even clearer and, hopefully, would therefore help to make it happen sooner rather than later. As regulators raise therisk weights on sovereign bonds or impose concentration limits on their holdings, banks will have to trade these bonds for ESBies at market prices, and will inevitably lead to losses for banks the need to recapitalize. Insofar as the introduction of ESBies eliminates part of the uncertainty from the crisis, the prices of sovereign bonds may increase, limiting this loss. But, it is inevitable that some recapitalization must take place.

28.07.13

379 of 441 John Peet, Centre for European Reform and Open Europe—Oral evidence (QQ 1-18)

John Peet, Centre for European Reform and Open Europe—Oral evidence (QQ 1-18)

Transcript can be found under Centre for European Reform, Open Europe and John Peet

380 of 441 Professor André Sapir and European Policy Centre—Oral evidence (QQ 134-147)

Professor André Sapir and European Policy Centre—Oral evidence (QQ 134-147)

Transcript can be found under European Policy Centre and Professor André Sapir

381 of 441 Dr Waltraud Schelkle—Written Evidence

Dr Waltraud Schelkle—Written Evidence

1. The Commission Blueprint and the Four Presidents report ‘Towards a Genuine Economic and Monetary Union’ (GEMU) contains a minimum set of proposals for a banking union and for fiscal integration that stands a chance to break the vicious circle of deteriorating bank balance sheets and deteriorating public finances. It constitutes progress that in both reports the Euro area crisis is no longer perceived primarily as a sovereign debt crisis. However, the immediate response is still dominated by the view that stricter fiscal discipline and coordinated structural reform will do the trick of getting the EU out of its stagnation. It will not as long as the ‘doom loop’ exists. EMU – and possibly the EU at large -- are on the way into a Japanese scenario of two decades of depressed growth.

2. The proposals for an integrated economic policy framework contain, in my view, little that would promise much relief from imbalances which are caused by different macroeconomic growth dynamics. In a heterogeneous monetary union, different growth and price dynamics are accentuated by the common interest rate that make regional real interest rates vary pro-cyclically with their business cycles. This is quite common and the UK has its own experience with a Bank rate that is too low for the housing boom in the South of England and too high for the deindustrialising North. Regional boom-bust cycles are a possibility with which the monetary union must learn to live as long as there is no budget to absorb them. The ‘Convergence and Competitiveness Instrument’ would make sense only if it has macroeconomic significance. The binding contracts could help if they intended to give budgetary support to major reforms in countries, which are asked, in the interest of the union, to reduce their debt burden considerably. But the Call for Evidence rightly suspects that they are merely meant to be bribes for the usual litany of structural (read: institutional and microeconomic) reforms. The proposed amounts are so small (the German government suggested €20 bn over seven years) that they not make any difference and can only be seen as a manoeuvre to fend off critics who bemoan that nothing is done for growth.

3. The proposals for a banking union in the Four Presidents report would go some way to break the vicious circle of bank and sovereign overindebtedness. Of particular importance in this respect is the possibility to recapitalise banks by the ESM (European Stability Mechanism) directly, ie without this overdue measure increasing deficits and/ or debt of the respective sovereign. However, the sums set aside for bank recapitalisation, which at the end of June 2013 are in the order of €60 bn, are so small that this small pre-committed amount may actually be destabilising. It does not allow the new Supervisory authority to be bold in its stress tests or risk speculation on the limited funds. In order to get around the fact that the ESM is small even if it were not restricted in this way, it must get a banking licence so as to have access to ECB credit if it needs to avert a speculative attack.

382 of 441 Dr Waltraud Schelkle—Written Evidence

4. For the same reason, namely that any pre-committed finite amount “tips the hand of the authorities in favour of the speculators” (Kindleberger), the common resolution fund needs a fiscal backstop that foresees joint liability of member states (Four Presidents report p.6). The fiscal capacity of the member states combined is large enough to ensure markets that national banking systems can be put back on a sound footing, while that of any single member state is not. The cost can later be recouped, entirely or partially, through a levy on the financial industry. It is inconceivable to me that the UK can completely stay out of this process of finding solutions for bank resolution, given the integration of the City into the euro area’s financial markets, the size of the British financial sector relative to the UK economy and its vital interest in having a system in place that protects the country from spillover of financial turmoil.

5. The Four Presidents report does not, at this stage, propose a common deposit insurance scheme but harmonized standards. This seems to me a sensible minimum. Deposit insurance schemes are essentially an element of national welfare states as well as an effective instrument of preventing bank runs. But once a bank run sets in, it is in any case the ECB as a lender of last resort, and not deposit guarantees, that must stop it. There is a reasonable argument by some experts that a joint guarantee scheme would prevent the flight of savers out of national savings banks, ie counteract the fragmentation of the single financial market with its magnifying effect on recession in crisis countries. This is clearly a problem. But I am not sure that a joint deposit scheme would help as it could and should not be unconditional and is thus prone to uncertainty as to how much joint guarantee of deposits there is. It would also create even more moral hazard in the financial industry. For the time being, I therefore see no urgency to go beyond the EU’s Deposit Guarantee Directive, ie harmonization of national legislation, which has already proven its worth during the financial crisis. This instrument would not bear another ‘Cypriot snub’, however, or it will be undermined for good. 79

6. The creation of fiscal capacity is desirable for economic and political reasons. But the necessary minimum can be created without a federal budget. The main economic reason has already been indicated in para’s 3 and 4, namely to break the link between banks and sovereigns in a world where financial markets have become very big relative to any national economy. Joint liability for parts of national public debt is a way of escaping the pre-commitment of amounts that are then tested – and found wanting – by financial markets. This has been the repeated experience of the emergency funds, EFSF and ESM, despite the enormous amounts committed. By contrast, the ‘Do whatever it takes’ speech by ECB President Draghi in London in 2012 did calm markets, even though it was based on the confidence trick of promising unlimited intervention without having to act on it. Joint, in addition to several, liability would signal this ‘Do whatever it takes’ by fiscal authorities of the Euro zone. The political reason for joint public debt management is that otherwise the ECB is pushed into a quasi-fiscal role. This is not because

79 I refer here to the initial proposal by the Cypriot government to raise the co-payment for its stabilisation programme by a levy on deposits below the EU standard of €100,000.

383 of 441 Dr Waltraud Schelkle—Written Evidence

governments gang up on the ECB and force it to finance their deficits, as especially German euro-sceptics insinuate, but because panicking bond markets force the hand of the ECB. Especially all those should support a minimum of fiscal integration who want to restore the autonomy of the ECB to conduct its monetary policy according to the mandate of stabilising the economy at large.

7. The various Eurobond proposals differ according to 1) whether they want to assure a common or nationally differentiated interest rates and 2) whether governments should get an entitlement to a particular GDP ratio (typically 60%) or get an allotment that varies according to national and Euro area cyclical considerations. In joint work with Professor Deborah Mabbett (Birkbeck, University of London), I have made a proposal for a Eurobond that sees it as a vehicle for coordinating macroeconomic stabilization policies. It found interest with the Green Party in Germany and an essentially similar proposal has recently been made by the French Conseil d’Analyse Economique (Artus et al 2013). Member states would have to agree annually – or more frequently if economic circumstances so require – on the overall volume of Eurobonds to be issued and the share of each member state. This would determine, within reasonable margins of error, the appropriate fiscal stance for EMU as a whole, based on the projected cyclical phase for the Euro area. By determining the quota and thus the contribution of each country to the overall stance, the facility could take account of the fact that we still have asynchronous business and asset market cycles in the monetary union. The Eurobond issue would be guaranteed collectively by the member states, and all would pay the same interest rate. Access to the Eurobond would be granted only if a government complies with this European fiscal framework. The European Semester would be the conduit for linking national budgetary processes to joint public debt management at the Euro area level (Schelkle 2012). The agreed quota would set the envelope for national deficit financing under the Eurobond issue. Parliaments would retain the right to exceed this envelope but the bonds would fall outside the joint guarantee and governments would face a reduced allotment in the following year.

8. Both Eurobonds and the shock absorption or insurance mechanisms that the reports consider are worthwhile minimalist ways of providing the necessary fiscal integration complementing monetary integration. Unfortunately, the immediate problem is to deal with the enormous debt that strangulates economies and prevents their recovery, with further adverse consequences on debt sustainability. A debt redemption fund, as proposed by the German Council of Economic Experts, would cater to this priority by mutualising debt over the admissible 60% debt-to-GDP ratio. This proposal and the calculations of how much each country would have to pay down over a time horizon of maximum 25 years to reach the 60% ratio also revealed the sheer size of the task. The worst off member state, Italy, would basically have to generate a primary surplus of over 4% of GDP over 25 years to get down to the Maastricht threshold of 60% (assuming the debt redemption fund had been introduced by January 2013; without the redemption fund the Council estimates that the country would require a primary surplus of over 7%

384 of 441 Dr Waltraud Schelkle—Written Evidence

of GDP). This suggests to me that the Euro area – and possibly other OECD countries, including the UK – should seriously reconsider a rejected IMF proposal to introduce insolvency procedures for sovereign debtors. Bruegel has made a proposal to that effect in 2010, in which the former chief economist of the IMF, Anne O. Krueger, was involved (Gianviti et al 2010). A share of public debt may have to be written down.

9. In sum, I think the four Presidents report contains the bare minimum of proposals that leave EMU a chance of escaping a situation of protracted stagnation and virulent crisis. Recapitalisation of viable banks and closing down of non-viable ones, are crucial elements of the banking union. Both needs the insurance of a fiscal backstop, and to that extent joint liability for the temporary debt incurred. The reforms must also abandon the futile pre-commitment of sums that make markets speculate on their exhaustion, forcing governments repeatedly to expand the commitment. A banking licence for the ESM is still a proposal that should be kept on the agenda. But the legacy of the enormous public debt may require even more imaginative solutions, such as the long-overdue insolvency procedure for sovereign debtors, alongside a debt redemption fund. Without these elements, I do not see how central banks can exit this phase of extraordinary liquidity provision, let alone how European economies can start generating enough jobs for thei citizens.

References:

Artus, P., A. Bénassy-Quéré, L. Boone, J. Cailloux, J. Delpla, E. Farhi, P.-O. Gourinchas, J. Tirole and G. Wolff (2013), ‘Komplettierung des Euro’, Les notes du conseil d’analyse économique, no.3 (April), Conseil d’Analyse Economique. Gianviti, F., A.O. Krueger, J. Pisani-Ferry, A. Sapir and J. von Hagen (2010) A European mechanism for sovereign debt crisis resolution: a proposal, Bruegel Blueprint Series vol.X, Brussels: Bruegel. Mabbett, D. and W. Schelkle (2010) “Beyond the Crisis -- the Greek Conundrum and EMU Reform”, Intereconomics 45 (April) 2010, pp.81-85 Schelkle, W. (2012) ‘European Fiscal Union: From Monetary Back Door to Parliamentary Main Entrance’, CESifo Forum 1, 28-34.

02.07.13

385 of 441 Dr Holger Schmieding and Professor Willem Buiter—Oral evidence (QQ 55-65)

Dr Holger Schmieding and Professor Willem Buiter—Oral evidence (QQ 55-65)

Transcript can be found under Professor Willem Buiter and Dr Holger Schmieding

386 of 441 Dr Daniela Schwarzer— Oral evidence (Q 230-247)

Dr Daniela Schwarzer— Oral evidence (Q 230-247)

Evidence Session No. 20 Heard in Public Questions 230 - 247

WEDNESDAY 6 NOVEMBER 2013

Members present

Lord Harrison (The Chairman) Viscount Brookeborough Lord Davies of Stamford Lord Flight Baroness Maddock Lord Marlesford ______

Examination of Witness

Dr Daniela Schwarzer, Senior Associate, German Institute for International and Security Affairs (SWP)

Q230 The Chairman: Daniela, a very warm welcome to you. Thank you very much for coming to the British Embassy today. We did not realise that it was going to be such an interesting place, today of all days. Thank you for bringing your two colleagues, who are coming to listen. Dr Daniela Schwarzer: Yes, they work with me on EU issues. It is a unique opportunity for our researchers to listen to such a debate, and I thank you very much for it. The Chairman: In 20 years’ time you will be doing the same as us—asking awkward questions. Dr Daniela Schwarzer: Maybe they will answer them. The Chairman: Daniela, we hope you will be able to answer some of our inquiries on economic and monetary union. This is the last phase of our inquiry. We hope to publish a report just after Christmas. You are our first witness here in Berlin. We go on to Frankfurt tomorrow. Perhaps I can invite you to say a bit about yourself, which will be very helpful to the Committee, who will introduce themselves as we go around. A note is being made by our scribe, John, in the corner there. We will send that transcript to you and would be very grateful if you would look at it, correct it and, if possible, improve on it—because you always have the best ideas when you go out of the room, and you may want to add one or two that would be helpful to us. Would you like to say what you do and then perhaps I’ll ask the first question? Dr Daniela Schwarzer: Thank you very much for having me. It is a great pleasure to be here and to discuss these issues with you. I head the EU integration division at SWP— Stiftung Wissenschaft und Politik—the German Institute for International and Security Affairs. It is a publicly financed think tank and the largest of its kind in Europe. We work on

387 of 441 Dr Daniela Schwarzer— Oral evidence (Q 230-247) all aspects of international, security and European policy. The division I head works mostly on EU integration matters. We have a second division working on external relations. I have been heading the division since 2008. I have just spent a year abroad, in Harvard and in DC, where I was associated with the Transatlantic Academy of the German Marshall Fund. Basically, I wanted to leave the day-to-day crisis debate for a little while and do what we are supposed to do, which is academic studies with policy relevance. Our institute has a very confidential relationship with all ministries and the German Bundestag. We often get solicited to hearings in Parliament. We work with all parties. We are politically independent in the sense that, when the Government changes, it does not mean that our director or our work programme will change. We have a board that is composed of representatives from all parties of the German Bundestag and from the ministries, the Chancellor’s Office, the media and the academic sphere. I have personally worked on euro area issues for quite a long time, so this is not a crisis phenomenon in my case. I have worked a lot on Franco-German relations. I have held advisory positions with the French Government and with the Polish Government, preparing their EU presidency. So I hope to be able to give you views, but not from the inside. That is not us, but you will have the chance to speak to representatives from the ministries, from whom you will get much clearer answers than I will be able to give. This is a specific time in German policy-making due to the coalition negotiations that are going on. I am familiar with the positions that the parties take into those negotiations, but I cannot preclude what will come out of them. I heard that your programme involves people who are much closer to policy-making, so please do not take me as a proxy for ministries or political parties. I can give you my thoughts on what they might be trying to do, but it is just an outsider’s view.

Q231 The Chairman: You have a fascinating background. We are also hoping to take you up on your recent Harvard experience, to add to your Franco-German and Polish experiences. Perhaps I could ask you, first, with respect to genuine economic and monetary union, whether you think that parts of it are undoable or will be very challenging to achieve. In particular, how far do you think Germany will go to achieve some form of genuine economic and monetary union? Dr Daniela Schwarzer: Genuine economic and monetary union is a vast field. I think that we should go about it in pillars and then discuss what is possible, what would be good and how we should go about it. If we start with banking union, a fundamental problem is apparent. There are some elements that can be implemented quite easily by secondary lawmaking, by an EU external treaty or whatever—something that is not part of the EU framework. In particular, from the German perspective, full banking union already involves questions about treaty revision. If you ask me about the possibilities of implementation, there is obviously huge concern about treaty revisions. There are two kinds, small and large. Analysis of the legal framework of banking union suggests that full banking union would require full treaty revision, not the small one that was done to accommodate the ESM. From a German perspective, this involves several questions. One is how this will play out in national ratification procedures, because obviously the threshold for ratification is higher if you go for full treaty revision. The second question is, if the treaty is opened, is it possible to limit the mandate of the discussion over treaty revisions to very technical and small points, or will we end up with a general debate? The Chairman: Which do you think?

388 of 441 Dr Daniela Schwarzer— Oral evidence (Q 230-247)

Dr Daniela Schwarzer: Well, given the UK’s stance on European policy at the moment, the big concern in Berlin is that it will be London that asks for things that Berlin will not want to put into the discussions—namely, a renegotiation of competences downwards to a national level. So there is this huge concern, and you will hear that from people who are much involved in the process. I would say that there is no one position in Berlin on how to go about this. Wolfgang Schäuble has said very clearly on banking union that he wants a treaty revision. From a legal perspective, this is almost a necessity. At the same time, if you talk to the Chancellor’s Office, you will hear that they do not want to ask the big questions. Perhaps we should leave banking union for a moment and move to the fiscal pillar. Some proposals on banking union immediately introduce the debate on a fiscal capacity for the euro area. If we talk about a bank resolution fund and a potential income base for such a fund, such as a bank tax, the question comes up about how this can be institutionally organised and how a euro area budget, which some people argue a monetary union should have, can be institutionally embedded. Who will control it and what should we do with the European Parliament? So fiscal union as such also involves the big, big institutional questions. The German position on the fiscal dimension is pretty restricted. There has been an idea to introduce bilateral treaties to enhance structural reforms and set up fiscal instruments that would be able to incentivise or accompany structural reforms in member states. That is one way of increasing the probability of structural adjustment in crisis countries and in potential crisis countries. That is the key priority of German policy-makers. The Chairman: We will probably come on to that. I would like now to borrow some of your recent American experiences and ask Lord Flight to ask a very current question.

Q232 Lord Flight: Looking at the global picture, a lot of the banking and economic problems ultimately have been the result of China running a surplus and refusing to let its exchange rate adjust. It has a huge imbalance and a build-up of banking funds. In an EU context, there is a similar point to be made with regard to Germany. Surely, at a time when the German medicine is being applied to less competitive states and their consumption is reducing, there is an absolute obligation on Germany to increase domestic demand growth. The US has been rightly critical of this, but there is no sign of policies being brought forward to do that. Dr Daniela Schwarzer: Yes. I have been among those in Berlin who argue that the adjustment has to be symmetrical, and not asymmetric. I am among those who have argued for three years now that the adjustment that has to take place under monetary union should be more symmetrical than the German Government wants. Already in 2010, I simply did not believe that this kind of adjustment could work and that the burden could be put entirely on the crisis countries. So what has happened in the German debate? With a colleague, I authored a piece—well before the six-pack was introduced, which includes the macroeconomic imbalances procedure—in which we argued for what we called an external stability pact, which was supposed to be a similar surveillance instrument. We suggested that the surplus countries, too, should be subject to supervision. So you are talking to the converted in Berlin, but you will talk to those with other positions during your two days here. The debate has evolved, which is a good sign. First, the position I held in 2010 was regarded with great hostility in Berlin. People accused me of wanting to harm German competitiveness. When it became a political debate in Europe, there was the same reaction. I have been at parliamentary hearings where precisely this debate took place. EMU policy- making was compared to football—“soccer” in American terms.

