Mark Carney: The European Union, monetary and financial stability, and
the Bank of England
Text of the Cairncross Lecture by Mr Mark Carney, Governor of the Bank of England and
Chairman of the Financial Stability Board, St Peter's College, Oxford, 21 October 2015.
* * *
I would like to thank Ben Nelson and Iain de Weymarn for their assistance in preparing these remarks, and Aaron
Clements-Partridge, Rashmi Harimohan, David Ronicle, Thomas Smith, James Talbot, Ryland Thomas, Nicola
Anderson, Phil Evans, Richard Blows, George Murphy, Mike Flood, Peter Nagle, Nicola Shadbolt, Sinead Meany,
Jumana Saleheen, Dennis Reinhardt, Bob Hills and Siobhan Clark for their work preparing EU Membership and
the Bank of England.
1. Introduction
It is a great honour to give this Cairncross Lecture in Wren's exquisite Sheldonian Theatre.
Sir Alec Cairncross was a celebrated economist whose career bestrode public service and
academia.
Born to a Lanarkshire ironmonger in 1911, he rose, via Glasgow University and Cambridge,
to serve as the first head of the Government Economic Service and later, much more
illustriously of course, as Master of St Peter's College.
His work serves as a reminder of how enduring are the most trying economic questions we
face.
His PhD thesis, eventually published after great anticipation in 1953, concerned British
investment at home and abroad during the last great wave of globalisation - a Golden Era for
global commerce that stretched from Canadian Confederation to the eve of the Great War.1
His professional preoccupations included how international capital flows, trade and labour
mobility influence people's well-being.
These factors remain uppermost in policymakers' minds as they seek to secure the resilient
dynamism we all need for sustainable prosperity. And they are among the factors I want to
consider this evening in discussing the impact of the UK's European Union (EU) membership
on the Bank of England's objectives.
Today we are publishing a report that examines this question.2
I would like to be clear at the outset what this report is about, and what it is not.
Our report is solely concerned with how EU membership affects the Bank's ability to
achieve our core objectives of maintaining monetary and financial stability.
It is not a comprehensive assessment of the pros and cons of the United Kingdom
"being in Europe."
And for the benefit of those of you who join us from the ranks of the nation's press corps, I
say again that this report it is not a comprehensive assessment of the pros and cons of the
United Kingdom "being in Europe"!
Answering that question involves much, much broader issues. Issues for others to analyse,
describe and debate. And even those contributions will only be partial responses to a
question that only the British people can decide.
So if the narrowness of my scope disappoints, I would invite you sit back. Literally. Admire
the Sheldonian's ceiling. Marvel at how Wren's original design bridged such an expanse with
neither beams that could individually span its width nor floor-to-ceiling columns that could
support it. Reflect on the allegory in the paintings that shows Truth descending upon the Arts
and Sciences, expelling ignorance from the University.
While you do, I will attempt my more meagre exam question.
The Bank's very great - yet rightly circumscribed - responsibilities are formalised in the
remits of the three major policy-making bodies of the Bank - the Monetary Policy Committee
(MPC), the Financial Policy Committee (FPC), and the Prudential Regulation Authority
(PRA).
The MPC's remit requires it to achieve price stability, formalised as 2% CPI inflation, and
subject to that to support the Government's economic policy including its objectives for
growth and employment.
The FPC works to remove or reduce systemic risks with a view to protecting and enhancing
the resilience of the UK financial system as a whole, and is subject to the same secondary
objective as the MPC.
And finally, the Bank of England's PRA is required to promote the safety and soundness of
individual firms; to contribute to securing an appropriate degree of protection for insurance
policyholders; and, subject to that, to facilitate effective competition.
Price and financial stability, as well as safety and soundness of banks and insurers, are
essential macroeconomic pre-requisites for sustainable prosperity, but they are not sufficient
for its attainment. They are the foundations not the edifice.
The Bank's responsibilities are enshrined in statute. We pursue them under operational
independence and are accountable to the people of the United Kingdom through Parliament
for their achievement.
