Stability and Growth Pact (EUC Report)

HL Deb 04 June 2003 vol 648 cc1395-430

7.26 p.m.

Lord Radice rose

to move, That this House takes note of the report of the European Union Committee on the stability and growth pact (13th Report, HL Paper 72).

The noble Lord said: My Lords, as a convenience to the House, it has been agreed that this debate on the stability and growth pact should embrace at the same time the debate on the report of the Economic Affairs Select Committee on the Monetary Policy Committee and Recent Developments in Monetary Policy. This debate will be less wide-ranging and perhaps more mundane than that which preceded it, but it is still important.

My committee decided to hold an inquiry into the stability and growth pact for two main reasons. First, the pact was very much a topical issue, with the two largest member states in the European Union on the verge of breaching it. Secondly, the Commission had proposed reforms of the operation of the pact which we examine in detail in our report. We held eight hearings and received a considerable amount of written evidence. Furthermore, instead of going to see the Commission in Brussels, the Director-General of Economic Affairs, Klaus Regling, came to the House to give evidence to our committee, for which we thank him. I am grateful to all our witnesses, to our committee staff—especially our Clerk and to my distinguished colleagues for their participation and commitment.

The first issue to address is why have the stability and growth pact. The first point to make on this is that while monetary policy in the euro area has been unified and is now run by the European Central Bank, fiscal policy still remains a matter for national governments, which are therefore free to decide on their own national expenditures and revenues according to their national preferences.

However, the member states have also set up a framework of fiscal rules in order to co-ordinate their fiscal policies. The Maastricht Treaty lays out the 3 per cent budget deficit criterion and the 60 per cent debt ratio criterion. It was those rules which helped dramatically to improve the EU's fiscal balances during the 1990s.

The stability and growth pact, which was adopted at the Amsterdam European Council of June 1997, complements and strengthens the provisions of the Maastricht Treaty. Member states agreed to commit themselves to maintaining sound and sustainable government finances through the medium-term objective of, close to balance or in surplus". They also agreed to a system of monitoring and early warning. I should mention here that though not a member of the euro-zone, the United Kingdom has signed up to the stability and growth pact and is subject to its rules. It cannot, however, be sanctioned for running an excessive deficit.

One of our witnesses argued that the EU's attempt at creating formal fiscal co-ordination should he abandoned forthwith and it should be left to market discipline to ensure the sustainability of member states' finances. The committee's view, however, is that market discipline alone cannot guarantee fiscal discipline and that formal co-ordination of national fiscal policies is required to guard against the risk of default and to deal with the so-called free rider problem in a monetary union where a profligate government run up large deficits without having to incur penalties.

Co-ordinated fiscal discipline can also help member states prepare for the economic effects of ageing populations while providing overall stability for the European Central Bank and for the markets themselves. However, despite the excellence of these general arguments for the stability and growth pact, it has been much criticised in the past two years as the world economy slowed down and several large member states, as I mentioned before, were in danger of breaching the rules of the pact.

Several witnesses argued that the stability pact itself stifles growth. The TUC told us that the pact had put too much emphasis on stability and not enough on growth, while another witness considered that the pact created a deflationary bias in the longer term. However, the European Commission did not accept that sustainable growth could be stimulated through deficits and quoted the examples of Germany, Japan and Portugal. The committee agreed that fiscal policy was not a good instrument for effecting long-term growth of the economy and that slow growth in Europe is due not to the stability and growth pact but rather to the member states' failure to implement structural reforms.

We also believe that it is important that the stability and growth pact is not over-rigid. We do not suggest scrapping the pact or drawing up new rules for it, but we strongly recommend that the existing rules are interpreted more flexibly. Indeed, this is the underlying theme of our report. Ideally, we believe it is sensible for countries to aim for broadly balanced budgets so that the so-called automatic stabilisers can be brought to play across the economic cycle without the danger of member states breaching the 3 per cent deficit criterion. But it is important that this medium-term target of budgets being close to balance or in surplus should be measured flexibly in terms of a cyclically adjusted or underlying budget balance and not the current value. We are therefore pleased that this proposal has been accepted by the European Council.

We also welcome the Commission's proposal, adopted by the Council, to allow a small deviation from the close to balance or in surplus budget requirement for member states which, as in the case of the United Kingdom, have low underlying debt ratios and need to invest in physical and human capital. We welcome the new emphasis on low debt ratios.

For the most part, however, our witnesses were much more interested, not so much in the medium-range target of close to balance but in the 3 per cent upper limit and whether this should be relaxed. Our conclusion was that the 3 per cent nominal upper limit should be retained. However, when deciding how the pact is to be enforced, the Council should not treat the 3 per cent as an absolute. Of course the Maastricht Treaty already allows for breaches in exceptional circumstances. In addition, we are proposing that in cases where a country has breached the 3 per cent reference value, the Council's decision whether or not to implement the excessive deficit procedure and all that goes with it, laid down in the Maastricht Treaty, should take account of the member state's underlying economic situation, including its position in the economic cycle and possibly its level of debt.

Looking further afield, we need to ensure that the stability and growth pact works more symmetrically and that member states are discouraged from acting pro-cyclically in times of boom. This merely stores up trouble for the bad times as was seen in the case of Germany and France. We oppose, however, the idea of applying formal sanctions. That would be not only excessively bureaucratic but liable to bring the whole pact into disrepute. In general, we believe that peer pressure—not us, but member states—is the most effective enforcement mechanism available and that the sanction of fines is a nuclear deterrent only to be used, if at all, as a measure of absolute last resort.

The Council should remain the final arbiter of all the enforcement procedures, as part of this peer pressure process. However, we believe that the Commission should have the power to issue an early warning direct to member states rather than go through the Council as it does at present; otherwise there is a danger of Council members refusing to pass on early warnings to their peers, as happened in Germany and Portugal.

To sum up our report, we are in favour of a stability and growth pact with budgetary deficit targets, but we believe that it should be interpreted in a common sense, flexible way.

I should like to say a few words about the Government's response to our report. We were grateful for the way in which the Financial Secretary to the Treasury answered our questions when she came before us, but we were disappointed by the Treasury's formal response to our report, which seemed to be an extreme version of straight bat-ism. However, I, for one, have been somewhat mollified by the further letter which the Paymaster-General sent to my noble friend Lord Grenfell in which she said that the Government will make clear their views in a study published alongside the assessment next Monday. I hope very much that they take account of our views in their paper.

