JOINT COMMITTEE ON EUROPEAN AFFAIRS debate -
Wednesday, 25 May 2005

Stability and Growth Pact: Presentation.

Vice Chairman (Deputy Andrews)

We will begin with a discussion on the Stability and Growth Pact with officials from the Department of Finance. We are joined by Donal McNally, second secretary, and Ronnie Downes, assistant principal.

I draw attention to the fact that the members of this committee have absolute privilege but this same privilege does not apply to witnesses appearing before it. The committee cannot guarantee any level of privilege to witnesses. Furthermore, under the salient rulings of the Chair, members should not comment on, criticise or make charges against a person outside the House or an official by name in such a way as to make him or her identifiable.

Mr. Donal McNally

I am responsible in the Department for the budget and economic division, which includes the budget preparations, economic policy and tax policy in matters such as travel. So there are two sides to my role. I am also the Irish representative on the economic and finance committee, which is the successor to the old monetary committee, and many of the preparatory discussions for the ECOFIN take place in that context.

I thank the committee for inviting us to come before it to discuss European developments regarding the Stability and Growth Pact. This discussion is apposite as I attended meetings on the issue last Friday and yesterday. I propose to make a short opening statement of approximately ten minutes, covering the areas that I hope will be of most interest and relevance to the committee's deliberations. Afterwards, I and Mr. Downes will be happy to deal with any questions.

I will begin with a short overview of the Stability and Growth Pact and what it is designed to achieve. European economic and monetary union, EMU, is an interesting hybrid creature in which monetary policy is determined by the European Central Bank, while fiscal or budgetary policy remains the responsibility of the sovereign member states. In 1996, when plans were being made to implement phase three of the EMU — that is, the adoption of the single currency — there were concerns in some countries about how well the new arrangements would work. In particular, there were concerns that a failure to adhere to sound budgetary policies at national level could lead to knock-on consequences for other member states. Excessive public deficits could lead to inflationary pressures, which would cause the ECB to raise interest rates for the entire single currency area or perhaps not to lower them as quickly as others. The idea of a Stability and Growth Pact emerged from that debate.

The Maastricht treaty of 1992 already included a requirement to avoid excessive deficits of 3% of GDP or higher. However, it was felt that something further was needed. Accordingly, at the Dublin European Summit in 1996, the elements of the Stability and Growth Pact were agreed after some difficult negotiations. The pact was formalised in a Council resolution and in two Council regulations in 1997. The pact consists, therefore, of resolutions by the Heads of State, Government regulations and a code of conduct, as well as the basic treaty requirements.

In essence, the pact comprises two arms. The preventive arm requires member states to pursue a medium-term budgetary objective of close to balance or in surplus, so that high budget deficits should be the exception and not the norm. In addition, member states must report each year on their budgetary position by preparing a stability programme which is subject to peer review by the other member states.

The second arm of the pact is the corrective arm. The excessive deficit procedure is activated by the EU Commission when a member state breaches the 3% deficit ceiling set out in the treaty. The procedure is designed to bring a member state back into compliance within a reasonable timescale. The process involves the issue of formal recommendations by the Council to the member state and can culminate with the imposition of financial penalties if the excessive deficit is not corrected.

Since its introduction, the Stability and Growth Pact has had a broadly positive effect in encouraging member states to maintain a more disciplined approach to public finances. Studies by the European Commission show that budgetary positions across the eurozone have improved significantly, relative to previous performance in the context of the EMU and particularly in the run-up to the adoption of the single currency. Overall, the pact has proved its worth in contributing to a relatively stable fiscal environment in the European Union.

Even its most ardent supporters would not claim that the pact is perfect, whether in its design or its implementation. The experience of recent years has highlighted some areas where improvement has been considered desirable. To begin with, it did not discourage member states from pursuing inappropriate fiscal policies during the years 1998 to 2000, when economic growth was relatively strong. When economic times are good, there is a natural tendency to allocate more resources towards spending increases and tax cuts. However, when the economic cycle turns the other way, these policies may prove to be unsustainable. This is what happened in some of the large eurozone countries. When the economic climate turned cooler after 2001, some countries found it difficult to contain their public finances and deficits began to rise above the 3% ceiling.

