Bank of Canada Wimps Out

The Bank of Canada did not cut its target interest rate enough this morning, leaving it a full percentage point above the US central bank rate. As I argued last week, the Bank of Canada should have matched the American Federal Reserve and cut to zero.

Astonishingly, the Bank of Canada’s press release acknowledges that we are headed for deflation: “Total CPI inflation is expected to dip below zero for two quarters in 2009.” If the Bank is serious about its stated policy of targeting 2% inflation, it should have cut interest rates more to avert deflation.

By projecting that inflation will not return to 2% until 2011, the press release confirms that rising inflation will be extremely unlikely for the next two years. It paints a dire but accurate picture of a shaken economy desperately in need of stimulus. If inflation is not of concern and the economy needs stimulus, it seems that interest rates should be cut as far as possible to provide such stimulus.

The Bank of Canada’s release concludes by acknowledging the need for “further monetary stimulus.” (It proposes to judge not the need for more stimulus, but the extent of such additional stimulus.) But if the Bank knows that it will cut interest rates deeper and monetary policy takes time to have an effect (if any), why did it not just cut deeper today?

The Bank of Canada’s timidity reinforces the need for a substantial stimulus package in next week’s federal budget.

UPDATE (Jan. 21): CanWest, Bloomberg, and Globe and Mail Update coverage


  • As the credi crunch grinds on and as banks promise to hike up interest rates to recover their profit margins (read this in this weekend’s globe) I suggest PEF create an indicator analogue to the TED spread that would capture the choking off of credit for business and households. For households we could use the average prime rate offered by the big banks or the average rate for a 5 year variable mortgage, for business’s have to find something else, I’ll let others suggest their indicator.
    The spread at the moment is 2.5 given that the average prime rate si 3.5. Now this might not capture the effective credit cost load for many households, a better indicator would mix weighed averages of the cost of personal credit lines, credit cards and mortgage rates. We could call it the Usury index.
    One thing I still haven’t figure out, why do banks need profits ? They don’t have particularly important capital expenses appart from big buildings and big computers, they don’t have to invest in any major way to keep going, and a case could be made that the more the innovate, the more the economy is unstable and the worse off we are.

  • I largely agree, although it must be acknowledged that the chartered banks were quick to cut their prime rates by the full 0.5% today, contrary to my prediction in this morning’s Toronto Star.

    However, the second point I made in that article is that the prime rate does not necessarily determine the interest rates actually being offered on new loans and mortgages. It would be interesting to get a better handle on these rates.

    Presumably, customers who already have lines of credit and variable-rate mortgages defined with reference to the prime rate are receiving the full benefit of a lower prime rate. But the final paragraphs of The Star piece report an instance of BMO hiking the interest rate on an existing line of credit.

    Bank profits would not bother me as much if governments did not keep cutting the rate at which they are taxed.

  • Erin: I happen to agree with you that the Bank should have cut to zero, and have said so a couple of times in the last month (at Worthwhile Canadian Initiative, and again on the CD Howe MPC). But:

    There is nothing astonishing about the Bank’s decision and its forecast that inflation will not return to target in 2011. There is no contradiction here. The Bank has always said that it targets 2% inflation “over the medium term”, and has always defined the “medium term” as roughly 6 to 8 quarters. It believes there are lags in the effect of monetary policy. Almost everyone believes this (I am tempted to go off on a rant against economists who build formal models of monetary policy assuming zero lags of any kind, but I will resist). The lag in monetary policy is probably not some fixed length, where it works all at once. Very aggressive monetary policy could usually bring inflation back to target sooner, but at the risk of then needing a very aggressive reversal to stop overshooting. So saying they think inflation will return to target in 2011 does put them at the outer edge of their targeting horizon, but it does not mean they have abandoned the target. Like you, I think they are mistaken, but it is a judgment call.

    The game between monetary and fiscal policy is interesting (I just posted on it at WCI). There’s chance that the Bank would have cut to 0% if it thought that a fiscal expansion was not coming. This sort of mutual reaction between fiscal and monetary policy can cause problems.

    Have you, or anyone else on this blog, ever called for the Bank to *raise* interest rates (or ever thought it should)? (I admit that’s a semi-rhetorical question). Do you see why I ask it?

  • Nick’s question is a good one but one that must be read in the context of policy that has leaned much more towards fighting inflation than anything else (unlike the US Fed, which has been more balanced and tolerated higher inflation).

    I think there would be circumstances that would merit a call for higher rates though my general preference is to keep the cost of borrowing low and also use other measures to keep credit from going too far off the rails (margin requirements and other regulatory provisions).