Noble Lords will forgive me if I end on a personal note. Those who are against the United Kingdom joining the euro will no doubt see the stability and growth pact as yet another reason for being against the euro. As a supporter of British membership, I see it as a necessary part of the development of economic and monetary union, and I believe that any weaknesses can be and, indeed, are being removed. They certainly should not be used as an argument for delay in joining the euro. If further changes are required, we should be there, inside the euro, making the case for them. I beg to move.

Moved, That this House takes note of the report of the European Union Committee on the stability and growth pact (13th Report, HL Paper 72).—(Lord Radice.)

7.38 p.m.

Lord Barnett

My Lords, I feel I should start by saying, "Unaccustomed as I am to speaking on three reports in one day", as a number of us will be doing in this debate. Before I do, I have been asked by my noble friend Lord Peston to move formally the report standing in his name on the Order Paper, and I am happy to do that. I should also like to thank our two Clerks, Christine Salmon and Susan Michell, who have done an excellent job for us, as has Professor Mike Wickens, our special adviser.

I should like to say a few words on the stability and growth pact report that was introduced so ably by my noble friend Lord Radice before I come to our report on monetary policy matters. My noble friend Lord Radice referred to what the committee said in paragraphs 49, 80 and succeeding paragraphs. It supports the stability and growth pact in principle but recognises a substantial need for some flexibility in the way in which it operates. I agree strongly with the committee and with the Government's agreement with the committee as well. That is obviously a sensible way forward, and I hope that it will be followed. There is a crucial need for that kind of flexibility, rather than the rigidity of the present system.

Like my noble friend Lord Radice, I have no doubt that the stability and growth pact will be used as a sixth economic test. The previous five are not worth considering, but the sixth would be even worse. It is not the place or time to consider whether we should be joining the euro, but it would be wrong to suggest that the stability and growth pact is a reason for not doing so. As my noble friend rightly said, if we are to make changes in the way that the stability and growth pact works, we are better inside than outside.

There is a clear need, as my noble friend Lord Radice and the committee points out, for greater coordination of fiscal policies throughout the euro-zone. Few people can doubt that. There is a need to provide a stability in which the European Central Bank can operate. Unfortunately—although the report does not say too much about that bank—the fact is that the bank needs to have much greater transparency and accountability if it is to be a successful central bank. We need that greater transparency and accountability if we are to know what the bank's actions or inactions are at any given time, and we do not know at the moment how the bank works.

Lord Radice

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

Lord Barnett

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

The Financial Times, in an article on 13th May by someone called Paul de Grauwe, said that, instead of creating clarity, the ECB has managed to create confusion about its true intentions". That is a very good comment about the way in which the European Central Bank operates.

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

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

As an aside—and this is nothing to do with our report—we in the UK need to appreciate how low our inflation is on what is called "hiccup" terms. To help Hansard reporters, I should emphasise that I refer to HICP, which is sometimes called "hiccup". I checked on the findings of the Office for National Statistics on what the level of inflation would be if we adopted HICP, and discovered that it would be around 1.6 per cent over the 12 months to March 2003, as compared to 3 per cent on the RPIX, which is the figure that we normally use. That would have very substantial consequences for the UK economy generally.

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

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

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

As paragraph 45 of our report makes clear, the time is ripe for some serious research into the operation of monetary policy in the past five years". There have been substantial changes in how that works. I hope that someone in the Treasury agrees with us, although the Government say that they have already published papers from the Treasury. In practice, as we say in the report, we need a more independent piece of research. We on the committee do not have the resources to do that, but perhaps the Treasury would provide us with the resources and we could do it ourselves. However, on the understanding that the Treasury may not give us that, could an independent piece of research be done by someone else? I note that the Government agree with much in our report, and I hope that they will come to agree with that as well.

7.48 p.m.

Lord Northbrook

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

In comparing the two reports, the success of the MPC since 1997 may be contrasted with the huge problems of the stability and growth pact. As a failure in the European Community's co-ordinated fiscal policy, it is matched by the ECB's lacklustre direction of monetary policy, which is causing major problems in countries such as Germany and Portugal. I look forward with great interest to the report of the noble Lord, Lord Radice, on the ECB. However, I should like to concentrate my remarks on the MPC report. Paragraph 14 states as the first conclusion: Although the operation of the MPC has been satisfactory so far, we conclude that a re-examination of its remit to include broader concerns than inflation alone might benefit the United Kingdom economy". That is a very sensible conclusion. While I am not an economist—I declare an interest as a City fund manager—I have to be aware of broad economic trends.

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

The deflationary problem is in my view a fundamental long-term issue. Its examination would help the committee to have a more global outlook and to consider, for example, whether the problems relating to Japanese deflation are relevant to the UK economy or whether German economic disinflation problems will replicate themselves here. I therefore ask the Minister to use his influence to persuade the Chancellor to broaden the formulation of the MPC's remit to something similar to that of the Federal Reserve Bank of the United States—where, as stated in footnote 4 on page 6 of the report, the remit in the Humphrey-Hawkins Act of 1958 setting up the Federal Reserve is to, maintain long-run growth of the monetary and credit aggregates commensurate with the economy's long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates". Another important issue with regard to the MPC's remit, which does not seem to have been covered in the report, although it has been mentioned by the noble Lord, Lord Barnett, is the Chancellor's proposed change to the inflation measure from RPIX to the European HICP. This important change would remove in particular housing costs from the inflation figures. As I understand it—and luckily my figures agree with those of the noble Lord, Lord Barnett—that would cut the rate of inflation by 1.4 per cent per annum. However, if adopted, it could cut government payouts to index-linked bondholders and index-linked pensions. Will the Minister, to whom I have given prior notice of the question, both confirm that and say whether the MPC's inflation target will be adjusted as a consequence? Does the Minister agree that the change would also bring forward the timing of interest rate reductions since inflation would fall below the current target of 2.5 per cent? It is for that reason that I largely applaud its possible introduction.

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

The final area of the report on which I should like briefly to focus is the section on UK fiscal policy. The committee noted: We are impressed by the unanimity with which witnesses supported the view that much of the deterioration of the fiscal position is cyclical and that fiscal intervention is therefore not necessary at present. We note that it is extremely difficult to know what is and what is not cyclical and we hope to return to this topic in a later report". The shadow Chancellor said in evidence to the committee: There was beginning to grow a suspicion that the length of the cycle would be determined by reference to the need to comply with the golden rule rather than the other way round". It is that vagueness in fiscal policy that contrasts strongly with the disciplined approach of the MPC in monetary policy. I believe—this is my one political point—that that is where the Government's economic strategy is most at risk.

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

7.57 p.m.