When it came to tackling these excessive deficits, the prescriptions offered under the Stability and Growth Pact were difficult for some to implement. Under the pact, member states were required to undertake budgetary cutbacks to bring down the deficit. However, undertaking severe cutbacks in a time of low economic growth was not viewed by many member states as a realistic option. Following a stalemate in November 2003, when member states were unable to agree on how to progress the procedure against France and Germany, it was decided that reforms were required to ensure that the pact operated more effectively.

As a result, the European Commission published a formal communication on 3 September 2004 outlining a range of reform proposals for strengthening economic governance in the European Union and clarifying the implementation of the Stability and Growth Pact. Since then, the issues involved have been the subject of several months of detailed debate and discussion among officials and Ministers. This process culminated in agreement on a package of reform measures at the spring European Council on 22-23 March 2005.

I will summarise the key elements of the reform package. There will be a greater focus on the need to run low deficits and surpluses during periods of strong economic growth. It will be presumed that unexpected extra revenue will be used for deficit and debt reduction. There will be a greater focus on reducing debt levels and achieving long-term budgetary sustainability, particularly as the population is ageing. There will be a more refined approach to determining the medium-term objective of budgetary policy, taking account of the various economic circumstances in member states. Some countries have much lower debt ratios than others.

Under the revised pact, more flexibility will be offered to countries which experience prolonged economic downturns. They will be able to consolidate their budgets over a longer timeframe of approximately two years, rather than having to pursue budgetary retrenchment which is too severe and which could depress growth further. There will be a greater clarity about the range of economic factors that can be taken into account in assessing, in qualitative terms, whether a small and temporary breach of the 3% deficit ceiling amounts to an excessive deficit.

Officials are ironing out the details of how the reforms will be put into practice. It is expected that the revised pact regulations will be in place by the summer. One of the benefits of the revised pact is that it involves the adoption of a more balanced strategy. It will have a stronger preventive arm to encourage more responsible budgetary behaviour in good times. It is hoped that this change will lead to fewer instances of high debt and a more realistic and credible approach to correcting excessive deficits.

The reforms in the pact will benefit Ireland because they will give it extra flexibility in achieving the medium-term objective. That flexibility can be availed of, when necessary, to maintain Ireland's high levels of public investment throughout the economic cycle. The pact recognises that countries with low debt and high investment needs can be accommodated in a sensible manner without a threat to financial stability.

I will now inform the joint committee of the fiscal position throughout the EU. The 25 member states face a variety of economic circumstances, which range from the strong growth economies of top performers like Ireland to the structural challenges faced by the transitional economies of the recently acceded member states. Ireland is one of eight member states with a budgetary target consistent with achieving a close to balance or in surplus budgetary position in 2005, as required under the pact. Of the other countries in this position, Denmark, Finland, Sweden, Belgium, Spain and Estonia have enjoyed healthy growth rates and sustainable fiscal policy-making in recent years and the Netherlands is forecast to reach the close to balance position in 2005. It took swift action to correct its 2003 excessive deficit and emerge from the excessive deficit procedure. ECOFIN will confirm at its next meeting that the Netherlands has emerged from the procedure.

Luxembourg, Latvia, Slovenia and Austria are in the middle range of budgetary positions, which means that while they are not close to balance, they are not in danger of running an excessive deficit. Some 13 member states are subject to or are likely to be subject to the excessive deficit procedure because their government deficits are approaching or are above 3% of GDP. Germany, France and Greece are subject to the procedure and, with the possible exception of France, are likely to continue to be subject to it throughout 2005. The UK corrected its excessive 2003 deficit by 2004 and is not subject to the procedure. Italy and Portugal may be subject to the procedure this year. The adverse fiscal and economic positions of the two countries will require great efforts to be made if compliance with the terms of the pact is to be achieved. Most of the six recently acceded member states which are subject to the procedure are on course to take effective action, although extra measures may be required if Hungary is to comply.

