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Interest rates killing businesses, suffocating consumers

Oct. 12, 2016, 8:48 a.m.

Ghana's current policy rate set by the Bank of Ghana is 26 per cent. Such a rate may be considered to be too high given the current state of the economy, with economic growth for 2015 recorded at four per cent.

At 26 per cent, the interest rate is ranked the third highest in the world after Malawi (27%) and Argentina (26.75%), according to data from Trading Economics.

As a result of this relatively high policy rate, the average interest rate charged by banks for personal and business loans is approaching 40 per cent.

This puts pressure on household incomes, and the profitability of firms and their incentives to invest. What at all is an interest rate, and what is the essence of it in a modern economy? How should this economic indicator be deployed in an economy in order that its full benefits can be reaped?

Before the development of modern economies, the idea of charging interest for the lending activity depended on the circumstances in which the borrowing was taking place, and on the nature of the item being borrowed.

As early as 5000 BC, Middle Eastern civilisations used to lend what we call "food money" for interest. "Food money" was essentially seed and animals, and because they could reproduce themselves to the benefit of the borrower, the charging of interest was justified. The requirement to pay interest was also acceptable, when at the beginning of the 2nd century BC, silver was used in exchange for livestock or grain, because silver could not increase of its own accord.

However, when a request for a loan resulted from a necessity, especially during periods of bad harvest, it was deemed inappropriate or morally wrong to demand the payment of interest. It was such moral objection that influenced the Jewish and Islamic religions' and the Catholic Church's proscription of usury. For many centuries, economists have attempted to devise reasons for the need of interest in the lending activity. One school of thought justified interest in the sense that the borrower received a benefit from what was borrowed, and the lender needed to be compensated for the risk of default.

Why we need interest

In pre-urban societies, loans consisted of seeds, livestock and tools, as already intimated above. Seeds and livestock could reproduce themselves many more times, and tools assisted in the tilling of the land. Thus, it was easier for the borrower to repay what they had borrowed, and also not morally objectionable for the lender to request some kind of interest. In 1770, the French Economist, Anne-Robert-Jacques Turgot, using a theory called fructification provided a justification for why interest rates had to be above zero.

She argued on the basis of opportunity cost, that the value of agricultural land would rise without limits if the loan rate was zero. That is because, the absence of a gain in lending money would move people towards investment in land. Thus, a loan had to have a positive rate of interest to make the lending of money also a viable investment option.

A careful analysis of the historical reasons for and against the charging of interest, reveals that demand for the same was generally acceptable if the lender was taking some risk and also passing up the opportunity for present consumption. It is this kind of thinking that has motivated the present day lending institution. As economies matured and became more dynamic, the charging of interest was not frowned upon, but was perceived as essential to productive economic activity; and by 1516, the concept of a lending institution had become widely embraced.

Essentially, therefore, we need an interest rate in modern-day society for four basic reasons - to encourage economic activity, to provide for risk, to account for inflation, and to earn some kind of profit.

First, if interest was not charged, surplus units would withhold their funds, since there is no economic incentive to lend.

Deficit units would lack the resources required for consumption and investment, which would severely curtail economic activity and inhibit economic growth.

Second, since there is the possibility of default, the lender must cater for this, by receiving some kind of interest.

Third, because money loses it value over time due to the presence of inflation, the lender should receive some kind of compensation in order not to suffer loss in value when their money is eventually repaid.

Fourth, and finally, the lender must earn some profit for engaging in such economic activity, and, thus, be rewarded for postponing present consumption. Consequently, given a default risk of say one per cent, an inflation rate of five per cent and a profit objective of two per cent, the interest rate charged on a given loan should be at most eight per cent, if we do not take the maturity into account. Thus, looking back in history, we see an overwhelming support for some kind of interest. It was usury, that is, the charging of very high interest rates that was frowned upon and objectionable. So why do we need low interest rates?

The need for low interest rates

We need low interest rates for both moral and economic reasons. For moral reasons, very high interest rates are seen as taking advantage of the poor and needy in the society who must rather be supported.

The economic reasons for low interest rates relate to their stimulative economic effect, their ability to improve bank's capacity to lend, their power to boost asset prices and their capacity to promote prevailing lower prices of goods and services.

First, low interest rates stimulate economic activity because it is cheaper for consumers to borrow and spend on durable goods. This increases the purchasing power of consumers and creates more demand for firms. Lower interest rates also increase investment by firms because more investment projects are likely to have positive net present values, and would ,therefore, be undertaken. Thus, increased consumption by households and investment by firms, as a result of lower interest rates, would boost the economy's aggregate demand and, therefore, its gross domestic product (GDP).

Second, low interest rates improve bank's capacity to lend because it improves banks' net interest margin (NIM). When NIM improves, it boosts profitability and thereby retained earnings which serves to increase banks' capital. Thus, banks' improved balance sheet, in the form of increased capital, will enable them to expand their lending. Third, low interest rates help to boost asset prices because households tend to have excess funds which they divert into the purchase of assets. Increased demand for assets lead to an increase in their prices, and consequently an increase in wealth of asset owners.