Lord Oakeshott of Seagrove Bay

My Lords, from these Benches and following the noble Lord, Lord Barnett, I thank the noble Lord, Lord Peston, for his indefatigable chairmanship of the committee. I also thank our two indispensable Clerks and our specialist adviser. The Government's macro-economic policy framework is based on the principles of transparency, responsibility and accountability…The Bank of England has operational independence to meet the Government's symmetrical inflation target". I am quoting, of course, not from our objective evidence-based report but from page 3 of this year's Budget Red Book. So transparency, responsibility, accountability and independence are the buzzwords favoured by the Chancellor and the Treasury. Tonight I want to scrutinise one constitutional corner highlighted in our report where these admirable principles are conspicuous by their absence—in the appointment of members of the Monetary Policy Committee of the Bank of England. We on these Benches welcomed the Chancellor's Damascene conversion the weekend after polling day in 1997 to independence for the Bank in setting interest rates. However, he is still in my view a sinner who has only half repented. Independence for the Bank of England? "Yes!", says the Chancellor. But an independent or even an open appointments process to pick MPC members? "Perish the thought! Gordon Brown just appoints MPC members by the divine right of Chancellors as invented by the Bank of England Act 1998".

Our Select Committee and its predecessor, in each of the last three reports on the MPC, have rightly raised serious questions about the appointments process. As we put it this time round, we favour a more open process, conducted in accordance with a Code of Practice analogous to the Code of Practice for Public Appointments published by the Office of the Commission for Public Appointments. We favour such an approach, partly as a matter of principle and partly as a way of enlarging and deepening the pool of people who might he considered for membership. The Chancellor has always rejected our view on the matter". We also said: Similar considerations apply to the appointment of staff of the Bank of England who become members of the MPC. It is difficult to discern any formal appointment procedures. As far as we can ascertain, posts are not advertised…We therefore recommend, as we have done consistently before, that members of the MPC should be recruited and appointed in a manner consistent with Nolan principles". The independent interest rate setting policies worked well so far because the Chancellor has appointed high-quality independent economists to the MPC. However, a benevolent individual dictator does not justify dictatorship. We all agree that interest rates should be fixed by independent experts, not by a single politician. How, then, can it be right for Gordon Brown to pick all of those experts personally and in secret, decide whether to reappoint them to a second term, ignoring the Nolan principles and with no advertisement, no application process, no questions asked and no reasons given for his choices?

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

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

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

A membership of nine works well for the MPC, so why should it not for such an appointments committee as well? One could have a representative of the Treasury; the Governor or another representative of the Bank of England; the chairman or other representative of the Commons Treasury Select Committee and the Lords Economic Affairs Committee; a distinguished businessman such as Niall Fitzgerald: and a trade unionist such as John Monks, or people of similar standing from the Court of the Bank. That would make six people so far. The other three members of such a committee should be former MPC members who have done the job already and know exactly what mix of expertise and temperament are needed. Most of us agree that the quality of independent MPC members has been uniformly high so far, even though their turnover seems excessive, with a short term of office of only three years and only one independent member out of eight reappointed so far. The Governor made his views clear in his evidence to our committee two years ago. He said: I think turnover is disruptive. In a sense to have an average outcome which is longer than the frequency of turnover we have had would be a positive thing. I do not know quite what one can do about it. frankly". Frankly, I do know what one can do about it—one can change the system, let members serve longer and stop Gordon Brown shuffling the MPC pack so often. I would far rather trust distinguished experts such as DeAnne Julius, John Vickers or Sushil Wadhwahi as part of a team nominating MPC members rather than a single Chancellor. Such a committee would shine out as a beacon of Bank of England independence. It would need to meet only once or twice a year and should have no problem in securing the most distinguished names to serve. It could even serve as a model of transparency and independence for future appointments to the European Central Bank.

The main Government argument that we have heard against a more open appointments process to the MPC is that it is "highly market sensitive". That is nonsense. The Chancellor told our predecessor committee that, there would be difficulties if it became known that a particular individual was under consideration because that would have an influence on people's perceptions of what might happen to interest rates". Here I declare my interest as an investment manager. That knowledge could look sensitive only to someone who does not know how markets work. How in practice would one change one's investments to reflect the chance that one person might be appointed to join a committee of nine people in several months' time, working to a very clear policy remit, when so much else would be moving markets far more in the mean time? Sir Edward George, in his evidence to the Select Committee, did not think that the appointments which had been made to the MPC were market sensitive. He must be right.

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

8.5 p.m.

Lord Burns

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

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

Enormous credit for the successful operation of the MPC is due to the Governor of the Bank of England, Sir Edward George, and I will be very sorry to see him retire from his post at the end of the month, even if Lady George does not share my concern. I saw at close hand over a number of years the skill and determination with which he discharged his responsibilities. He will be a difficult act to follow but I also wish his successor, Mervyn King, well in the role. He has done an excellent job in establishing the high level of analytical support for the decisions of the committee in his present role. I am sure that he will also carry out his job as chairman of the MPC extremely well.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Finally, I want to touch on one subject that our committee did not dare mention: the implication for the remit of the MPC of the Government's policy towards the euro. Clearly, we cannot say much about this today as we do not yet know the results of the Treasury's tests, although we do not have very long to wait to see them. It is not difficult to see that if the Government embarked on a clear strategy to join the euro at some point in the future and wanted to direct policies towards being in a position to join, it could have some implications for the remit. At its simplest that might mean a change in the measure of inflation to be targeted to the harmonised index, as described earlier by the noble Lord, Lord Barnett, and at which the Chancellor hinted in his Budget speech.

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

8.17 p.m.

Lord Sheldon

My Lords, I want to speak mainly on the report of the committee on the stability and growth pact. There are serious matters that have been mentioned in the report of the Select Committee on Economic Affairs on monetary policy. In paragraph 41 it states that, there are substantial imbalances in the economy at present". These are important and serious matters. They are, the imbalance between consumer spending and investment: rising house prices, and the attendant rise in mortgage equity withdrawal; and the trade balance and current account deficit". It goes on to state: In relation to these imbalances in the economy we consider that some intervention in the future may be necessary". The committee was right to flag up that issue; it is most important.

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

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

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

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

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

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

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

I should mention the need to keep down the level of debt in the European Union in order to anticipate the burden on public finances and the consequences for public services of an ageing population. For the European Central Bank, that was the basic long-term justification of the stability and growth pact. The bank held that sticking to the pact might over time, maybe decades—because it takes take a very long view—create the room in budgets to cope with the costs of the ageing of the population which are expected to rise over a 30-year period by something in the neighbourhood of between 5 per cent and 6 per cent of GDP. Those are vast sums of money. So the question is: what realistic penalties can we impose on a country that is not meeting its obligations? Are fines really realistic? If a country were, in effect, found guilty and therefore fined, we have only to think of the political effects that that would produce. It is foolish to establish penalties that will never be used, and I cannot see those penalties being used. So we must consider the matter differently.