Effectively discharging our responsibilities requires a deep understanding of the forces
affecting the UK economy. EU membership entails some of the most important.
There are three ways in which EU membership affects the Bank of England's objectives:
 First, to the extent it increases economic and financial openness, EU membership
reinforces the dynamism of the UK economy. A more dynamic economy is more
resilient to shocks, can grow more rapidly without generating inflationary pressure or
creating risks to financial stability, and can also be associated with more effective
competition.
 Second, increased economic and financial openness means the UK economy is
more exposed to economic and financial shocks from overseas. As a result of closer
integration within the EU and, more recently, with the euro-area crisis, this may have
increased the challenges to UK economic and financial stability; and
 Third, EU regulations, directives and rules define many of the Bank of England's
policy instruments particularly in relation to financial stability. These must be
sufficiently flexible and effective to manage the consequences for the United
Kingdom of shocks originating at home and abroad.
All of these forces are in flux.
For the majority of the period since the UK joined the EU, the first factor - greater openness
and deeper integration afforded by EU membership - very likely increased the UK's
dynamism.
To be clear, by dynamism I mean the ability of an economy to grow and progress. Dynamism
is reflected in the rate of productivity growth, the degree of labour engagement, the pace of
new business creation and the rate of new innovation. In the period since joining the EU, the
UK has had among the fastest per capita growth rates in the G73 has consistently been one
of the top destinations for foreign capital amongst advanced economies as well as the top
destination for Foreign Direct Investment in the EU. Today, the UK economy stands as one
of the most flexible not just in the EU but across the advanced world.
Since the crisis began, the second factor - shocks arising from our biggest and closest
trading partner - has challenged UK dynamism and made it more volatile.
In the aftermath of the crisis, it is essential that the third factor - EU rules, directives and
regulation - continues to support the UK's ability to address risks to financial stability in the
future.
2. Openness, dynamism and stability
The UK is an open economy par excellence. In fact, the UK has bet on openness for almost
two centuries. A bet that has paid off handsomely.
From the repeal of the Corn Laws onwards, the UK has acknowledged that impediments to
free trade are seldom, if ever, "first best" responses to the many maladies from which market
economies can suffer.4
Where the UK has led, others eventually followed. In time, every major advanced economy
has come to embrace openness as a strategy to promote the well-being of its citizens.
Today, the UK's trade totals around two-thirds of its GDP (Chart 1). Its external assets and
liabilities exceed ten times GDP. And its share of global Foreign Direct Investment (FDI) is
around two times its share of global activity, accounting for the largest share of FDI into the
EU (Chart 2).
Its openness extends beyond the real economy to the financial economy.
The scale, complexity and degree of global activity of the UK financial system are unmatched
in the European Union (Chart 3). More foreign banks operate in the UK than any other EU
country, and more than half of the world's largest financial firms have their European
headquarters in the UK. The UK has the largest global share of cross-border bank lending,
foreign exchange trading, and OTC interest rate derivatives. It has the world's third largest
insurance industry and its second largest asset management industry. The UK banking
sector is four times GDP and non-bank financial institutions are a similar size (Chart 4), while
financial services accounted for 8% of output and around 31⁄2% of employment in 2012.
From this real and financial openness flow two important consequences for the UK economy
and for the Bank's objectives.
2.1 Openness and dynamism
The first is dynamism.
Cross-border integration of goods, services, labour and capital markets increases an
economy's dynamism through increased specialisation, enhanced competition, and greater
possibilities for diversification and risk-sharing.
Greater openness boosts the size of markets that UK households and firms can access. In
turn, trading in larger markets spurs innovation and promotes the adoption of new
technologies from abroad. It also intensifies competition and drives efficiency improvements
not least by allowing firms to exploit economies of scale.
The openness associated with the free movement of labour can help better match workers
with firms, alleviating skills shortages and boosting the supply side or the potential growth
rate of our economy.