389 of 441 Dr Daniela Schwarzer— Oral evidence (Q 230-247)

The Chairman: But we still say “football”. Dr Daniela Schwarzer: You still say “football”. If the Germans adjust, it will mean we have lost the match. That did not bring us very far. One thing happened in, I think, spring 2012, which I saw as a very positive signal. Labour negotiations in the public sector led to wage increases that were pretty substantial. As such, that was good news, because it had a signalling function for the rest of the economy. But the politically good news was that Wolfgang Schäuble at the time commented on the wage agreement. He said, “This is good and it will help rebalance the euro area”. It was just one sentence in an interview, but it was crucial to see that there was more openness. Now, the SPD has had many internal debates on the issue over the past few years. Obviously, their voters are very much interested in precisely the debate about rising wages and measures to fuel domestic demand. Indeed, they have been testing the ground on whether they can make a public case that this is good because it is good for the euro area. Politically, this does not sell well in the German debate, because we will not change policies just for the euro area. However, what does sell well is the message that domestic consumption needs more support and that public investment has a key role to play. If you look at the key positions that the SPD put forward in the electoral campaign, it was precisely that. The topic of inequality and the question of low-wage sectors of society played a big role. The question of underinvestment from the public side in infrastructure, education, research and development was something that the SPD pushed. Interestingly, this is nothing that would run against business interests in Germany. So I see this new alliance building up, and Merkel is not against it. In one of her last statements before the election, she said, “We need to invest more than we did in the past”. So we are on a path where Germany, out of self-interest, will readjust its economic policies, with a positive impact on the euro area. External pressure does not help. I am deeply convinced that everything said and what recently came out of the US did not really influence the debate here—rather the contrary, because there was an element of distrust and a feeling that they were trying to weaken us while making us help others. That has to be broken. The whole political message has to be that we need to do this for our own well-being and precisely because it will support corporate competitiveness. If we invest in the sectors that I pointed out, it will help German business and maybe reincentivise private investment. German companies are strong in investing, but not so much in Germany. The Chairman: Is there a credible mechanism to make that work so that it would be acceptable to the German people to, as it were, increase internal demand? Dr Daniela Schwarzer: The investment bit can work pretty easily. Looking at the budget, we are in a pretty comfortable situation. There is money that can be spent. Support for low- income groups of society is also something that you can communicate. We do not need a specific mechanism; it can be part of the coalition treaty, and the SPD is doing a lot to get those things in. Again, it is not out of a big European interest but simply because it will help us. There is one final element. The SPD have a fairly strong negotiating position because they are taking the coalition treaty to a member vote after its conclusion. The domestic demand and social investment bit is important to them and they will make sure that it gets into the agreement.

Q233 Lord Flight: You are particularly well qualified to comment to us on Germany and France and the up-to-date position on their differing views on GEMU. Do you think that there are problem areas? Is Germany worried about the French economy? Many economists have pointed out that France might turn out to explode the most.

390 of 441 Dr Daniela Schwarzer— Oral evidence (Q 230-247)

Dr Daniela Schwarzer: There are many problem areas. These are not new and they are not really surprising. The old Franco-German conflict over the functioning of monetary union dominated the Maastricht negotiations and led to a compromise in the specific set-up of EMU and bits and pieces that were added afterwards to accommodate French concerns, in particular. However, there is a realisation now that the compromise did not make it into the hearts and minds of people in all member states and we are now facing the tough questions. It is precisely the same conflict again. The German position has been very consistent since the late 1980s or even before, when the Maastricht negotiations started. Germany wants a monetary union where there is an independent stability-oriented monetary policy, where there is no shared debt liability, where there is as little risk sharing as possible and where there are only very limited transfers. It wants a fiscal and economic policy co-ordination framework that would lead all member states to adopt policies that are very much in line with German thinking on sustainable public finance and sound, competitive economies. What we see now in the Franco-German relationship is that, after the arrival in office of François Hollande, the French have started to be more open in their views on how EMU should be further developed. During the Merkozy period, until spring 2012, Mrs Merkel had a clear leadership on the initiatives that were co-signed by both. President Sarkozy was able to negotiate bits and pieces into them, but there was no coherent alternative French view at the time. My perception is that François Hollande now, after more than a year, is trying to do this. This has so far materialised in the French position on the fiscal capacity of the monetary union. The French Treasury issued a policy proposal hidden under the title of a working paper just two weeks back, which argues for a macroeconomic stabilisation function—basically, an instrument to provide for cyclical stabilisation among the member states. It also argued for a European unemployment scheme. As I said, when the Germans think of a euro area budget, they think only of those carrots for structural reforms. This is a matter of Franco-German debate. On the working level, if not yet so much on the political level, the French work in close co-operation with the European Commission on those proposals. For example, DG Employment is working on the unemployment insurance scheme. In Germany, the reaction that I have seen so far from the Finance Ministry was very prudent and very much trying to prevent this. The reason, in my view, is that it sees it as a transfer mechanism, so you can easily calculate, given the high unemployment figures, the prices. Those are big volumes. Lord Flight: Maybe it is negative. Dr Daniela Schwarzer: But they do not take a long-term view. If you imagine that the system had been put in place at the start of EMU in 1999, Germany would have benefited from it in 2002, 2003 and 2004, when it was the sick man of Europe. The cyclical situation in Spain and other member states was precisely the opposite of the German situation then. When you make this point to German policy-makers, it seems that there is a kind of expectation, which needs further reflection, that this situation will never be back in the eurozone. I think right now that there is a kind of assumption, given our strength at the moment, that we will be there for quite a long time and we will be the ones paying for the others. Any kind of budgetary mechanism that is perceived as being an open transfer mechanism is rejected on the German side.

Q234 Lord Flight: You did not comment about the weakness of the French economy. In agriculture, there is a massive transfer payment to France. It is interesting that Germany remains strongly against transfer payments but has done little or nothing about the biggest one of the lot.

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Dr Daniela Schwarzer: They would have liked to do something, I think, but for political reasons as well as a sense of realism about what is possible in the budgetary framework negotiations, they never really tried to take a veto-player position on that. The French economy is a matter of huge concern in Berlin. There is a kind of unspoken agreement that there will be no comment on it, because it is not helpful. The perception is that one will talk about best practices and, if there is interest on the French side, one can think about joint initiatives that may be useful. However, despite the way in which the German economy is commented on—we discussed this with the imbalance question—Germany would not do that on the French situation. Look at concrete policy measures that have been taken in France in the past 12 months—taxation, for example, or the new industrial policy initiative, with the grand projects and the big investments, which is being sold by the Élysée Palace with a video that really goes back to Colbertism. It is amazing if you see it; you will think that it is a joke, but, no, it is the official video, making allusion to the big industrial projects of the last 150 years. This is something that Germans view with, let us say, a bit of astonishment. The references to previous policy or political tradition are so strong, while the hope and expectation was that there should be more convergence. France at the moment is not seen as a likely crisis case but, if Italy becomes a crisis country, we do not have to think far to see the repercussions on the French banking sector and the French economy. This would immediately hit Germany, given the very close financial, economic and political relationships, so there is a big concern to prevent that happening, although I do not think that there is a real plan on how to do that if it comes to it.

Q235 Viscount Brookeborough: I apologise—this goes back to the first question on imbalance. Historically, how did that come about, and why did the Government allow it? Why did they want their imports and exports to far exceed their domestic consumption? Surely from a political point of view, when the population knows that Germany is doing well, there must be a reaction when they do not have spending power. Dr Daniela Schwarzer: Yes—that last bit is surprising as a European comparison. So how did it come about? The German Government would answer your question by saying, “We didn’t do anything about it; it just happened”. Viscount Brookeborough: They ignored it and were happy to see it. Dr Daniela Schwarzer: Well, the official view was that this was an evolution of the private sector and was about corporate competitiveness and low wages, and that there was autonomy among the social partners—“We did not make it happen and we cannot change it now”. That is the easy excuse. The whole German success model, and in particular the reforms undertaken by the Schröder Government that liberalised labour markets, led to a view among the social partners that wage agreements should improve the competitive position of Germany. We should also consider the close relationship with the unions, which precisely do not take the view that you mentioned. It is surprising that they do not argue, “We want a bigger share of that wealth”. That is part of the German socioeconomic model and culture. I would say that this electoral campaign was the first one where the SPD, mildly, and Die Linke, the left-extremist party, more strongly, made the case for a more equal distribution of wealth. Both parties campaigned on a minimum wage. It is now very likely to be in the coalition treaty at roughly €8.50. That will probably be the agreement. Die Linke wanted €10 but they are not sitting at the negotiating table. That gives you a sense that we are really catching up. France has had a minimum wage for ages, but we look at the annual renegotiation and no one has said, “Us, too”. This is really the first time. I think it is because

392 of 441 Dr Daniela Schwarzer— Oral evidence (Q 230-247) there is a sense of certain sectors of society feeling poverty. Child poverty is an issue in the German debate. Viscount Brookeborough: Do you think that it is in the culture because of the two Germanies coming together—it was a very difficult time and people do not mind it being difficult in order to get that? Dr Daniela Schwarzer: That is part of it, but I would say also that we are very much used to defining our success in economic terms. Throughout the past decades, national pride was not linked to political power or military power but to a very stable currency that we were proud of. It was a symbol, but we had to give it up. The replacement for that in the national consciousness is a strong economy. The discourse that this is necessary to strengthen the German export sector, or the German economy generally, is something that people will agree to.

Q236 Lord Davies of Stamford: Good afternoon, Ms Schwarzer. I am a Labour Member of the Committee. I am very glad you mentioned the Hartz reforms, achieved by the Social Democratic Government here. It is very encouraging for all of us in the EU, and for countries outside the EU, that labour market reforms can have such a palpable effect on performance in a relatively small number of years. Can I get back to the issue of banking union? Do you believe that the three components of banking union that have been announced—a single supervisory mechanism, a single resolution procedure and a single retail bank deposit insurance scheme—are all essential? If you think that they are, what will happen if one or more of them does not occur? As you know, there has been no progress at all on the retail deposit insurance scheme. Dr Daniela Schwarzer: I think that they are key. For the short and medium term, the resolution bit is essential because the asset quality review that will take place in spring may reveal problems. It may turn out that the ESM will not have sufficient means to cover them. So I think there is a very strong incentive to come up with a solution—not only to have a resolution procedure but also to have a resolution fund. A number of commentators in the German debate have now started warning about this aspect. So far the Government in a way have got away with their position in the German policy debate, saying that they do not want the resolution fund and that it should be a national responsibility. But if you take seriously the Council conclusions of June 2012, where the declared political objective was to break the link between public debt and instabilities in the banking sector, you can in a way question the German position, and whether this will be at all possible without a bank resolution fund. I think that the pressure is growing on Germany. Lord Davies of Stamford: Are you telling us that Germany will accept a common bank resolution fund? Dr Daniela Schwarzer: I cannot tell you that; you will have to ask the people from the parties who are negotiating the coalition treaty. I just perceive that those who have argued strongly against it have softened their positions, and that maybe something is changing with regard to the timeframe. You can easily say, “We’ll have it in future and we’ll introduce a kind of bank tax. The private sector will pay for itself and we will have nothing to do with it”. But that position may not be sustainable if the asset quality review really reveals substantial needs for bank resolution. That will then be the topic for 2014. Lord Davies of Stamford: I have a question that I intend to ask the Bundesbank on Friday, but I will ask you, too, even though you are not an expert. Do you think that there is a real risk that the asset review in Germany will show up problems here?

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Dr Daniela Schwarzer: I cannot judge—and I cannot exclude it, either. It is beyond my expertise.

Q237 Lord Davies of Stamford: Let us move on to get a clear position of the German position on banking union. Herr Schäuble said, memorably, that without a new treaty all we could expect on bank resolution was a timber-framed structure rather than a steel-framed one. What exactly did he mean, and what concretely are the differences between a timber frame and a steel frame? Dr Daniela Schwarzer: That is a question for Thomas Westphal, whom I heard you are seeing tomorrow. Lord Davies of Stamford: They both involve recourse to the ESM, for example. What are the differences between the two, and will the timber-frame version be helpful? Dr Daniela Schwarzer: My view is that we should go for a steel frame, but what he means, I can only interpret. I think his view is that without a treaty change, there can be elements but not full banking union. One issue that the Germans put forward in the legal debate is that dealing with bank insolvency is not an EU competence. So there is an argument that we need to create an EU competence before we manage this within an EU framework. Lord Davies of Stamford: And that can only be done by a treaty—is that what he thinks? Dr Daniela Schwarzer: Well, that seems to be the reasoning of the Finance Ministry. I know that there are contradictory legal positions. The Commission legal service is much more easy-going on those questions, but the German view is to have it as clear-cut as possible and to introduce elements into the EU treaty that empower the European Union to do these things. Lord Davies of Stamford: It is an alarming picture that you are setting out. You are saying that the asset review next year is likely to throw up some really difficult provisions that cannot be met by banks recapitalising themselves or by the individual member states handling recapitalisation, because poorer countries such as Greece and Cyprus will not be able to do that. We do not want contagion once again between a banking crisis and a sovereign debt crisis, where the sovereigns are overwhelmed by the problems of their banks. You are telling us that the asset review, reporting next summer, may face us with those kind of dilemmas. Dr Daniela Schwarzer: That is the risk I see. Lord Davies of Stamford: You are also telling me that here in Germany you have not yet decided as a Government—there are differences between ministries—whether it will be necessary to have a treaty first, as a prerequisite for a bank resolution system. That looks as though there is no chance at all of getting a common bank resolution system in place in time for a crisis that may hit next summer. Is that right? Dr Daniela Schwarzer: That is my view. I encourage you to ask those questions of the ministries, because, again, I have an outsider’s view and positions may have moved on, but that is my risk scenario. It is a worst-case scenario.

Q238 Lord Marlesford: I am really following this up. The ECB will have to make the asset review. Of course, one must remember that the banks themselves are extraordinarily incompetent at knowing what their assets are. Sometimes they become insolvent through sheer greed, carelessness or bad banking, and very often they simply do not know. Do you

394 of 441 Dr Daniela Schwarzer— Oral evidence (Q 230-247) think that the ECB will be able to get the real picture, or will it be a whitewash? Will they be looking for the truth or trying to avoid the sort of crisis that you have just described? Dr Daniela Schwarzer: That is a very important question, but, again, I do not know the people who are going to do the job. From the institutional perspective, I would say that the ECB is between a rock and a hard place. On the one hand it wants to prove its independence in assuming those supervisory functions, and that it can do a credible job. There has been a lot of criticism out there with regard to the two stress tests that it has already conducted. People said that it had not looked at the right things, was too soft in its interpretation and did not want to bring to the surface what might have been on the banks’ books. There is now the expectation that this time it has to perform. On the other hand, the ECB is responsible for the monetary and financial stability of the euro area. If the worst-case scenario that we have just discussed is true, the review might bring to the surface restructuring and recapitalisation needs that will not be met by the European mechanism but will fall directly back into national budgets. There is the ESM, of course, but the lending volume has been reduced—I do not know the exact numbers—and it may not be sufficient if we have serious recap necessities in Spain, Italy and France. So the ECB has to balance those two objectives and my view is that the overarching objective is to maintain the euro. Lord Marlesford: To maintain confidence rather than tell the truth. Dr Daniela Schwarzer: Those are speculative assumptions. I am just pointing out— The Chairman: The asset quality review could undermine confidence in the banks. Lord Flight: In a way, it strikes me that German policy is extraordinarily selfish. It wants the euro, it wants the EU to hang together and it does not want to go back to the deutschmark, but it is unwilling to spend a penny on the important things that are needed if you want to sustain the euro. Somehow, I think that they are blind as well in that, meanwhile, the amount owing to the Bundesbank under the target system keeps going higher and higher, and the more problems there are, the more that will increase. So Germany cannot escape paying for it to some extent. I find it extraordinary that, with someone who should in many ways be a strong leader, she is quite the reverse—there is a sort of unwillingness on the part of Germany to do the things that are necessary. Dr Daniela Schwarzer: I will be the devil’s advocate. Obviously those costs are seen by the Government, so the target 2 debate has been big in Germany. Hans-Werner Sinn has been pushing it and people are well aware that we have hidden risk-sharing in the ECB—and, eventually, hidden losses that will surface and will not be hidden for long. It is a deliberate political choice to assume that strategy and not any other. One could have moved forward by introducing Eurobonds or at least pooling a certain amount of debt in a debt redemption fund, or assuming greater joint liability for the banking sector. All those choices were not made and there were reasons. One is that Merkel has to get every one of her policy decisions through the German Bundestag. Before the last general election, she had to respect the positions in the FDP, in which there were very critical voices, and the CSU, which is the Bavarian sister party of the CDU. That is one thing. The other thing is that it was clear roughly a year before the general election that there would be a Eurosceptic party—the Alternative für Deutschland, the AFD. They scored 4.7%. That is a low turnout, given the length of the crisis and the perception among the public of what Germany had done. You say that Germany has not paid a penny, but if you went out to Friedrichstrasse and asked people, “Do you think you are paying for Greece?” they would

395 of 441 Dr Daniela Schwarzer— Oral evidence (Q 230-247) say, “Of course we do”. So the perception is not that we are giving credit and earning money in interest, but that we are bailing out the Greeks. There is this big communication problem, and she balanced those. Despite the fact that I am critical on the substance of her policy choices, the politics worked well. The AFD did not get into Parliament. She maintained the coalition, she got re-elected and she inspires huge trust among Germans. I think that they are willing to let her move on in crisis management now. The situation of the new Government, if it works out with a grand coalition, will be more comfortable in Parliament with a strong majority and a partner in the coalition that has consistently been more “European” in the sense of being more open to those measures that you seem to think are necessary. So there might be a policy change. The last point is that the restriction on the previous Government, which of course will persist, is the German Constitutional Court. A large number of constitutional decisions had to be taken because MPs went to Karlsruhe on the ESM and on many other things as well. There is a constant red line for the Government not to invite a moment where the Constitutional Court brings down a European decision, which will then have repercussions on trust in the financial markets in the eurozone. That is the thin line she has been treading.

Q239 The Chairman: Just before I go to Viscount Brookeborough, could you just say a little more about the potential conflict between the supervisory duty of the Central Bank and its monetary policy? Do you see a clash or conflict there? Dr Daniela Schwarzer: Yes, there is a certain conflict. With regard to the resolution, I tried to point it out. I think it starts earlier, before resolution and supervision. You see partly what you want to see, probably. The ECB, in assuming its supervisory functions, will come into conflict with national Governments. That direct conflict is something that the ECB is trying to prevent. Legally it is independent, but there is political independence as well—there is little interference. The concern is that, when it comes to conflict situations, Governments will try to limit its independence. When it comes to the moment when supervision leads to the need for resolution, we have precisely the conflict that we have just discussed. Is it really the moment to surface such a problem or is it better to keep it down? I am not saying that the ECB is not going to do its job, but I see institutional risks here.

Q240 Viscount Brookeborough: Do you think that there is a need for deeper policy integration among euro area member states? How far do you think this element of GEMU should go? Do you think that it is practical? Do you think that we can ever get the different nations to come towards a common policy, especially given what you said about the German Government? As you said, they are always going to be trying to put their coalition together and they were not quite sure what they wanted at a certain stage. Obviously policy has to be medium term. Dr Daniela Schwarzer: How far does economic policy integration need to go? First, the framework that we have now is something that I perceive as pretty fragile. It is basically a process based on rules that are in some member states perceived as purely technocratic rules and objectives that lack legitimacy in national debates. The interesting question will be whether the Commission will take Germany as a case in its next review process and whether it will dare. The problem is not only a lack of legitimacy but the question whether the process is designed to discipline the most powerful member states or whether it has a tendency to be applied to the weaker. We have seen the case of fiscal policy surveillance and co-ordination when Germany and France broke the stability and growth pact, where it did not hold. The political mechanics may apply again in the same way.