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

8.26 p.m.

Lord St John of Bletso

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

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

Several commentators believe that the pact has been dead for some time and cannot be revived. Although the committee called for reform of the stability pact, my personal opinion is that the pact should be torn up and completely new fiscal rules drawn up. The noble Lord, Lord Barnett, mentioned an article in the Financial Times in May; I refer to the lead article on 7th May headed: Patching the pact—The EU should start afresh for stability and growth". The central theme of the article was that for every member country, the overriding principle for budgetary control should be to maintain a sustainable debt position.

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

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

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

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

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

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

Some national statistical institutes have scarce resources to compile the government's accounts and are not immune from political pressures. Countries must convince outsiders that their accounts give a true and fair view of their obligations. There is a suspicion that some countries manipulate their figures with off-sheet financing.

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

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

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

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

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

Although I support the co-ordination of national fiscal policies throughout the European Union, so as to maintain sound public finances, market discipline alone cannot be guaranteed to ensure the sustainability of public finances. The maintenance of a sustainable position of debt and effective measures of enforcement are critical. For the European Union to formulate a new set of budgetary rules, a new treaty and new attitudes would be needed. Without both of those, as the lead article in the Financial Times of 7th March said, The Euro Zone is doomed to annual damaging fiscal squabbles just as debilitating as those of the past couple of years". Finally, I again thank the noble Lord, Lord Radice, for his able stewardship of the sub-committee and of the report. I should mention our specialist adviser, Professor John Driffill, and our extremely able Clerk, Dr Richard McLean. It was gratifying to see that, at long last, our report made some headway in the broadsheets. It is always a concern that many of the great reports produced by your Lordships get such scant public exposure.

8.36 p.m.

Lord Lea of Crondall

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

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

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

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

The British position is rather two-edged in some respects. It is that in the euro-zone there are various deficiencies of economic policy and that the pact is not really sufficient to deal with them. Those countries have to pull up their socks before the euro-zone is allowed to join Britain in a wider European scheme. I hear my noble friend say "Fog in Channel"; that quip was the other way round too. They may be allowed to join Britain in the new euro-zone once they have pulled their socks up. This is part of the logic of many people in considering the debate.

I was intrigued that Robin Marris wrote in today's Financial Times: Arguments against UK entry into the euro-zone based on the Stability and Growth Pact are redundant. The pact reflects thinking of none other than Gordon Brown when in his early days in office he used to denounce Keynesianism. Yet the Treasury now complains in effect that the pact is not Keynesian enough. The fact is that the four big European economies are now very similar. It may surprise some people to know that the latest GDP numbers at purchasing power parity are as follows: EU 100; Italy 105; Germany 104; UK 102; France 100. At a pub quiz night not many people would get that right. There is not a lot to choose between them.

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

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

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

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

On the broader debate between the European growth and stability pact and the European Central Bank, which, as my noble friend pointed out, is the next project for Sub-Committee A, there is scope for looking more at the linkages between the role of what one might call the "fiscal policy side" and the monetary policy side. Is it not the case that we now have a reversal of traditional views on such matters and that it is the role of monetary policy to stimulate growth by cutting rates? Indeed, it is generally said: cut rates, stimulate growth. But fiscal policy, as in the growth and stability pact, can never do anything to stimulate growth; one can only, as it were, remove restrictions in that sense. A new consensus, as emerged in that respect, should perhaps be questioned.

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

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

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

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

8.50 p.m.

Lord Peston

My Lords, I thank my noble friend Lord Barnett for taking from me the burden of introducing the Economic Affairs Committee report on the MPC and related matters. Like him, I am unused to debating three reports on the same day and 1 felt that introducing one was as much as I could cope with.

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

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

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

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

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

Thirdly, 1 am surprised that no one else has raised the important reference at paragraph 41 of the EAC report to the imbalances in the economy. That is a large part of what we were on about. While agreeing that they are in part cyclical we have to note that they are not entirely self-adjusting. Yet—this is what puzzles me as an economist—they do not appear to be leading to any kind of crisis.

Lord Vinson

Yet.

Lord Peston

Not at all. Certainly the fall in sterling relative to the euro is not a crisis. Equally, while the fiscal position must be subject to constant scrutiny, even the most sceptical observer would not be inclined to call it critical. And somehow or other, although I do not understand how, in some way we are even getting through the fall in equity prices throughout the world without a calamity.

However, there is no room for complacency and I am confident that the MPC itself is alert to the dangers. However, as I have said, professionally I regard all the questions of imbalance as important but difficult to explain.

I turn now to the stability and growth pact. It is generally accepted that the conduct of fiscal policy should be rules-based, but should have a flexible element too. Economists differ on the right balance, but decision makers in the real and the financial sectors require some reassurance, first, on the medium to long-term fiscal stance being aimed at by the Government and, secondly, on how fiscal policy adjusts to short-term shocks. Although we may disagree on the precise detail, in broad terms we have got the balance right in this country. This does not mean that there is no room for argument on the nature of the cycle and how the fiscal position is to be measured, not least as to what counts as public expenditure and what is the true measure of the public sector's liabilities. But the debate here in our country is open and takes place between people who know reasonably what they differ on and who can also agree to differ.

The same cannot be said about the stability and growth pact. As my noble friend Lord Sheldon and other noble Lords have pointed out, it is set out too formalistically. It is interpreted even more rigidly. Above all, it is not subject to the same kind of critical scrutiny of our own fiscal and monetary arrangements. It fails especially on the criterion of transparency. In this regard one can simply contrast the scrutiny by the European Parliament with the scrutiny of the Treasury Select Committee, the scrutiny of your Lordships' Economic Affairs Committee, and the scrutiny now undertaken by Sub-Committee A of the European Union Committee.

Although I may disagree with one or two noble Lords, I have to say here that I believe, overall, policy has not been satisfactory. While the pact may have brought stability, as the noble Lord, Lord St John of Bletso, pointed out, it certainly has not been conducive to growth. Sub-Committee A received evidence from the TUC making it clear that that was its view and I have to tell noble Lords that it is also absolutely my view.