Given the diverse economic circumstances of the countries involved, a flexible and strategic approach is needed to set member states on the right fiscal track. We hope the revised pact will enable the issues involved to be addressed effectively. If members have any questions, we will be happy to try to answer them.

Vice Chairman

I thank Mr. McNally.

Senator Dardis

I thank Mr. McNally and Mr. Downes for attending this meeting and making the presentation. The Stability and Growth Pact is essential because governments do not have control over the euro. Eurozone countries, which depend on the European Central Bank, cannot individually influence the management of the currency. That the Stability and Growth Pact is essential if the currency is to operate effectively has been proven by the successful operation of the currency to date. There are very few countries in which the euro is not accepted.

Germany and France, when their economies were out of kilter, were treated much more leniently than was the case with Ireland, which was slapped on the wrists some years ago. It seems that larger countries receive preferential treatment. As Mr. McNally said, an implicit weakness in the entire process was highlighted when the EU had to introduce a reform package. Italy and Portugal exceeded the 3% threshold. I am interested in how that feeds back into the currency. Compliant countries are affected if other countries do not comply with the rules of the game. In such circumstances, the currency comes under pressure and the countries which comply with the rules cannot influence the defence of the currency.

The countries which have been misbehaving and have caused problems seem to be able to get away with it. We need to ensure that the instruments which are used to bring such countries back into the general range specified in the pact are effective. If the Department of Finance does not consider that the instruments are sufficiently effective, how does it believe they can be made more effective? The stakes are significant. A few countries seem to be able to have a substantial effect on the currency. Under the European Central Bank system, the other countries are not in a position to defend the currency or make the management of it more effective.

Mr. McNally

As a small country, Ireland, regardless of whether it is inside or outside the eurozone, will always be influenced by external circumstances. It had no influence on economic policy in the UK when it was part of the sterling area. Small countries always face such risks. Senator Dardis was correct to point out that the pact has monetary and fiscal elements. When negotiations took place about the single currency, some member states, particularly the Netherlands and Germany, were concerned that some countries would have an inflationary effect. They thought that would lead to increased expenses for the rest of the countries. Both elements of the pact are designed to try to counteract that.

It is clear that both Italy and Portugal will be above the 3% threshold. Portugal will exceed the threshold significantly as a consequence of the one-off measures it took in years gone by when it was staying below the threshold. Some 2.3% of Portugal's deficit of 5.2% last year was met by one-off measures, with the result that it reduced its deficit to 2.9%. One-off measures may include amnesties and the sale of real estate, which is common in Italy. One cannot repeat such measures because such assets run out after a while. The Portuguese problem is that its one-off measures have not included the necessary underlying structural measures.

The case of Italy is the subject of discussion. Last Monday, EUROSTAT published some revised figures which suggested that Italy had exceeded the limit because its treatment of a number of items had changed. That is always a problem. If one's deficit is 2.9% of GDP, it does not take much of a wobble for one to exceed the 3% threshold.

I would like to refer to the Portuguese experience. One of the important new elements of the Stability and Growth Pact is that it concentrates on getting member states to take corrective action on a sustained basis without resorting to one-off measures. Such measures can be acceptable if they solve a problem and help countries to drop below the 3% threshold for a single year. However, they will ultimately leave countries exposed. The pact aims to get countries to make consistent progress back to the 3% threshold by dealing with such problems. I refer, for example, to their using structural measures which will have a long-term effect. That will make the pact more effective.

The Senator referred to the costs which arise when the currency is affected by countries' failure to stay below the 3% threshold. The European Central Bank takes its own view of such matters, on the basis of the amount of money in the system, liquidity and the threat of price inflation. The ultimate effect in terms of paying for this is through the interest rate system. If circumstances were different, I do not know whether the ECB would lower interest rates — that is difficult to judge — but obviously it will ascertain the fiscal position in deciding the interest rates environment.

