The Bank of Canada’s risky policy

Published on May 11, 2016

The Financial Post ran my article this morning about the Bank of Canada’s risky monetary policy, as explained by its governor Mark Carney in a speech earlier this week. -- 15 December 2010

Carney vows to keep pouring oil on the fire
Maxime Bernier, MP for Beauce

The Bank of Canada is in a bind. In a speech in Toronto on Monday, its governor, Mark Carney, admitted to an extremely risky strategy that could lead to even greater financial and economic imbalances than those of the past three years. But, he said in so many words, the bank has no choice but to continue to throw oil on the fire and urge everyone to stay as far away as possible from the fire.

After briefly explaining why we may be in for an extended period of very low interest rates, Mr. Carney spent about two-thirds of his speech detailing how cheap money “could potentially distort behaviour in public, financial, corporate and household sectors.”

In some countries, he said in the usual impenetrable jargon of central bankers, low interest rates might “create short-term flexibility” – meaning that it is easy for governments to borrow billions of dollars and bail out everyone – but this exposes them to difficult times ahead when rates go up and if markets abruptly change sentiment.

The conviction that rates will stay low is also likely to induce more risky lending behaviour in banks, a key factor in the financial debacle south of the border.

Mr. Carney also warned about the creation of zombie firms as in Japan. These are bankrupt companies that stay afloat because cheap money allows banks to roll over the debt they cannot repay, thus delaying the necessary restructuring and wasting resources.

Finally, the point that caught all the media attention is that, thanks to very low interest rates, “the proportion of households with stretched financial positions has grown significantly.” Data from the bank show that credit continues to grow faster than income. Canadian households are becoming even more indebted than American ones, and we could experience widespread default on mortgages and credit cards should another shock happen.

The bank’s conventional economists are finally agreeing with a lesson taught by the Austrian school of economics – that artificially cheap money does not bring long-term growth and only serves to create imbalances that eventually will have to be purged. In the Austrian view, the cheap money policies of the 1990s and 2000s fuelled the dot-com and real estate booms in the U. S. and elsewhere, leading inevitably to crashes.

So, why are we getting more of the same? The bank has only increased the overnight rate from 0.25% to 1%, still a historic record low level. It is not increasing interest rates further to prevent all these adverse developments because the bank is legally bound, in an agreement with the Minister of Finance, to keep the inflation rate at around 2%.

Raising interest rates would force businesses and households to reduce their borrowing and spend less, and would likely slow down the economy in the short term. Because the U. S., Europe and other regions are all pursuing Keynesian policies and creating money at a crazy pace, it would also strengthen the Canadian dollar, make imports cheaper and affect our export industries.

Although it does imply some short-term pain, this might be the only way to prevent other bubbles from forming and to keep Canada safe from the dangerous inflationary policies of our trading partners. But here is the catch: It would bring the inflation rate down. So, this policy avenue is closed.

Instead, Mr. Carney offers us three “lines of defence” that are clearly an admission of impotence. First, he advises everyone to “resist complacency and constantly reassess risks.” Yet, as he explained in his speech, people are not likely to heed this advice under strong incentives to do the opposite. The second line of defence is “enhanced supervision of risk-taking activities.” Nice to have, but am I alone in thinking that supervising the effects of a risky policy is not exactly optimal when the supervisor is himself the source of the risk? And third, the bank can deploy “counter-cyclical buffers” to prevent excess credit creation- that is, it can reverse its conscious policy of creating excess credit if it gets out of hand.

The contradictions in Mr. Carney’s speech are astounding. But they all derive from the constraint of having to artificially boost the economy so that prices increase by 2% a year, no matter the longer term repercussions.

Some months ago, I suggested that the bank’s inflation target should be lowered to 0% when it is reviewed next year. In the current situation, it would allow more room to raise interest rates and reduce all the risks that Mr. Carney is warning us about. It would more clearly preserve our purchasing power and reduce the distortions that inflation causes throughout the economy. And it would help prevent the cycles of booms and busts that we have been experiencing for the past couple of years.

Let’s have a real debate about all this instead of simply pursuing a policy with such obvious defects as the one laid out by Mr. Carney.