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Germany tends to argue for a strong European Commission in surveillance. Merkel has recently said something about upgrading the Commission and its role, going as far as giving it competences to interfere with national budgets and economic policy. Germany says that because it assumes that the rules that have been defined—they are not politically neutral; they go in one direction—have been strongly influenced by German thinking. The perception is that there is no real danger of a clash between the set-up and Germany, but, again, when the stability and growth pact was put forward by the Germans in 1995 and 1996, they did not assume that sanctions would ever have to be applied and they never assumed that Germany could break a rule. I worked a lot on that historical period and the people who drafted the stability and growth pact tell me that they never expected this. I simply do not believe that what was not true then should be true now—namely, that there will be no conflict between Germany and the set-up. There is something that I would call a kind of legal overstretch, in the sense that we have all kinds of rules and obligations but, if you do not respect them and they have no real impact on national policy design, you eventually create a framework that has no credibility whatever. I would say that, in general for the EMU debate, the old concept of subsidiarity, which has recently been pushed into the debate by German policymakers, is very useful. Let us look at the substantial questions in the monetary union that need joint decisions. In my view, those are mostly macroeconomic. For that, I would argue for a stronger democratically legitimised decision-making authority, while many other decisions should be left to the member states. I would not put too much trust in the belief that you can in the longer term, going far beyond the crisis, really try to take the politics out of economic policy, because this is happening. There is a clear policy bias in the rules and this makes, to put it bluntly, a very left policy impossible for a member state. The attempt to depoliticise economic policymaking is not compatible with the way national democracies should work.

Q241 Viscount Brookeborough: Thank you. I believe that you have set out in a joint paper the case for a euro area insurance mechanism, in the form of common unemployment insurance. Would you say a little more about that? Dr Daniela Schwarzer: I am one of those who do not believe that we are beyond cyclical divergence in the euro area. The European Central Bank sets an interest rate that is based on average data. Given the divergence between countries, we have a situation that was there before the crisis. The data from 2005 onwards showed that economic cycles were longer and more extreme in both ways—upwards and downwards. The monetary policy does not fit member states that deviate too far from the average. You can ask what kinds of adaptation mechanisms exist with regard to labour flexibility. There are limitations in the EU. Of course we can do a lot, but we will never overcome the language barrier for labour mobility. Lord Davies of Stamford: You should come and see the all the Poles and Lithuanians in the UK. Dr Daniela Schwarzer: Yes, you have lots of them, but we still see few Spaniards who come to Germany. There are problems. Viscount Brookeborough: Do you consider that language is the big issue and that that restricts labour mobility? Dr Daniela Schwarzer: It is about language, culture and the openness of our country, basically. It is about integration policies and education policies—many things. There is a lot to do, but I do not think that we will in the medium term reach a situation where we have a

397 of 441 Dr Daniela Schwarzer— Oral evidence (Q 230-247) degree of labour mobility that is comparable to that in the US. That is one adaptation mechanism. Another one is the fiscal one. Again, I am taking the US example as a benchmark. You can see that, despite the much larger factor mobility in the US, fiscal stabilisation through the federal budget, including an unemployment scheme, plays a big role. Lord Flight: There are massive transfer payments. Dr Daniela Schwarzer: Yes. Colleagues and I looked at different ways of constructing a fiscal stabiliser. Of course, you could have a budget with a tax and say, “It’s either income tax or corporate tax that has the largest stabilising function,” but that is politically totally unrealistic. This is one reason why we said that an unemployment insurance scheme could have a good stabilising function. It could be constructed in a bilateral or multilateral way without necessarily being linked to the EU institutional framework—hence it can be institutionalised without a treaty change. You could select the number of member states flexibly. If there is one country that definitely does not want to join, there is no real problem. With regard to the question whether it immediately harmonises national social systems, we suggested that no, it would not; it would provide unemployment payments only for a limited number of months, because it should only stabilise cyclically, not structurally. We suggested six months, or maybe 12 months, or something in between. It should be only a certain amount. If, as a Government, you have a very strong preference for a strong welfare state, you can add in terms of length and volume what you think your unemployed should have in your country. It would be a kind of basic regime that members would join and, on top and in terms of length, they can add whatever they want. That is a way, we think, of avoiding getting into a debate about harmonising welfare systems, as my view is that that will not and probably should not happen. The Chairman: Perhaps to round off this conversation, Baroness Maddock has a question.

Q242 Baroness Maddock: I think that you have partly answered the question that I was going to ask. I was going to ask you about the fact that there is a lack of fiscal stabilisation capacity across Europe and what the German viewpoint was. I do not know if you want to add any more to that. I think that you have also answered the other point that I was going to raise on this, which was about the scale of the top-down approach to this. I think that you indicated to us that that is a bit difficult and that the proposals that you were making were much more in the line of subsidiarity, if you like. Dr Daniela Schwarzer: Yes, well I do not represent the German position right now. I am going far beyond that; I have probably spent too much time in Paris—no, that is a joke. I see an economic argument here. The reasons that we discussed for the wish not to install anything that looks like a huge transfer union make this a sensitive issue in Berlin, so I see no move towards this. For instance, the new Government will not argue for such a regime. Maybe there will be a deal with the French, because that is the way in which the Franco- German relationship works. Eventually, they will give some credit to the French proposal and have a small thing, but then Germany will emphasise, as ever, instruments to improve competitiveness and to bring down deficits and debts. So, no, there is no real support here for that question. The Chairman: Should we move on to Lord Marlesford, after which, Baroness Maddock, I would be very interested to open up a fresh line of inquiry.

Q243 Lord Marlesford: It is really on this pretty fundamental question or controversy over mutualisation, in whatever form it takes place—Eurobonds or anything else. We are well aware that Germany has been very hesitant about that, to put it mildly, if not strongly

398 of 441 Dr Daniela Schwarzer— Oral evidence (Q 230-247) opposed to it. I wondered, despite Draghi saying, “We will do what it takes”, how happy the ECB would be to have mutualisation of a debt that was itself unsustainable. I wondered what you feel is going to happen on this mutualisation argument, whether from Eurobonds or anything else. Dr Daniela Schwarzer: The German view on mutualisation is that there is a high risk that it immediately invites moral hazard. The whole approach since 2010 was to help out but at the same time to put pressure on the Governments to implement policies that, from a German perspective, would improve the competitive and sovereign debt situation. Now, on how the ECB sees that and whether there will be any move, I think that the Germans will stick to precisely the opposite principle—that is, they will try to make the no-bailout clause credible again. The German view on how this should work is that, at the moment, member states need to do their homework. I would give a different answer. I would say, yes, the no-bailout principle is key, because for political and democratic reasons but also for constitutional reasons we cannot have monetary union where there is a bailout obligation or anything like that. But in order to make it credible, we precisely need banking union, because right now that is the weak bit. We need to help the member states—the crisis countries—to get on to a sustainable track again. Structural adjustment alone does not help, so we need transfers limited in time. The SPD has proposed a Marshall Plan, although I would not use that term, but we need something of a temporary transfer mechanism that really helps them to develop growth potential again. That is the answer that I would give and my strong sense is that this view is slowly but surely gaining some ground and the Social Democrats can eventually be instrumental in this. For the other bit, as we discussed earlier, there is a silent acceptance of the ECB playing the role that it is playing. OMT so far is only a promise but, if it comes into practice, policymakers know that it is a very strong mechanism that mutualises risks. This is the choice, because anything more explicit would probably hit constitutional and political obstacles. The Chairman: Baroness Maddock, Daniela Schwarzer may feel reluctant to reply to our next line of questioning.

Q244 Baroness Maddock: This is about the UK position. We have made it quite clear that we are not really up for much of this, if I can put it like that, in GEMU, but at the same time we are very worried about how this will affect the single market, because that is the one thing we have a bit of agreement on in England politically. People are keen to pursue it. How realistic do you think our position is? Dr Daniela Schwarzer: Well, I think the Berlin perspective is that there is huge interest to keep the UK and Poland close to us. Because of the Franco-German difficulties that we discussed earlier, sometimes I think that German policy-makers feel a bit alone in the EU. They look at the Finns, they look at the Dutch, and maybe the Austrians, but then who? As soon as there are conflicts in the Franco-German relationship, Germany is with a bunch of smaller member states. It needs allies in ideology, in a way. The single market is key to German economic performance and is really the building ground for the whole EU from a German perspective, but I sense that the mood has changed in the sense that we will not do it at any price. If the UK is perceived as being unco-operative and preventing progress with regard to deepening monetary union and if there is a risk of the UK pushing up the price in the sense of, “If you do not do this, we will negotiate ourselves out of that”, the tolerance is pretty low to follow that line and help the UK to negotiate its way partially out of the EU. That is something that Germany does not want. If policy-makers were asked whether they

399 of 441 Dr Daniela Schwarzer— Oral evidence (Q 230-247) were open to explore ways to strengthen the single market with the UK and the Poles in a joint initiative, of course the answer would be yes. Germany is among those member states that constantly argue to hook in the non-euro area members in debates, discussions and instruments that are being created. My perception is also that there is an increasing differentiation between pre-ins, such as Poland—who else was there?—and those who deliberately chose not to be part of the club.

Q245 The Chairman: Is it that we have not perceived that yet? I agree with you. I think a separation is beginning, but has the UK not fully appreciated it? We have the rules about the EBA and, when we are down to the last four, we are in the last-four saloon, as it were. Have we not appreciated that? Is that what you are telling us? Lord Davies of Stamford: We could end up as the last one. Dr Daniela Schwarzer: I am not sure how the thinking goes in London. I sense that there is an increasing perception that it is necessary and legitimate for euro area member states to look after themselves, because this, after all, is the core of the single market. The UK perception is that if you deepen, you endanger the single market, but I would ask the opposite question. What happens if it fails? What would be the repercussions on the single market? I think that they would be far more disastrous, because if we had the reintroduction of extra-competitive devaluation and so on, this would probably have repercussions on other fields of single market policy. I think that there is no real conflict of interest between London and Berlin, as long as the joint objective is to maintain the single market, but if this is combined from the British perspective with pulling out and putting everything that has been achieved in the European Union up for debate, the Germans are not willing to go along with that. Baroness Maddock: One problem that we have is that London is the financial centre of Europe. This skews the whole picture. Would you like to comment on that? Dr Daniela Schwarzer: I have difficulties in judging the position of the City of London because on the one hand it looks like there is a clear interest in being kept out in order to have a competitive advantage with less regulation and so on, but at the same time there is the potential that if that happens the continental financial market gets protected. Why not? This would be the price. Lord Davies of Stamford: How “protected”? Dr Daniela Schwarzer: That you pass whatever. I am not a specialist on banking regulation and stuff. I think of rules that would make it more difficult for whatever—interbank lending or such. Lord Davies of Stamford: Protectionist rules adopted by the eurozone. Dr Daniela Schwarzer: I am not saying that this is foreseeable now, but it could be a logical consequence. If the City of London tries to be the hub outside continental Europe and tries to have a competitive advantage, there will be a reaction.

Q246 Lord Flight: Very quickly, the German medicine for uncompetitive economies is in many ways very right, but unless it is accompanied by either a significant devaluation, which it cannot do because of the euro, or substantial transfer payments, it drives these economies into the dirt. It seems extraordinary, given Germany’s history during the past 100 years, that Germany should be presiding over such policies, because the political risks of extremists coming to power at some stage in Italy, Greece or Spain are really quite high and the longer their economies are ground into the dirt, the higher that risk grows.

400 of 441 Dr Daniela Schwarzer— Oral evidence (Q 230-247)

Dr Daniela Schwarzer: I totally agree. This debate is lacking in Berlin. I make that point not as eloquently as you did, but I am trying to make it as strongly. What has happened in the past year is that youth unemployment has moved to the forefront of the debate. I think that the measures agreed in June, with a volume of roughly €8 billion, are too small to really deal with the problem, so more should happen. Politically, yes, we do not live up to our responsibility and we do not make— Lord Flight: It is the blindness that I find so extraordinary. You would have thought that of all people in Europe, the Germans would be the most aware of those dangers. Dr Daniela Schwarzer: Yes, we should be. I agree.

Q247 The Chairman: Could you explain a mystery to me: the Karlsruhe Constitutional Court. Whatever goes before it, it seems to come out the other end that, provided that the German Government does the right thing by itself and therefore within the context of Europe, it will be okay. Is that a very unfair interpretation? Dr Daniela Schwarzer: No, it is not. The Constitutional Court has taken decisions that were a pain for the Government, but they applied not to substantial European policy measures but rather to the relationship between the German Parliament and the Government. Part of the constitutional complaints that were filed to Karlsruhe in the past few years were precisely on that relationship: increasing parliamentary control; obliging the Government to be mandated before it goes to each European Council; and the question of the ESM, which was negotiated next to the EU framework—that was treated by the Government not as an EU issue but as a question for international law, which is formally correct, but Parliament then has much less to say. There have been all those disputes. The Constitutional Court agreed to almost everything in substance, although it tried to define some red lines. There has been speculation, for instance, on the potential lending volume that would be acceptable to Karlsruhe for the ESM if Governments decided to increase the lending volume. It is only speculative, but it has said things like it should be reasonable. The question is then, “What is reasonable?” People say one federal budget or two federal budgets. There is this debate. Karlsruhe does impact the debate but, so far, it has not stopped anything. What is happening consistently is that all those decisions have been so relevant to financial market expectations that the risk that Karlsruhe had to balance was a deepening of the financial market crisis. I agree. Basically it legitimised what the Government did. It said something on fiscal union. It basically said that there are very clear limits if the authority of the German Parliament is limited in any way and it does not maintain full budgetary authority. That is linked to the EMS bit but is also linked to the fiscal union question: if we install some kind of fiscal capacity, what would this mean? It has made it very clear that if this was going to happen, we would need a constitutional change of our fundamental law in Germany. It is not that all those rulings are without any consequence, but they have never stopped anything on the European level so far. The Chairman: Colleagues, I am going to thank Daniela Schwarzer very much indeed for coming along this afternoon. The Committee has found your replies absolutely fascinating. We will go away and study them, and we will send you a transcript of what we have exchanged. When you get a few really good ideas as you leave the room, please add them. I am going to do something which is so un-House of Lords-like that I hope my colleagues will forgive me. The last thing you talked about was youth unemployment, and who do you bring along this afternoon but two young people? I hope they are not unemployed. I wonder whether in front of your very good teacher you would like to say something to the House of Lords about whether you think that your elders and so-called betters are getting it right in

401 of 441 Dr Daniela Schwarzer— Oral evidence (Q 230-247) terms of dealing with these matters. You have just come back from America—you are wearing an American tie—so perhaps you would like to start, and then perhaps you would like to continue. Philipp Liesenhoff: Thank you for giving me the opportunity. Yes, of course, I work for Ms Schwarzer and I totally agree with everything she just said. Lord Flight: You did not have to say that. Philipp Liesenhoff: The one thing that I am working on now is the integration of financial markets. My question to all of you, I guess, is: how much is it a discussion in London that financial integration, although you could say it is part of the problem, is also a part of the solution? The eurozone has suffered from mal-integration. The debt channel was overstretched but there was almost no equity. Is that something that you discuss? How far is that debated in London?

The Chairman: While we are trying to think of a good answer to that very difficult question, do you have a question or comment or something that you would like to say to us from your perspective? Anna-Lena Kirch: I see that one of the huge challenges is making more communication to the European peoples and especially to European youth. That is also a question from my side. How much is there a feeling that maybe the youth in Great Britain have a different stance on European integration and may see that there should be more integration? The Chairman: Thanks very much for those two questions. I am looking round to see whether any of my colleagues have recaptured their youth. I find that Lord Davies and Lord Flight have. Lord Flight: From a banking perspective, the substantial loans are largely from banks in London to the weaker economies, which wound back with fear and were ultimately replaced by the Bundesbank financing. That is not going to come back in a hurry, and I think it will come back only if there is a feeling that the problems have been solved. There is the reverse of that—that it will drag on in agony, but if something major does not happen it will blow up one of these days. It is very interesting that on the other side, equity wise, money is pouring into Europe from London right now because companies are cheap, there are many strong companies, large and small, and it is perceived equity-wise as one of the most attractive parts to invest in, so you have that rather strange turnaround in terms of debt and equity. On the equity front, people are not blind to the political and currency risks, but there is the ultimate view that real businesses can sustain that sort of thing where Governments and banks cannot. Lord Davies of Stamford: You raised an important point about financial integration. Anybody who wants to devise a single currency—and unlike my friend Howard here, I have always been in favour of this project and thought that ultimately it would work very well, which I believe to be the case—must be concerned with a stabilisation mechanism. What do you do when you cannot use the stabilisation mechanism of a currency that appreciates or depreciates? In fact, external depreciation is a very crude and often very expensive form of stabilisation. In other words, it generates internal inflation because it produces solvency problems if residents of the country that is devaluing hold debt in another currency that is revalued. Obviously, they find themselves in a difficult solvency position. Devaluation and revaluation are not easy mechanisms, but nevertheless you deprive yourself of one stabilisation mechanism, so what do you replace it with?

402 of 441 Dr Daniela Schwarzer— Oral evidence (Q 230-247)

One answer in a single market, such as the European Union, must be factorability. We talked about labour markets, which are very important. A lot can be done there. On the whole, I think that the academic world has underestimated the extent of mobility in the labour market. I am not saying that we have got to the stage of the United States, but anybody who comes to Great Britain will see enormous evidence of labour market mobility and, what is more, it is working both ways. What you will see is that, as Spain recovers, people will go back from England to Spain, which will be quite rational. That is very important. Factorability also includes capital markets. Everybody talks about transfers as being public sector transfers. There is a role for that. What is our equivalent of federal funds in America? We have stability funds and that sort of thing. We have to look to see whether we need more of that. It comes back to the issue that we were talking about of who is paying for it. The most important form of stabilisation through capital markets is in the private sector, so rationally what happens if you have country in crisis, like Spain or Greece, is that factor cost prices diminish, labour is cheaper and land is cheaper, so people invest there. That is happening. There is an enormous flow now into real estate in Spain. It is all flowing back there. I have not heard much about flows into Greece, but maybe they are to come, and into Cyprus. These things happen, but I just want to say that you cannot have too much of these stabilisation mechanisms. I like your unemployment scheme. I shall ask you about it privately afterwards. I do not know whether you have done any calculations into the extent of share of GDP it will amount to in different scenarios, but that is the sort of thinking that we need, because we want more stabilisation. It is a very important thing to have. Viscount Brookeborough: I believe that you mentioned communication and connectivity. This is where Europe, if it does not fail, has simply not succeeded. The European Union has expanded, and the communication and connectivity have simply not gone anywhere with it, definitely as far as we are concerned. I live in Ireland, and as far as I am concerned many people do not know who their MEPs are. People get only bad news, not the good news. The latest bit was the size of our toilets or something which was in the paper yesterday or the day before, or about the water that could be used in them. It is quite simply not succeeding in communicating, and unless we educate the young more and more to be part of everything, they simply feel they have no role in their destiny. Lord Marlesford: I suggest to you that one of the great distortions of the capitalist system at the moment—we all know the reasons for it—is low interest rates. It does not make any sense at all if under a capitalist system capital should have no value. That is causing flows in particular ways. The only thing that worried me about what I heard this afternoon is any suggestion that there should be pressure on German companies to cease to invest abroad, because that is a really an anti-globalisation policy. If German companies reckon they can do better by investing overseas, it is a very serious step to try to discourage them. Dr Daniela Schwarzer: I did not speak about pressure. I said I hope that there will be incentives also to invest in Germany. The Chairman: Daniela, I have done my formal goodbyes, but my goodbye is to you and your two colleagues. If and when you are in London, it will be my pleasure to show you round the House of Lords and the Palace of Westminster. I shall then tell you a very romantic story about how when I was younger, possibly, than you I first became a pro- European because I engaged with young people as a person who hitchhiked 10,000 miles around Europe in the days when you could do that, and I met with almost nothing but kindness from the younger people and the older people I met throughout Europe, which was

403 of 441 Dr Daniela Schwarzer— Oral evidence (Q 230-247) still very much split between east and west and which, thankfully, has become united since then. Baroness Maddock: Chairman, I hitchhiked as a girl in Germany over 50 years ago. Lord Flight: I did it on a motorbike. The Chairman: Thank you very much.