Senator Dardis

Our growth rate is very high by general European standards, in particular compared to the low growth rates of countries like Germany, which is paying for unification. To what extent is pressure being applied through the Stability and Growth Pact to make growth rates converge? In other words, could good performers like Ireland find themselves in a situation where growth would reduce to a norm that would be universal across the Union?

Mr. McNally

Our growth will be dictated by three factors: the rate of increase in the labour force, our productivity increase, and the state of the international economy. We have the potential to grow by between 5% and 6%, which comprises perhaps 3% due to labour force growth and 2% to 3% due to productivity. Whether we achieve this depends on international growth, exchange rates and interest rates. These are the factors likely to be affected by the Stability and Growth Pact environment, which will set the limit.

If our labour force continues to grow at a faster rate than that of the rest of Europe we will continue to have a higher potential growth rate. For example, some suggest the United States will always be able to grow by 1% more than the European Union simply because it has a labour force growth rate of 1%, whereas the rate of increase in the EU is practically zero. Convergence should occur but there will still be differences between different parts of a monetary union.

Senator Dardis

Is Mr. McNally confident Ireland has domestic control over enough levers to be able to keep running at an enhanced level relative to other member states?

Mr. McNally

The levers available to us are incomes policy and competition policy. Therefore, we have some control in terms of our competitiveness. However, the exchange rate is set by external factors. We are not playing a round of golf with only one club in the bag; we have a number of clubs.

Deputy Mulcahy

I welcome the officials from the Department of Finance. We discussed this matter at some length when the former Minister for Finance, Mr. McCreevy, came before the committee. We all recall that the European Commission was at that time threatening effectively to bring the Council to court for breach of European law because the Council approved a new set of regulations which altered the situation pertaining under the Maastricht treaty. While I am not sure if that matter was referred to the European Court of Justice, the result of any deliberations certainly never came before the committee.

We should remind ourselves why the Commission acts in this way, namely, because it is a matter of law. It is a question of whether certain countries have at any stage breached European law, or whether, in this case, the Council of Europe was about to breach that law. Our responsibility as an overseeing committee is to inquire as to whether there was a potential or actual breach of the law, and to determine what happened.

As I understand it, when countries adopted the Maastricht treaty, and Ireland voted for it in a referendum, they voted for the 3% threshold. Therefore, my first question to Mr. McNally is whether, if we intend to alter the Stability and Growth Pact and allow certain countries to breach that 3% threshold, this change must be enshrined in a new treaty as in effect it alters the Maastricht treaty.

Mr. McNally made the point that flexibility is required to a certain degree. It is fortunate that Ireland is enjoying a period of growth. However, we should be conscious, in a friendly way, of our neighbours who may not be doing quite as well, for different reasons. Nobody wishes them ill but the concern of the committee must be for Irish consumers. Does Mr. McNally agree that if large member states breach the 3% threshold, or borrow more and spend more in their own economies, they will pump inflation in those economies? If that is the case, the ECB has only one way to react — by increasing interest rates. Therefore, the lack of fiscal discipline on the part of one or two member states might entail higher mortgage rates for Irish consumers. Is that a realistic scenario?

On the issue of debt, is Ireland under the 60% threshold? Will Mr. McNally provide a list of European countries above and below that threshold?

Vice Chairman

To add to the question on the legal status of the pact, Mr. McNally's submission stated that legal status was formalised in a Council resolution and two Council regulations in 1997. To clarify Deputy Mulcahy's question, is the pact enforceable in the European Court of Justice by the Commission or is it a political pact?

Mr. McNally

I have some information on where member states stand, which I will come to shortly. The Stability and Growth Pact is an amalgamation of a number of elements, including the contents of the treaty, which set the reference values of 3% of GDP and 60% for debt, and the procedure set out in the treaty at Article 109, which indicates how the process works.

If the Commission thinks a member state is heading towards the 3% threshold, it can issue an early warning. If a country goes over the 3% threshold, the Commission must decide whether an excessive deficit persists. Although a country is over the 3% threshold, the Commission can decide not to initiate the procedure. For example, the United Kingdom at the end of 2003 was over the 3% threshold but as the UK fiscal year is at the end of March, it undertook to be back on course by the following March. The Commission agreed on the understanding that the situation would be rectified by March, which it was. It was pointless to initiate the procedure in that case.