And greater openness can enhance the allocation of capital by better matching lenders with
borrowers, potentially financing growth-enhancing investment. Foreign Direct Investment has
particular benefits. By creating stable and long-lasting links between economies, it assists
economic integration and boosts dynamism by establishing channels for technology transfer
and skills improvements.
The impact of openness on dynamism is not unambiguous, however. It depends on a range
of factors including an economy's factor endowments, the complementarities that exist
between these and its production technologies, and the correlation of shocks between the
domestic and world economies.5
Although openness supports dynamism, integration also brings greater exposure to foreign
shocks.
2.2 Openness and stability
Those observations point to a second important influence of openness on the UK economy:
stability.
As the UK has become more open over time, its interdependence with other economies,
including others in the EU, has increased.
For the macroeconomy, this has two opposing effects.
First, openness can enhance the investment returns and opportunities to diversify risks of
households, firms and financial institutions.
Well-managed openness can therefore grow wealth while enhancing risk-sharing, insuring
households' consumption, smoothing their working patterns, and augmenting their borrowing
and saving opportunities.
That insurance helps people plan for the future in the knowledge they'll have to change their
plans less abruptly when the unexpected happens.
The flip-side is that openness can change the nature of the unexpected itself, altering the
type and scale of shocks hitting the economy.
For example, the complexity of financial linkages can grow and become more opaque,
creating new vulnerabilities and more severe shocks.
And openness has the potential to exacerbate existing distortions or inefficiencies. In times of
euphoria, foreign capital can flood in and amplify domestic trends. The speed of its flight
when passion turns to panic can then deepen the bust that follows boom.
Most obviously, openness ties the fates of trading nations together.
That can mean a "second engine" for growth from abroad. But it can also mean a dragging
anchor when things go awry across borders.
3. Role of the EU in UK dynamism and stability
How has the EU affected the UK's dynamism and stability? Let me begin with the first.
3.1 Role of EU in UK dynamism
In some respects the UK is the leading beneficiary of the famous "Four Freedoms" first set
out in the 1957 Treaty of Rome.6
These are the free movement of goods and services, capital and labour, enhanced over time
through a range of measures to reduce impediments across the EU.
So although the UK's dynamism is the product of many factors including deep human capital,
well-developed physical infrastructure, a competitive fiscal regime and the rule of law; the EU
has arguably bolstered it by establishing the world's largest single market with free
movement of goods, services, capital and labour.
The UK has further benefited from these dynamics by retaining relatively flexible labour and
product markets.
In product markets, home and foreign firms receive close to equal treatment; the
administrative burden on start-ups is second lowest in the G7; incumbent firms receive the
lowest regulatory protection in the G7; and product market regulation is light (Charts 5-8).
Partly as a result, in 2012 the UK economy created firms at more than three times the rate of
the US.7
Taken together, these measures promote competition and spur innovation which ultimately
benefits us all.
And the UK has managed to combine some of the most flexible labour markets in the G7
with some of the most cooperative labour relations (Charts 9-10).
This relative labour market flexibility helps the economy to absorb shocks, illustrated by the
experience of the Great Recession. UK unemployment rose by less than in the US, and has
fallen faster than in the euro area. Since the start of the Global Financial Crisis, UK jobs have
grown 3 percentage points more than the US.
Moreover, people's attachment to the workplace has remained broadly intact. Compare that
with the case of some euro members, where youth unemployment in particular has been
devastatingly high, and with the US, where there was an unexpected rise in worker
discouragement, with many working age adults exiting from the labour market altogether.8
This out-performance is positive for the UK's dynamism in the medium run.
More to the point, that means more people in work, building not losing skills, with real
prospects for higher wages and better living standards.
That is important because the UK still has work to do to close the gap between its
productivity performance and the world frontier, defined by the United States (Chart 11).
However, over the broad sweep of its EU membership, the UK's productivity growth
performance compares favourably. And its potential growth is at the top of the class of the
major advanced economies.
