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ECB rate rises can help stall Government taxes

HOW much are interest rate hikes setting you back? How many more hikes are in the pipeline? What can the Government do to ease the pain? And, last but not least, how on Earth can rate hikes be justified at a time like this?

After Thursday's decision by the ECB to raise interest rates by a quarter point for the second time since 2008, these are the questions facing the nation.

For an average punter with a €250,000 mortgage, the two latest hikes will see pre-tax income fall by around €70 a month, or €840 a year. How much more pain is on the way?

The answers to this come in four categories: bad; worse; good; and better.

The "bad" news is that although half a point above its previous 1 per cent trough, ECB base rates are still 2.75 points below the previous peak of 4.25 (from July 2008). The "worse" news is that the ECB has gone as high as 4.75 per cent in a previous cycle. Splitting the difference and assuming the next peak is 4.5 per cent (and assuming rates rise in quarter point jumps), then between now and July 2013, Joe Average's pre-tax income will fall by around €5,200.

I guess you're ready for the "good" news now: the good news is that unlike government taxes, ECB rate hikes observe Newton's law of physics. Yes they go up. But they come back down again. And there is even "better" news than that... but I'll come to that later.

The real trouble with ECB rate hikes is really their timing. Between now and 2013 (or 2014 if things slow down) our domestic economy's recovery will be fragile, though exports will do well. From 2014, it should be more robust and more immune to rate rises.

So while Ireland and the eurozone both need interest rates to return to long-term normality, rate hikes don't help Ireland right in the short term.

But before we blame the ECB, we should remember that in 1996 when we applied to join the euro, the Germans were sceptical of our ability to keep up. And they were right. They told us that if we wanted to join the big boys, then we had to get our economy in synch with theirs.

The Fine Gael/Labour coalition of 1994-1997 made that promise, but the subsequent government ignored it -- and in the run-up to the 2002 and 2007 elections, wheezes like benchmarking, double-digit pre-election rises in public sector spending, SSIAs and -- most damaging of all -- the Financial Regulator's failure to curb bank lending growth knocked our economy way out of synch with the eurozone.

Not that Europe is blameless. It allowed interest rates to fall too far and let Germany and France tear up the Stability Pact in 2003. But mainly, our last government is to blame for this crisis, and attempts to direct public anger at an ECB which repeatedly warned the last government to curb borrowing are perverse.

Besides, blaming central banks for the economy is like blaming the weather: winter follows summer and, likewise, rate hikes must follow rate reductions. The ECB can't just change how it works because 1 per cent of the eurozone's population elected three bad governments in a row.

No, rate rises are inevitable over the next two years, and complaining about them is futile. But there are things that the Government can do to ease the pain. And here is where the "better" news comes in: rate rises are a powerful reason not to raise taxes, but to instead focus on cutting waste.

By cutting higher public pay and pensions, by means-testing welfare for the well-off, by privatisation and by scrapping local authorities and quangos that are surplus to requirements, the Government can achieve fiscal adjustment by 2014 -- and in a way that will do far less damage to domestic demand than tax rises.

By 2014 the need for tax rises will have vanished. So by raising rates now the ECB may be doing us a huge favour. Remember, by cutting rates from 2014 on, the ECB will give back what it is now taking from us.

Another thing that the Government can do to tackle the impact of rising rates is to extend mortgage interest relief to help the most vulnerable.

Is the ECB right to raise rates now? Politicians will attack it. But if those politicians had listened to the ECB's advice on curbing lending in the past, we wouldn't be in this mess. As usual in Ireland, the unpopular are unpopular because they tell us what we need to hear, not what we want to hear.

The cost of our bailout is horrendous (estimates put the figure at €16bn). But it is a once-off cost and it is being used as a distraction from the real cause of our debt crisis: the €18bn borrowed each year to fund public spending.

The real argument in favour of rate hikes is that if the financial crisis has proven one thing it is that low interest rates are a dangerous addiction, a habit we need to wean ourselves off. In 2003 the ECB brought its main refinancing facility to 2 per cent, laying an important foundation stone for the Irish property boom. But even after last week's hike, ECB base rates are still half a per cent lower than in that trough. This is because when the financial crisis hit in October 2008 the ECB cut rates by 3 percentage points in just seven months.

Sensible interest rate levels must be restored for real recovery to take root. The failure of two bouts of "quantitative easing" in the US should be noted by those who would like to see the ECB become more like the Fed, having a mandate to drive growth.

The eurozone, where growth is driven by government reforms and where central banks stick to keeping inflation low, is a much better model and is leading to faster, higher quality recovery.

Rate hikes will bite -- but the right response is not to blame the ECB, but to avoid tax hikes and stick to the winning formula for recovery: strong exports, cut wasteful government spending and keep taxes as low as possible.

Marc Coleman presents 'Coleman at Large' at 9pm on Tuesday and Wednesday on Newstalk 106-108fm

Sunday Independent