Professor David Wong, in an article carried in The Sunday Gleaner of December 20, entitled 'A fairy-tale view of interest rates', which was in response to an earlier article by me ('Debating interest rates', December 6), suggested that the Government could use its influence to determine interest rates. He claimed that my "simplistic view" of interest-rate formation was not informed by the structure of the market for loanable funds in Jamaica.

My analysis did implicitly take account of the structure of the loanable-funds market in Jamaica. I did not assume a perfectly competitive market where no player would be able to affect the price/quantity combination which would prevail. I did state that the Government was a large enough player to determine which one of the given price/quantity combinations would prevail at the time it seeks to borrow. The crux of my argument was, however, that the Government is not in a position to determine the set of price/ quantity combinations from which it must choose i.e., it cannot by itself simply determine that it is going to borrow a large sum of money at a low interest rate.

Whether the Government has some monopsony power (i.e., the ability of the buyer to determine the price) or not, does not change the essence of my argument, because the Government does not have complete monopsony power. My argument is that there is some reservation rate below which people will not be willing to lend to the Government the amount of money which it would like to borrow. How that rate is determined will of course be a function of the alternatives available to people who have money to lend. In a perfectly competitive market, the quantity-price combinations at which people are willing to lend is nicely define; in a monopsony situation it is more problematic, but reservation levels do exist.

Monopolist example

Readers are more familiar with monopolies than they are with monopsonies, so I will use an example with a monopolist to demonstrate that a sole seller is not in a position to determine the price-quantity combination all by himself.

There is one supplier of electricity to consumers in Jamaica (a monopolist), and most people would consider electricity a necessity. However, as the price of electricity rises, people are willing to buy less, and in fact, there are prices above which individuals will stop buying. The electricity company cannot by itself determine the price of electricity and the amount sold. Obviously, the income of the consumer is a major factor in determining how much he will buy at various prices; but equally important are the alternatives available to him.

In Jamaica, as the price of electricity rises, people with electric stoves will shift to gas or some other source of energy for cooking; they will seek light bulbs, which use less electricity, etc. All of these are mechanisms for consuming less electricity as prices rise until the ultimate price is reached where no electricity is consumed at all. Equally so, if there is a sole buyer, he cannot all by himself determine how much is to be traded, and at what price.

Wong wants to use more advanced economics textbooks to examine the loanable-funds market in Jamaica. In particular, he wants to model this market in game-theoretic terms as a bargaining game. Let me briefly but succinctly use the bargaining framework to demonstrate that the results from my earlier article hold.

Access to international private-capital markets

The Government of Jamaica at this time does not have access to the international private-capital markets. People in Jamaica who have money to lend, however, do have access to this market, i.e., they can buy US treasury bills, buy stocks and shares on foreign stock markets, put their holdings in foreign bank accounts, etc. The Jamaican Government is locked out of the international capital market, while Jamaican lenders have access.

From a bargaining perspective, Jamaican lenders have more options than does the Jamaican Government. It is well known that in any bargaining situation, the party with more options has the upper hand, since it is less costly to him if that deal is not consummated. This means that the hand of the lenders in Jamaica today, in any bargaining game with the Jamaican Government, is stronger than the hand of the Government.

The approach by the Government to the International Monetary Fund (IMF) for a loan, born out of necessity, is an attempt to strengthen its hand in bargaining with creditors. With loans from multilateral institutions, the Jamaican Government will need less private credit. The scarcity premium, which private creditors are able to extract, would, therefore, be reduced. The IMF and other multilateral institutions will not finance budget deficits year after year, therefore, the Government has to reduce its desire for borrowing if future rounds of bargaining are to result in lower interest rates, i.e., the Government must either cut expenditure and/or increase taxes if interest rates are to fall.

