Interest rate liberalization in Malta

Abstract

Interest rates form the basis of many economic decisions. When households get new loans, they borrow money by taking mortgages. When a firm decides to build or modernise a plant it issues common stock to raise capital. When the government runs a deficit it sell bonds to obtain funds to finance the deficit. In short, households, firms as well as governments, all borrow money sometime or another. When they borrow they transfer future consumption to present consumption. For this, they have to pay interest rates in exchange for the use of the lender's money. Hence because of its importance, many countries including Malta, have chosen to maintain interest rates at very low and fixed levels. Such a policy has been justified by the desire to: (i) increase the level of investment (ii) improve sectors the allocation of investment among (iii) avoid the possible inflationary impact of interest rate liberalization. The issue of interest rate liberalization in Malta, or the freeing of all interest rates from a government imposed structure, has been the subject of debate for the past few years. This paper is intended as a contribution to the current debate on this issue. It proposes a case for liberalization, backed by the belief that the market mechanism is superior to regulation and would therefore result in the "right" rate which clears the market for loanable funds. This rate would maximise financial intermediation for any given monetary policy regime. It is true that administered rates can sometimes be correct or adequate, but they can just as well not be, no matter how the administering authorities try to set rates equal to market rates. This is especially so, since the inflation premium which interest rates embody is inherently not measurable; thus making it is impossible to determine the "right" interest rate short of market pricing itself.