An important driver of that dynamic has been FDI. Since the establishment of the single
market in 1992, the UK has been the top recipient of foreign capital in the EU.
Evidence suggests that the openness of EU economies to foreign investment has improved
firm-level productivity both through technology transfer and enhanced management practices
(Chart 12). This has likely been complemented with labour flows leading to better-matched
skills.
Broadly speaking, the evidence suggests that UK has successfully harnessed the benefits of
openness afforded by its EU membership while avoiding some the drawbacks of reduced
flexibility from which some continental European economies suffer.
3.2 Role of EU in UK stability
If the impact of EU membership on openness and dynamism is relatively clear, its effect on
stability is more complex.
Greater dynamism makes a given burden of debt easier to service, enhancing resilience to
shocks. And the common rules and diversification afforded by EU membership bring the
potential for financial stability benefits.
But there have also been challenges.
Greatly increased financial openness, in part associated with EU membership, has made the
UK financial system larger, more complex and more exposed to shocks from abroad.
These developments reinforced domestically generated vulnerabilities in the run up to the
Global Financial Crisis. The UK, along with many of its main international partners, lacked
the institutions and tools for managing and addressing them when they crystallised.
As a result, when the crisis hit, global shocks were transmitted virulently across borders,
doing great damage to the financial systems and real economies of many countries. The UK
was particularly affected given its high degree of financial openness.
Most recently, challenges arising from European Monetary Union (EMU) have been
particularly evident. Our ties are close. 40% of our exports go to the euro area, and major
UK-owned banks have financial exposures to the euro area totalling almost twice their
capital, worth a quarter of UK GDP.
These figures underscore the importance to the UK of further building the resilience of the
euro area as part of a strengthened European Union.9 In this regard, the progress made in
recent years is particularly welcome. Nonetheless, as highlighted in the European
Commission's "Five Presidents' Report", the euro area remains "unfinished business."10
Actions to complete European Monetary Union should be taken with regard to their impact on
all members of the European Union. From the Bank of England's perspective, steps to
ensure financial stability for those within the euro area should not impede the achievement of
financial stability for those without, including the United Kingdom.
4. Impact on the Bank of England objectives
So what does this analysis means for the achievement by the Bank of its statutory
objectives? Let me begin with monetary policy.
4.1 Monetary policy
Put simply, economies with sustainable dynamism can grow more quickly before running into
excessive price pressures. The UK's greater openness as a result of EU membership
provides potential for both greater growth and shocks.
The MPC naturally takes these into account when setting monetary policy for the UK. While
they have posed challenges at times, the influence of EU membership on these dynamics
does not prevent the MPC from achieving its price stability objective.
Under inflation targeting the MPC has ultimate control over the UK's nominal destiny,
allowing the flexibility of the exchange rate and free capital flows to facilitate adjustment to
global shocks.
The precise path of that adjustment is a policy choice we are free to make, within the
framework provided by our monetary policy remit.
For example, at the onset of the crisis, a large adjustment of the UK's real exchange rate
was necessary to rebalance from domestic to foreign demand, reflecting the severe
headwinds to domestic growth from deleveraging by UK households.11
The consequences of this real adjustment for inflation depended on the monetary policy
response. The MPC was able to strike an appropriate trade-off, consistent with its remit,
between the needs to stabilise inflation and to avoid undue volatility in employment and
output. Some have put this more colloquially as "looking through" the effects of sterling's
depreciation on inflation on this occasion.
More persistent shocks require monetary accommodation. For example, the euro area's
difficult sequence of internal price adjustments, together with its overall fiscal restraint and
tight credit conditions, imparted persistent headwinds to UK growth, and, had they not been
addressed, on inflation.
Those headwinds contributed to a persistent lowering of the "equilibrium" interest rate in the
UK - the rate required to maintain demand in line with potential. That called for Bank Rate to
be held lower for longer in order to lean against the disinflationary impulse emanating from
abroad. And low real rates have had to be complemented by targeted macroprudential
measures to insure against the risks of excessive indebtedness.
