What the Government Should Do Now

Ask any businessman and they’ll sing you the same song about how important interest rates are. They’ll tell you about how interest rates affect their cost of acquiring capital; making it more expensive to produce their goods and services. They’ll tell you that this high cost of production affects their ability to compete with companies in other countries. They’ll even tell you that this high cost of production brought about by the high cost of capital, affects even the businesses that they sell to as a portion of their output becomes the input of other firms in the economy. If they told you all this they would be telling the truth. High interest rates make it more expensive to invest in new businesses and more expensive to operate existing businesses.

With all this though, this is not the major reason why high interest rates are really bad for the economy. No. For that you need to look at the impact on consumers. The fact is, while investment expenditure accounts for less than 10% of the island’s total output, consumer spending accounts for close to 82%. This of course means that consumer expenditure (as is the case with most economies) is the major driving force in the economy.

Therefore, anything that stifles consumer spending is actually negatively impacting more than 80% of the gross domestic product (GDP). High interest rates have a huge negative impact on consumer spending and hence the overall economy.

For instance, take a look at the impact of high interest rates on home and motor car purchases. These are two so-called big ticket items that are pre-dominantly financed with loans. They are also two sectors that have a significant interrelation ship with the rest of the economy.

So for example, when a sharp rise in interest rates force the cost of mortgages higher, this has the immediate effect of reducing the volume and value of mortgage loans. This is clear and easy to see. But what does it really mean?

For one, it means that there will be less activity in the financial services sector; a major contributor to overall output in the economy in terms of investment and employment. Lower profits in the financial services sector will normally translate into lower levels of spending in other areas such as branch openings and the level of advertising.

In addition, the decrease in mortgage loans would lead to a fall in housing construction which has a serious knock-on effect on the retail/wholesale sector through reduced sale of hardware and building material. The lower level of mortgage loans will also negatively affect the transportation sector as there will be less hardware items being bought and therefore less to be transported. This multiplier effect on home construction will also extend to the furniture retail sector, restaurants and a host of other sectors. The same is true with motor car purchases when interest rates rise.

The long and short is that the sharp rise in interest rates in the past three months has dealt a terrible blow to the economy; both in terms of increasing the cot of capital and making it harder for businesses to finance their operations, but also in terms of making it more difficult for consumers to finance the acquisition of important assets such as houses, cars and furniture. The net effect of course is that the reduced spending means lower sales for the very companies that are struggling with the direct impact of the higher cost of capital.

The risk of course in trying to mitigate this is that if you lower interest rates sharply, this may cause a further run on the Jamaican dollar; with individuals and companies better able to afford loans that may be used to purchase U.S. dollars in the hope that if the dollar slides even lower they will be able to sell their recently acquired stock of U.S. dollars at a significant profit.

However, lowering interest rates would not have to happen overnight. A structured and properly communicated programme of interest rates reduction could and should be implemented.

In addition, there are other policy tools that could and should be employed to boost economic activity, slow the rate of losses at the island’s financial institutions and shore up employment.

Firstly, the government should increase the minimum wage tomorrow morning. They should do so before noon as there is no time to waste. Here’s why: there are approximately 200,000 persons earning minimum wage in Jamaica (about 16% of the employed labour force). Increasing the minimum wage by say, J$400.00 per week would mean a higher cost of operation for the island’s companies to the tune of approximately J$80 million extra per week. That’s true. However, it would also mean J$80 million in additional spending on their goods on services; which would translate into a total weekly boost to the economy of over J$300 million when the multiplier process is complete. That’s a lot of additional spending in the economy for an J$80 million increase in the wage bill. Put differently, most of the hundreds of millions of dollars in additional expenditure would be earned by the very companies that had to pay the increased wages. They would be significantly better off if the Government were to increase the minimum wage.

After they increase the minimum wage, the Government should also increase the income tax threshold (the announcements should probably be made at the same press conference). Why? For precisely the same reason that it makes sense to increase the minimum wage. he fact is, the typical worker who is positively affected by increases in the minimum wage and the income tax threshold are not earning high salaries and are therefore, very, very likely to spend any increase in salary that they earn as soon as it is earned.

While the Government may not be able to reduce interest rates at the pace that is needed, they should increase both the minimum wage and the income tax threshold as soon as is physically possible.