Hamish McRae: ECB's real-life monetary policy experiment may have lessons for UK

There is not much dispute that core Europe could do with higher interest rates. Or to put the point slightly more softly, the main economies could stand a further modest rise in what are still negative interest rates in real terms.

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And so it was yesterday. You can see the logic behind the increase in the European Central Bank's main refinancing rate in the two graphs. On the top you see that economic growth for the eurozone as a whole may have slowed a little from the initial post-recession bounce, but it is decently positive, ticking along at an annual rate between 1.5 and 2 per cent.

The three leading economic institutes on the Continent, IFO in Germany, Insee in France and Istat in Italy, came out with a new forecast yesterday. They note that growth is moderating after a strong first quarter but they expect it to continue at 0.4 per cent through the second half of this year, or an annual rate of 1.6 per cent. For the year as a whole, thanks to the strong first quarter, growth could be around 1.8 per cent. That may not sound a lot but it is probably about the long-term growth potential for the eurozone. There is a separate debate to be had as to why growth in Europe is not higher and what might be done to lift it, but that is a long-term issue and far beyond the scope of the ECB.

The bottom graph gives a perspective on the rise in interest rates from Citicorp. If the capacity of the eurozone economies is running close to its long-term average then that is a prima facie case for a neutral monetary policy. Short-term rates ought to be mildly positive in real terms. But as you can see, they remain solidly negative, as they are well below the rate of inflation – not as far below inflation as they are in the UK, but that is our problem. Meanwhile, capacity utilisation is pretty much back to normal. So the ECB president, Jean-Claude Trichet, is quite right to be hawkish. Expect a further rise in rates in October.

What does this do for the periphery? Viewed from a British or North American perspective, you would say that any rise in rates would be damaging to countries with stagnant economies. That, after all, is the argument against a rise in rates here or indeed in the US. There must be some merit in this, for at the margin, higher rates ought to slow the economy.

But whether it really does much to damage Greece, Ireland, Portugal and the other struggling economies is open to question. Their problems are much bigger and really turn on the fact that they are unable to borrow any money on the bond markets. The people who might lend to them think they are likely to default on their debts, and so to lend would be irresponsible. It is a point worth making again that while we read of the interest rate on Greek debt being 18 per cent or 22 per cent or whatever, that is only the notional return on existing debt: what you will get if you buy Greek debt on the markets, assuming they keep up the payments. It is not the rate on new debt because they cannot sell any.

You have to see the crass comments from the European politicians attacking the credit rating agencies in this context. You can see why they are upset that despite all their assurances the agencies saw fit this week to downgrade the debt of Portugal. This does create a technical difficulty for the ECB in accepting downgraded debt as collateral for cash. It may be that, having been over-optimistic in their credit-ratings three or four years back, the agencies are now being overly pessimistic.

But in attacking the agencies the politicians make themselves look silly. They show how little they understand about finance. It is potential investors they have to impress – and the more they bang on about the iniquity of it all, the more likely investors are to run scared. You don't get a mortgage by slagging off the building society's assessor.

Three things worry me.

One is that the bond markets will remain closed to the countries that have been bailed out for a long time. It could be five years or more. If that is right you have to ask whether the eurozone authorities will be prepared to carry on providing them with what will really be indefinite finance. Paradoxically, the more they rely on Europe to fund themselves the longer other investors will shun them: eurozone support creates an artificial market that excludes mainstream investors.

The second concern is that the present rumbling doubts about other eurozone countries will become deafening. Spain is obviously in the firing line, but so too may be Italy and Belgium. The risk of having to take "a haircut" (ie not be paid back in full for the money you have lent) may be small, but if you are investing pensioners' money are you carrying out your fiduciary duty to look after their capital? There is an interest rate that might compensate for the risk, but that rate may be too high for the country to afford. Why lend to Italy when there is a chance, however small, that you may not get your money back?

The third concern is that businesses in the weaker eurozone countries will be penalised by having to pay more for their capital. Rationally, a well-run Spanish bank should not need to pay more for funds than an equally well-run German one, but investors may not be rational.

The encouraging news in all this is that the euro itself has been remarkably solid throughout. You read stories of it being under attack on the exchanges, but the reality is that it has performed better in recent months than sterling or the dollar. It is to the considerable credit of the ECB and Mr Trichet personally that the currency should be so staunch. You still lose money by holding euros, for that is a mathematical inevitability while interest rates remain below the rate of inflation. But you would lose a lot more by holding sterling or even dollars.

A footnote on the position of the UK. The data remains confused, with a bounce back in manufacturing output in May after the April fall (associated with the extra bank holidays) and a continued slow recovery estimated by the National Institute. The great question – sharpened by this rise in eurozone interest rates – is whether economic policy is having much effect on growth either way. We have a tightening fiscal policy and a still-loose monetary one. A commonsense reaction to that would be to say that they cancel each other out – and there is nothing wrong with common sense. But the high inflation associated with the loose monetary policy is cutting real incomes and hence reducing consumption. So it may be less effective than it says on the tin. The key indicator remains employment. If the economy is still creating new jobs we can relax a little. Fingers should remain crossed.

Looking ahead, the ECB decision to keep nudging up interest rates will turn monetary policy into something of a real-life experiment. Of course it is not a controlled one and you never know the counter-factual: what would have happened if another policy had been adopted. Still, the US and the UK have followed one course; Europe is following another. If in the months ahead the European recovery becomes more secure, then economic theory will need some rewriting.