Some judgment must be taken of whether there is an excessive deficit. If there is such a deficit, the procedure includes recommendations for countries to take action within a certain period. However, at each stage it is up to the Council to decide whether it moves on to the next step. In the difference of opinion between the Commission and the Council, much of what was at issue concerned those steps. The Commission took the view that once the train left station A it went to station B, then to station C, and ultimately to the financial penalties. Germany and France took the view that the Commission should first issue a recommendation to them and that they would then attempt to rectify the situation over a four month period, but that the Commission could not automatically move on to the next step regardless of their efforts. The train does not have to necessarily continue; it can stop and the procedures can be reconsidered.

The key issues were whether to act in a mechanistic way or to take an informed view. However, in the end, the Council decides on the excessive deficit, whether there has been a breach and whether member states must take action. When a certain stage is reached, there are automatic consequences. To say a country has breached the law, as with any law, one must first be caught and then prosecuted and so on.

Deputy Mulcahy

Is this matter before the European Court of Justice at present?

Mr. McNally

That was the issue of contention. The Commission then took the Council to the European Court and a decision was made in the middle of 2004. The Commission communication came out in September because it waited until it knew what the court had decided. The matter was something of a draw in that the court stated — I am subject to correction on this — that the Council should have only acted on a recommendation from the Commission, but also that simply because time limits exist does not mean those limits are absolute. The Council does not have to act because the time limit is four months. It can allow itself more time and decide to give people another chance to operate the procedure. The proposals for reform came about as a result of this draw, so to speak.

There is always a tension between the Commission, which would like matters to be automatic, and finance Ministers, who do not wish to show up and be instructed to stamp a document. They do not like to be told that they cannot influence matters which are key to their respective economies. Such tension is always there. The provisions of the Stability and Growth Pact try to accommodate both in terms of doing more to prevent the situation from arising and acknowledging that one can exacerbate a position of low growth. Lower growth in some of the main European economies is not necessarily in Ireland's economic interest. That is why the pact must allow for some judgment and sense on the part of finance Ministers.

Deputy Mulcahy

The absolute core of the question relates to the legality of the issue. If the figure of 3% is to be altered, should this not be enshrined in a new treaty?

Mr. McNally

If you were altering the reference values, but those reference values stay. This relates to the procedure of determining whether there is an excessive deficit and the action which must be taken in order to get back on side. The elements of the Stability and Growth Pact which are being changed relate to regulations and the code of conduct, the operation of the process.

Deputy Mulcahy

Is Mr. McNally saying that the figure of 3% is still law?

Mr. McNally

The 3% is stated in the protocol to the treaty and cannot be changed except by unanimity of all member states.

Deputy Mulcahy

My fear is that the Council, by rewriting the rules, will try to shimmy around that figure and negate what was established in the treaty. It should therefore be a matter for scrutiny by this committee because the people who voted for the treaty should be notified if this sort of development is happening.

Mr. McNally

There is no change to the figure of 3%. More time may be allowed to a country to get back under that figure. There may be special factors which put a country over 3% or close to it for a short period of time and it should be given extra flexibility in this regard. In no way are the rules regarding the figures of 3% or 60% being breached. It is a matter of procedure.

Ireland has high growth but low growth can be quite debilitating. This is certainly the case with regard to some other countries. The Stability and Growth Pact allows that where a member state suffers negative growth, which is defined as a reduction in GDP of 2%, it will not be pursued in respect of its excessive deficit. That particular criterion has been changed to accommodate periods of negative growth and sustained low growth. Zero growth for three or four years can be as debilitating as negative growth for one year.

It is correct to say that inflation will be affected if member states breach the 3% rule and that the lack of fiscal discipline affects the rest of us. We have a common interest in what happens with regard to this issue. The effect is likely to be in terms of the European Central Bank's view of interest rates and the inflation outlook. It is correct to say that this is a matter of common concern which is the reason the pact is referred to as such. It is an agreement between countries to try to co-ordinate their economic activity in the common interest.

