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Thursday, 5 July, 2001, 13:04 GMT 14:04 UK
Treasury doubts on the euro
The European Central Bank building
The European Central Bank - still learning?
The Treasury mandarin in charge of deciding whether the UK should join the euro has expressed doubts about how interest rates are set in the eurozone.

Sir Edward George and Gordon Brown
Do the two work in tandem?
Gus O'Donnell, the head of the government economic service, said that coordination between finance ministers in the 12 eurozone countries, and the European Central Bank (ECB), which sets interest rates, was still evolving.

He argued that the UK system - where the Treasury sets the inflation target, and Mr O'Donnell sits as treasury representative at the Bank of England's Monetary Policy Committee - was more effective in avoiding conflict than the arrangements used in the eurozone.

In Europe, the ECB has its own independent inflation target - currently 2% - which is not set by politicians.

And he warned that the difficulties of forecasting the future course of public spending in the eurozone could lead to problems for the ECB in setting interest rates.

Mr O'Donnell, in a rare public appearance, was speaking at the Institute for Fiscal Studies, the main think tank that analyses UK government spending.

Tandem bicycle

Mr O'Donnell likened the UK system of coordinating fiscal and monetary policy to a tandem bicycle, where the Bank of England was in the driving seat, but sometimes had to put on the brakes if the Chancellor tried to pedal too hard.

He contrasted that to the eurozone system, where 12 finance ministers try to sit on the back of the tandem bicycle and push in different directions.

He said that there was a problem coordinating fiscal policy across 12 countries which may be at different stages of the economic cycle, that added to the problem that finance ministers and central bankers may not be working in harmony.

Mr O'Donnell expressed the hope that eurozone finance ministers might adopt some of the UK's conventions in measuring public spending, which take account of inflation and the effects of the economic cycle as well as the difference between investment and current spending.

Symmetrical target

Mr O'Donnell's scepticism echoes the fears of his boss, Chancellor Gordon Brown, about early UK entry into the eurozone.

Last month Mr Brown ruled out a quick referendum on the euro, and hinted that the Treasury would only publish its assessment of whether the UK economy would benefit from UK membership in two years' time.

Mr Brown has also expressed concerns about the lack of accountability and transparency at the ECB, which unlike the Bank of England does not publish the minutes of its meetings or appear before national parliaments.

Mr Brown was worried that the ECB's sole objective is keeping inflation low, whereas the Bank of England has a symmetrical inflation target, forcing it to take action if inflation is too low as well as too high.

Economic shock

Mr O'Donnell told BBC News Online that the main advantage of the symmetrical target was that it allowed the Bank more flexibility in setting rates without damaging its credibility.

But he admitted that there could be a conflict with the Treasury if the economy suffered a shock, for example, the collapse in the value of the pound.

In that case, the Bank and the Treasury might take a different view of how quickly it was necessary to deal with the inflationary threat, and raise interest rates.

However, Mr O'Donnell pointed out that the external value of the pound was now the Bank's problem, not the Treasury's.

Credibility

Mr O'Donnell argued that the effective coordination between the Treasury and the Bank of England had increased the credibility of government economic policy.

And the success had altered people's expectations about inflation, so that long-term interest rates in the UK were now below those in Germany and the United States.

So far, UK inflation has kept within its target range - which Mr O'Donnell admitted was a relatively arbitrary number - and the Bank has not had to write a letter of explanation to the Chancellor.

And so far, the Treasury has kept the public finances under firm control.

But in the next planning period, pressures on the system could increase as the government faces a choice between higher spending, higher taxes, and more borrowing.

If it is coupled with an economic slowdown, it could provide a real test of the effectiveness of the new system of economic governance created by Labour.

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See also:

04 Jul 01 | Business
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05 Jul 01 | Business
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05 Jul 01 | Business
European interest rates held steady
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