Interest-rate rises versus the public interest

In going along with rate rises, European governments are saving the European Central Bank—not their societies.

The current mix of high inflation and recession in Europe has put any green, leftist or social-democratic party in an unenviable position. The European Central Bank is raising rates and there is nothing politicians can do about it. At the same time, these very same rate rises prevent meaningful public investment, as the costs of government borrowing rise too.

The mainstream, centrist view is that one can only hope to provide a temporary, targeted cushion to vulnerable households. Any other spending plans are quickly deemed implausible or irresponsible by fiscal hawks, who point to rising bond yields as seemingly incontrovertible evidence.

Yet enthusiasm for raising rates in a recessionary environment is only one of the many contradictions at the heart of European monetary and fiscal policy. If these are not solved, poverty, inequality and social insecurity are bound to rise.

Incoherence and deadlock

Why is this contradiction allowed to play out? The answer is part conceptual, part institutional.

Conceptually, it is accepted that inflation is driven by supply issues related to the war in Ukraine, as well as pandemic-induced disruption of supply chains. But contemporary public financial institutions—including central banks—are designed to tackle demand-driven problems, such as economic overheating or a wage-price spiral.

These distinctions may not be clear to the general public, which enables central bankers and politicians endorsing rate rises to elide supportive claims about ‘pent-up’ demand going back to the Covid-19 fiscal stimulus, the current threat of a wage-price spiral (for which there is no evidence) and future expectations that inflation will rise. The conceptual incoherence is compounded by the institutional deadlock, described by Daniela Gabor, in which the ECB is trapped.

Appropriate response

The bank fears the dominance of fiscal over monetary policy, as in earlier Keynesian times. It knows that it cannot do anything about the sources of inflation. Yet it is not ready to condone an appropriate institutional response to the crisis, in the (Keynesian) form of public investment, which would require holding rates or pinning down bond yields.

Europe faces the challenge, on the supply side, of having to reorient its entire energy regime, unimaginable without large-scale fiscal-policy commitment. The ECB might hope that the energy transition would be carried out by the private sector. But then another contradiction arises: how can such investment be induced by raising the cost of capital?

The ECB speaks about engaging in swift action in an uncertain environment, as if this justified rate rises. Yet swift action is actually needed by eurozone governments—the only entities able to mobilise resources on a sufficiently large scale—and the bank’s activity effectively prevents it.

Contradiction turns into hypocrisy when central bankers speak about the need for policy alignment among the various actors. For it is difficult to work with someone who insists that they, and they alone, can set the course of action while no one else can tell them—being ‘independent’ of accountability—what to do.

European governments are like hostages given a false sense of agency: they act seemingly guided by their free will, when in reality everything is already determined for them. In a recessionary environment, they should be thinking about the appropriate size of a compensating fiscal stimulus, yet instead they are thinking about how to keep the stimulus as small as possible.

Perverse outcome

The final contradiction concerns the intended versus possible outcomes of raising rates. They are supposed to bring down inflation by making new investment more costly, alongside the increased expense of servicing debts. This drains some demand from the economy and reduces the volume of investment, recalibrating expectations of growth, and price rises, and thus wage demands.

As noted, this mechanism works as intended when inflation is demand-driven. But when prices rise due to supply issues (the elevated cost of energy in this case) demand is already becoming drained. And raising interest rates, instead of depressing inflation, could add to it in at least two ways.

First, interest paid by governments will necessarily increase. Unless governments are then willing to tolerate spending cuts, in an already recessionary environment, this will necessitate additional public spending and so borrowing. This in turn will increase inequality—the higher interest payments flowing to well-off bondholders—without adding to the productive capacity of the economy (as would additional public investment).

Secondly, while raising rates should eliminate any risk of a wage-price spiral, as businesses cut investment and unemployment increases, moderating the bargaining position of labour, it also increases households’ debt-servicing costs. And while lowered union density would militate against effective wage demands, well-paid professionals who tend to have bigger mortgages and debts will likely see a bigger rise in interest payments in absolute terms—and are in a better bargaining position to demand higher salaries.

Thus, raising rates may produce the very outcomes it supposedly seeks to tackle.

Policy mix

For the political left, the alternative policy mix should be clear: in the short-term keep rates low (and co-ordinate this globally to prevent their competitive elevation), provide income support to low- and medium-income households, so as to sustain demand, and offer transparent aid to businesses to ensure competitiveness. In addition, introduce a windfall tax on profits enjoyed by the fossil-fuel energy sector. The aim should be to ensure economies are ready to bounce back in the spring and growth can resume, rendering any worries over slightly increased public debt irrelevant.

The long-term goals should be clear to everyone, regardless of political position, who does not work in the fossil-fuel industry: invest in renewable-energy capacity, the energy efficiency of buildings and environmentally sustainable public-transport systems. Public finance will play a major role in this task, even if the financial ‘plumbing’ is more complicated—involving public development banks, public-private partnerships and so on.

But these measures will be difficult to implement if the alpha and omega of policy is instead to be the maintenance of central-bank ‘credibility’. Rather than accept its institutional shortcomings, the ECB is doubling down, reflecting the austerity bias inbuilt in the European Union since the Maastricht treaty.

The credibility of the bank could thereby be saved only at the expense of that of democratic political institutions—governments and parliaments. The current energy crisis is thus not just about inflation. It is about redesigning our governance institutions to ensure democratic accountability and a fair distribution of resources.