In terms of debt levels for 2004, seven countries had less than 40% — Ireland being one of them; nine had between 40% and 60%; six had between 60% and 80%; Belgium had between 80% to 100%; and Italy and Greece had over 100%. Therefore, nine countries had more than 60% and 16 had less. I can supply this information separately to the committee. The Euro 12 average was 71% and the Euro 25 average was 64%. Quite a few countries are above the 60% reference value.

Deputy Mulcahy

It appears that new Europe is better than old Europe in terms of debt.

Vice Chairman

I see a press release being prepared.

Deputy Mulcahy

We could if the Chairman insists.

Mr. McNally

Government debt had less relevance in a Soviet context than in a non-Soviet context. They have very low levels of debt because they only had to tell banks to lend money to X, Y or Z. New countries such as Cyprus and Malta, which had a more capitalist system, have debt ratios of 60% and 70%. New Europe has a lower debt ratio for historical reasons. Even where countries are above the level of 60%, the reference criterion is that they are making satisfactory progress towards 60%. The rule is not absolute that a country is in breach once it reaches 60.1%. There is a table in the documentation which gives a deficit overview.

Deputy D. Wallace

I welcome Mr. McNally and thank him for his presentation. My question has already been answered but I would like to put it on the record. As Senator Dardis said, the Stability and Growth Pact has impinged on Ireland. The development of the Cork school of music did not proceed and was held up because it breached the pact. To a layperson it seemed the package was reformed when the big nations, such as France and Germany, came under pressure. However, smaller nations such as ourselves had to comply and it had implications for us, perhaps to our advantage. Nevertheless it would appear to the general public that when the pressure came Europe was able to reform the package to accommodate the larger nations' problems.

Vice Chairman

Senator Dardis made the same point in that there was preferential treatment in respect of larger nations. Has Ireland ever been really tested in terms of a slowdown in growth and how that might impact on our economy? Such a situation almost came to pass in 2002 and 2003, and there was much pressure at that time. We do not know how a slowdown might affect us. We are one of the most open economies in the world. The UK is not in the euro zone but is subject to the restrictions of the pact. If there is a slowdown in this country, the UK's position is much more flexible than our own in that it is outside the euro zone, and we are more vulnerable in that respect. Members have made the point regarding preferential treatment for bigger countries.

Mr. McNally

Reference was made to mortgage interest rates. One of the beneficial effects of the euro and the Stability and Growth Pact which supports it is the reduction in interest rates which took place over the period. We were 16% above Germany in the 1980s, which was unreal. That rate decreased and produced an enormous saving in terms of interest on the national debt. We figure that it freed up some €1 billion in resources since 1997 and these were used for spending and for tax cuts. There are different views regarding the use of such resources. Some people complain that we should have higher interest rates because of our high growth. Our mortgage interest rates are probably lower than they would otherwise be. However, that is the criticism of other countries which feel that we should put up interest rates because of the housing boom, but we cannot do this. Interest rates in the United Kingdom are double that in the euro zone.

We have some experience of the effect of a slowdown on growth, in that a surplus of 4% in 2000 disappeared in 2001 when our growth rates slowed down very quickly. That is part of the reason for keeping close to balance. If there is a sudden slowdown we can find ourselves close to the 3% limit and that is the reason for trying to keep to balance over the course of the economic cycle. We will have a surplus when times are good and a deficit when times are not so good, but on average we should try to stay close to balance.

It is difficult to gainsay the fact that if we have problems close to the 3%, we might not get the same understanding as others have experienced. The rules are the same for all but depending on the circumstances different views can be taken. It is the case that some countries were being proceeded against more actively than others. One might say that in the case of Greece, but the situation in Greece requires to be addressed because it has such a high deficit. It will not help that country if the position is not addressed in some way.

As I mentioned earlier, in talking about Germany and France we have to remind ourselves that growth in those countries is important for the rest of us. Requiring countries that have low growth to take measures that might depress it even more might not produce a result with which we would be entirely happy.

