Credit Crunch

Whereas Jim Stanford’s latest Globe column argues that central banks should be as willing to intervene on behalf of manufacturing as on behalf of hedge funds, Andrew Coyne’s column in today’s National Post argues that central banks should intervene as little as possible and not bail anyone out. At least Coyne’s position is consistent and avoids the double standard identified by Jim.

Duncan Cameron’s latest Rabble column follows:

It is actually credit, and not money, that makes the world go around. That is why the upset in credit markets, provoked by the issue and sale of poor quality “sub-prime” mortgage debt by U.S. financial institutions, has captured world attention.

When borrowers cannot borrow, because lenders will not lend, you have a credit crunch. Without credit—the willingness to lend money today in the expectation it will be repaid later—those affected cease their activity, and the economy slows, causing job losses, personal bankruptcies, and cessation of business by many firms.

It was to ensure healthy credit conditions that the Bank of Canada was created. With the great depression as a backdrop, the need for government action to restore lending was obvious, so Canada created a central bank, and gave it a legislative mandate to act as a lender of last resort to financial institutions, to be the government’s banker, and manage government debt, “regulating credit and currency in the best interests of economic life of the nation.”

For decades, finance ministers and central bank heads from the leading industrial nations (G10) have met to set the agenda for monetary policy. In recent years, a monomaniacal concern with controlling consumer inflation has dominated other legitimate concerns, such as runaway asset prices, where the value of stocks, companies, old masters and real property including houses has skyrocketed.

More importantly, the G10 have concluded, quietly and in secret with virtually no public debate, that central banks lending to governments was what provoked consumer inflation and that such lending should be kept to a minimum.

Moreover government deficits were said to prevent productive private investors from making use of savings, which were mobilized instead by government, through bond sales to finance its deficit. So government borrowing to fund government investment in social housing, health, education, recreation, amateur sport, culture and physical infrastructure was to be curtailed in the name of economic efficiency and productivity.

As government surpluses became the norm, as in Canada, interest rates could be safely lowered. These lower interest rates fueled the demand for private loans. But, despite record profits, companies were not making important new productive investments in efficient machinery and equipment. Rather private credit was used to acquire existing assets, pushing up prices. Speculation, rather than investment, fueled new private borrowing.

Easy credit provoked a merger and takeover boom that led to the sale of a huge chunk of the Canadian economy to foreign investors, while the Bank of Canada patted itself on the back for controlling inflation. In reality, lower inflation was more attributable to falling prices through the transfer of manufacturing capacity to China and other low cost areas, than to the Bank of Canada.

Private credit for profit was good, public credit for basic needs was bad; this was the new central bank credo in Canada, overturning without parliamentary consent, its legislative mandate.

The U.S. credit markets were happy to give rich private pools of equity capital and speculative hedge funds access to levered loans whereby the lender gave the borrower up to five times the amount of the down payment when funding a purchase.

This works when the value of the assets purchased goes up. Buy a stock for $100, put down $20, and when the price goes to $200, sell it, and pay back the lender $80, and pocket $120, for a $20 down payment, or six times your cost, less interest costs.

Unfortunately, the same scenario works in reverse when asset prices fall. The $200 stock falls back to $100 and the $40 dollar down payment turns into an additional $100 out of pocket expense, as the lender demands to be paid in full for the lost stock value. So, the so-called investor has paid $140 for a stock now trading at $100, and still owes the lender $100 for its remaining value as well. Paying $240 for something that can be sold for only $100 scares the boldest hedge fund manager, especially when the stock price starts to fall even further.

The concern today is that the fall-out from de-levering will affect the real economy of jobs and incomes. De-levering means retiring loans, and reducing credit exposure. Borrowers have to sell their best assets in order to pay lenders for the lost value of sub-prime mortgage securities. Lenders fear lending to even credit worthy borrowers.

With lenders worried about falling asset prices, all of a sudden government debt looks very attractive. The so-called flight to quality leads to purchases of government short-term securities paying low rates of interest.

While U.S. financiers have flooded world credit markets with poor quality debt, given good “investor grade” ratings by U.S. credit agencies such as Moody’s and Standards and Poor’s, the Canadian government has been busy paying down its high quality debt.

Faced with sell-offs by individual investors, mutual funds, and money market funds run by Canadian financial institutions have been scrambling. Lenders have pledged to rollover shaky short-term debt into longer term securities.

Clearly, the Bank of Canada has neglected its role of ensuring that governments, not speculators, can borrow money at a reasonable rate and that pension funds and investment funds have access to a range of quality government debt instruments for their portfolios.

Instead, the Bank has turned a blind eye to the reckless credit practices of U.S. finance, and permitted speculative excesses in Canada to drive up asset prices, while denying the role government deficit spending plays in the creation of safe, reliable investments in the form of government debt.

The world credit scare should be turned into a debate on how to best mobilize our national credit “in the best interests of the economic life of the nation” to quote the Bank of Canada legislative mandate once again.

Duncan Cameron is associate publisher of rabble.ca. He writes from Vancouver.

One comment

  • From his column–
    “More importantly, the G10 have concluded, quietly and in secret with virtually no public debate, that central banks lending to governments was what provoked consumer inflation and that such lending should be kept to a minimum. Moreover government deficits were said to prevent productive private investors from making use of savings, which were mobilized instead by government, through bond sales to finance its deficit. So government borrowing to fund government investment in social housing, health, education, recreation, amateur sport, culture and physical infrastructure was to be curtailed in the name of economic efficiency and productivity.”

    I think that’s interesting in regards to what the Liberal gov’t did in the 90s by cutting health care funding. Lower the taxbase by reducing health care? How does that make any long-term sense for the funding of a gov’t? And how does a gov’t borrowing some money from a central bank increase inflation, when they would borrow the same from a private bank (but with higher interest rates/more profit for them/higher cost to taxpayers), how does that increase supply– and for our health care system, you could say there’s much more demand than supply– over the edge so that inflation kicks in? And it’s certainly interesting in light of Brian Mulroney wanting to change the BOC Act and change it’s focus towards only inflation-combatting; I remember Chretien campaigning and criticizing the Bank at the time for its inflation-combatting policies..

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