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Don’t fix the interest rate

  • Published at 07:01 pm January 18th, 2020
The number should vary Bigstock

What happens when the cost of providing loans is higher than 9%?

A basic truism in economics -- well, in reality, not just in the ivory towers of theory -- is that if the price of something is set below the cost of production then that thing vanishes. Everyone producing anything at all is at least endeavouring to make a profit by doing so. If we insist -- by price fixing -- that production creates a loss, then people will simply stop. After all, doing nothing still leaves you with more left over than working and making a loss.

This is the basic problem facing the government, as it attempts to set interest rates the banks may charge. It might seem lovely -- it obviously does seem lovely to those in government setting the price -- that interest should be in single digits for industrial loans. But what if the cost of providing the loans is higher than 9%? The loans will simply disappear, they will not be made.

We have seen this problem before, of course. Hugo Chavez, then his successor Maduro, in Venezuela, decided that it would be wondrous is food were nice and cheap for everyone. So, they decided that they knew what the price of chicken, beans, rice should be. And they set them nice and low. The result being that this was below the price of production, no one produced, and the country began to starve. 

They also decided to set the price of the staple of the Venezuelan diet arepas with the result that they’re near impossible to find. Other things made from the same source material, corn flour, can still be bought. For a baker can buy the raw ingredients and make the other things and charge the market price for them. But if he makes arepas then he must charge the state price and make a loss. So, no arepas are made, other things are. The price fixing has made arepas disappear

Many will be familiar with Marie Antoinette’s alleged answer “let them eat cake.” This was actually a line in a play, not something the French queen said herself. But it was in reference to there being a shortage of bread in Paris. So, let them -- well, it was the same thing. Bread prices were controlled, cake prices were not. So, when the price of wheat rose rather than making bread, the bakers made the cakes which didn’t ensure them a loss. 

OK, well, bread in Paris, corn cakes in Caracas, they’re different from loans in Dhaka, right? Except economic principles are the same wherever and whenever. Set the price of something below the production cost and that thing will disappear. Well, it has disappeared from the legal market at least

We have evidence of this about loans too. The Federal Reserve Bank of New York made the point about payday loans. Lending small amounts of money for short periods of time costs a lot when we translate all those costs into an annual interest rate. As much as 500% a year when calculated using the official formula to create an APR. 

Shrug, that’s just how much it costs. There was even one attempt to set up a not for profit service offering the same loans and that had to charge 290% APR just to cover those costs.

So, if we set maximum interest rates at 36%, as a number of US states do, we’re going to find that there are no payday lenders in those states. As is true, we don’t find payday lenders in the states with a 36% interest rate cap. We’ve just set the price that can be charged below the cost of production. Therefore there is none of that thing being produced.

Which brings us to Bangladesh and the 9% interest rate that a bank can charge on a commercial loan. It might even be possible that this is a reasonable rate for some lenders to some customers. But that is to miss what happens across the banking market. Some people are riskier to lend to than some other people.

Banks compensate for this risk by charging higher interest rates to those riskier people. If they’re not allowed to then those riskier people -- as with the payday borrowers -- just don’t get lent any money. The Bangladeshi banks are asking that lending to SMEs (small and medium enterprises) -- not be included in that 9% price cap. SMEs are indeed riskier to lend to than large companies. Not allowing the banks to charge for that risk means there will be no loans to SMEs.

For it really is true that there are basic economic rules. Set the price of something below the cost of production and that thing vanishes because no one will produce it. Demand that SMEs only get charged 9%, alongside larger, more creditworthy, borrowers and SMEs will get no loans.

This isn’t a good idea either, as the future growth of the Bangladeshi economy depends upon those smaller companies being financed so they can grow.

It’s all a bad idea, in fact, the government should change its mind. For why would we want a system in which smaller companies cannot gain access to credit at all? 


Tim Worstall is a Senior Fellow at the Adam Smith Institute in London.