Both of these points illustrate that the UK's openness is central to the deliberations of the
MPC in formulating monetary policy strategy. But neither openness nor any obligation of EU
membership ultimately prevents the MPC from doing its job.
4.2 Financial stability
The impact of EU membership on financial stability is more challenging.
Given the close integration of the UK financial sector with the rest of the EU, it is imperative
that the EU has a robust regulatory framework. This is in the process of being achieved.
Through its membership of the EU, the UK is promoting a strong global regulatory
framework, and UK authorities have worked in close concert with our European partners to
find solutions to the fault-lines of the past. Examples include moves to end Too Big To Fail by
enhancing bank recovery and resolution, a solution developed locally at the Bank of England,
implemented regionally in the European Union, and now agreed globally through the
Financial Stability Board.
Given the scale of the UK's financial sector relative to its economy, the Bank of England also
has a special responsibility to the UK, to Europe and the world. The UK must ensure that the
system is robust to shocks and that financial institutions can be resolved in an orderly
manner.
After all, financial stability is a national responsibility, with the UK taxpayer serving as the
ultimate backstop of the UK financial system.
The comprehensive reform of the UK's institutional framework for financial stability since the
crisis creates a coherent architecture of national macroprudential and microprudential
regulators and supervisors. This is now commensurate with the scale and nature of the risks
that the UK's high degree of financial openness can pose. And it provides the foundations for
the UK to remain the world's leading international financial centre, one which can safely be
home to the largest global, systemically important banks and insurers.
The effectiveness of our reformed domestic framework for financial stability depends in part
on the quality of financial regulation set at the EU level as well as the flexibility we have to
apply that regulation to meet the UK's specific financial stability challenges. In the main this
combination has been achieved thus far.
However, there have been some limits on flexibility in certain areas, including:
 a bonus cap restricting the proportion of pay that can be clawed back in the event of
excessive risk taking or poor conduct, thereby weakening discipline from
remuneration;
 trigger thresholds for contingent convertible capital instruments that some may judge
too low; and
 a reduced role for national discretion in insurance supervision.
While common international standards and effective EU rules should continue to support the
operation of the single market, it is imperative that UK authorities, including the Bank of
England, continue to retain the flexibility to impose the high standards necessary to manage
the world's leading global financial centre.
This flexibility may be challenged by how EU financial regulation evolves. Ensuring the Bank
of England has the instruments necessary to achieve its financial stability objective will
depend on the EU continuing to have regulations of the highest standards, which strike the
appropriate balance between harmonisation and flexibility, and which accommodate
necessary national responsibilities, including for supervision.
5. Principles of a new settlement for financial stability
A successful and sustainable Economic and Monetary Union is important for the dynamism
and stability of both the euro area and the UK. Since the crisis, many euro-area economies
have undergone difficult reforms to improve competitiveness. Adjustment mechanisms to
address the underlying problems of the euro area have been built, including measures to
create a Banking Union and the development of the European Stability Mechanism, a
permanent crisis resolution facility for euro area countries.
Although much has been accomplished, further financial and fiscal integration within the euro
area will be necessary to put EMU on a more sustainable basis. In particular, closer financial
integration requires increased risk sharing in the public and private sector. That risk sharing
can be achieved by the development of the more complete Banking Union in the euro area
and, more broadly, a Capital Markets Union for the EU.
How financial regulation in the EU evolves in future will be critical to the resilience of both the
euro area and the UK economy. Closer union between euro-area member states is likely to
necessitate further harmonisation of financial regulation across the euro area. By extension,
those regulations can affect the rest of the EU.
In that light, it is important that any future EU legislative measures, designed to meet the
needs of deeper integration in the euro area, do not adversely affect the Bank of England's
ability to ensure the stability of the UK financial sector or compromise the single market.
It is desirable, particularly given the weight of the ECB and of the members of the single
currency within the EU, that there are clear principles to safeguard the interests of non-euro
member states.