I had raised the issue in my previous article of what determines the interest rate that people are willing to accept. This is a legitimate question whether we are dealing with a few players or many players. People always act in their self-interest. It is naïve to think that there can be some sort of social partnership where people voluntarily decide to put the good of society before themselves. Unfortunately, in Jamaica, we have sought to substitute politics for economics. In the game-theoretic language which Wong would use, we have sought to turn a non-cooperative game, i.e. one in which people are motivated by their own interest, into a cooperative one, where the welfare of the group is given precedence over individuals via a social contract. If this is possible, I would say let us throw religion in while we are forging this new way of behaving.

The best that people can do for themselves is a function of the alternatives open to them. People will accept a low interest rate if that is the best that they can do. The best that they can do takes account of all the possibilities open to them, holding their wealth in financial assets, as well as non-financial assets. If the interest rates on offer are insufficient to maintain the real value of an individual's wealth, that individual will move his wealth out of financial assets into physical assets such as commodities, real estate, gold, etc.

Jamaica is an open society, which means that a part of the set of options open to Jamaicans is investing abroad. The average annual inflation rates between 2000-2008 in the USA and the United Kingdom were 2.83 per cent and 2.94 per cent, respectively. In Jamaica, it was 11.46 per cent. During this period, the lowest inflation rates experienced by the USA and the UK were 1.58 per cent and 1.67 per cent, respectively, both in 2002.

Variations in rates

The highest rates were 3.84 per cent and 3.97 per cent, respectively, in 2008. In Jamaica, the lowest inflation rate during the same period was 5.7 per cent in 2006 and the highest, 16.8 per cent in 2007 and 2008. The average inflation rates in the USA and the UK are much lower than in Jamaica. Also, variations in these countries are in a much narrower band. Volatility adds to the uncertainty of what future inflation will be.

In 2005, the inflation rate in Jamaica was 12.6 per cent. The following year it was 5.7 per cent, and then it shot up to 16.8 per cent in 2007. If a person had kept his wealth in Jamaican dollars under his mattress from 2000-2008, he would have lost almost 12 per cent of the value of that wealth each year, or approximately 64 per cent over the entire period, because of inflation.

If that person had converted that wealth to US dollars or English pounds, and placed that money under his mattress, his loss would have been less than three per cent of its value each year, or less than 21 per cent over the entire period, due to inflation. It takes a much smaller interest rate on US dollars or English pounds to preserve the value of one's wealth than would be required for Jamaican dollar assets.

In addition, the volatility of the Jamaican inflation rate increases the uncertainty involved, thus forcing a premium on the Jamaican dollar interest rate, which would be required for people to continue holding their assets in Jamaican dollars. So it is not true to suggest that the international interest rates are the lower limits of what people in Jamaica will accept. Recall also that the options open to people include non-financial assets. A person buying a lot of land is likely to be protected from inflation because the price of this lot of land will rise in tandem with inflation.

Empirical evidence

Wong has stated that Edward Seaga might have a better understanding of the matters of interest rates than I do. This may, in fact, be true. But I dare say, it could not be for the reasons which Wong has posited. The central bank and the Ministry of Finance cannot jawbone any interest rate which they would like. The empirical evidence is there to support the conclusion that the central bank and the Ministry of Finance are not able to set whatever interest rate they wish and at the same time attract the amount of loanable funds they want. Both institutions have in the past failed to attract the amount of loanable funds with the interest rates they have offered, no doubt with much behind-the-scenes cajoling.

The balance sheet of the Bank of Jamaica (BOJ) in November 2009 revealed it had lent $3 billion to the Ministry of Finance. The governor is quoted in a newspaper article as saying that the BOJ had also lent the Government money earlier this year and late last year. No doubt this became necessary as a result of the failure on the part of the Ministry of Finance to attract the quantum of loans which it desired at the interest rates offered. The implication of the central bank's accommodation of the Treasury's inability to raise funds on the market is an interesting topic best handled on its own.

Peter-John Gordon is a fellow at the Sir Arthur Lewis Institute for Social and Economic Studies, UWI, Mona. Feedback may be sent to columns@gleanerjm.com.