    So if someone is hitting you over the head with a hammer, you can’t criticize by saying you only ask for the hammering to stop, when did you ever ask to be hit harder with the hammer.

  • Well said, Marc. If one believes that monetary policy should balance the objectives of full employment and low inflation, then one will tend to favour lower interest rates than an entity fixated on low inflation.

    Another point is that this blog and I began commenting on interest rate announcements in 2007. Since then, lower interest rates have in fact been the appropriate policy, so I make no apology for never having called for a rate hike.

    Nick, I did indeed note your advocacy of a zero target rate. It’s too bad that your wisdom has such limited effect on the C. D. Howe Institute’s median recommendation.

    I agree that monetary policy functions (if at all) with a significant lag, which is why I see some urgency to announcing interest rate cuts sooner rather than later.

    You are correct that, given this lag, allowing some deflation in 2009 could technically be consistent with the 2% target. But my sense is that the Bank has not been particularly even-handed in administering this target. It tends to quickly hike interest rates, without much nuance about monetary policy lags, in response to up-ticks in inflation. Yet it seems much more tolerant of falling below the target. We have discussed this possible bias before.

  • I need to say that, in response to Nick’s use of the term ‘game’, while appreciating that he is likely referring to the small-minded moves of others, the suggestion that progressives pull up a chair, get the cheesies out and join this game, is disturbing.

    This would be a moment that some tables need to be turned. As Jackson Browne has sung , ‘they’ve turned the nature that i worship in, into a robber’s den’.

    I also think, Nick, that this is not a time to be speculating about whether unions should exist or not, from your item on this blog last month. It is profoundly a time to listen to those that are kept out at the gates, who are so far away from ‘the game’ that they can only weep or rage at those cloistered in the halls of learning or policy-making.

    The moment is now. We need All initiatives Fully engaged in a major shift that will support, directly, the ‘least of these’. I realize it is difficult when there is a spectrum of economists who carefully gauge their moves on what other economists across the spectrum do or say. But at this time we really need people who will have the courage, and take the trouble, to walk away from the board, listen to those suffering the most, then translate those realities into policy.

    Then we need a government in place to enact policy which is rooted and grounded in the lived experience of the majority in this country.

    But if our economists are only looking sideways at eachother…

  • I think Marc is bang on here. In the US you did find progressives questioning the wisdom of what they held to be too low interest rates. But that is precisely because the fed was not setting interests rates with such a slavish devotion to inflation. In fact one could argue the FED under greenspan was slavishly devoted to proving the worth of neoliberalism and deliberately set rates too low in the hopes he could generate Golden age levels of growth and unemployment.

    Regardless of that conjecture however, the conditions existed whereby progressives in the US could argue that rates were too low but not from a NAIRU perspective.

    In Canada, the opposite question could be posed. When have conservative economists ever claimed the (outside of this crisis) in the last 15 years that BOC policy in general was too conservative?

  • This issue is one of several in which self-described progressives have gone badly off track, for at least two reasons.

    1) If we’ve learned anything over the past 40 years, it’s that the power to print pictures of the Queen is not the same thing as producing long-run productive capacity. You cannot build a long-run policy out of the short-run tradeoff between inflation and unemployment.

    2) Since inflation amounts to a regressive consumption tax, a policy of low inflation is progressive. The rich can protect themselves from inflation by buying assets. The poor – whose buying power consists primarily of cash – cannot.

  • 1) If we’ve learned anything over the past 40 years, it’s that the power to print pictures of the Queen is not the same thing as producing long-run productive capacity. You cannot build a long-run policy out of the short-run tradeoff between inflation and unemployment.

    Why was productivity so much higher in the US than Canada given they had lower interest rates, lower unemployment and higher inflation?

    Good news is we are going to get to test the theory that low interest rates always and everywhere leads to inflation and declining unemployment over the short term.

  • Stephen said:

    “a policy of low inflation is progressive”


    And if my mother had wheels, she’d be a tricycle.

  • Sadly, that’s pretty much the most sophisticated counter-argument I’ve seen so far.

  • Martha does like her syllogisms.

    However, if Todd’s mother had wheels she could be anything with wheels not just a tricycle. Also Todd did say wheels (plural) so that rules out unicycles and mono-wheels. Further the syllogism did not contain any reference to any particular type of vehicle or toy for that matter. Hence the conclusion does not necessarily flow form the premise: ie that Todd’s mother would be a tricycle IF she had wheels. Although it could have but so could have several other conclusions.

    That is the problem with a poorly formulated syllogism, some jerk inevitably comes along and makes fun of it. Others just admire its apparent elegance and thus accord it a sophistication it does not warrant.