The future direction of EU financial reform should recognise that the EU comprises multiple
currencies with multiple risks.
Such principles would enable the Bank of England to continue to ensure that EU
membership contributes fully to the attainment of the Bank's statutory objectives.
***
Overall, EU membership has increased the openness of the UK economy, facilitating
dynamism but also creating some monetary and financial stability challenges for the Bank of
England to manage. Thus far, we have been able to meet these challenges.
Our efforts have been helped by the strong domestic framework for financial stability that has
been put in place post crisis. Going forward, these should be further buttressed by an
evolution of the EU regulatory framework that continues to work for all members of the EU.
The increased resilience that brings is a necessary condition for dynamism. And a dynamic,
resilient domestic economy will enhance the prosperity of the people of the UK and beyond.
And for those still looking upwards in wonderment? The genius of Wren's ceiling was its
inspired interlocking beams, individually insufficient to span the Sheldonian's diameter, but
collectively arranged so that each could support another, perfectly balancing the forces of
those pushing down with others pushing up, resting, ultimately, on the foundations Wren
began in 1664.
And this is the architecture of Europe: a single market whose participants are interlinked,
relying on and complementing each other. Just as Wren's wooden lattice supports Robert
Streater's art, this market network supports the creativity of Europe. Of course, the weight of
the ceiling doesn't disappear but rests on hidden foundations. So too does the single market
rely on invisible supports, some of which are the responsibility of the Bank of England and
European regulatory authorities. While these foundations have worked well thus far, they
may in time need to be buttressed to realise the full creative potential of the peoples of the
United Kingdom and Europe.
Charts
Chart 1: UK trade is two-thirds of GDP Chart 2: UK receives largest share of EU FDI(a)
Source: OECD (a) EU-15 countries' share of average annual FDI inflows into
the EU: 1993 to latest.
Source: UNCTAD.
Chart 3: Global activity of UK financial system Chart 4: ... and UK financial system is very
unmatched in the European Union... large relative to GDP(a)
Notes: Bars show share of global activity for cross-border Source: Radcliffe Report (1959), Wilson Report (1980), ECB,
lending, interest rate OTC derivatives and foreign exchange OECD, Swiss National Bank and Bank calculations.
and share of global assets for all other categories.
Cross-border bank lending and mutual fund asset data are
from 2014; all other data is from 2013.
Source: BIS, City UK, IMF's GFSR, Bank calculations.
Chart 5: Foreign suppliers receive close to Chart 6: UK administrative burden on
equal treatment to domestic firms in the UK(a) startups second lowest in G7(a)
Source: OECD (2013), Product Market Regulation Database. Source: OECD (2013), Product Market Regulation Database.
Chart 7: Incumbent firms least protected in Chart 8: UK product market least heavily
UK(a) regulated in G7(a)
Source: OECD (2013), Product Market Regulation Database. Source: OECD (2013), Product Market Regulation Database.
Chart 9: UK employment protection in middle Chart 10: ... while securing favourable
of the G7 pack(a)... labouremployer relations compared to Japan and
Germany(a)
Source: OECD Employment Protection Legislation. (a) Indicator based on responses to the following question in
the WEF Executive Opinion Survey: "In your country, how
would you characterize labour-employer relations? (1 =
generally confrontational; 7 = generally cooperative)".
Source: WEF Global Competitiveness Report 2014.
Chart 11: UK still has work to do to close the Chart 12: Firms report FDI as a channel for
gap between its productivity level and world technology transfer, particularly in the UK(a)
frontier, but growth since 1970 compares
favourably(a)
(a) Output per hour measured in 2014 US$, with price levels (a) Indicator based on responses to the following question in
converted using 2011 PPPs. the World Economic Forum Executive Opinion Survey: "To
Source: The Conference Board Total Economy Database. what extent does FDI bring new technology into your country?
(1 = not at all; 7 = to a great extent - FDI is a key source of
new technology)".
Source: WEF Global Competitiveness Report 2014.