404 of 441 Detlef Seif, MdB/MP (CDU), Bettina Kudla, MdB/MP (CDU), and Manfred Zöllmer, MdB/MP (SPD)—Oral evidence (QQ 287-296)

Detlef Seif, MdB/MP (CDU), Bettina Kudla, MdB/MP (CDU), and Manfred Zöllmer, MdB/MP (SPD)—Oral evidence (QQ 287-296)

Transcript can be found under Ms Bettina Kudla, MdB/MP (CDU), Mr Detlef Seif, MdB/MP (CDU) and Mr Manfred Zöllmer, MdB/MP (SPD)

405 of 441 Dr Federico Steinberg—Oral evidence (Q 66 -77)

Dr Federico Steinberg—Oral evidence (Q 66 -77)

Evidence Session No. 5 Heard in Public Questions 66 - 77

TUESDAY 18 JUNE 2013

Members present

Lord Harrison (Chairman) Viscount Brookeborough Earl of Caithness Lord Carter of Coles Lord Davies of Stamford Lord Dear Lord Flight Lord Hamilton of Epsom Lord Kerr of Kinlochard Baroness Maddock Lord Marlesford Lord Vallance of Tummel ______

Lord Boswell of Aynho

Examination of Witness

Dr Federico Steinberg, Senior Analyst, Elcano Royal Institute, Madrid

Q66 The Chairman: I have great pleasure in welcoming Federico Steinberg who has been kind enough to come from Madrid to be our final witness this morning. Colleagues, Federico Steinberg has given me advice that he, too, has to flee very quickly back home again and so without further ado we will begin the questioning. You may know that we will be making a transcript of this event. We will ask you to check that and add to it. You know that it is webcast and will be available to the public. I would be very grateful if you could tell us your institute back in Madrid. I also understand you would like to make an opening statement and I would be very grateful if you could do that. Thank you very much indeed. Dr Steinberg: Thank you very much. First, I would like to thank you for the invitation. It is a great honour and it speaks very highly of this institution that you are interested in opinions of experts outside the UK and in the eurozone. I have quite a lot of time because the flight is at 5 pm. My name is Federico Steinberg. I am senior analyst for international economics at the Royal Elcano Institute, which is an independent think-tank in international relations, very similar to Chatham House. I am also professor at the Autónoma University in international economics. I thought it would be interesting, reading the questions you proposed, to give a two-minute introductory statement, very brief, on why we are here, and where I think we will be in the

406 of 441 Dr Federico Steinberg—Oral evidence (Q 66 -77) foreseeable future. As you have discussed in this Committee, I think that we need to understand the eurozone crisis was caused by a combination of events, on the one hand the global financial crisis that came and hit us from outside. Without that coming from the US, and it has to do with the way we regulated the financial system, we would probably not be talking about this today. However, there were intrinsic failures of architecture and governance within the eurozone that made the crisis much worse and that, in particular, started what we now call the eurozone debt crisis. Those are the ones that we will get into in detail on, I am sure. They are more or less trying to be addressed. It is important to take a political economy approach to understanding the crisis. The current situation has dramatically changed the balance of power within the European Union and within the eurozone. It has given creditor countries much more power and it has made debtor countries policy-takers instead of policymakers. I admit that southern European countries have never had a lot of influence in European affairs but now they have zero influence or very little influence, and in particular this has redefined the way we do things in the European Union. I think that the principle, first, of equality among member states and, secondly, the principle that solidarity is at the heart of the Union because of the historical reasons why we created the Union have been somewhat diluted. I would not say they have been eliminated, but at this point it is crucial to understand these dynamics. More importantly, I think that at the end of the day for all these new elements on the new governance agenda—banking union, fiscal union, economic union and political union—the key place to look at is still France. We are not looking at France at this point but at the end of the day my reading of the crisis is that Germany would like to take advantage of this situation to force on France reforms that France would not otherwise make. The southern European countries are just places where you try this strategy to see if it works, but we will only resolve this or, to put it clearly, Germany will accept that mutualisation, some sort of model of federal budget, a good banking union—we can talk about what that means—if and only if France accepts changing some elements of its economic model. The German strategy has to do with the role of European globalisation, of course, and that is where we have to look. In terms of where we will be going, my reading of the crisis is that this will take quite a long time. Things will get worse before they get better. I am not particularly worried about the competitiveness problem in the southern countries, maybe a little about Greece and Portugal but certainly not about Spain. I think we will do the internal devaluation that is needed. We have been doing it and we will do more. That is not a problem. I see some problems in terms of the sustainability of debt in some southern countries and for that we need a more active ECB. I think at this point European leaders have understood that it is too risky to play with fire, to play with the exit of anyone from the eurozone, be that Greece or Cyprus. I think that the political commitment of European populations in the south towards the European project is much larger and much more intense than we thought. I am personally surprised why Cyprus did not exit. I do not understand it from an economic perspective. I have to understand it from a political perspective. There are security issues there, for sure, and those are probably more important than we normally think. My reading is that we will stay together—“we” meaning the eurozone plus the new members of the eurozone because, as we know, some countries are deciding to join the eurozone at this point—and we will muddle through, doing the minimum necessary to maintain the boat afloat; that is, with Germany accepting these little elements as the situation gets worse. But in normal times of calm, like now, we are most likely to see a slowdown in

407 of 441 Dr Federico Steinberg—Oral evidence (Q 66 -77) the progress. So, paradoxically, we need things to get worse so that we can construct this Genuine Economic and Monetary Union.

The Chairman: On that point, I shall turn to Lord Hamilton, whose interest must have been whetted by some of the things you said on southern Europe.

Q67 Lord Hamilton of Epsom: You have echoed Dr Schmieding’s view that this is all going swimmingly. We are seeing devaluation happening in all the countries including yours. Wages have been lowered. Indeed, your balance of payments, I gather, is starting to look up. On the other hand, I think even you think that economic growth is not going to come back very quickly in your country. Youth unemployment is in excess of 50%. How long politically can you go on with these appallingly high levels of unemployment without eventually infecting your politics and leading possibly to extremist parties, partition, the break-up of your country? Are you quite philosophical about all that? Dr Steinberg: I am more an economist than a political scientist but I will try to answer. I think this is the key question. If the eurozone breaks up it will be because anti-Europe parties get into power, not because of bank X or bank Y collapsing or someone needing a bailout. In the case of Spain, a number of elements make it less likely for this to happen in the next few years, so we still have quite a lot of room for manoeuvre. The reasons are the following. First, the Spanish political system is one that facilitates the formation of stable Governments in general by our electoral law, so small parties have a hard time getting a lot of seats. Secondly, there is a very strong identification in Spain between Europe and modernity, Europe and progress, Europe and the solutions to Spanish endemic problems, and this comes from Ortega y Gasset who said, famously, that Spain is the problem and Europe is the solution. As such, you do not see any anti-European party in Spain. You do not see it even in the Izquierda Unida, which we can call extreme left, if you want something like Syriza in Greece. We do not have an extreme right party in Spain, maybe because of our historical Franco regime tradition. Therefore, it is very difficult to find an anti-Europe party emerging. I think that despite that we are seeing lots of protests by teachers and doctors. We have seen sectoral protests but no common element that could channel these protests towards the formation of an anti- European party. In fact, one of the parties that is rising as an alternative to the two big parties is one that would like to see more reforms faster, so it is more European than anti- European. Secondly, on youth unemployment, which is a problem and not only in Spain, we have to be careful with the numbers in one sense. There are lots of students who would normally not be part of the labour force. They would not be an active population because they are studying, but given that their families are going through a difficult situation, many are looking for a job while they are studying, so they are becoming an active population where they would normally not be so. If you correct for that—we have done some studies at our institute—that puts the number down to approximately 35%. You can discuss how many of these will finally drop out from school or from university and end up looking for a job actively, but I would say those figures are a little bit exaggerated. Another element that is important is that Spain has the highest number of home ownership as a percentage in Europe. Some 85% of families own their house, and 59% of them have already finished paying their mortgages completely. If you add that to the issue that family networks in Spain are quite strong, many young people can go back to live with their

408 of 441 Dr Federico Steinberg—Oral evidence (Q 66 -77) parents. That means that if you own your house and you have a little salary, you have something that is enough to survive and do not need to join movements that are really anti- system or anti-Europe. In that sense, I am not worried at this point. Of course, if there is no growth in three years I will be worried, but I do not foresee that.

Q68 Lord Boswell of Aynho: Thank you very much for that slightly reassuring account, and I realise it is important we do not take a literal account of the figures but, going behind it, there are always variations between particular regions, for example. Yours is a country that is differentiated by region and relative prosperity and—indeed, this is an issue that, as you know, is current in the UK—has some interesting pressures towards greater regional autonomy or even separation. How bad is it in some of your regions, and is that something that can be contained within the Spanish political system? Dr Steinberg: Yes. I do not think there will be a separation of Catalonia or other regions from Spain. Honestly, I think that the nationalist government in Catalonia embarked on a risky bet. I think that they were making an electoral calculation because they anticipated the elections. They decided to do the elections earlier because they thought that in four years the recession would be over and, therefore, they would have a chance to win again, whereas if the elections were when they were supposed to be, the recession would still be there so they might lose. To justify changing the date of the elections, they constructed this idea of being much stronger and asking for a referendum on independence and so on. I think that the result was not very successful in the sense that they did not get an overwhelming majority. They are still in power but in a coalition. I think that there has been a general feeling in Catalonia that maybe a majority of the population would like to be outside of Spain and inside the eurozone, but with a treaty in your hand that is not really possible and they know it. I do not know and I am not a political scientist—let me just say that clearly—but at this point I do not see that as a big risk as well. I understand that it is interesting from outside to see those developments and they are difficult to understand, but at this point I do not think that will happen.

Lord Boswell of Aynho: Just factually, presumably the greatest unemployment pressures are in the south, even if those are not the areas of greatest separatism? Dr Steinberg: Yes. For that also, there is another element I did not mention before. The black economy, the informal economy is very large in Spain. Nobody knows how large, of course, but it has been estimated at between 18% and 23% of GDP and it has clearly gone up with the crisis. The southern regions, which have official rates of unemployment of about 30%, probably have a larger share of the black market economy and therefore their real unemployment rate is a bit lower. These are regions that are used to living with relatively high levels of unemployment. Even at the peak of the boom in Spain, average unemployment was 8%, which is still very high, and this has to do with the labour laws, but in the south it was higher than that. Again, I do not see that as risky or unsustainable if we see growth at some point in the next years.

Q69 Lord Dear: Thank you for coming. Can I ask you first about GEMU and the whole situation there? Although I know you cannot speak authoritatively about Italy and France, taking Spain, Italy and France as a sort of southern European economic belt, if you like, in your view is there any common ground in those three countries, particularly on how GEMU should develop? Internally, in your own country, in Spain, do you have what we call red lines, any rigid rules or constraints around GEMU or are you more flexible on the way it might develop?

409 of 441 Dr Federico Steinberg—Oral evidence (Q 66 -77)

Dr Steinberg: I think that Spain, France, Italy and the southern countries would share the view that we need a more active European Central Bank at this present moment to reduce the risks of pay risk reappearing, and more active monetary policy, both in the conventional way of lowering interest rates a little bit more but also on trying to secure funding or make funding available for small and medium-sized companies in southern Europe, which are really not getting the money. Therefore there is a problem with the transmission monetary policy mechanism, and the ECB designed the OMT policy to deal with that, but again more active, and also to depreciate a little bit in Europe in this context of currency wars we are in. But at the end of the day, in the case of Spain, I think that the current Government is committed to structural reforms, and in that sense would like to be closer to Germany in the sense that the Spanish Government want to appear in front of Germany as a country that is serious about reform, that is taking the steps required to gain competitiveness, and therefore it is possible, in exchange, to ask for some more solidarity. I would say that, as a general view, southern countries in Europe want debt mutualisation, a big budget and so on, a more active ECB, as I said. But then at least Spain—I cannot speak for Italy or France— understands that it has nothing to gain by taking a confrontational approach towards Germany, because we understand that the only way to have a confrontational approach towards Germany is to threaten exit and that is not a credible threat for Spain. It could be for other countries but not for Spain. In the second part of the question, which I think is very relevant, what are the red lines? I think Spain has no red lines, and let me explain. Spain, as I said before, tends to see more pulling of sovereignty and more giving up sovereignty—it depends what you want to call it— as something that is positive, and I would say this is unfortunate. This in part has to do with our own history. If you look at the recent history in Spain, most of the reforms that made us a prosperous nation after the Franco dictatorship were facilitated, if not imposed, by European integration. I see no big resistance. The average Spaniard wants economic growth and prosperity but does not care that much about giving up sovereignty, and this debate about legitimacy of the troika and so on is very much constrained, I think, to the current situation. In France I think it is very different. France has an issue with a fiscal union. France would like to see all the carrots of the fiscal union, meaning a big budget and eurozone mutualisation of debt, but none of the sticks; that is, that Brussels can tell them they do not like their budget and they have to rewrite it. I think that France has an issue with that, but I do not think Spain has an issue with that. Spain is very interested in proceeding as fast as possible with banking union. I think this is a must for Spain because, as you know, there are still doubts about the sustainability of some of the banks in Spain after the banking bailout, and because we understand that to break down the vicious circles between sovereigns and banks it is essential to complete the banking union. Also, we think that in banking union Spain has a priority, I think, which is to ensure equal treatment. We have seen some differentiated treatment depending on the country, and I think the government argues, and I would agree with that, that this is not a rules-based system. If we are really about rules, as the Germans say they are, we should have the same rules for all.

Lord Dear: A very short question on the north-south divide. There is a view in some of the popular press here, not necessarily the more esoteric press but the more popular press, that sooner or later, probably sooner, there will be some sort of north-south divide

410 of 441 Dr Federico Steinberg—Oral evidence (Q 66 -77) between the economies. From what you say, if I understand you correctly, that is not going to happen in the case of Spain and you would not want to see it. Dr Steinberg: North-south divide? You mean creditors and debtors across the eurozone? Lord Dear: Yes. Dr Steinberg: I think that there is a division between north and south that has become explicit, as I said, between creditors and debtors. What I am saying is that at the end of the day in Spain the Government will not lead a group of southern European countries against Germany. I do not think that is going to happen.

Q70 Lord Davies of Stamford: Professor Steinberg, there has been an amazing range of developments and measures taken over the last three years, the bailouts, the bail-ins, the governance and stability pact, the fiscal co-ordination, the two-pack, the six-pack, the ESM, the conditional facility from the ECB since last September. One can hardly remember all that has been going on, and of course you and other countries have been going through your own austerity programmes, structural reform programmes and labour market reform programmes. We have the first stage of banking union in respect of common supervision. Do you think the essential elements are now in place to resolve this crisis and to create the right framework for our prosperity and new growth in the future in the European Union, or do you think there are any important elements lacking that still have yet to be conceived or developed? Dr Steinberg: I think we have to distinguish that some of the elements that are in place are not for this crisis, they are for the next one. So far so good, to have them. Anticipating new macroeconomic imbalances in the eurozone is very important, but we need to solve the legacy assets problem, not the next imbalances problem.

Lord Davies of Stamford: There is no inconsistency in doing both things, is there? Dr Steinberg: Of course, but what I am saying is that many of the things we have done were useful things but we are missing some elements to solve the crisis today, which would be basically the attitude of the European Central Bank, I think. As I said before, a more active policy and a recognition—and this came in the debate before—that in order to clean the sovereigns, or some sovereigns not Spain, you would need some haircuts and maybe the ECB to absorb some losses, first to purchase more bonds and then maybe to absorb some losses, I think that is going to happen, and the sooner we realise that this has to happen the better. The same goes for Greece. I think that Greece needs a second restructuring of its debt, and I think that that is going to happen after the German elections, but the sooner we do it the better. The IMF has said recently that they made a mistake not forcing a restructuring of the debt sooner. To sum up, I think we need more action on the monetary side to compensate the fact that we have a very contractionary fiscal policy and that we will have a contractionary fiscal policy in the years to come because we have to bring down the deficits, and that is okay. That is a fact. Maybe we should slow down that pace a little bit, but we have to continue that, and to compensate for that we need more expansionary monetary policy and maybe some help through exports outside the eurozone. Secondly, an understanding that the crisis has to be resolved not only by forcing adjustment and internal devaluation in the southern countries, but also through growth of wages in creditor countries, because I think the eurozone runs a big risk at this point, which is going into deflation. If we go into deflation things are going to be much worse. Why do I say that?

411 of 441 Dr Federico Steinberg—Oral evidence (Q 66 -77)

If you take into account the inflation level in the eurozone area, it is coming down, and many countries in the south that have increased taxes are showing levels of inflation that are higher than they would be if you take this increase in taxes out, and that will happen next year. Greece is already in deflation. If we see deflation, deleveraging the financial sector is going to be much more difficult, and therefore I hope that the ECB is looking at that closely. It does not look like they are doing it, but I hope they are doing it. That concerns me.

Q71 Lord Carter of Coles: Dr Steinberg, you noted the importance of a banking union to Spain. Do you think that this is going to break the link between bank and sovereign debt and make it, therefore, much easier for your country to get on to a secure financing basis? Dr Steinberg: I think a full and proper banking union would break that. It is not only the three legs we normally talk about, it is also the ability of the ESM to lend directly to banks, not to the sovereign. So direct bank recapitalisation is also very important and I think that is under negotiation but that should also be accelerated. If we get the full package, that would be enough. I am worried that we might not get the full package on time, the full package meaning single supervisory resolution fund with the ability to close down the banks and a common deposit insurance mechanism.