  • Erin: fair enough. If you have been commenting on the Bank’s policy since 2007, that’s too small a sample for anyone to conclude you have a downward bias.

    By the way, (and this goes to Travis’ point) the CD Howe median recommendation does have a slight upward bias relative the the Bank of Canada. (The Bank and the CD Howe agree 70% of the time, and in that remaining 30% the CD Howe mostly, but not always, wanted it higher). But there’s usually some individual members wanting a lower rate. This doesn’t mean the CD Howe rarely called for cuts; it’s just that when it called for a cut the Bank nearly always did cut.

    I notice I seem to have a slight downward bias myself, relative to the Bank.

    Erin and Mark: since the Bank began targeting inflation at 2%, the *average* rate of inflation over that period has been almost exactly 2%. So on average the bank was right. It did not set interest rates too high (or too low). So, with the benefit of hindsight, we cannot criticise the Bank for having interest rates too high, *if we accept the inflation target*. A (non-rhetorical) question: do you want a higher inflation target? If so, is it because you believe there is a long-run trade-off between inflation and unemployment, and that unemployment would be permanently reduced if the bank were targeting (say) 3% inflation, so that we had 3% inflation on average?

    Aside from the shape of the LR Phillips curve at 2% (it might be non-vertical if we get lower than that), I tend to agree with Stephen: inflation is a tax on currency, and I think the poor hold a larger percentage of their savings in the form of currency.

    Leigh: No, I didn’t mean the word “game” in that sense at all. I meant it in the sense of “Game Theory”, i.e. the strategic interaction between the Bank of Canada and the government, not the spectator sport sense. If we get the wrong sort of interaction between monetary and fiscal policy (if they are not “coordinated”, if you like), we can end up in a rather nasty equilibrium.

    We disagree on unions. That’s probably mostly because we disagree about whether unions have good or bad effects on real people’s real lives. But I hear your point about not just listening to the elites. (There’s been too many times, across disciplines, and across the political spectrum, when the elites have just been wrong).

  • I’ve just done the maths.

    The CD Howe recommendation is on average 0.07% above the Bank. My recommendation is on average 0.02% below the Bank. So the biases are smaller than I thought.

  • Alright,

    Let us quit with Martha’s syllogisms and take up Mr. Rowe’s.

    “The Bank and the CD Howe agree 70% of the time, and in that remaining 30% the CD Howe mostly, but not always, wanted it higher.”

    Yass, and had I gone to the good private schools in Canada too would be around seventy percent in agreement with the BOC and thirty percent in my own sectional interest or narcissistic intuition. And if I married well I might find myself better connected than that (Havergal for example). Carney is immaculate in this regard. I heard an interview with him on the BBC. Pure silk with a hint–mind you just a whiff– of single malt. He is, my comrades, the most polished of upper class and upper Canada accents you can find. Rarefied one might say.

    But if we take an honest butcher’s hook (Nick will understand if he’s not a rabbit in the hat) that you need more than an inflation rate and an interest rate to confirm the connection between a specific interest rate and a specific inflation rate (particularly with an open economy). That is, you could have interest rate that was plus or minus X% and have the same inflation rate but a different unemployment rate. ANY comparative (in time or in place) analysis of interest rates and inflation will not give you a stable (good in all times and in all places) relationship.

    Hence, any argument that the BOC got it right with respect to their target is simply a circular argument. You must PROVE that a lower or higher interest rate would have produced a different level of inflation. Which empirically you can’t so you rest on the syllogism: lower interest rates–below the natural rate (yes their is another side to that proposition) = higher inflation and over the medium term and lower employment and higher income inequality

  • Ironically Travis, I agree with your argument. Here’s my more formal proof that your argument is correct: . But notice that the same argument applies to fiscal policy. And it also applies to any argument that monetary policy affects output and employment.

    We could only prove empirically that monetary policy affects inflation if we ran an experiment where the Bank of Canada set interest rates at random, by tossing a coin. But we haven’t seem that experiment run, and we hope we never do.

    But then, if the Bank of Canada were wrong in its belief (that higher interest rates reduce inflation and lower interest rates increase inflation) it would be a very big coincidence if the Bank of Canada’s wrong-headed attempts to target inflation at 2% resulted in an average rate of inflation almost exactly equal to 2%. So, unless we believe it’s a sheer coincidence, the Bank must be right.

  • Stephen, I agree that too much inflation is bad, but believe that the goal of controlling it must be balanced with the goal of promoting real investment and employment. So, to answer Nick’s non-rhetorical question, I do not support inflation-targeting. I prefer the Federal Reserve model of an explicit commitment to balance inflation control and full employment.

