Interest-rate illusion

Peter-John Gordon, GUEST COLUMNIST

Much has been said about the role of high interest rates in the financial crisis of the mid-1990s. The discussion taking place, however, focuses on the wrong set of variables. Unfortunately, some of the participants in this discussion, who ought to know better, have chosen, for their own reasons, to perpetuate an illusionary discussion using meaningless variables. The interest rate has become a political variable rather than an economic one. Constant repetition of falsehoods to the uninitiated has created a veneer of truth.

A personal example illustrates the point about focusing on the wrong variable. I received my first permanent job in 1978 upon graduation from university. My starting salary was $8,100 per annum. It would be wrong to imply that a youngster graduating from university last year, starting at a salary of $1 million, is 123 times better off than I was in 1978. In fact, my salary of $8,100 in 1978 was worth $1,264,000 in 2010, i.e. I was better off in 1978 with my $8,100 salary than a youngster was last year with a $1-million salary.

What is going on here? We should not be focusing on nominal values, as they are meaningless; rather, it is real values which are important. The intervention of inflation creates a wedge between nominal values and real values.

The interest-rate discussion is taking place using nominal values rather than real values. Nominal interest rates and real interest rates are two completely different things. Real interest rates are what affect economic decision-making and the economy, not nominal interest rates.

If I lent $1,000 at a nominal interest rate of 20 per cent, and I am repaid in full after one year, I will receive $1,200. If the price of corn was $1 per grain when I lent this money, the loan was equivalent to lending 1,000 grains of corn. If the price of corn moves from $1 at the time of lending to $1.10 when I am repaid, my $1,200 will only allow me to buy 1,091 grains of corn. My real interest is 91 grains of corn; hence the real interest rate is 91/1,000, which is 9.1 per cent.

The real interest rate is often calculated using a linear approximation; real interest rate = nominal interest rate - inflation. In the example above, had I applied this approximation, I would have obtained a real interest rate of 10 per cent (20 per cent minus 10 per cent). This approximation actually overstates the true value of the real interest rate. The more accurate calculation of the real interest rate is obtained using Fisher's equation, i.e. real interest rate = (1 + nominal interest rate)/(1 + inflation rate) - 1. Using the Fisher's equation, I have calculated the annual real commercial lending rates for the period 1980-2010, shown in the graph accompanying this story.

Interest rate volatility

It can be seen from the graph that real interest rate volatility was at its greatest in the 1990s, moving from a low of -18.7 per cent in 1992 to a high of 22.3 per cent in 1998. The average rate for the 1990s was 10 per cent, compared with 6.5 per cent for the 1980s and 3.7 per cent between 2001 and 2010. If we examine the period 1991-1994, the average annual real commercial lending rate was -0.85 per cent. A negative interest rate means that the lender is paying the borrower for the privilege of lending him money.

Since the financial crisis started in 1994, it is difficult to draw the conclusion that high interest rates precipitated the crisis. It is true that while the real interest rate in 1994 was 8.7 per cent, in 1993 it was 17.6 per cent, the highest rate up to that point over the period being examined. I should point out that the real interest rate in 1987 was 16.9 per cent, a mere 0.7 per centage points lower than in 1993. There was no financial crisis at that time.

Lest someone try to make the point that the rates did not stay high for a long period of time when the 1987 peak was reached, the average rate for the four years 1986-1989 was 12 per cent, while that for the four-year period 1992-1995 was 13.8 per cent.

It is not a coincidence that many of the voices which have been lamenting the financial meltdown and the Government's response to it have been persons whose businesses have suffered. Is their analysis of the economic environment and their responses to it dispassionate or self-serving? Before the meltdown, the country was experiencing an economic bubble. Were the super profits being made then a result of the economic environment, or the business acumen of the entrepreneurs?

Other voices have blamed the bubble and its correction - the bust - on the premature deregulation of the Jamaican economy. They claim that the regulators were not up to the job. I do not wish to entertain a discussion on the economic sophistication of the regulators; clearly our education system could be better, which also includes economics education. Having said that, we merely have to look at other countries where it could be reasonably argued that their regulators have the best training available in the world, yet these countries also suffered bubbles and busts. Inherent in capitalism are economic cycles, i.e. booms followed by busts; sometimes these booms are artificial (bubbles).

Playing catch-up

Regulators everywhere in the world are always playing catch-up because financial innovation carries with it risks which are sometimes unknown until after the fact. Regulators use each crisis to learn something new, hoping that they will be able to lengthen the time span between crises and reduce the severity of future crises.

Movement from one economic regime to another is never smooth or painless; observe the transition from centrally planned economies to market economics in Eastern Europe and the former Soviet Union. Of course, one would like to minimise the dislocation when moving from one regime to another, but to think that the Jamaican economy would transition from a highly regulated economy to a liberalised economy smoothly is simply being unrealistic.

For those who argue that the speed was too fast, I would respond by saying that some decisions are better implemented in a single step rather than over time; if we decided to change from driving on the left to driving on the right, we could not implement this decision for trucks this month and cars in three months time. It would have to be in one step, and there very likely would be some amount of chaos. However, the chaos associated with the alternative would be greater.

Understanding the financial meltdown of the 1990s is an area rife for academic research. It is difficult to envision economic research being done by a commission of enquiry, even if such a tribunal was entirely staffed by eminent economists. However, having decided to proceed with a commission of enquiry, one wonders why persons of independent expertise, with knowledge of similar crises in other countries, have not been invited to share their knowledge about the root causes of these crises. One also wonders if the then governor of the Bank of Jamaica will be invited to share his understanding of the causes and effects of the crisis.

Peter-John Gordon is a lecturer in the Department of Economics at the UWI. Email feedback to columns@gleanerjm.com and pjmgordon@hotmail.com.