Lord Carter of Coles: Which bit of the package would you least like to lose? What would be the most dangerous for Spain? Dr Steinberg: For Spain, what is essential is to have a single supervisory mechanism, basically because that sends a message that progress is on its way, not because at this point that would change anything that has to do with Spanish banks, and then very clear rules about resolution of banks with, if possible, a fiscal backstop that is credible, and by that I mean that uses more than private money. Now on the table is the idea that just the banks will finance that, and I think that we need something stronger. Probably not the ESM—I think the ESM is better for sovereigns and to create something else for banks, but something that is big, permanent and is there.

Lord Kerr of Kinlochard: By the way, I do not entirely accept that the influence of Spain had been close to zero and is now— Dr Steinberg: I exaggerated. I am sorry.

Q72 Lord Kerr of Kinlochard: Having watched the influence that Prime Minister González had over Prime Minister Thatcher or having watched the Edinburgh European Council when it was perhaps Prime Minister González’s triumph, I think you are unnecessarily modest. What about fiscal capacity and what about fiscal discipline? Is it particularly difficult in Spain, where the crisis did not result from fiscal ill-discipline, to contemplate the sort of structures that we find in, for example, the Franco-German paper? What is the Spanish reaction to that? Dr Steinberg: I like the point you made that the fiscal deficits and the increasing debt in Spain were not the cause of the crisis, and I think this is something that we would like to re- enforce and to explain to the creditor countries. It is the consequence of the crisis. I think that there is an understanding in general in public opinion that you cannot live with permanent fiscal deficits. What I think that people would like to see—public opinion and the Government—is a reduction in the speed of adjustment. Within that framework, I think that there is no big resistance in Spain for that. Obviously, the problem is that that has to be negotiated, and the European Commission has given Spain more time now.

412 of 441 Dr Federico Steinberg—Oral evidence (Q 66 -77)

In a way, I would like to see the European institutions pressuring Spain much more on the structural reforms side than on the speed of the adjustment of the public sector deficit. What is useful for Spain, coming from Europe, is the ability to have an external force that puts pressure on some industries or some sectors that need structural reform that have powerful lobbies inside, and that has been the history of Spain. That goes more to the idea of contracts, which we will talk about in a minute, I guess. In that sense I think that the Spanish population would like to see more of their reforms. Also, in the case of the cuts in the budget deficits, there are some issues of redistribution and how you make those cuts. That is an issue in public opinion, of course.

Lord Kerr of Kinlochard: Yes. How would fiscal transfers work? What sort of mechanism? Do you see a specific euro facility, as is proposed in the Franco-German paper, or contractual relations as proposed by the Chancellor, which presumably would have to have some sort of incentive attached to them, or a stick if not a carrot? There would have to be something. How do you see that working? Dr Steinberg: I would like to see it. I doubt that it will be in place soon. I think that if we look at the theory of optimal currency areas, we all know that we need some sort of mechanism to transfer funds from one region to another if we have an asymmetric shock, and especially given what we have learned in the last decade, it is probably likely to happen at some point again that we have an asymmetric shock. I think it is necessary for that to be there in the medium term. In the case of Spain we would like to see it relatively fast. In the case of Germany and other creditor countries—the Netherlands, Austria, Finland—what they have in mind is that they will do it only once the southern countries have Germanised their economies; that is, have made the structural reforms that Germany did in 2003 and 2004 under Schröder that, according to the German narrative, and I do not know if that is correct, prepared Germany to compete in globalisation. I have some sympathy for that idea. I think that in southern Europe we have not understood what globalisation is about, and this is very serious. We have to make the structural reforms, we have to make these important changes in our economic structure, but I would like to see that as a voluntary process of reform domestically. Going more precisely to your question, I think that it might happen as a fiscal capacity going within the eurozone, not at the European Union level probably—that is another issue—but very limited in size until Germany understands that the south has made these reforms.

Viscount Brookeborough: Would you like to tell us what you think about a potential euro area budget in the future: whether it is a very long way off, whether you would expect countries like your own to support it, and what you feel about it being funded and the new own resources that might be involved? Dr Steinberg: This is interesting because all the people who see the European Union and study it with a lot of enthusiasm always talk about the necessity for a big budget. That never happened and what allowed transfers between countries was a financial crisis. This is in a way paradoxically that the money crosses borders when we have a big risk of falling apart. The discussion of the budget in a way takes much longer and it is not a decision you should have to make when you have the financial crisis in front of you. I think that if we go to this Genuine Economic and Monetary Union we would need to increase the size of the budget to put it at least at 7% of GDP, according to some of the estimates. There are many

413 of 441 Dr Federico Steinberg—Oral evidence (Q 66 -77) numbers, but I had this in mind as something that could make it operational, and that is probably not going to happen in the next decade, I would say. I say 7% as a way to be able to fund the number of policies that we need to make the European Union work properly and the eurozone particularly, asymmetric shocks, but that would require an element of conditionality that is much stronger than what we have today. I would emphasise that, and this goes back to the idea of contracts, probably you need to have clear guidelines on how you spend that money. You need contracts for countries in the south, of course, but also for countries in the north if they do not do some of the reforms that the European Commission requires.

Viscount Brookeborough: Do you think that can only happen if it is an EU budget and therefore all the nations would have to be within the eurozone? Dr Steinberg: What I envisage is the EU budget to stay as it is at 1%, and then an incremental budget for the eurozone.

Q73 Viscount Brookeborough: Yes, but do you think the eurozone would have to include every nation within Europe in order for there to be a euro area budget? We would have to take the euro. Dr Steinberg: Yes. I see. I think it is possible to design it as a separate thing or to have opt- outs or different negotiating ways of countries that want to stay in the European Union and do not want to be in the euro. I think that is possible to design. I would say you have a budget for the EU and then a larger budget for the eurozone, and this could be made compatible but you probably have to have important negotiations or tough negotiations about how to do it.

Q74 Lord Vallance of Tummel: Can we move on to debt mutualisation? Is some form of mutualisation necessary for Spain and, if so, what form might that take that perhaps would allay some of the natural fears of the net creditors about markets? Dr Steinberg: I think, for obvious reasons, all debtor countries would like to see full mutualisation tomorrow. That is not going to happen, and that is probably not a good idea also because, as I said, I think that what we have learnt in this crisis is that countries reform only under the pressure of financial markets. They do not reform under the pressure of the six-pack or the two-pack or their peers at the Commission. It will be necessary to have some form of mutualisation to fully solve the crisis, and that will have to include some of the legacy assets. As was mentioned previously, that is already happening somehow in the case of Ireland with the promissory notes, that the ECB accepts to monetise partially part of the debt informally, in other cases to extensions and reductions in interest rates of ESM loans. From the different proposals, my view is that we will end up having something similar to the redemption fund proposed by the German economic experts, just because Germany is the hegemon in Europe today. Out of the different proposals, theirs will be taken more seriously.

Q75 Lord Carter of Coles: On the issue of varying levels of competitiveness, the question is: do we need continuous transfers to deal with those imbalances or is there another way of solving that problem if we want to keep the union together? Dr Steinberg: I think that it is possible. As I said before, I am not particularly worried about competitiveness issues to solve the crisis, in the sense that I think that countries can adjust their unit labour costs through internal devaluation. If we take the six-pack seriously and

414 of 441 Dr Federico Steinberg—Oral evidence (Q 66 -77) therefore we use this instrument to monitor imbalances that are building up and countries take them seriously and there are changes in policies when those are identified, that would be enough and you would not need such strong adjustments in the future. I have to say that what we have seen in the past decade in the eurozone is an asymmetric shock of enormous proportions because nobody understood what the euro was about, particularly financial markets. I think that markets have learned from this experience, and in the future the accumulation of imbalances, if it happens, will not be that large, even without the six-pack. With the six-pack it will be even smaller. In a way, I think that markets have understood that within an imperfect monetary union—and I think the euro will be an imperfect monetary union for many years to come because we will not have a full political union, which is required to have a United States of Europe or something like that—risk premiums between different bonds have to be there and that there is credit risk and there is sovereign risk even in a monetary union. This shock was too big, I think.

Lord Carter of Coles: How far do you think wages can be pushed down? We heard earlier that they have been pushed down by perhaps 15% already in Greece. What do you think will happen in Spain? Dr Steinberg: I think that in Spain they will go down as much as necessary to start competitiveness. Let me explain. Given that there will not be anti-Europe parties getting into power, given that sectoral protests will be sectoral not general, I think, and given that people with property, which is most of the Spanish population, have a lot to lose from a complete breakdown and financial apocalypse, then we will do whatever it takes in terms of how much wages have to go down. The key thing would be to have a narrative within Spain, which we do not have at this point, about how we share the burden of adjustment between the different groups, and why we are doing this. If we have the narrative, given that we have the courage in the population to do it, it will be much easier. We now are doing it but we need a new narrative.

Q76 Earl of Caithness: What is your view of the UK’s position? You are entitled as participating members to take the drift in the direction that you want to. What is your reaction to a country like Britain, where we are saying we do not want to participate, but all the evidence that we have from British institutions is that you have to be there in the room, at the table, influencing the negotiations? Dr Steinberg: Let me start by saying that I think the UK has made a very valuable contribution to the European Union in general and I hope it will continue to do it. I think that the European Union without the UK would not be what I would like to see. Having said that, for a number of reasons—I will give you only one—and this was mentioned before, I think that what the European Union countries will be doing in the next few years is a level of deeper integration that is unprecedented, and it is up to the UK to decide if it wants to be part of that fully or only to a certain extent. The other countries have nothing to say about that, of course. What is perceived in a bad way, I think, in continental Europe is an obstructionist attitude of vetoing things. I think it is possible to maintain an agreement. It is absolutely possible to maintain the internal market and complete free trade, and even the business model or economic model of the UK, but the British Government have to be careful about not appearing to obstruct something that we think in continental Europe is absolutely essential for us to survive. If we can make a deal about it, that would be good.

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Earl of Caithness: If you proceed with this further it will not be Genuine Economic and Monetary Union but perhaps, we hope, better economic and monetary union - do you see your attitude towards Britain changing or the need for Britain to change its attitude? Dr Steinberg: I think that there is going to be a point, if we in the eurozone do this thing really well, where the UK is going to have to make a hard choice between being in or out, in the full package or out of the package. That will not happen soon but at some point I think it will happen. At that point I would love to see the UK in fully.

Q77 Lord Marlesford: You have indicated already that there need to be a lot of reforms in Spain, particularly on the tax front, and to try to stimulate the economy to deal with the very high unemployment that you still have. There is one area in which I do not understand Spanish policy at all: VAT, value-added tax. In Britain, you do not have to register for VAT until you have a turnover of €90,000, which means that a painter who paints my house is a single employed person; I do not pay 20% extra if I employ a big company. Your threshold, the only country in the EU, is zero. In other words, everybody has to register for VAT. Why do you have such a totally different system and neglect the huge employment opportunities you give to small craftsmen and people by having a VAT threshold? Dr Steinberg: I have to say I am not a fiscal expert so I do not have a thorough response to that. I guess that we have in Spain a number of elements of red tape and bureaucratic difficulties that affect small and medium-sized companies, and that would be one of those as well. This is one of the places where some level of tax harmonisation coming from the EU to us, if this is actually a big problem, would be more than welcome, but I cannot give you an answer on the specifics of why that is the case.

Lord Marlesford: Each country in the EU fixes its own threshold. The Spanish Government could say tomorrow, “We will have, say, a €50,000 threshold”. Then a lot of little people who are out of work could get jobs and paint people’s houses. Dr Steinberg: Yes. This probably has to do with the law tradition in Spain that is somehow different from yours.

Lord Marlesford: Perhaps a change needs to be made. Dr Steinberg: I am all for tax harmonisation within the European Union if we can all agree on the grounds of changing things we are doing wrong.

Lord Hamilton of Epsom: Presumably a lot of people do have the work in Spain and do paint Mark’s house and they get paid in cash, and that contributes to the black market. Dr Steinberg: Yes. It is true it is probably an element that really forms the black market economy. The Chairman: Seňor Steinberg, muchas gracias first of all. You are the witness that we have been missing all along. What has been so refreshing in your evidence to us is not only to have a better understanding of a country like Spain, but also the wise words you had in getting us to think about the southern mentality in all this with GEMU, and of course to identify the source of potential problems or solving the matter with France. So we are extremely grateful for you coming over today and we would ask you to look at the transcript but I can say that if there is anything further you might add to what has been such an illuminating session we would be most grateful if you would do that for us. In the meantime, do keep in touch and we hope to see you before us many times in the future. Many thanks indeed.

416 of 441 Sir Nigel Wicks—Oral evidence (QQ 179-188)

Sir Nigel Wicks—Oral evidence (QQ 179-188)

Evidence Session No. 15 Heard in Public Questions 179 - 188

TUESDAY 8 OCTOBER 2013

Members present

Lord Harrison (Chairman) Viscount Brookeborough Lord Dear Earl of Caithness Lord Carter of Coles Lord Davies of Stamford Lord Flight Lord Kerr of Kinlochard Lord Marlesford ______

Examination of Witness

Sir Nigel Wicks

Q179 The Chairman: Colleagues, it is a great pleasure to welcome Sir Nigel Wicks to the Committee as we return to the subject of genuine economic monetary union, which we have been pursuing for a while now. I remind Sir Nigel that, as he already knows, we make a transcript of these exchanges. We will send you a copy and would ask you to correct it. You could also update or improve any answers that you give and offer any further thoughts that would be useful to the Committee, which hopes to publish its report just after Christmas. Perhaps you would just say a little about yourself. I think the last time you and I met, you held the position of chairman of the monetary committee, which was very interesting to know. You may have some preliminary comments, but perhaps I could start by asking you about what is set out for genuine economic and monetary union in the Commission documents and the President’s document. Are there bits that are essential? Are there bits that are inessential or, indeed, may even be dangerous for the purposes of what is trying to be achieved here? Sir Nigel Wicks: Thank you my Lord Chairman. I will begin with what I what I would call three preambular comments. One of my present roles is as chairman of the British Bankers’ Association, but I have to emphasise that I do not come along here today as a spokesman of the British Bankers’ Association. The reason is that we have some 160 members, drawn from banks all over the world, and one is unlikely to get a co-ordinated view about the sort of questions that you will ask me from all those 160 banks. I sometimes talk about herding cats—that would be herding lions, and would be impossible, so I will speak very much from a personal basis.

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The second point is that some of my comments may seem to come from a rather sceptical, or Eurosceptic, point of view because I will be critical of some of the things that are happening in the European Union. That interpretation would be wrong: I speak as a supporter of the European Union but, I hope, as a candid supporter. The third preambular point is that I hope, although it may not sound like it, that my remarks are interpreted as being made in a spirit of humility. I say that because we are not members of the euro area and it is not our currency. It is other people’s currency, although obviously what happens with it very much affects us in the UK. When talking about what the euro area should do, as I say, I do it with a degree of humility, bearing in mind that it is not my currency. Do I think there are bits that are essential? Yes, I think there are bits that are essential to the future smooth running of the euro area. They are the bits effectively to do with the banking union. Of those bits, the single supervisory mechanism is essential. The single resolution arrangements are also essential. However, under both headings, the arrangements have been fashioned within the constraints of the present treaty, which is not optimal for the purpose for which it is being used. What do I think is inessential? That brings me on to a very fundamental point. If you look at the development of the euro area, we have, almost by definition, a centralised monetary policy and are getting into a centralised budgetary policy, with the six-pack, the two-pack and all that. We have a lot of rigidity at the centre with budgetary and monetary policy. If the euro area is to prosper, you are going to need as much flexibility in the euro area’s microeconomy as you can get, compatible with the free and effective workings of the single market. If you read the Commission paper—Mr Barroso’s paper—but also, to an extent, the paper of Mr Van Rompuy, there does seem to be a tendency to begin to centralise what I would call microeconomic policy and to reduce the flexibility of individual member states to react within the straitjackets of centralised monetary and fiscal policy. After all, if you look at the euro area—a very large geographical area—you have member states within it whose economies are in very different states of developments. To take an obvious example, Hamburg is probably the most efficient port in the world. However, the health and safety rules and labour rules applying to the port of Hamburg will apply exactly to the port of Piraeus. Now, Piraeus has made great strides in efficiency in recent years and I think it will make great strides in the future, but to have the same rules for health and safety, and various other labour market rules, is ill-judged. There are essential bits in the banking union but there are things which I think are inessential, and the tendency to centralise microeconomic policy is one that ought to be avoided.

Q180 The Chairman: When it comes to the question of possible treaty change, if I understood what you said about the single supervisory mechanism and the single recovery mechanism, you implied that they might not be in the best form, were there the opportunity or ability to actually have a treaty change—recognising all the political difficulties about that. Sir Nigel Wicks: My Lord Chairman, you interpret my comments absolutely correctly. I would argue that there are already certain aspects of the financial and monetary arrangements in the European Union that could have benefited from a change in the treaty. What do I mean by that? We have the so-called three authorities: ESMA, which looks after the securities market; the EBA, which looks after banking; and one that looks after insurance and pensions. I am sure that you will have had briefing on the infamous Meroni rule and will know about it. Because of the Meroni rule, the so-called authorities are actually agents of the Commission. I have spoken to colleagues and friends in the Commission and have explained to them the difference between the two FSAs we had: one was the Financial Services Authority, which had its own statutory powers and own statutory functions, and was answerable to Parliament but not under the direct control of Ministers, and the other

418 of 441 Sir Nigel Wicks—Oral evidence (QQ 179-188) the Food Standards Agency, which was an agency of the ministry. It is probably not right to refer to the three so-called European authorities as authorities: they are more agencies. But the Commission had no alternative if the three agencies were going to be set up, because of the Meroni rule. I think that better arrangements could have been made if the constraints imposed by the Meroni rule had not been in place and if we had had a treaty change that would allow freestanding authorities for the three areas. That is one point, which is history. Coming to the single supervisory mechanism, I am going to be a heretic and say something that is certainly not the view of the BBA. It is certainly heresy in this town. I believe, along with the Bundesbank, that it is not right, appropriate or correct to associate, in the same institution, prudential supervision and the exercise of monetary policy. That is the view of the Bundesbank and it is my view. There is a very obvious conflict of interest there and, again, it is difficult if not impossible to set up under the present treaty a freestanding authority responsible for supervision, separate from the European Central Bank. There is another reason why we would need a treaty change if the single supervisory mechanism was going to work as it should. Although I am not advocating that the UK join the euro, there are some non-euro member states that would like to join the single supervisory mechanism but the governance makes it very difficult for them to do so, because it is governed by the governing council of the ECB; by definition, if you are a “euro out” you are not part of the governance of the single supervisory mechanism. Again, that is one reason why I think we should have a new treaty, although I understand the political difficulties. On the resolution mechanism, the Commission is to be congratulated on the imagination and ingenuity it has used to go as far as possible within the current treaty arrangements to establish that mechanism. It is immensely complicated. If a bank got into trouble, first, whoever is running the supervisory prudential mechanism would say, “This bank needs to be wound up”, which is the ECB’s job. You then have the so-called supervisory board of the resolution mechanism, which would come into play. After that, if they agreed, it would then go to the Commission, which would pull the trigger. It would not do anything more than say “yes” or “no”. Then it is consigned to national regulators to do the actual work and the winding up, in consultation with the supervisory board. All my experience is that when a bank gets into problems and has to go into resolution, you do not have much time. With Lehman Brothers and Barings—both of which I was involved in, in different aspects—you virtually have a weekend. It seems very optimistic to think you could go through this convoluted procedure in a weekend and do so in confidence, which would need to be maintained. We do need a new treaty for the resolution mechanism and the Commission recognises that. If you read the arrangements that the Commission has proposed for the resolution mechanism and you listen to gossip in corridors, you get the impression that the Commission is not really keen on being in this business of resolution. But is has no alternative under the present arrangements.