Furthermore, the way in which the pact has been interpreted bodes ill for an expanded Union. The problem is not the one of a single interest rate and it is not the one of a single external value for the euro. It is that within such a desirable common monetary framework there must be more fiscal flexibility than at present. Within broader limits, countries must be regarded as the best judges of their own economic needs. I must add here that while I regard reform at the micro-economic market mechanism level as desirable, this, as a matter of fundamental economics, does not solve the macro-economic problem.

I am one of those who has always regarded what might be called the EMU problem, or EMU question, as one of balance. I have argued that, in my judgment, the balance favours EMU and our joining it. But I have never taken the view that those who see the balance the other way are either disreputable intellectually or idiots. I reserve that judgment for those who see that there is no downside and for those who see that there is no upside. Unfortunately, too many people do not have a balanced view.

I have to say that I would have joined at the outset. Despite not being privy to all the marvellous research documents that the Treasury has made available to the Cabinet and which I assume that we shall all be able to access early next week—I cannot wait for this vast amount of material, and of course our detailed scrutiny of it in your Lordships' House, which should not take more than around three weeks working all day—I would still join. Even if I could not see all the documents, I would still do so.

My only doubt, which arises as a consequence of our failure to join in the first place and our dithering since, is that by the time we do make up our minds to join, the stability and growth pact will be set in stone, as well as the way in which the ECB conducts monetary policy. It may be that some will then say that, as a result, joining would be disadvantageous. I would not go that far, but I can say that, were that to happen, we would have only ourselves to blame.

8.59 p.m.

Lord Taverne

My Lords, I read the report of the Economic Affairs Committee on the Monetary Policy Committee with interest. But if I may sound a note of dissent, however convenient it is to combine the debate on that with the debate on the stability and growth pact, I do not see much of a common theme between them. With the exception of the remarks made by the noble Lord, Lord Peston, it is interesting that most of those who have spoken did so about their own committee report and did not cross the border to the other field. I shall therefore speak about the stability and growth pact, except to say that I very much agree with the noble Lord, Lord Burns, that a single inflation target seems more sensible than having two targets of inflation and growth.

The stability and growth pact has been declared to be stupid. No less a person than the President of the Commission called it stupid. Many people have blamed it for the period of low growth and relatively high unemployment that we have seen in recent years inside the European Union. Some of those who have attacked it have been very eminent—the Financial Times, the noble Lords, Lord Peston and Lord St John of Bletso. Yet, to my surprise, after hearing the evidence of most of our witnesses, the general conclusion to which our committee came was "not guilty". It should be adapted, it should be made more flexible, but on the whole the report does not find that the stability and growth pact is to blame.

I think our report is very good, and I do not say that in a self-congratulatory fashion. It had a very able chairman and a very good Clerk. It is written extremely well, it is well argued and has a good logical flow.

Let me start with the background. On the face of it, there is a case to be made against the stability and growth pact. Contrary to what many people now state, over the past 20 years the European Union has strongly outperformed the United States. Despite the fact that it is now declared to be sclerotic, it has certainly outperformed the United States in terms of productivity growth and, over 20 years, generally in terms of unemployment. Even today, after a short period of much faster growth in the United States, productivity per hour worked is still higher in France, Germany, the Netherlands and Belgium, and is very close to it in a number of other EU countries. The only laggard is the United Kingdom itself.

That is against a background of a much more attractive form of capitalism. I greatly prefer the European form of social capitalism to what Professor John Kay has called the American business model. There is more security of employment, more consensus, fewer hours are worked, holidays are longer, there is far greater equality and not the same concern for financial engineering and maximising shareholder value. There is more investment and innovation, partly because there has been more security and much more intracompany innovation, a particularly strong feature of the German economy. However, the past five years has seen slow growth in Europe and high unemployment, particularly in Germany, which, after all, makes up something like one third of the total economy of the European Union.

I come back to the question of whether that is the fault of the stability and growth pact. Would we be better off without it? Our answer was no. Everyone agrees that it makes sense to have fiscal policy which is of common concern to all members of a monetary union. The noble Lord, Lord St John of Bletso, one of our witnesses, suggested that we should concentrate on debt, not on deficit, and that deficit was not important. This was very effectively answered by the evidence of a very impressive witness, Mr Klaus Regling of the European Commission. He said that, deficit is important for the conduct of monetary policy. When you look at the policy mix and what really affects the European Central Bank, it is the deficit. When they look at this year and see the economic situation, price developments, where the pressures are coming from, it is not so important whether a country has 40 per cent of GDP debt or 80; for the management of monetary policy this year what is really important is how big the deficits are". He goes on to say: Looking at it another way, even if a country has a very favourable debt situation, no ageing problem, no long-term sustainability problem, if it is a big country and it decides during a normal economic situation to all of a sudden shift from a surplus in the public finances of I per cent of GDP to a deficit of 2 per cent, this has an impact on monetary policy, on the policy mix". That is a very powerful argument.

If we need to have rules, one obvious way is to have an economic government, but no one is ready for an economic government of Europe. That is not a realistic possibility, whatever the euro-sceptics say. But we need rules. This point was eloquently expressed in a question from the noble Lord, Lord Lea of Crondall, who said, "If we don't have rules, all that lot would spend all our money".

We cannot leave it to the market, either. That was put well in paragraph 46 of our report, which said that where previously—before there was monetary union—interest spreads, might have gone up by between 100 and 500 percentage points in reaction to fiscal policies that the market saw as profligate or unsustainable, today in the Eurozone the spreads were 'down to below 50 basis points,' which was 'not surprising' because of the absence in the Eurozone of exchange rate risk". Therefore, we cannot simply leave it to the market. We must have rules.

Then it is said that the rules are much too tight and rigid. To some extent, that point was conceded in the committee, because we do call for a much more flexible approach. However, is 3 per cent really an unreasonable limit, especially if it is seen as a benchmark for the exercise of peer pressure rather than as an absolute limit? There was a good essay by Barry Eichengreen and Charles Wyplosz, which pointed out that only in exceptional circumstances were there budget deficits of more than 3 per cent in EU countries in the period since the war for more than one year. The evidence that we heard was that the 3 per cent limit—if people manage their fiscal policy sensibly—leaves plenty of room for the automatic stabilisers to work.

The problem faced by Germany and France is that they pursued pro-cyclical policies in boom years. The suggestion that there would be faster growth if they were only allowed to borrow much more has not been supported by most of our witnesses. The ideal mix is a much tighter fiscal policy and a loose monetary policy. The evidence that we heard was that Germany's position would be no better whether it had a deficit of 4 per cent or 5 per cent. The mantra is that Germany has been affected by interest rates that are too high, but historically interest rates are relatively low for Germany at present.