As I said at the outset, there are elements of judgment involved in this process. It is not totally mechanistic in its approach but it sets parameters, procedures and a process of peer pressure. That may be underestimated but my experience is that Ministers of Finance who attend the euro group every month find it uncomfortable if their colleagues continually say to them, "What is the problem? Why can you not do this and be like the rest of us? What is the solution?" The peer pressure should not be underestimated. I do not put it forward as the saviour of all but it has an effect. It can be difficult when Ministers have to explain the reason matters are not going the way they thought they would go six months ago.

Senator McDowell

One of the difficulties of the pact, and it will continue into the future, has always been the fact that monetary policy, largely determined by reference to an inflation target, is decided centrally by the bank, whereas policies that might stimulate growth are effectively the responsibility of national governments and therefore the business of local Ministers for finance. An institutional tension exists that is not resolved and probably not capable of resolution short of a European economic policy, and we are a long way from that.

I want to ask two specific questions, one of which is not specifically related to the growth pact but the current value of the euro. There appear to be very few indications of the competitive stress we thought we would suffer because of the effect of the high value of the euro on the Irish economy. Will Mr. McNally comment on that?

Second, the proposals for reform are not as explicit as we might have liked in terms of giving us the power to invest in public services, and particularly in infrastructure. Does Mr. McNally take that as being under the general heading of the need for a medium-term balance or is it more explicit than I could find in the reform package?

Mr. McNally

The ECB would say that low inflation is a prerequisite of growth. There may be more than one pathway to Heaven, so to speak, but stability and growth are the two elements. As Deputy Quinn would be aware from the discussions, there was a major debate on stability and growth in terms of whether stability is necessary for growth or vice versa. That was a key element in the final agreement.

On the current value of the euro, I do not have with me the figures on competitiveness but we have suffered a loss of competitiveness. Perhaps we have weathered that better than some might have expected, but we must continue to keep a focus on it because economic circumstances can change fairly quickly and dramatically.

On the investment element, the Council conclusions mention the extra flexibility. They state that each country should have a medium-term objective which would pursue a triple aim. In other words, instead of having zero for everybody there would be a range. They state that this limit should provide enough of a safety margin with respect to the 3% limit. In other words, countries like Sweden and Finland pursue surpluses. Because of their particular tax and welfare structure, if the economy drops their surplus will disappear very quickly. They will always seek a surplus. That is what is called a safety margin. It is a case of not getting too close to the cliff edge in case one falls over and trying to keep away from it.

The conclusions further state that they should also ensure rapid progress towards sustainability. As I understand it, that means that the extra flexibility is not used, for example, to reduce the retirement age. Measures should be taken that help sustainability. It further states that taking this into account, they should also allow room for budgetary manoeuvre, in particular taking into account the need for public investment. That is what is mentioned in the conclusions and that phraseology will be contained in the regulations also. There is a clear signal, therefore, that this extra room for manoeuvre takes into account public investment in particular.

Senator McDowell

Does that mean that in times of growth, such as we are currently experiencing, we are not governed as rigidly by the in surplus or close to balance requirement?

Mr. McNally

The regulations have to be agreed and accepted at the next ECOFIN and Council of Heads of State and Government. The procedure is that the range could be from minus 1% to 0%. We could put forward a case for flexibility up to minus 1%. That is a matter for the Government to decide and then that would be assessed in the context of stability and growth programmes where the other countries would say whether that is reasonable. There is a debate in the discussions on the regulations as to whether these issues should be set by the member state or presented by the member state and agreed by others. Going back to the notion of a common interest, we would be in favour of a situation where the member state would propose this and others would have a chance to say whether it is reasonable.

The next steps in the process will be for the flexibility to be provided, the Government to say it will use it, put it forward in the Stability and Growth Pack and for the Commission and others to say it is reasonable in that we have low debt, high potential growth and we are trying to address the problem of an ageing population. It is a process, although it is not a unilateral process in that others will have a chance. We say others should have the chance because——

Senator McDowell

Is that the measure of flexibility we are looking for — up to 1% deficit in times of growth?