Q181 Viscount Brookeborough: Sir Nigel, do you think the proposals do enough to ensure that the market pressures on Governments will be more effective than in the past, and that sovereign risk is appropriately priced? What changes, if any, would you like to see? Sir Nigel Wicks: I think the honest answer is that it is very difficult to say. At the moment— this is an exaggeration; nevertheless, I will make the exaggeration—virtually no financial instrument is properly priced. Why? Because of the interventions of various central banks, and they are right to intervene, with quantitative easing, outright monetary transactions of

419 of 441 Sir Nigel Wicks—Oral evidence (QQ 179-188) the ECB, the LTRO and, of course, what the Fed has done. So the answer at the moment is very few financial instruments reflect what you might call fundamental value. They reflect, to a significant extent, the activities of central banks coping with the emergency, and that is probably right. Viscount Brookeborough: And therefore intervention from outside? Sir Nigel Wicks: Yes. To go to your question, what in a steady state—and we are far from a steady state—creates fundamental values and market signals is the appreciation or perception of market operators that they either gain money or lose money, based on their objective reading of what is happening in the markets and the future. That is what, in the long term, we have to work towards: it will have to be recognised that if you invest in a sovereign it is not risk free—there is a risk to it. It depends on which sovereign it is, of course. It is similar with banks. I think we are far from that position at the moment, but that is something that we ought to work towards. The Chairman: Can we deal with an asymmetric shock to the financial system with what is planned and supposed by GEMU and its struts? Sir Nigel Wicks: Assuming that the supervisory mechanism, the resolution mechanism and, of course the macroprudential body—the financial stability body—were up and working properly, you would expect to see that asymmetric shock coming down the track at you, and you would hope that action would be taken to mitigate the consequences of such a shock. Either capital buffers would be increased for banks, or in the case of sovereign you would expect the six-pack and two-pack arrangements to be wheeled into effect. But I have to say that I would start from the situation—and I hope I would finish there—that there would be no government rescues of banks. There should be arrangements—and this is what the regulators are trying to do—whereby banks can fail. That would mean not only shareholders but bondholders losing money. Obviously smaller depositors would be protected. It would also mean that if a sovereign found itself in a situation, despite all the efforts of the six-pack, the two-pack and so on, the bondholders would then have to lose money, as they have done with Greece. But if there is any impression that the central bank and Governments would step in to reward failure, that is only, in my view, in the longer term likely to encourage failure. Lord Marlesford: Very quickly, on Sir Nigel’s first answer, if the three agencies were to become freestanding, would the accountability of the machinery be so similar to the ECB? Sir Nigel Wicks: I would say that if they were freestanding, their accountability would be direct to the European Parliament for what they do, rather in the way in which the ECB accounts to the European Parliament, and rather as the Bank of England accounts to Parliament here. I hope I will have an opportunity in a moment to say something about accountability, because that is a crucial issue that is elided away in the documents that the President of the Commission and the President of the European Council publish. The Chairman: We will certainly leave the opportunities for that to happen. I will come next to Lord Davies. I am anxious to move on.

Q182 Lord Davies of Stamford: Thank you Chairman. Sir Nigel, the British Government’s role or line on all this seems to be that they do not want to be part of this new supervisory, regulatory and resolution regime, but they want to have the maximum influence on its establishment, and they have not limited themselves to expressing views on

420 of 441 Sir Nigel Wicks—Oral evidence (QQ 179-188) the substance: they want to express views even on the appropriate basis and the treaty of any measures that are taken. Is that a realistic and sustainable position? Sir Nigel Wicks: It depends very much on the tone in which that advice is given. I am not commenting on the tone that different bits of the British Government take, but if the tone is, “We are here to help. We want to make it work well. We have certain expertise, because we have a very large international financial centre here in London”, we will be heard. I will give you a small anecdote from my experience. When I chaired the European Union’s Monetary Committee during the discussions on the transition to the euro, some questions came up about the redenomination of national currencies—the and the German mark—into the euro. Some draft legislation was put before the Monetary Committee for us to give our view on. The British—I was not the British representative but the chairman of the Committee—gave some views. We were rather promptly told, not rudely but kindly, that it was very interesting to have views from the British but that since they were not going to be part of the euro, perhaps those views were not really to be taken much notice of. They were then very politely reminded by the British representative that they perhaps should go back to their own countries and find the law which the various swap contracts—the international financial contracts—were written in. That law was often, or usually, English law. My European colleagues then came back and said, “We see your point. A lot of these difficult matters are actually governed by English law, so perhaps you Brits do have something to add”. We then got together with some English lawyers and found a formula that allowed, on the appointed day, all the European currencies that were moving to the euro to be converted. It worked, and it was never challenged. There was some fear it would be challenged in the US courts, but the advice was, “Look, if the English courts are happy with it, the US courts will be”. We were able to influence that, because we were there to help, which we did, and to make it work. If we approach the discussions in a sort of, “Well, it’s so difficult. You’re making a mess of it. It’s all going to break up. You shouldn’t be doing this”, you will not be listened to, but if we go there and say, “There are some technical issues we can help you with”, we will be listened to and we will be able to make a contribution, at the same time as maintaining what I would call our national interest. Lord Davies of Stamford: Historically, we certainly had a fine reputation for financial service expertise and for our ability to successfully manage and regulate financial markets. Do you think that after RBS, Lloyds, the LIBOR scandal and the rest of it, that reputation stands as high and that credibility and the ability to exercise influence are as great as they were historically? Sir Nigel Wicks: Clearly, those incidents that you have referred to have brought shame on the financial community in this country, and rightly so. But you have to look around the world, I am afraid, to see that there have been financial disasters in many countries—I will not talk about what happened in France, Germany, Brussels or Spain. We certainly need— and this goes back to the point I made in my initial remarks—to make any comments that we make with a due humility and recognising these points. If we are strident, we will not be listened to. In fact, we will turn people off. If you do it in the right tone, often privately— there things are often best done privately and not in public speeches—we can have an impact. We are still going to have a major international financial centre here, whatever happens in the euro. Frankfurt, Paris and other centres in Europe are going to be important, but I doubt whether in the foreseeable future—in a longish time—the euro area will say, as it were, “What happens in London doesn’t matter”. I think it will matter. What happens in the euro area matters to us in London, they will say, so we have to come to some sort of accommodation to meet our mutual interests. That is perfectly possible with the right frame of mind and the right tone of voice.

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Q183 Earl of Caithness: I want to pursue that a little further. The Committee was in Brussels last week, and much of the sadness that I think many of us felt was that Britain’s role was not taken in the same way it was a few years ago. The quality of advice was as good as ever, but there seemed to be a slight lack of interest in Europe at the same time. Given that more and more financial decisions are going to be taken by the inner core of the eurozone—for instance, the FTT is progressing at some pace, however that pace might be described—are we going to be marginalised more and more? How do you think we should counteract this, and what effect will this have on the health of international banking in London? Sir Nigel Wicks: I will take your last question first about the effect on international banking in London. Why is London a thriving international banking centre? To be quite frank, it is not because of the sterling market. The sterling market is there, and it is an important market, but people do not come to London to work in the sterling market; they come to London because it is a good place to do European wholesale business and international business. But they do not have to be here, and we can already see some repatriation of business out of London, not because of what is happening in Europe but because of various maybe necessary regulatory and supervisory changes in the UK. So my answer to the last part of your question is that we do depend on Europe to a large extent. People are here because it is a good place to do financial business in Europe, and we must keep that. It is at risk. It would be against Europe’s interest, but if we were to leave the European Union, which is the policy of certain people, the advantages of coming to London as a place to do European business would be much reduced. To sum it up, we have to provide a marketplace. We can provide a good marketplace for European business at the moment. If we lost that, I think we might find business being done elsewhere and the euro area itself would suffer because there would be less liquidity. Bankers might start turning to other centres, not just to do euro business but to do other foreign business. I was at a meeting in Europe this time last year when an Asian central bank governor deplored the fact that Asian financial business was virtually always transacted in London. Asian money was taken to London, business was done and very often the money came back to Asia. So why could it not all be done in Asia, the central bank governor asked? The answer is because in London we have a critical mass of finance expertise and the law is good here for that sort of business. Once we start to lose a significant amount of euro area business, that undermines the rest. International financial business is here partly, maybe even mainly, because we are a good place to do European financial business. Lord Flight: Very quickly, I quite agree with your comments about not bailing out banks. I think it is realistic to think of medium-sized and smaller banks being allowed through a resolution process but not a Crédit Agricole, a Lloyds or an RBS, where government is often involved anyway. Pinning everything on the principle of “no taxpayer bailouts” sounds great but is it realistic? Sir Nigel Wicks: If I might look across the Atlantic, Washington Mutual and Wachovia were large organisations. They both no longer exist and, as far as I know, the US taxpayer is not in hock to them. I accept that we lost a significant bank, even if it was relatively small: we ran down Northern Rock—or Barings, it might have been. There was no taxpayer money involved in Barings. If we work on the basis that those large banks that you refer to are going to be bailed out, they will be bailed out and then others will be bailed out. I do not work on that basis. We have to put up institutional arrangements—this is to do with recovery plans, which is another issue—where it is impossible for banks to be too big to fail, or too complicated to fail, which is another aspect. I do not know whether the British Bankers’ Association would agree with this, although they probably would, but I think we

422 of 441 Sir Nigel Wicks—Oral evidence (QQ 179-188) have to work on the basis of putting ourselves in a situation where, if the recovery arrangements do not work, the resolution arrangements must work and there should be no longer-term recourse to taxpayers’ money. That has to be the objective. If you depart from that firm objective, you are more likely to find yourself in a situation in which you do not want to find yourself.

Q184 Lord Dear: Sir Nigel, good morning. Changing the focus to the banking union, I think I can guess what you will say in answer to my very short question, because you have almost bumped up against it already. Do you think, personally, that the three-pronged model is the best one for a banking union? Sir Nigel Wicks: By the three-pronged model you mean the supervision model? Lord Dear: Yes: supervision, resolution and deposit. Sir Nigel Wicks: The issue that concerns me is the third element, the common deposit guarantee. That is the one that I am not sure about, quite frankly. I need to be convinced that there has to be a Union-wide deposit guarantee. Maybe there should be a Union-wide deposit guarantee up to £85,000 or €100,000, but not beyond that. You might argue— Lord Davies of Stamford: No one is suggesting that. Sir Nigel Wicks: Well, they nearly got not too far from it with Greece and the Greek banks. But I need to be convinced that we should do it even up to £85,000. Lord Dear: Cyprus. Sir Nigel Wicks: Sorry, I meant Cyprus, yes. Lord Davies of Stamford: The matter was resolved during the Cyprus crisis. Sir Nigel Wicks: It was, but after a very large wobble to begin with. Lord Dear: They did not have that in the early stages: they reeled back to the €100,000 half way through the crisis. Sir Nigel Wicks: They did in the end. I do not know why they got themselves in a muddle to start with, but they then got themselves on the right track. The Chairman: Is your criticism of the deposit guarantee scheme approached from an economic point of view or a political one? Sir Nigel Wicks: No, it is a moral hazard point. This has nothing to do with the BBA, which would disagree entirely. Deposits look to be guaranteed up to £85,000, which they are, although again the Icelandic situation was a very interesting one, in that the question is who guarantees it and whether that is done by the Government or by other banks. Lord Dear: For the sake of clarity, I understand that you have doubts about the common deposit insurance but are you comfortable with the single supervisory mechanism and the single resolution mechanism? Sir Nigel Wicks: Absolutely. Lord Flight: When it comes to deposit insurance, if Germany has a better scheme than France, then all the retail deposits in euroland will go to Germany. That is a very simple argument for having the same scheme. Sir Nigel Wicks: You can argue that. If the Germans wanted to do that, you could argue that that is a choice for the German banks and the German taxpayer. You can make that argument. I have to say that what concerns me very much about the European Union as a

423 of 441 Sir Nigel Wicks—Oral evidence (QQ 179-188) whole and where it will have problems, even if they will not be ones that make it fall to pieces, is that it will be overcentralised. As I commented earlier on, we have a centralised monetary policy and it looks as if we are going to centralise fiscal/budgetary policy, or at least the overall budgetary totals. You have to have some flexibility at the micro level, otherwise everything will be so constrained that it will not be able to develop. That is why I am hesitant about taking the power to insure national deposits out of national hands. Why should a German, for example, be on the hook for insuring a Spanish or Portuguese deposit?

Q185 Lord Kerr of Kinlochard: Can I take you back, Sir Nigel, to the single resolution mechanism, about which you spoke interestingly at the start? You congratulated the Commission in its ingenuity in constructing, within the existing treaty, this rather elaborate and—in your view, if not your exact words—rather dangerously complex structure. I have three questions. Do you think it would be essential to have treaty reform if you were creating a strong, fast-moving single resolution mechanism? It seems to me that if you are going to have a supranational body closing down banks, you had better have that written down with the firmest kind of judicial and juridical certainty, which is in a treaty. Secondly, do you think the Commission is not in that area only because nobody wants an IGC and treaty reform, or do you think that the loose “timber-framed” structure—in Schaüble’s words—is the most that, despite Schaüble’s article, German public opinion is likely to wear in the next few years? In other words, do you think that it is likely that the next coalition Government in Germany will agree that Germany should be paying for a supranational body that bails out or closes down southern European banks? Thirdly, what about the legal base? You talked about the ingenuity of the Commission, but are you happy that the single resolution mechanism is on an Article 114, single-market legal base? Sir Nigel Wicks: Let me answer those three questions. Maybe unusually, I agree with Lord Kerr’s answer to his first question. You are right on your first point and I do not really have anything more to say. On the “timber-framed” point made by the German Finance Minister, I think we will not get a change until the timber frame is tested. We will find, when it is tested in a hurricane, that it will be found wanting. Let us hope it is a small hurricane, or a small bank that goes down, but it will be found wanting. It is the only thing that is on offer at the moment because to have something that would be “steel-framed”, to use his words, you would need treaty change. I think there is a very great reluctance in the European Union to have any treaty change at the moment because, however sensible it is likely to be, people are in the mood of saying no. Remind me Lord Kerr of your third question, which was more complicated. Lord Kerr of Kinlochard: Article 114. Sir Nigel Wicks: The treaty is infinitely elastic. I was once on the Lamfalussy committee, which was the committee that worked out how some of the secondary legislation was going to work. We put some recommendations forward and knew we were straining right at the edges of the treaty. Although there are obviously more than three institutions of the Union, the three principal ones—the Commission, the Council and the Parliament, the last after a bit of reluctance—agreed with the Lamfalussy Committee’s proposals. If the three principal institutions agree that what is proposed is within the treaty, the court is likely to be very much influenced by that unless there is an egregious over-interpretation. Also, I think the answer would be that there is nothing else on offer. If you have a fire, you have got to put it out and you might as well use, within the framework of present treaties, all the instruments to put it out, even though it might mean stretching them a bit. It is probably just within them but not as comfortable as you might want it to be.

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Lord Kerr of Kinlochard: Thank you very much. On the legal base point, could I persuade you to break the habit of a lifetime and add a political dimension to your wisdom? The British Government seem to have some doubts, presumably inspired by legal advice. I personally agree with you—if the matter ends up in the Court of Justice, you are right as to how it would be settled. From my political point of view, it is ideal that there should be a single-market legal base, which means that the legal status of the British negotiators, even though they are negotiating on something that is not actually in its detailed provisions going to apply to them, is not in question: we are full members of the party. There is no question of getting into the sort of mess we got into in December 2011. I am rather in favour of all this. Are you in favour of the legal base as proposed by the Commission? Sir Nigel Wicks: It is the only one that is available at the moment. I strongly agree with your argument that you can separate the management of the euro and the management of the single financial market—the management of the euro is very much a matter for the ECB, as it is at the moment—but I think we have to be very careful that the management of the euro does not, as it were, cause a division in the single financial market. There is a real risk that that will happen, and we have to be very careful about that, because if you allow that principle to be accepted, I think I know where it will finish up. So I agree with what I suspect is the fear behind what you say. We have to maintain the single market as a single financial market for all the member states, and the euro is a currency of some of the member states. The Chairman: We have only 10 minutes left. I am going to ask Lord Carter if he would be kind enough to put his question, and perhaps Lord Kerr could follow up at the same time.

Q186 Lord Carter of Coles: Thank you. Sir Nigel, my question is on the integrated economic policy framework being pursued by the euro area and is very simple: it is about the requirements. Do you think that member states may be more compliant than they have been in the past in this area? Sir Nigel Wicks: That absolutely goes to the heart of the debate, if I may say so. Both President Van Rompuy’s document and document of the President of the Commission, Mr Barroso, have very interesting statements. I will quote from page 35 of the Commission document. It says, “At the same time”—it is talking here about general principles— “…whatever the final design of EMU, the role of national parliaments will always remain crucial in ensuring legitimacy of Member States’ action in the European Council and the Council” but especially in the conduct of national budgetary and economic policies even if more closely co-ordinated by the EU”. There is a similar statement in President Van Rompuy’s document as well. You read that statement, but when you read the rest of the document you see that it forgets that statement. It is a centralising document. It almost brushes aside the statement I quoted. This is, and will be, one of the crucial political issues at the moment in the European Union: how to harness what I would call the national parliaments into the European design. I am not criticising the European Parliament, which in many ways is a very effective scrutiniser of legislation. Going back to my BBA role, I look at the documents that we prepare. Often we like what comes out of the European Parliament; they improve legislation. But this issue of consent comes from national parliaments rather than the European Parliament. I am not attacking the European Parliament; it is just that it does. The Chairman: Sir Nigel may want to know that actually the Select Committee, our parent Committee, is now looking into the role of national parliaments and the European Parliament and how they work. You did say that you wanted to say a little more about accountability. That was the point.

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Sir Nigel Wicks: That is the point. We talk about subsidiarity. The whole treaty arrangements pay lip service to subsidiarity. I am not sure how often subsidiarity has changed much. The first protocol of the treaty talks about the role of national parliaments. I do not think that protocol has changed very much. I do think there is a big lacuna there, where national parliaments do not have a role. I think we went wrong—in 1979, I think it was when we used to have Members of Parliament from the national parliaments going to the European Union. It is interesting that the United States has two Houses. The European Union has one House, which is probably more like a House of Representatives than a Senate. This arrangement is impossible to foresee in the European Union—at least, it is very unlikely to happen—but there is a need to buttress the role of national parliaments throughout the Union in the governance of the European Union. The Chairman: I am going to ask Lord Kerr to ask the other question very briefly and then turn to Lord Marlesford.