There is no great output gap in Germany, either, because wages are actually rising. It is difficult to know whether there is an output gap, as the Economic Affairs Committee also pointed out. However, there is no particular evidence that Germany's problems at the moment are caused by a big output gap, and that if it was only allowed to borrow more and expand by fiscal policy, its problems would be solved. The reasons our witnesses gave for Germany's problems were structural, and the legacy of reunion.

In so far as the European Union needs structural change, it does not mean that we should adopt the American business model. The Netherlands has been as successful as almost any European country in reducing unemployment and improving economic growth. It has a much more successful record than this country, I am sorry to say. That has proved that if one combines a degree of flexibility and competition with the consensus model—sometimes known as the Polder rather than the Rhineland model—one can deliver economic success and not lose the many advantages of social capitalism.

In terms of longer term historical context, we have seen a seesaw between the United States and the European Union. There was a time when Europe felt that it was unable to compete with the United States. Many years ago, a hook entitled La Défi Americain was published and asked how we could meet the American challenge. Then it shifted the other way. I remember a speech by the late Lord Jenkins in the early 1970s, before he was Lord Jenkins, when he looked to the United States and saw gloom and Europe was the place of excitement, innovation and growth. "Westward look, the land is bleak-, I remember him saying.

Now, in the past few years, there has been an American success. Some of the gloss has come off that success. Their success has been partly an inflated share price bubble and partly inflated profit figures. Mr Robert Gordon has been a fairly effective critic of the so-called "new economic miracle" in the United States. They may face a lot of problems with the twin deficit. I am not going to make any forecasts. I will not predict whether the see-saw will tilt again the other way. However, suitably modified and flexibly interpreted, the findings of our committee were I think sensibly that the stability and growth pact was not something that would stop that happening.

9.11 p.m.

Lord Saatchi

My Lords, like the noble Lord, Lord Lea, but I am afraid unlike the noble Lord, Lord Taverne, I am grateful to the usual channels for the fact that we are debating these two subjects together. As the noble Lord, Lord Burns, said, it allows your Lordships' House to look at how the euro-zone rules may affect the MPC and UK monetary policy. So I begin by right away joining other noble Lords in congratulating all the members of both the committees, led by their two chairmen, the noble Lords, Lord Peston and Lord Radice, on both their most thorough, comprehensive and excellent reports. Both committees have upheld the high standards set for them and have demonstrated again, I hope for all to see, why your Lordships' House deserves its new role in the scrutiny of economic policy, as the Government have now recognised.

I begin with the MPC. We, like the committee and the noble Lord, Lord Burns, do not propose any immediate or major changes in either the remit or the composition of the MPC. We, like the committee, fully support the fact that the inflation target is a single target and that the approach to it is symmetrical in the sense that deviations below the target are treated in the same way as deviations above it. Having said that, there are three questions that I should like to put to the Minister about the report and the Government's response.

First, we think that the committee is perhaps a little modest in its definition of Parliament's role in MPC appointments. I should be interested in the Government's point of view. In the United States, the appointment of the chairman of the Federal Reserve is approved both by the banking, housing and urban affairs committees of the Senate and then by the Senate itself. So while not going anywhere near as far as the noble Lord, Lord Oakeshott, we do propose that the appointment of the Governor of the Bank of England, the Deputy Governor and members of the MPC should be approved by a joint committee of both Houses of Parliament. We think that that would help bolster their independence, make the process more transparent and increase the power of Parliament. I am sorry that the committee does not agree on that. I look forward, as I said, to the Minister's views.

Secondly, our MPC model of monetary policy relies on the single weapon of the short-term interest rate and the one target of 2.5 per cent inflation. I wonder whether the Minister thinks that that model—whatever the resulting definition, as the noble Lord, Lord Barnett. raised the question—adequately reflects the fact that the overall inflation rate is made up of the composite of two inflation rates. I am referring to public sector inflation and inflation in the rest of the economy, the composite of which gives the overall familiar national inflation rate which is targeted by the MPC. That might not matter very much when the two rates are similar, but as the Minister knows, there is now a remarkable gap between the two. It is interesting to ask what the policy implications would be if people were more aware of that. For example, an analysis of official data from the Office for National Statistics reveals that government expenditure on goods and services rose by 7.6 per cent in nominal terms in the first quarter of this year, compared with the first quarter of last year. The data estimates that the real inflation-adjusted increase in the volume of services provided was just 1.5 per cent. So the official figures imply that public sector inflation has now reached 6 per cent per year—up from 5.5 per cent in the previous quarter.

That raises some serious questions. If public sector inflation is 6 per cent and the total is 2 per cent, what does that make inflation in the private sector? Is it zero? Is it deflation? Apparently, shop prices fell by 0.1 per cent in April, which was the thirteenth monthly decline in a row. My noble friend Lord Northbrook referred to the new fears of deflation. That is my first concern and I would be interested in the Minister's view.

My second is that it means, insofar as I can calculate, that nearly £80 out of every £100 of taxpayer's money now being spent on schools, hospitals and other public services is being spent on higher salaries, benefits and administrative costs, with only £20 of every £100 going towards increasing the volume of services provided. Does the Minister agree that further scrutiny of the disparity in inflation rates between the public and private sector might be very interesting?

My third concern is that in its document, Reforming Britain's Economic and Financial Policy, the Government time and again praise the MPC for "acting in a proactive manner". Is it not at least curious that, on the one hand, the Government praise the flexibility accorded to Britain by the current MPC system, but that, on the other hand, say that they intend and want to eliminate that flexibility by joining the euro? Is it not a supreme irony that at the very moment when we reach unprecedented, historic, cross-party consensus on the framework for monetary policy, it is only the Conservative Party that is in favour of maintaining that framework?

It is not just the possibility of joining the euro that creates anxiety about the framework. The noble Lord, Lord Burns, drew our attention to that. Perhaps I may draw to your Lordships' attention the fact that the Convention on the Future of Europe raises the question before anything arises about joining the euro. It makes a clear injunction towards the co-ordination of economic policies, but I can find no echo of it in the Bank of England Act 1988. Indeed, the committee restates the familiar remit of the MPC on page 1 of its report, but neither there nor anywhere in the iconic Bank of England Act 1988 can I find any mention of the EU, of the objectives of the EU, of EU guidelines or of co-ordination with the EU. I would be interested to hear the Minister's response to that.

