Hamish McRae: Don't worry about eurozone rate rises - it's growth that's the problem

A week from now the European Central Bank will increase interest rates, for at last the eurozone economy is deemed strong enough to stand it. Or at least that is what has been strongly hinted at by its president, Jean-Claude Trichet, and so is the overwhelming expectation of the markets.

In one sense it is good news. The remit of the ECB is to maintain inflation below 2 per cent but it has consistently failed to do so. So by rights it should have increased rates much sooner to try to curb it. But it has been inhibited by poor eurozone growth. So increasing rates is a sign of confidence. M. Trichet also made it clear, speaking to a European Parliament committee on Monday, that this is not the start of a series of increases on the lines of the US Federal Reserve. And he pointed out that eurozone interest rates would still be very low.

All that is very sensible. European interest rates are indeed low by any standards. The ECB rate of 2 per cent has not changed since June 2003. The neutral rate - the rate where monetary policy would neither stimulate the growth of the economy nor inhibit it - is calculated to be about 3.5 per cent. Capital Economics reckons that rates will indeed rise to this level over the next year, but acknowledges this is somewhat higher than the markets expect.

At the moment, real interest rates (ie allowing for inflation) are either very low or actually negative depending on how you calculate them, as the first graph shows. If you deflate the rate taking headline inflation, they are negative and have been for a couple of years; if you take core inflation, they are only about 0.5 per cent.

There have been the inevitable rumbles about the forthcoming rise but it is very hard to argue that, taken overall, eurozone interest rates have been a serious drag on growth. Rates may have been too high for Germany and too low for Spain and Ireland but overall they cannot have been the core problem.

But growth is a problem and one that has repeatedly disappointed. The next graph, from Barclays Capital, shows the ECB projections for growth - as you can see all the lines slope downwards, as the bank has had to cut its initial forecasts as each year develops. To print this is not particularly to get at the ECB, though it is the best example I know of serious economic forecasters being unable to learn from their past mistakes. It has, incidentally, not been too good on its inflation projections either, as the last graph shows.

The real point is that there seems to be a greater bias against growth in the eurozone than anyone could believe possible.

The problem is domestic demand. European companies are doing well, as the rising share markets reflect. Exports are fine, with Germany passing the US last year as the world's largest goods exporter and this year growing quite well on the back of export demand. French exports have been fine too, helped as are Germany's by the fall in the euro against the dollar this year.

But domestic demand is flat. What is to be done?

I suspect this will become a really big political issue across Europe over the next year. Is it tax? Mervyn King, the Governor of the Bank of England, blames the slowing of the growth in domestic demand here on rising taxation and it would figure for Germany. Not only have taxes drifted up but they are set to rise further under the new - and pretty bodged - economic programme of Angela Merkel's coalition. You cannot get out of paying taxes, so the threat of higher tax makes people more careful about their discretionary spending. Consumer spending has fallen in Germany for the past nine months.

Tax must have something to do with this reluctance to spend but I cannot believe that is the whole problem. Growth in consumption is quite high in much of Scandinavia and Spain, the former at least a high-tax zone. I suspect it has more to do with the lack of innovation, the relatively low level of business start-ups and the emigration of young graduates - all associated with the lack of competitiveness that the Lisbon agenda was supposed to tackle. Countries that have been successful at innovation, most obviously in Scandinavia, have been successful at growth - and vice versa.

If this line of argument is right, then a rather different set of reforms are needed than the conventional ones of the Lisbon programme. Instead of more public spending on research (which may have the perverse effect of drawing scare resources away from commercial applications) there should be more attention to the European twin deficits: innovation and entrepreneurship.

The good news is that within Europe there are pockets of excellence in both areas. Scandinavia (again), Munich and Cambridge all provide examples of regions that are generating commercial applications from technical innovation. It has been sufficiently widely documented that less progressive regions ought to be able to learn from actual success.

There is also some good-ish news on entrepreneurship. For a start we are trying to understand it better. Thus the OECD set up some new research this year to develop new indicators of entrepreneurship, beyond the usual business start-up stuff. The financial indicators of venture capital and private-equity growth show the UK is performing well, though this does not exactly square with growth of entrepreneurs as such.

But it is inescapable that on these measures the general European performance, particularly continental European performance, is poor by comparison with North America, and the reasons for this are not fully understood. If European companies are quite good at innovation vis-à-vis US ones, and they are, why aren't European economies as a whole?

One answer is to say that there are cultural differences and indeed there are. But that does not help much because it is extraordinarily difficult to change culture. The more helpful response is to look in detail at why innovators and entrepreneurs in Europe feel more constrained than their US counterparts. It is odd that an enormous amount is known about consumer attitudes, why people buy things, but very little about producer attitudes, why people sell things ... or don't.

Next week there will be a row about the ECB increasing interest rates. In the months to come there will be a row about the German tax plans, and from what I have seen of them, quite rightly so - it is not very bright to increase VAT when you want people to buy more goods and services. But it will be an old-fashioned row, focusing on macroeconomic demand management issues. Watch instead, in the months to come, for new thinking about innovation and entrepreneurship. If that starts to show through, then it will be time to be more bullish about Europe.