WHY does the European Central Bank want to raise interest rates? Every European government says it shouldn’t. The International Monetary Fund and the European Commission say it shouldn’t. The Fed and the Bank of England say, privately, that it shouldn’t. And the economic statistics certainly say that it shouldn’t. Yet Jean-Claude Trichet, the ECB President, has more or less announced that eurozone interest rates will rise this week.

Does this mean that M Trichet “knows something” that nobody else understands about the condition of Europe? Or is it that M Trichet does not know something that everyone else understands very well? For example, that economic policy has progressed a long way since the Bundesbank’s pre-Keynesian sado-monetarism. Or that a central bank’s credibility now depends on sustaining demand, as well as controlling inflation. Or that supply-side reform is politically impossible and economically counter-productive in the absence of pro-active management of demand. Or simply that, when you’re stuck in a hole, the first thing to do is to stop digging.

Ever since the euro began, the ECB has rejected all criticism with arrogant condescension. Like the Delphic oracle, it has claimed to see deeper truths that lesser mortals could not discern. Year after year, it has produced wildly over-optimistic forecasts that have turned out to be totally wrong. This is beautifully shown by Credit Suisse First Boston’s tragi-comic chart, shown here.

Every December, the ECB produces a forecast showing recovery “just around the corner”. Every six months, with clockwork precision, these figures are downgraded. But each time the ECB produces a new forecast, which shows recovery still “on the horizon”, just postponed by 12 months.

Such pie-in-the-sky predictions have always been a stock in trade of financial hucksters. When I showed this ECB forecast chart to a friend who had spent many years in the underbelly of US finance, he grinned with instant recognition: “I haven’t seen an example as good as this since working at ITT for Harold Geneen.” Is this what M Trichet means by “reinforcing the credibility of the ECB”? But I must offer an apology. Regular readers may believe that I have become obsessed with Europe, after devoting four of my last six columns to the eurozone. How can I justify all this repetition? The answer is simple: in the year ahead Europe is the region whose precarious condition will be the biggest source of global uncertainty. America, Britain, Japan and China are all on fairly predictable trajectories, making reasonably well-managed transitions from very rapid economic rebounds from the 2001-02 recession towards more moderate, sustainable growth.

Europe, by contrast, has enjoyed almost no recovery and manages its economy on principles that totally mystify the rest of the world. This is why Europe is now the biggest source of uncertainty for global prospects; whether 2006 turns out to be a year of prosperity or disappointment is probably more dependent on events in Brussels and Frankfurt than in Washington or Beijing.

This is especially true of Britain. With domestic demand likely to remain tepid for at least another six months, the Treasury and Bank of England are counting on exports to provide short-term support for British economic activity. But the eurozone is Britain’s biggest trading partner, accounting for more than 50 per cent of the manufactures and 40 per cent of the services that it sells abroad. Thus if European growth turns out to be substantially weaker than the 1.5 per cent to 2 per cent range now pencilled into official forecasts, Britain’s prospects and the Treasury’s forecasts will be in disarray.

So what are the chances of Europe enjoying the sort of recovery official forecasts are projecting — an acceleration from this year’s 1.2 per cent to 1.5 per cent growth rate to something near 2 per cent in 2006?

My justification for returning to Europe so soon is that the chances of such a recovery have dramatically shifted in the past few weeks. Last month the widely predicted eurozone recovery of 2006 seemed very unlikely. Now it is completely impossible. In fact, it is almost certain that Europe will completely overturn all conventional expectations; instead of recovering, it will probably be much weaker in 2006 than in 2005.

What has happened to guarantee this is M Trichet’s bizarre announcement that the ECB will increase rates, presumably on Thursday. A slowdown is now inevitable because the main engine of growth in Europe last year and the only possible source of stimulus for the year ahead was higher house prices. Combined with modest financial deregulation, the low level of eurozone rates was starting to create a virtuous circle of rising house prices, bigger mortgage borrowing and stronger consumer spending, which has helped to drive the growth of every major economy outside Europe in the past decade. But this virtuous circle has been slowing for almost a year now, as consumer confidence has weakened. After the ECB’s rate hike, it is likely to come to a standstill.

I have argued that the biggest economic issue for Europe today is not structural reform but the ECB’s attitude to the interaction between low interest rates, rising house prices, financial deregulation, mortgage borrowing, and consumption. Would it allow an Anglo-Saxon style virtuous circle to develop and become a solution to Europe’s under-consumption? Or would central bankers see rising house prices and mortgage borrowing as a dangerous symptom of profligacy, to be stifled before it got out of hand.

In other words, would the ECB view the mobilisation of housing wealth by Europe’s consumers as a solution or a problem? M Trichet has given his answer: After four years of stagnation, when inflation is practically non-existent and when even such conservative institutions as the OECD are pleading for more expansionary policies, the ECB seems to want less credit, weaker consumption and slower growth.

Well, if that’s what M Trichet wants, he will get it. While central bankers cannot create prosperity, they can very reliably destroy it. In this one respect, there can be no doubt about the credibility of the ECB.

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