Q187 Lord Kerr of Kinlochard: On the point about that macro-economic conditionality, you must have been thinking for 20 years about whether it can be made an effective club in the golf bag of economic union. The Stability and Growth Pact clearly did not work. It is quite hard to see how, if a national Government is in very serious trouble, any system of fining, which would make its troubles worse, is going to be politically imposable. You and I saw the Stability and Growth Pact blown out of the water by the French and the Germans, and Prodi saying that fining was stupid and not trying to make the system work. Now we have this idea of binding contracts, which seems to have started in Germany and been picked up by the Commission—here it is in their proposal. Do you think that that one can work? If not, how do you bring macroeconomic conditionality into the policy toolkit? Sir Nigel Wicks: I do not think that binding contracts will work, because they are not actually contracts, and to refer to them as contracts is misleading. A long time ago I was an executive director on the World Bank and the IMF, and it is what we would call conditionality: you get the money if you do this. There are quite serious doubts about whether World Bank conditionality—IMF conditionality is separate—actually worked. A country doing something that it does not want to do and does not have the political will but takes money to do something, that is not a good way forward. You will ask me what the answer is, Lord Chairman. I am afraid it is a very brutal answer: if a country gets itself into a mess, it has to sort out that mess itself. It will have lots of warnings that it is getting itself into a mess, but it has to sort out that mess itself, even if it means that it goes to the Paris club, which is where countries go to that cannot pay their official debts— or to the London club, if the debts are private sector debts. I believe that that is the way forward. It is a very harsh measure, but that is the way forward, and I do not think that these so-called binding contracts bind anyone—they are not actually contracts. The Chairman: Lord Marlesford, I wonder whether I can ask you to be relatively brief.

Q188 Lord Marlesford: Another crucial proposal seems to be in great difficulty: the euro area budget. Is it going to happen? If it is, how will it be designed, how big does it have to be, and who is going to fund it? Sir Nigel Wicks: I look forward still, at my advanced age, to a long retirement, and even if I live to be 100, which is in another 25-odd years, I do not think I will see the circumstances that you talk about. I do not think we will see the Parliament, the Commission, being given a budget as we have a budget over here. I think they will have to work as they do now on a

426 of 441 Sir Nigel Wicks—Oral evidence (QQ 179-188) balanced budget—what they spend they have to get in—but I do not think they will have a macroeconomic-type budget where they can, as it were, play the economic cycle. I do not think that is likely in the foreseeable future, and I think it is undesirable given the present state of European integration. The fact that national parliaments, as we said a moment ago, have a greater say in the running of the European Union is one reason why giving those sorts of powers to the centre would, at least given my expectation of the development of the Union, be a big mistake. The Chairman: Sir Nigel, one last question from me, if I may. If the matter of tone is really important in how Her Majesty’s Government communicate. What else would you advise them to do to obtain the best within GEMU and banking union for the United Kingdom? Sir Nigel Wicks: That is a difficult question, and my answer abstracts from the present state of United Kingdom politics. The Government ought to have the motto, the approach, “We are here from the United Kingdom and we are here to help”. They really ought to say it in a tone that makes people believe that they do want to help, and their actions ought to be such that they do help while obviously having regard to the national interest. The national interest is clearly that the euro area has to work. It is still our largest market, our major export market, and if it does not work we will be in trouble. Business, and particularly government, has to have the attitude, “We are here to help. We want to make it work, and we will, consistent with our national interest, do everything we can to make it work”. The Chairman: Sir Nigel, we wish you a long and happy retirement over the next 31 years or so, and I hope that you will be able to consult your yellowing copy of the MacDougall report that a number of us around this table were very familiar with. We are also very grateful for your comments today. We, too, hope that whatever hurricanes assail the euro and the single market, they will be small, as you describe them. In the mean time, let me thank you on behalf of the Committee. I ask you to look at the transcript that we send you and, as I say, if you have any further thoughts, we would be most grateful for them. We are most grateful to you for finding your way here today. Sir Nigel Wicks: I will send your clerk a very small article that I wrote last year for some publication, which is I think relevant. It may be of some interest to you. The Chairman: Thank you.

427 of 441 Guntram Wolff—Oral evidence (QQ 109-120)

Guntram Wolff—Oral evidence (QQ 109-120)

Evidence Session No. 9 Heard in Public Questions 109 - 120

TUESDAY 1 OCTOBER 2013

Members present

Lord Harrison (Chairman) Earl of Caithness Lord Hamilton of Epsom Lord Kerr of Kinlochard Lord Vallance of Tummel ______

Examination of Witness

Guntram Wolff, Director, Bruegel

Q109 The Chairman: I would be grateful if you could say a little about yourself and about Bruegel. We are familiar with Bruegel—I think we have interviewed nearly everyone in Bruegel at one time or another on banking union and economic governance. A transcript will be made of the exchange we have today. We will send it to you and would be grateful if you could look at it, correct it and improve upon it. You may have an arrière-pensée as you walk out of the door and think, “Oh I forgot to say that”, and we would be grateful for any further thoughts that derive from the meeting. Do you want to introduce yourself? Guntram Wolff: My name is Guntram Wolff. I am a German citizen and have been in Brussels for more than five years. Before joining Bruegel two and a half years ago, I was at the European Commission, with DG ECFIN. Before that, I spent four years at the German central bank, the Bundesbank. Before that I took a PhD at the . I am very grateful to be here. I have been the director of Bruegel since May this year, having been deputy director for roughly two years. The Chairman: That is exceptionally helpful. We should advise you that we have just met Olli Rehn and that we are meeting you and others today. We have a full programme tomorrow as well. In November, we are going to Germany—both to Frankfurt, to the ECB, and to Berlin. We are hoping to meet colleagues there and would be very pleased to receive your advice about those we might meet. If you could also ask them to hurry up and form a Government, we will know the appropriate Ministers to interview; otherwise it will have to be Schäuble again! Guntram Wolff: I am not sure they would listen! The Chairman: To start, I wonder whether you can say, in respect of GEMU, as we call it here, what elements you regard as essential and what elements you regard as either inessential or which might queer the pitch of the objectives of genuine economic and monetary union and might actually detract from what it is trying to achieve.

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Guntram Wolff: Thank you for the question, which is of course an excellent one. I will start by saying that when I received the document with your questions, the question that really intrigued me—which perhaps I could ask about before I answer—was the one about the needs and priorities of France. I thought it was a very interesting question and wondered what the main motivation was behind it. Why pick out France in particular?

Q110 The Chairman: I confess that we had originally intended to go to Paris and Berlin and we rather thought, especially with the importance of the ECB, that we would concentrate on Germany. However, we were very anxious not to leave out the French voice as it were, Liêm Hoang Ngoc, a French MEP. There are a couple of others who will perhaps give us that view. But we thought that you were the very man to help us. Guntram Wolff: When it comes to France, I have a particular relationship in the sense that I am on the Conseil d'analyse économique, the advisory council of academics to the French Prime Minister. I am engaged in France and of course Bruegel also has a French link. To come to your original question: what are the essential elements? The first question is whether we should stop at those elements that are essential or not. Should we aim for something that is viable or something that is optimal? That is an important question, which needs to be asked. My fear is that we may end up with something that is just about viable but not really optimal. Ultimately, the legitimacy of what we get will be undermined, because citizens will be unhappy with a non-optimal outcome. That is a very important question. If we look at what is really essential to make it viable, the one thing that is really the game changer is the banking union. You may have seen that we have done a lot of work and published a lot on this. The most recent paper was on the reshaping of Europe’s financial system in light of the banking union, which we presented in Vilnius at the informal ECOFIN meeting just a few weeks ago to Finance Ministers and central bank governors. The point we make in that paper is that, for the banking union to succeed, we need not just supervision but a strong and centralised resolution authority, which does resolution and bank restructuring in such a way that the resulting bank landscape is a truly European one. What does that mean? It means that we have to end the practice of national champions. We have to stop banks operating mostly in one country and being exposed mostly to the risks in one country rather than to a portfolio of eurozone debtors. In the paper, we show a number of things, first of all that there was significant financial integration before the crisis. This financial integration has been mostly in the wholesale interbank market, not in the retail market. Of course, wholesale market integration proved very vulnerable to sudden-stop phenomena and to shocks, and when that happened the banking system retreated behind national borders. The little retail banking integration that we had was significantly reduced by national regulatory and supervisory action. We now have a banking system where the banks are extremely exposed to their own sovereign but also to all the other creditors of the country in which they are located. That feeds the negative spiral between banks, sovereigns and the economy as a whole. To really break this link, we do not need just resolution, a kind of common fiscal backstop and so on but we need banks that operate across several countries and which, on their asset side, are truly European banks. For this to happen, the practice of national championing needs to end and the link between banks and national politics needs to be reduced. That is the key issue that we need to achieve. If we manage that, we probably have a pretty viable monetary union. The one thing we do not discuss in this paper—and I have to say that we do not discuss it in this paper not because we forgot about it but because the issue is so complicated that we did not know how to tackle it—is the role of the City of London in the UK. It is not a small thing. It is something that Europe needs to think much more seriously about. Of course,

429 of 441 Guntram Wolff—Oral evidence (QQ 109-120) many of the big banks that operate in the eurozone have major parts of their business in London. In other words, if we talk about a centralised resolution authority, I guess we have to think of the Bank of England being somehow involved. I do not think that there has been a process of serious reflection in Brussels, and not really in Berlin. In Berlin, there is a bit of thinking in this direction. My sense is that there is an acknowledgment that that may be one of the reasons why the network solution for bank resolution proposed by the German authorities at the moment may be a good way of moving forward. Basically, you vote for centralisation and mutualisation of risk in the eurozone, but at the same time you gain a network approach which would allow the involvement of the UK authorities and the Bank of England in this network. That may be a reason why a network approach is interesting. That may be part of the reasoning in Berlin on the issue.

Q111 The Chairman: Let me jump in here. Do you think that there has been enough thinking within the Bank of England and the UK authorities about that important development? Guntram Wolff: The Bank of England will soon have a famous Brussels-based deputy governor who is thinking about these issues quite a lot. The Chairman: We will see him later. Guntram Wolff: We recently had a discussion about this. It is an important topic. If you ask me, the key question for the Bank of England and the UK in the coming years is to enter this process in the right way. It is really key because continental Europeans will move ahead somehow. The somehow could be such that the City of London will be left alone, and then we will all of a sudden see the City of London as an offshore financial centre which will be faced with a lot of regulatory and supervisory barriers, and basically be deprived of parts of its business market. Lord Hamilton of Epsom: How do you see these European banks being created, then? Do you see there being takeovers or amalgamations and mergers? How is this going to happen? Guntram Wolff: That is a good question. In this paper we show that cross-border mergers have been really minimal. There have been very few over the past years. Lord Hamilton of Epsom: But they have been resisted, have they not? Guntram Wolff: They have been resisted and have also partly been prevented by the differences in supervisory, regulatory and resolution standards. Lord Hamilton of Epsom: Before you lambast the City of London, there has been no resistance against European banks coming to the City of London, but there has been a lot of resistance the other way. For instance, it would be almost impossible for a British bank to take over a major French or German bank. Guntram Wolff: Yes. There is political resistance.

Q112 Lord Vallance of Tummel: Can I bring you back to your networking of central banks and regulations? Would you prefer a network which is based upon nation states or one that is based on currency, which of course would have far fewer claims? Guntram Wolff: The “first best” for the eurozone would be to have one resolution authority with one fund and one set of rules applicable to all countries and all banks throughout the entire eurozone. This resolution authority should ideally have very close contacts and, ideally, agreed mechanisms of how to do resolutions with banks that operate

430 of 441 Guntram Wolff—Oral evidence (QQ 109-120) in the UK and in the eurozone. The first problem with this first-best solution is a legal problem. That frankly is not my competence, so all I can report is that there are very different views on whether Article 114 is the appropriate basis on which to do such a thing or not. All I can say is that this is a genuine concern in my home country. It is not something that is just used— Lord Vallance of Tummel: Setting aside the law and talking as an economist? Guntram Wolff: Talking as an economist, we need a centralised resolution authority that matches the centralised supervision. Lord Vallance of Tummel: Something based on nation states rather than currency? Guntram Wolff: No, it should be for the eurozone. Lord Vallance of Tummel: So you just have one, and then your network within the EU as a whole would include the UK, the eurozone and any other independent country? Guntram Wolff: Exactly. The Chairman: Earl of Caithness, would you like to come in at this point? There are other questions I would like to take since we have passed on to this subject.

Q113 Earl of Caithness: How viable do you think your idea is for banking union? It is going to involve treaty change, and that does not look at all likely in the foreseeable future. If that is not likely, you are going to get your viable rather than optimal answer. The Commission started off having three legs to the banking union. The common deposit scheme seems to be falling by the wayside; according to the witness we have just talked to, that could happen the day after tomorrow. How is this going to work in the mean time? What do you think of the current proposals for the single resolution mechanism? Is what the Commission is doing at the moment more likely to allow another crisis to happen rather than keep the present one at bay? Guntram Wolff: Why more likely? Earl of Caithness: Because it is not a complete answer. It is a partial answer, and that allows the banks and markets to behave in ways that will allow a crisis to happen, and it would not if there was your optimal solution. Guntram Wolff: Look, I think the proposal from the European Commission on the SRM really suffers from at least two major problems. The first is the issue of bail-in. It is a political and economic mistake to postpone the bail-in to 2018. That is very late and has created complete chaos. In the bank recovery and resolution directive it says 2016. It is a big mistake and it will make the realisation of this project much more unlikely. If we want to use a common fiscal fund at all, which is arguably what we need, we can use it only if private creditors are involved relatively early on in the whole process. Otherwise no one will accept bailing out banks in other countries. I mean, we will not even accept bailing out banks in our own countries on the scale that we did any more. The second thing is the legal role of the Commission as such. Here I have to admit that I am torn. On the one hand, I see the value in giving the power to the Commission. The Commission is the only game in town, the only authority we have at the moment outside of the ECB. It is the only authority that has some practical experience of doing this kind of thing, including the programme work in Spain. At the same time, the Commission is a body that has a treaty-based role of controlling the kind of state aid that would happen in case of a

431 of 441 Guntram Wolff—Oral evidence (QQ 109-120) bank resolution. Being the one who is doing it and at the same time controlling it seems to me an inconsistency. I guess the last one is a political point that there is not a lot of trust in the Commission in a number of member states. Earl of Caithness: What would you propose instead of the Commission? How would that work? Guntram Wolff: That is a difficult question. The key issue is that we give it only to an institution that can act based on some form of qualified majority voting. If we give it to an institution that works on unanimity, such as the ESM, it becomes very difficult because to close, and to resolve, a major bank based on unanimity—I do not even want to think about it. Earl of Caithness: Before, you made a very interesting comment that a lot of member states do not trust the Commission. How then is one going to move the Commission to come up with a more sensible proposal? Guntram Wolff: I do not know. This is a complicated question. I guess you have to call the right person in the Commission. The Chairman: Before I invite Lord Kerr to come in, can I talk about the European Central Bank and its role: whether you think it is being closely examined or not, whether it has overstepped its powers and whether we should pay more attention to it? Incidentally, we are going to see Dr Constâncio when we go to Frankfurt in November, who has spoken to this Committee before when we looked at the European banking union.

Q114 Lord Kerr of Kinlochard: Can I piggy-back on that question? You raised a possible conflict of interest in the Commission if they were the policemen of state aids, as they are, and the operator of this new system. Is that conflict not even clearer inside the ECB, where monetary policy might take one in one direction and prudential or supervisory activity in directly the opposite direction? Guntram Wolff: Right. Has the ECB overstepped its competences? I do not think so. The ECB is a very thorough institution. Its action is in my view fully within the treaty—including, by the way, on the OMT programme, where I testified and made the point that this is perfectly in line with the scope and mandate of the ECB. In terms of the role of the ECB in the banking union, that is a very interesting question and it has two dimensions. One is the supervisory dimension, to which you referred, and the other is on resolution. I have a clear view that on bank resolution, the ECB should stay out of the process. They can sit on the Committee if they want, because they come as a supervisor, but they should not be involved in resolution decisions because those decisions may in the end involve fiscal resources. We do not want to tempt the ECB to get involved in those, so there should be clear separation there. On the supervisory side, the big concern in Germany is that having supervisory responsibility will undermine monetary policy independence and therefore monetary policy may be too dove-ish. This was a major concern at the time of the reform of the German supervisory system, where at some stage the Bundesbank had the political possibility to get full supervisory competences. I think that was in the time when Axel Weber was the head of the Bundesbank, and he did not want it. He rejected it even though at the time it was a major thing for the Bundesbank, which basically had no major tasks any more. Everybody thought “Why don’t they take this new task on?”, but he did not do it because of the concern that it

432 of 441 Guntram Wolff—Oral evidence (QQ 109-120) might undermine monetary policy independence. Frankly, the argument is a bit overplayed, in the sense that if ever we have a problem in a bank, it will affect anyway the liquidity provisioning of the central bank. In addition the central bank, having the supervisory information, will be able to act much earlier on liquidity provisioning to banks. They could stop providing liquidity to banks much earlier if they knew from the supervisory information—if they were able to withdraw the banking licence, which they will be able to do. Take the example of Cyprus: the ECB had provided liquidity for a long time to the Cypriot banking system. Basically, everybody was suspecting that this was not really appropriate but it did not have the supervisory control, and the national supervisory authorities in charge said, “Well, those banks are perfectly solvent”. Then it takes a big step. If the supervisor says that the bank is solvent, it is a big step for the ECB to stop providing liquidity. Basically, it cannot stop it as long as there is some collateral that it can accept. Lord Kerr of Kinlochard: Coming back to the SRM, you are against the Commission having this authority and you are against the bank having it? Guntram Wolff: I am torn on the Commission, I have to say. I am not completely against it. Lord Kerr of Kinlochard: Okay, but what is the alternative? It is not the bank—I agree with you—so where is it? It is a new institution, by the sound of it. Guntram Wolff: Yes, it appears that this may be feasible. The main argument against it was the Meroni judgment, which basically said that the Commission cannot delegate such functions. But if I am informed correctly, the attorney at the European Court of Justice has come up with a legal opinion saying that it is possible and that this Meroni thing is not binding any more. I am an economist and it is a very complicated legal debate, but it seems to me— Lord Kerr of Kinlochard: But that is how it could go. Guntram Wolff: I think one could/should create a resolution authority—in an ideal world, outside the Commission—which can draw on the ESM. Lord Kerr of Kinlochard: I fundamentally disagree with you. One of our problems these days is that the Commission lacks authority and has got weaker. The next thing will be competition, where there is still the argument that that should be run by an independent and separate institution and not the Commission. I am uneasy about the Commission becoming simply an executive and not responsible for big judgments. Do you not think, first, that the Commission is getting a bit weak and, secondly, that this would weaken it further? Guntram Wolff: I agree that the Commission has become weak. That is one of the fundamental problems that we are having, so we should certainly strengthen the Commission. The question is whether this is the right way to strengthen it or whether it would not overburden the Commission with tasks that would put it fundamentally into conflict with other tasks that it is fulfilling. It is a complicated question, but my basic sense it that it would probably push too much of the burden on to the Commission, at least in the current circumstances. Let me give you one other example where the Commission has too many tasks at the moment, which is the troika. The troika is not actually the Commission: it is the commissioner for economic and financial affairs who is responsible, together with the Eurogroup, and is acting on behalf of the Eurogroup in the troika programmes. There are a lot of competences here, so there is a lot of executive authority in being on the ground and shaping the programmes. It is a very detailed and strong executive authority, but in a sense it

433 of 441 Guntram Wolff—Oral evidence (QQ 109-120) is not really an authority, because it is not the Commission that has the ultimate political clout and legitimacy. It is the Eurogroup that gives the mandate and that puts the Commission and the commissioner in a very awkward situation of being, on the one hand, an agent of the Eurogroup and, on the other, an independent Community institution that should enforce community policies throughout the European Union as a whole. My sense is that we need to think carefully about how we strengthen the Commission and at what place we can best strengthen it. As I said, I am torn on the resolution issue. I would prefer the Commission to do it rather than just having a completely loose network, if that is also clear. We live here in a world of second and third bests, if not fourth best. The Chairman: Do you think the ECB can cope with all those new demands, as you query whether the Commission can? Guntram Wolff: The ECB has a very tough job. I have to say the workload for the six executive board members has increased dramatically and, frankly speaking, probably it would be good for the ECB to have at least a seventh executive board member to take care of those jobs.

