Of banks, supermarkets and the market economy

Having lived in Latvia for almost 30 years and having witnessed the country’s remarkable transformation towards a market economy that is highly integrated within the European Union, I am saddened by the current political debate regarding the banking system, in particular the idea of capping the interest rates that banks can charge. Allow me to argue – and warn – against this suggestion.

The economy is very much about sending signals There is at least one area where Latvia (and its two Baltic neighbors) have been very consistent since regaining independence: Steady transformation towards democracy, integration into the European Union and the adoption of a rules-based market economy.

This transformation has been possible via membership of a long list of organizations that promote these values, such as the European Union (EU), the World Trade Organization (WTO), the Organization for Security and Cooperation in Europe (OSCE) and more.

This has sent signals to local and foreign investors that this is a country where the rule of law is adhered to (albeit sometimes slowly), where property rights are respected, where income and profits are fairly taxed, of course, but not excessively. All of this welcomes investment, local and foreign, to the benefit of the country. And it has worked quite well – the three Baltic countries enjoy higher incomes and are of course infinitely freer than Russians or Belarusians.

Credibility is everything

This process of creating credibility in the economy is slow but rewarding. It is therefore of theutmost importance not to jeopardize this credibility.

And then we can look at e.g. the banks and the supermarkets. Setting up a bank or a supermarket chain is a long-term investment that requires a lot of capital – I have no idea when Lidl will have earned back all the investments they have made here so far but they must believe in the profitability of being here since they chose to come. With the added benefits their goods and prices give to you and me and the extra tax revenue that goes to the state. Win-win is an overused cliché but it applies here.

But what if the rules of the game are suddenly and unexpectedly changed? Let’s say that [supermarket chain] RIMI is ordered not to charge more than 0.50 EUR for 10 eggs – in the name of “protecting the consumer”. I have this feeling that not many eggs would be sold since RIMI would not be able to acquire eggs from its suppliers at such low prices. I would be hurt, you would be hurt and RIMI would be hurt – we could call it “lose-lose”.

But this is how capping the interest rates banks may charge would work and the following would happen:
Banks will lend less since it is not so profitable – contrary to what is intended by politicians who would like to see higher lending volumes, not lower.

The little lending that would prevail might go to well-connected individuals or companies – feel free to think Russia in this context.

Sending signals

It would send a signal to existing banks and potential newcomers that Latvia is not the place for doing banking services. Some banks may leave and with fewer banks there will be even less competition in the market – and less competition means higher interest rates, not lower.

And, crucially, Latvia would have lost its credibility as an investment-friendly economy – a credibility, it would take a long time to rebuild.

In short, why flush down the toilet in a few months the credibility that this country has so determinedly and patiently built up in the past 32 years?

This does not mean that one cannot criticize the banks or that the banks are saints (they are not) – I have at least two points where I am dissatisfied with them. Bank lending rates increase almost immediately after ECB rates are up – while upwards adjustment of interest rates on our deposits seem to follow a snail’s pace. And why do no banks offer long-term mortgages with fixed interest rates?

Morten Hansen is Head of the Economics Department at the Stockholm School of Economics in Riga
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