Mr. McNally

The range is set from 0% to minus 1% and it would be the upper end of that range. In going towards minus 1% we have to examine the safety margin, which is a measure of how close we should get to the 3%. Our safety margin currently is minus 1.3% and the minus is within that, whereas Sweden's safety margin is a surplus and therefore the situation there would be different. Those safety margins are set on the experience of economic growth over a period of time and the effect it has had on the finances. In Sweden and other countries much of it is income tax and there are high safety nets. When the economy goes down, the revenue stops and the expenditure increases. That is a fact of life.

Deputy Quinn

My apologies for being late. I was negotiating a different kind of growth and stability pact of a more personal nature.

I have two questions for Mr. McNally. He will recall that one of the major factors of concern when the SGP was being negotiated was the initial effect of a default on the stability of the currency. The Italian economic performance is less than marvellous, to be diplomatic about it, yet it does not appear to have any effect on the strength or weakness of the euro. While the fears were predicated on an analysis of theory, practice seems to confront that. Has this been a matter for informal discussion among people such as Mr. McNally?

Do some Asian banks fear that if they use the euro as a reserve currency instead of the dollar they will undermine their own currency by selling dollars? These matters cannot be spoken about publicly by bankers but we need to know politically. What future does Mr. McNally envisage for the euro as a reserve currency and what timeframe does he have for it?

The euro started as a traded currency on 1 January 1999 which was also when the irrevocable locking of currencies to the euro occurred. Taking that as the commencement date of the euro, as opposed to the date of the launch of the notes and coins, I suggest that Mr. McNally and his colleagues should commission studies for its tenth anniversary. The enormous benefits of an end to currency fluctuation to this country and to Europe have blazed a trail and that path will be travelled by Mercosur countries such as Argentina or southern African countries. Anyone under the age of 33 does not really know what interest rate fluctuations are. One used to wake up in the morning to discover that one's mortgage had increased by as much as £200 or £300 and one was powerless.

Those are my three questions, on the Italian dimension, the reserve currency and any intention to analyse, celebrate and mark the tenth anniversary of this unique achievement of the European Union which has had more success than people thought it would.

Mr. McNally

Having been involved in the National Prices Commission during the 1970s when inflation rates were 23%, as a slightly older person I find it difficult to believe that 2% is considered to be inflation. Experience often dictates one's reaction. Deputy Quinn is correct. I remember times when the interest rates here were crippling and we were concerned with the effects on liquidity and interest rates of even small amounts being exchanged. Now one must pinch oneself to realise that. Undoubtedly what was undertaken in the run up to the introduction of the euro, such as reducing deficits, was of enormous benefit. The amount of resources freed up from the reduction in interest rates was not insignificant in terms of choices made available to Government.

The ECB publishes a report each year on the role of the euro. My best recollection is that it is making progress in playing a role as a reserve currency, but the dollar reigns supreme in some areas. Oil prices are denominated in dollars and it is difficult to envisage the euro taking over. Currency holdings of Asian countries are an issue. When the Koreans stated they would diversify their reserve holdings there was some worry about the effect it would have on the dollar. It did have an effect on the dollar and there may be a bind.

I am reluctant to speculate on the position of individual countries but new entrants to the excessive deficit procedure this year is an issue. Portugal is involved and the Commission has yet to confirm whether Italy has an excessive deficit. Quotes have appeared in newspapers but it has not yet made an official statement. Perhaps the people in mind when the Stability and Growth Pact was launched were not the Germans or the French as they were at the 3% level. They must have found it difficult to believe they were first into the dentist's chair.

It is possible to find good and bad aspects to this but from an Irish perspective the euro, the Stability and Growth Pact and the entire experience have been successful. It has not hindered us in any way nor has it reduced our potential growth. As a small country we will benefit from the increase in stability and certainty in an international context.

Vice Chairman

I thank Mr. McNally and Mr. Downes.

Sitting suspended at 2.56 p.m. and resumed at 3 p.m.