Q115 Lord Kerr of Kinlochard: I agree. On the EBA, I wonder whether it is ever going to become very important. It seems to me that the big issues will be discussed now between the ECB as supervisor and the Bank of England—the two big beasts. There will then be sham discussions in the EBA or discussions at a level of generality so high that, whatever the outcome, it does not stop the ECB doing what it wants to do and the Bank of England doing what it wants to do. I do not think this clever voting arrangement that has been constructed is worth the paper it is written on. It seems to me that it is a short-life thing of great political value in the short term and of no real value in the medium and long term at all. Am I being too cynical? Guntram Wolff: Probably not. I guess one question is what happens with Sweden. Sweden simply needs a place and it is not a big beast like the Bank of England. Sweden is kind of important in the overall puzzle in the sense that Swedish banks are heavily involved in the Baltic and so on. Lord Kerr of Kinlochard: But the Swedes are very clever and will keep alongside the ECB in a way that the British probably will not because we are not so clever. Guntram Wolff: The Swedes are certainly clever. Lord Hamilton of Epsom: I do not accept that. You admire the way the Europeans have managed this crisis, do you, John? The Chairman: Let us stick to our witnesses. As an addendum to that, can I ask you about the stress tests? We have interviewed Mr Enria twice or three times, by the way. Do you think that the EBA were doing those and now they have been put with the ECB? Do you think that was wise? Guntram Wolff: Was the asset quality review wise? I think it was done and the regulation now clearly says that the ECB has to do the asset quality review. Now the question is, given that they have to do this asset quality review, how can they do it in the best possible way without undermining their own credibility and without discovering so many problems that no one is prepared to tackle those problems? Basically, it was the right decision to get the ECB, before it becomes the supervisor, into the business of assessing the banks that it will be supervising later on. The problem is that it puts a huge credibility risk out there for the ECB and for everybody else if the ECB does not act strongly on this review and on those tests. I think there are three things: one is a quality review, one is a stress test and then there is a

434 of 441 Guntram Wolff—Oral evidence (QQ 109-120) third one which I always forget. I think the stress test is exercised by the EBA, but the big thing is the asset quality review. My fear is that the ECB will be left in the ring and will basically have to choose between a rock and a hard place. If they are too tough and governments are not prepared, there will be a huge gap which nobody will know how to fill. If they are too soft, nobody will believe them and they will undermine their own credibility from the beginning, so, basically, I think the ECB will have no choice but to be pretty tough. That is why we need to push this whole thing and governments need to be prepared.

Q116 Lord Vallance of Tummel: We understand that you would be in favour of some form of euro area budget. Setting aside political and legal constraints because we are talking as economists for the time being, could you scope that for us? What would be the purpose of the budget? What sort of size would it need to be to do the job and where would the resources for it come from? Guntram Wolff: As I have said, the essential thing is the banking union. To make the monetary union a better working and more worthwhile place, it would be good to complement it with a minimum budget. What could this budget consist of or what functions would it fulfil? Going back to Musgrave, there are basically three things for governments to consider, one is public goods, one is stabilisation and one is redistribution. As regards public goods, the big question is: what is the use of public goods? Basically, the only two eurozone public goods that I can think of, which are closely related, are the integrity of the currency area—that is, having a stable currency—and a stable financial system. The two are, of course, interlinked, so part of the budget function would be to serve as the budget backstopping the banking union. Lord Vallance of Tummel: Is that to back up the ESM? Guntram Wolff: Exactly, or it could complement the ESM, or the ESM could be transformed into a nucleus treasury with a nucleus budget. This is very important. In terms of other public goods, I do not think that we have many eurozone public goods. We have a lot of EU public goods or world public goods. We have security and environmental things but all those issues are not eurozone specific; they are EU specific. In terms of stabilisation, there are basically two reasons why we need a eurozone budget. The first is that, with purely national fiscal policies, the budget constraints become so binding at some stage and spreads increase so much that countries have to stop any stabilisation policy and have to consolidate, particularly in times of severe crisis. Then essentially the entire economy is in a downward spiral, which does not arise just through fiscal reasons but comes as much from the increase in financing costs for the private sector. It is a dramatic downward spiral. Any monetary union usually has some mechanism that temporarily helps to smooth such big shocks. The second reason why we need this federal eurozone stabilisation is because with decentralised fiscal policies the euro area-wide stabilisation that will be offered will be less than optimal because basically everybody hopes that their neighbour is doing the stabilisation. That is a clear argument for some centralisation of stabilisation. Having said that, let me emphasise that, as regards risk absorption and asymmetric shock absorption, the main factors are capital markets and credit markets. If we have banking union and a more integrated financial system, 60% to 70% of the country specific shocks will be absorbed by those. But then, there is the 30% remaining. That is where I would allocate the fiscal function, so to speak. How much do we need? We do not need very much. In the paper I published in December, I said that it could be a maximum 2% of eurozone GDP, but it could be 1%; with 1% you could do a lot already. If you think about 1% and you think that a quarter of the eurozone is in a major recession, a 1% budget would allow a 4% transfer to that quarter of the eurozone, which would be significant support. But 1% is not a little; it is still a lot of money.

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Lord Kerr of Kinlochard: Both too little and too much. It is politically far too big for some member states of the eurozone such as Germany to envisage agreeing it in the short term, and it is far too small to have any real stabilisation effect, unless the recipient country is very small, such as Greece or Portugal, but if it was Spain or Italy it would have no significant effect. I do not really understand it, and it seems to me that it is probably some way down the road. I get the impression that it is not going to be agreed by this Commission and this Parliament. Is that correct? Lord Vallance of Tummel: I would just embellish on that. Various bits of academic work have been done on an optimal monetary union, and the figures on GDP in the middle would be somewhat higher than 2%; 7% might be a figure plucked out of the air. Guntram Wolff: How do I see the 1% to 2% is the question that you both raised. First, part of the stabilisation comes from the fact that you would give this authority or Treasury the power to go on the bond market. In other words, if the eurozone as a whole is in a major recession, and you have a guaranteed revenue stream of 1% of GDP—let us say we have a proper tax that is also 1% of GDP—I can borrow on the bond market as the Treasury and I can borrow at an interest rate of 3%. You can do the maths; I can easily borrow 20% or 30% of GDP. So with a revenue stream of 1%, I can borrow a lot. I need only to be credible on this revenue stream. If we are talking about asymmetric shocks, I would only tackle major recessions. For small recessions, national stabilisers can do the job. But with a major or balance sheet recession, where GDP, as in Spain, drops 5%, 10%, 15%, in such an instance you want a transfer target to that country for two, three or four years with stabilisers. How much do you need for that? Even without borrowing, with a 1% eurozone you can get 4% or 5% of GDP into that country per year. I think it is feasible. On the political point, I guess you are right. But it is much more realistic to go for this 1% or 2% than to start having a discussion about centralising the whole social security system and going for 20%. That is not going to happen. We are not going to become the United States of America. Lord Vallance of Tummel: I have one other theoretical question. Do you see some form of debt mutualisation as being a prerequisite of a robust currency union? Guntram Wolff: Probably not.

Q117 Lord Kerr of Kinlochard: This is a very discriminating and highly intelligent committee, so of course we read everything that you produce at Bruegel. Something that caught our attention was your paper in March suggesting that non-euro area countries should join the single supervisory mechanism. We do not seem to be following your advice, as a country. Would you like to summarise for the record your argument and why you think we are getting it wrong? The Chairman: We were grateful for the mention in one of your papers of this House of Lords Committee. Guntram Wolff: Thank you for the kind attention you are paying to our research; that is good to hear. This paper studies very carefully the SSM proposal—at the time it was still a proposal and had not been passed—in all its dimensions, and asking whether it was a fair proposal for non-eurozone countries to join. The argument is that, within the treaty remits, it is the best that we could come up with—namely, Article 127(6) gives clear limits on what kind of decision-making structure within the SSM is feasible and possible. That accommodates the concerns of non-eurozone countries to the greatest extent possible. Why would it make sense to join? There are then a number of dimensions; basically, it

436 of 441 Guntram Wolff—Oral evidence (QQ 109-120) makes especial sense to join if banks are highly integrated with the eurozone banks. Poland has a banking system very much owned by eurozone banks, so it makes sense to join, because those subsidiaries and branches of eurozone banks in Poland are currently supervised by just the Polish authorities and not by the ECB. That creates frictions because there are basically two different supervisors for one integrated bank, which undermines the integrity of the single banking market. So, in perspective, especially in the case of Poland, which wants eventually to join the euro, they want to become much more integrated and it makes sense to join. That is the argument there. On the UK, if you want to join the euro, certainly I would advise you immediately to join the SSM. Lord Kerr of Kinlochard: That is a slightly recherché answer, if I may say so. The proportion of the British population wanting to join the euro at the moment is probably quite low. The Chairman: Lech Walesa’s ambition that Germany and Poland would be united would be an interesting forerunner of any such working together of Germany and Polish banks. Have you heard that one? Guntram Wolff: No. The Chairman: Lech Walesa opined that. Guntram Wolff: Frankly, on the UK, there are two logics for the banking union; one is the single market and one is monetary union. The way in which it is constructed is very much on monetary union logic at the moment. In that sense, the UK entry into SSM would not make sense; but of course the single market dimension is equally important. If we create a monetary union that functions but which undermines the single market, it would be a mistake with dramatically negative consequences. I do not have a final answer. Lord Kerr of Kinlochard: Do you therefore agree that the British Government were correct to take the eurozone to the Court of Justice over Draghi’s attempt to insist clearing houses clearing euros must be inside the eurozone? Guntram Wolff: I have to say that that is a very difficult question to which I do not have a clear answer. I have the impression that the topic is politically overplayed compared with the other issues that are on the table.

Q118 Lord Hamilton of Epsom: You answered Lord Vallance’s question about debt mutualisation by saying that it probably would not happen. On the other hand, Chancellor Merkel has just been re-elected in Germany on the basis that the Germans were not in the business of underwriting the eurozone. I am not quite sure how true that was, because there is something like €800 billion sitting in German banks, which has come from all the Club Med countries. So in a way Germany is underwriting the whole eurozone, whether you like it or not. Surely all this is crisis-driven. Do you see eurobills? Nothing seems to happen until there is a very major crisis, and then things do happen. Do you see the Germans signing up to eurobills? Guntram Wolff: At the moment I do not see them signing up. The main reason is that we do not need eurobills as long as the ECB is acting the way it acts. Basically, the OMT and euro bills are almost perfect substitutes, or it comes very close to being a perfect substitute. Now if Karlsruhe and the German constitution report come out with a judgment which would undermine the ability of the ECB to act as it is acting, we could see the re-emergence of the crisis in the sense of spreads widening dramatically. Then the big question is: what is

437 of 441 Guntram Wolff—Oral evidence (QQ 109-120) feasible and what can we really do? I have to say that I share a lot of Mrs Merkel’s scepticism of eurobonds. This idea that we can sign up to a joint and several guarantee without a major step-up in the institution framework is, I think, wrong. We will not be able to do this, and we will not be able to do it credibly. If Mrs Merkel, Mr Letta and Mr Hollande sign a joint and several, each of them knows that he/she will never be able to step in for any of the others if any of the others deviates. We need to create some form of treasury before going for eurobills or eurobonds. The Chairman: Just before Lord Hamilton continues, Lord Vallance has a question. Lord Vallance of Tummel: For the avoidance of doubt, when I asked you a question earlier on about debt mutualisation on eurobills and eurobonds, I thought your answer was in principle and in theory that you did not think it was necessary, rather than it was something that you did not think might come about, which is a different question. Perhaps we should ask you to elaborate very quickly on why in theory you do not think it is necessary. Guntram Wolff: It is not necessary as long as you have a banking system that is not infected by sovereign debt, which we do not have at the moment, and as long as the ECB is able to do what it is doing currently—namely, acting as a lender of last resort to governments—that prevents self-fulfilling. Lord Vallance of Tummel: And as long as you do not have national banks that have national champions that are operating across Europe? Guntram Wolff: Right. Lord Vallance of Tummel: It becomes almost a surrogate for debt mutualisation? Guntram Wolff: Yes.

Q119 Lord Hamilton of Epsom: Supposing the eurozone remains afloat—I am not saying that that is guaranteed—you will see the eurozone countries integrating more and more, possibly even passing their own treaties, which do not spread out to the 28 but are merely exclusive to the eurozone members. Where does this leave the United Kingdom? Is it not inevitable that we will get more and more marginalised in the whole process of integration, which we want to have absolutely nothing to do with and for which there would never be any support in England? Where does that leave us at the end of the day? Surely we will diverge to a greater and greater degree? Guntram Wolff: This is a very big question. Let me start by saying that I recently published a memo, copied to Merkel, in which we published some survey results of German business. We basically asked the 30 CFOs of German DAX corporations—and got a very good reply rate: over 20 replied—whether they thought the UK will leave the EU in the next five years. The answer was no. “Would it matter to your business if the UK was to leave?”. The very clear answer was yes. So German business in my view has a strong interest in keeping the UK in the EU, and my understanding is that UK business has a strong interest in keeping the UK in the EU as well. So basically from the business side there is a clear interest, because the single market has benefits for consumers as well as for business of course. The second point is how the power play looks on the continent if the UK is not involved. I think it looks very bad. It not a very good situation either for Germany or for any other country to be in. The UK is a central player in the whole arithmetic of countries in the EU, so it would be a very bad development if the UK was marginalised or put outside the EU. Having said that, I do think that the eurozone will indeed be followed, in a good scenario, by

438 of 441 Guntram Wolff—Oral evidence (QQ 109-120) additional treaties, probably outside the EU treaties, that will integrate some of the functions that we were just discussing—banking resolution perhaps, with a little budget—at the eurozone level. Then the big question is how this will influence the whole of the UK. I guess there are basically two lines of thinking. I know of at least one strong line of thinking on this. It is not my line of thinking; I am just saying what it is. It is, basically, “We move ahead in the eurozone, we create something that is viable, perhaps even attractive. The UK is a rational country and it will eventually see the benefits of this and join”. Lord Hamilton of Epsom: That viable eurozone has to be relevant in the global marketplace. I have never heard anyone in Europe even talk about the global marketplace, but anyway that is another argument. Guntram Wolff: Basically, the EU there would be on the continent, if I may speak so frankly. We would create something vital and strong but with centralised institutions and centralised resolution, and basically the City of London would have no business model any more unless there was movement towards joining. I think that will be the big game. Lord Hamilton of Epsom: I would remind you though that when Britain refused to join the eurozone, all the alarmists then said that the City of London would be completely marginalised and would have no dealings in eurobonds. It is the centre for eurobonds, and is one of the major financial centres in the world. We have slightly been there before.

Q120 The Chairman: Let me conclude with two questions. It is interesting that Prime Minister Letta said the other day that were the UK to withdraw from the European Union it would spell the end of the European Union. I have never heard that spoken about before. Guntram Wolff: He said that at the dinner at Bruegel. I tend to agree with him. The Chairman: I had not heard it before and it certainly makes me think. Let me conclude with a couple of questions. First, we have just been asking Commissioner Rehn about the difference between diluting and breaking the link between sovereigns and the banks. I am not quite sure what the answer was, but I think it was that it sounded better in Finnish. I wanted to ask you also to put on your chapeau as adviser to the Conseil of the French Prime Minister and perhaps give us an aperçu français on the whole question. It is a very unfair thing to ask you to do, but it is the last question. Guntram Wolff: OK. On the difference between diluting and breaking, I am not sure whether it is more understandable in German! We would probably operate in grey zones. We currently have a correlation of one between sovereign risk and corporate and banking risk, and that should come down significantly. “Diluting” is coming down significantly, and going to zero would break the link fully. A zero correlation is probably unfeasible. There will always be a little bit of correlation because banks will be exposed, but the more you internationalise and Europeanise banks the more the link will be broken and the more the correlation will come down. That is the technical answer. On the French take on the whole thing, I guess there are many comments to make. First, France in my view has to enact significant domestic reforms of its domestic economy. Those reforms are necessary not only to revitalise the French economy but for it to become a stronger player in the discussions. Secondly, France is very absent from the debates, which is really unfortunate because France is of course a major player. It is not perceived as being one of the main players in these discussions and that is not healthy for the EU. Those are the two main points. From a French perspective, the big question is always how close you want to get to the German positions and to the positions, let us say, of Spain and Italy. You have to strike a balance such that you take the Germans with you. It is important not to alienate the Germans too much.

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Certainly, in Germany there is a lot of scepticism as regards the French Government at the moment. Lord Hamilton of Epsom: Not only in Germany. Guntram Wolff: You get a lot of criticism in Germany of the pace of reform and so on. The Chairman: Guntram Wolff, the small party of five that we are of the Committee is grateful, as ever, to Bruegel and for the high standard that we have come to expect over the years from you in particular. We are most grateful for the diverting hour and 10 minutes that we had with you and for your making that time. As I said, we will send a transcript. Please correct it and add marginalia. If there is any follow-up, please let us know, because we hope to publish sometime soon. In the interim, I say a very big Vielen Dank to you for helping us out today. Guntram Wolff: Thank you very much.

440 of 441 Manfred Zöllmer, MdB/MP (SPD), Bettina Kudla, MdB/MP (CDU) and Detlef Seif, MdB/MP (CDU)—Oral evidence (QQ 287-296) Manfred Zöllmer, MdB/MP (SPD), Bettina Kudla, MdB/MP (CDU) and Detlef Seif, MdB/MP (CDU)—Oral evidence (QQ 287-296)

Transcript can be found under Ms Bettina Kudla, MdB/MP (CDU), Mr Detlef Seif, MdB/MP (CDU) and Mr Manfred Zöllmer, MdB/MP (SPD)

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