The mention of Europe brings us conveniently to the second report, on the stability and growth pact. I believe that after the great inflation of the 1970s, the priority of policymakers was, as Sam Brittan put it, "to lock the monetary cupboard" to prevent governments trying to expand too fast for short-term political advantage. And so it was, as the noble Lord, Lord Lea, said, that the Bundesbank made its great gift to the euro-zone—what economists called "a pre-nuptial contract written in blood"—the stability and growth pact. The committee's report and many noble Lords who have spoken support the need for some form of co-ordination of national policies to maintain public finances across the EU. The committees says on page 38, in its conclusions, which were supported by the noble Lords, Lord Radice, Lord Sheldon and Lord St John of Bletso: Market discipline alone cannot be guaranteed to ensure the sustainability of public finances". As the noble Lord, Lord Taverne, said, we cannot leave it to the market. I believe that the thinking behind that conclusion is that excessive public borrowing always weakens a currency and that once a country is in the euro, it may be tempted to borrow and spend at everyone else's expense, raising interest rates for all. That is, as the noble Lord. Lord Sheldon said, the famous 'free-rider' problem. However, we have a disagreement about whose rules are to apply: ours or theirs. The Chancellor has set out his two fiscal rules, against which he says the performance of fiscal policy should be judged: the golden rule and the sustainable investment rule. Noble Lords are familiar with both of them. The Treasury believes that its model is better. I am not clear whose rules will prevail. I hope that the Minister can shed some light on that.

The committee does not approve of that rule-based approach, as the noble Lord, Lord St John, made clear. While agreeing that, the Commission's proposals provide member states with a useful aim and sound objective", it concluded: They should be interpreted as guidelines rather than as rules". As many noble Lords, including, I believe, the noble Lord, Lord Peston, have said, the mechanism operates too formalistically and it bodes ill for the euro-zone. The committee wants the rules to be interpreted in a flexible way, that: takes account of the particularities of each individual situation", and which is, sensitive to the specific circumstances of each country". Romano Prodi, the European Commission President, agrees with the committee that it needs to, implement the stability and growth pact in a more intelligent and forward-looking way". Mr Francis Mer, the French Finance Minister, also agrees. If noble Lords will allow me, he said: Le pacte de stabilité Européen n'est pas inscrit sur le marbre". The committee says: The Council should not treat the 3 per cent figure as an absolute limit". It should, it says: take account of the underlying economic situation, including the Member State's position in the economic cycle and possibly its level of debt". It goes on to say that it, should not be treated…as an enforceable rule, any breach of which would activate the excessive deficit procedure". The noble Lord, Lord Barnett, referred to that as the crucial need for flexibility. As the noble Lord, Lord St John, said, the current Oxford Review of Economic Policy in the article by Allsopp and Artis, also condemned the SGP's emphasis on what it calls, the legalistic imposition of rigid rules with little economic justification". To complete that happy consensus, the Government, too, welcome any move to a more country-specific interpretation of the pact, as it allows them to continue their programme of priority public investment in public services. In their response to the committee's report, the Government said, in paragraph 165, that they support a "prudent interpretation" of the SGP. So anxious were the Government to make sure that we get the message that they repeated the phrase "prudent interpretation" five times in their two-page response. Why is that? Only a mean-minded cynic would say that the Government's motive is that their own forecast for public debt, on which the committee rightly says there should be more emphasis, has shot up from £34 billion to £118 billion in 18 months.

It is understandable that when people see those who are either in breach of the pact's rules or are about to be in breach of the rules, they wish to change things. To some people, that crumbling of the fiscal rules underlying the euro will lead to economic disaster. Others respond that in the current economic circumstances, a sustained period of public deficit is just what the euro-area needs. Either way, not everyone is impressed by the quality of the debate. The Economist, for one, said that the pact needs substantial reform, preferably to the point where it ceases to exist". It describes the stability and growth pact—I am sorry to say this to the noble Lords, Lord Barnett and Lord Radice—as: The best argument against joining the euro".

9.25 p.m.

Lord McIntosh of Haringey

My Lords, I have the task, which was identified by the noble Lord, Lord Taverne, of trying to find a common theme between these two reports. I also have the much more pleasant task of doubly congratulating the chairmen, members and everybody who gave evidence or took part in the production of these two excellent reports.

The common theme that I look for is macro-economic stability in this country and in Europe through sound fiscal and economic policy delivering, as we believe it has, not only sustained economic growth but low unemployment.

That is the case in this country. Clearly, as the Budget has made clear, no country can remain immune to the effects of global uncertainty. As a result of the economic framework that the Government have put in place over the past six years, Britain is better placed than many of our competitors. We are better placed than in the past to withstand difficulties. We have no intention of being diverted from our priorities of investing in public services and encouraging enterprise for achieving full employment, tackling child and pensioner poverty to build a Britain of economic strength and social justice.

The strength of the UK's economy can be attributed to the sound fiscal and monetary frameworks in place, which ensure that fiscal policy plays its proper role by supporting monetary policy during this period of global economic weakness. It has certainly been tested in recent times. There has been a background of hesitant—to say the best—global recovery, stalled by continuing concerns around the world. But we are on track to meet the fiscal rules over the economic cycle to ensure that public finances are sustainable in the long term.

Specifically in terms relevant to the stability and growth pact, the average surplus on current budget is projected to be comfortably positive over the projection period, meeting the golden rule. Our net debt is set to stabilise at 34 per cent, which is well below the 40 per cent that is necessary to meet the sustainable investment rule. It is at the lowest level in the G7 and among the lowest in the EU.

Clearly, we are cautious in our forecasts. The noble Lord, Lord Northbrook, raised that point, but I shall not read out tables of figures. But I am prepared to write to him to set out our forecast on the relevant criteria against the consensus. They are set out in table 2.4 of the Budget document, but I am happy to set them out in the terms in which he asked the question. The assumptions behind our public finances, as has been the case for a number of years now, are independently audited by the National Audit Office to provide a safety margin against unexpected events. The cautious assumption for equity prices, for example, rises only in line with GDP, locking in the recent falls rather than assuming that they will be reversed.

I turn to the European side of things and the stability and growth pact. There are assertions about the way in which the pact is being implied. I can best illustrate the situation by reading out the recommendations hot off the press from ECOFIN yesterday when it declared that France came within the situation of an excessive government deficit. The ECOFIN council recommended that the French authorities put an end to the present excessive deficit situation as rapidly as possible and by 2004 at the latest, in accordance with Article 4 of Council Regulation No. 1467/97. The council has established a deadline of 3rd October 2003 for the French Government to take appropriate actions to that end and expects the French authorities to achieve a significantly larger improvement in the cyclically adjusted deficit in 2003 than that currently planned. That gives credence to what was said about the way in which the cyclical adjustment has been taken into account in ECOFIN decisions. The council also expects France to limit the increase in the general government gross debt to GDP ratio in 2003.

