Business

European interest rates: A tale of two cities

German flag and union flag
Image caption There are real differences in economic policy between Frankfurt and London

It was the best of times, it was the worst of times.

It sounds like a good start to a book, but it is also not a bad description of the current state of the economy across Europe.

Yet for all the talk about the crisis in the eurozone, especially in Greece, Portugal and the Irish Republic, it is interesting that the real difference in European economic policy is not inside the eurozone but between Frankfurt and London.

In London, the Bank of England left interest rates unchanged at 0.5%, an historic low that it has held for well over two years. That is despite the fact that inflation in the UK is running at more than double the Bank of England's target and could rise further.

In Frankfurt, the European Central Bank increased interest rates for the second time since April, to 1.5%, as it worried that inflation, at just 2.7%, was well above target and may become established in the eurozone.

The reason for this apparent contradiction in the actions of those most conservative and uniform of people, central bankers, is quite easy to explain though.

Yesterday, the German government published its draft budget, which showed that unemployment had fallen so far and tax receipts risen so fast that it will pay off its debts even faster than previously hoped - by another 4bn euros ($5.7bn; £3.6bn) next year alone, and it might even be able to afford some tax cuts in the near future.

Germany would be looking even more robust if it did not have to find billions more to bail out the weaker areas of the eurozone. If German workers start to think that they are entitled to some of the rewards for that performance and demand wage rises to make up for rising prices, inflation may well become established in the eurozone.

Image caption Germany's economy is powering ahead

The ECB is acting now to try to stop that happening, regardless of the cost to Athens, Dublin and Lisbon.

In the UK, the NIESR (a well-respected economic think tank) is predicting that economic growth for the second three months of 2011 will be 0.1%. The actual figures will be announced on 26 July, but if the NIESR is right it means UK economic growth will have been as flat as a pancake for nine months.

It will also start to put pressure on the chancellor, whose plans to repay Britain's debt mountain are based on a growing economy.

The Bank of England is keeping interest rates low here because workers are probably unable to demand pay rises anything like as high as inflation, and because encouraging economic growth is seen as more important than fighting inflation at the moment.

All of this does not, of course, mean that all is rosy in the eurozone, far from it.

For the Irish Republic, Greece and Portugal, which are struggling under a mountain of debt, having to be bailed out and facing seemingly endless austerity measures, an increase in the cost of borrowing is about as welcome as an invitation to inspect the guillotine blade a bit more closely.

But the ECB has to look at the whole eurozone and make its decisions based on that, and it has decided that fighting inflation is a far, far better thing to do.

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