In addition, the Council notes the commitment of the French authorities to ensure that the budgetary consolidation continues in the years after 2004 as reflected by the December 2002 update of the stability programme; namely, through a reduction in the cyclically adjusted budgetary deficit by at least 0.5 per cent GDP per year in order to move decisively towards the medium-term position of government finances close to balance or in surplus, and bring back the debt ratio to a declining path.

The Council notes the commitment of the French authorities to ensure a tighter control of expenditures in 2003. It welcomes the commitment of the French Government to achieve the pension reform already in process to secure the long-term sustainability of public finances. I have to say that that is slightly ironic in a week in which there is an immobilisation générale in France against the Felon project. Nevertheless, that is the way in which the stability and growth pact is being operated. It can be seen that it is by no means as rigid as has applied.

The Government firmly support the premise of a strong stability and growth pact which is founded on sensible fiscal policy co-ordination, as set out in the EU treaty. All speakers, whatever their view about the details of the stability and growth pact, have supported the policy for co-ordination of fiscal policy and for convergence. Even the noble Lord, Lord St John of Bletso, who was the most dramatic opponent of some of the provisions of the stability and growth pact, was in favour of co-ordination and convergence.

My noble friend Lord Radice and others talked about having the existing rules implemented more flexibly. That is not language the Government use. The noble Lord, Lord Saatchi, chooses to make fun of it, but our view is that a sensible fiscal policy coordination is consistent with the UK's prudent interpretation of the stability and growth pact, which takes into account the economic cycle, sustainability and the important role of public investment. That is what "prudent interpretation" means. It would lock in long-term fiscal discipline and sustainability, enhancing credibility while allowing the automatic stabilisers to smooth fluctuations in output and allowing appropriate increases in investment in public services.

Under those circumstances, that is a stability and growth pact we wish to support. The noble Lord, Lord Saatchi, asked how that relates to the UK fiscal rules. They cannot and should not be compared on a likefor-like basis. Their starting points are different, but their underlying ethos is common—securing and sustaining sound public finances. As the noble Lord said, we have the golden rule and the sustainable investment rule, but, consistent with a prudent interpretation of the stability and growth pact the Government's fiscal rules operating together have both allowed automatic stabilisers to operate fully over the economic cycle; they have contributed to macroeconomic stability: and they have allowed the Government to undertake much needed quality public investment while staying within the 3 per cent deficit limit.

I turn to the committee's report on monetary policy. We are grateful for the very wide degree of support from the committee for the operations of the independent Monetary Policy Committee. We were glad to have at least a modification of the views of such noble Lords as my noble friends Lord Barnett and Lord Peston, who were opposed to considerable elements of the Monetary Policy Committee when we debated the Bank of England Bill in 1998. After all, the Monetary Policy Committee continues to deliver RPIX inflation around the Government's target of 2.5 per cent with inflation expectations anchored close to the Government's target, having fallen from over 4 per cent in 1997. As the noble Lord, Lord Burns, said, this delivery has been going on for a period approaching 10 years, which is quite a long time in the life of an economy.

Long-term interest rates are around their lowest levels for over 35 years. That has reduced the Government's debt interest payments and freed up resources for investment in public services. Again there is a query about the inflation target. There are still those who would wish to go away from a single inflation target to more complex targets. As the noble Lord, Lord Northbrook, reminded us, that applied to the Federal Reserve Bank under the Humphrey-Hawkins Act. We do not take that view and I am glad to have the support of the noble Lord, Lord Burns. We think that inflation targets are clearly and easily understood. They make the monetary policy objective transparent, they make it possible for the public to monitor it and they provide an effective anchor for monetary policy and inflation expectations. As the committee discussed, those targets are a weighted average, but they are a weighted average between manufacturing and service inflation. They are certainly not a weighted average between the mythical public sector inflation, to which the noble Lord, Lord Saatchi, referred, and which I hoped that I had demolished for good in the past couple of weeks, and private sector inflation. It is clear that inflation has to be the right target.

I turn to the question of which measurement of inflation is used. The noble Lord, Lord Northbrook, and my noble friend Lord Barnett referred to this point. In the Budget Statement the Chancellor announced only that the Treasury would continue to examine the detailed implications of changing the inflation target to an HICP basis. The implications are being examined from a monetary policy perspective only. We have already made it clear that, for example, the basic state pension will rise each year by 2.5 per cent or by the September RPI, whichever is the higher. We have made it clear that social security benefits will rise in the normal way, and it is certainly true that gilts will continue to be treated in the current way because they are legally tied to RPI. There is no difficulty about having a different criterion for different purposes. Even in the euro-zone, where the European Central Bank uses HICP, the Greek and French governments use different measures for inflation indexed bonds. There is no problem about that. There is a review continuing of which I am not going to pre-empt the outcome, except to assure my noble friend Lord Lea that the review will involve discussions with stakeholders who are concerned, as he is, particularly with wage setting.

The noble Lord, Lord Northbrook, seemed to think that there is a conflict between the inflation target and the Government's objectives for growth and employment. I hope that the summary figures that I have given show that that is not the case. Price stability is a necessary condition to ensure sustainable growth and high employment. There is some evidence to suggest that high and variable inflation can damage growth and productivity. That evidence was fairly strong over a longer period in the 1960s and 1970s when I was in business on my own account. The framework is designed to ensure that price stability is the long-term objective of monetary policy. I have to say to the noble Lord, Lord Northbrook, that there is no evidence that it leads to low inflation—or certainly not to deflation.

The noble Lord, Lord Burns, and my noble friend Lord Peston are right that the target must explicitly recognise that external events and temporary shocks may hit the economy. The target does reflect that. The MPC will need to find the most appropriate way of responding to those shocks. It does that in case inflation moves more than one percentage point away from the target through the open letter system.

We have had a valuable debate. It has been inevitably polarised by the interests of those who have taken part, but I hope that I have been able to bring the debate into the context of the broader objectives of UK monetary policy, and to indicate in doing so my support for the work of the two committees.

Lord Radice

My Lords, at this time of night, I shall not make a "right of reply" speech—as noble Lords will be glad to hear. I thank noble Lords for their high-quality speeches. To my surprise, there was overlap between the two subjects—it was not always to my taste, but it was there. Above all, the arrangement allowed both reports to be debated, which might not have happened otherwise, so there was a severely practical reason for it. On the whole, the debate has been a success. I commend the Motion to the House.

On Question, Motion agreed to.