    However, I am not convinced that inflation is regressive. The poor undoubtedly do hold a larger percentage of their savings as cash. However, the rich undoubtedly hold more cash savings, relative to their incomes, than the poor. On balance, reducing the value of cash holdings (and cash debts) narrows the gap between rich and poor.

    Furthermore, the rich cannot necessarily avoid inflation by buying other financial assets. In the last period of high inflation, the 1970s, real returns on financial assets were close to zero, but real wages rose considerably.

    Even if inflation is a regressive consumption tax, you (Stephen) support regressive consumption taxes. In particular, you advocate increasing the GST.

  • Nick wrote:

    “But then, if the Bank of Canada were wrong in its belief (that higher interest rates reduce inflation and lower interest rates increase inflation) it would be a very big coincidence if the Bank of Canada’s wrong-headed attempts to target inflation at 2% resulted in an average rate of inflation almost exactly equal to 2%.”

    That was not what I argued. And in fact Nobody here has argued that at the most abstract level higher interests rates do not (eventually) lead to lower inflation. The debate has always been between how high those rates have to be and what the cost is of moving too slowly or too fast in reducing the rate of inflation.

    Specifically, what I argued was that there was not any direct connection between a Specific interest rate and a Specific inflation rate and a Specific unemployment rate.

    If we can agree that inflation is caused by two main factors: capacity and expectations. Capacity can be broken down into two sub-categories: capacity utilisation and labour supply. Expectations can be reduced to previous experience and expected policy response.

    Now take a situation in which:
    Natural rate of unemployment is 4% and
    the actual unemployment rate is 7%.
    Capacity utilisation is 65%
    Inflation has been trending lower since the last 4 years The BOC has a stated target of 2%.

    It would be surprising if the the BOC did not have a range of rates to select from and still achieve its 2% target. And did we not see lower interest rates and lower rates of inflation walking hand in hand?

    That does not contradict the abstract general rule that higher interest rates will cause lower rates of inflation. But it comes in the ceteris paribus variety.

    If I had argued that an increase in a stock price was accompanied by an increase in demand for that stock would you accuse me of having argued that as an abstract general rule the law of supply and demand had been contradicted?

  • Nick, the questions remain; do those engaging in fiscal and monetary ‘Game Theory’ consider the ramifications of social policy, environmental policy, and other policy in their equations seeking ‘equilibrium’? ‘coordinated’ toward which priority goals, the 2% target only? and why? It seems there is a larger ‘macro-macro’ world ‘out there’ which demands recognition. Would this perhaps be a part of what Chris Borst was referring to as an economics ‘autistic no longer’, along with others responding to Iglika’s earlier blog item on revisiting perspectives?

  • Leigh: To answer your question, I would say that the Bank of Canada should *not* have any goals other than monetary stability (something like the 2% target, plus other closely related things). For these reasons: it is unelected, and shouldn’t try to do anything except what it has been mandated to do; because if it can fulfill that mandate it will make it easier for the government and the rest of us to do those other things; because it has (usually) only one instrument and hence can only hit one target; and because it is fairly good at doing that one thing, and would probably do a really bad job if it tried to do anything else.

    Put it another way: there might be some jobs in society for which a (mildly) autistic person might be well-suited 😉

  • Stephen said:

    “Sadly, that’s pretty much the most sophisticated counter-argument I’ve seen so far.”

    It always fills me with trepidation when economists can’t distinguish between a critique and a counter-argument.

    Try again, Sonny.

  • The Bank of Canada Act text


    “WHEREAS it is desirable to establish a central bank in Canada to regulate credit and currency in the best interests of the economic life of the nation, to control and protect the external value of the national monetary unit and to mitigate by its influence fluctuations in the general level of production, trade, prices and employment, so far as may be possible within the scope of monetary action, and generally to promote the economic and financial welfare of Canada;”

    under ‘Government Directive’ :
    “(2) If, notwithstanding the consultations provided for in subsection (1), there should emerge a difference of opinion between the Minister and the Bank concerning the monetary policy to be followed, the Minister may, after consultation with the Governor and with the approval of the Governor in Council, give to the Governor a written directive concerning monetary policy, in specific terms and applicable for a specified period, and the Bank shall comply with that directive. ”

    The mandate suggests a larger focus Nick, and the directive suggests elected officials have a key role.

    My understanding is that the Bank of Canada between 1938 and 1974 was used to get us out of the Great Depression, and to build social and other infrastructure. What if it had played this role earlier on- and prevented the Great Depression?

  • Even if inflation is a regressive consumption tax, you (Stephen) support regressive consumption taxes. In particular, you advocate increasing the GST.

    Yes, because it’s easy to compensate for those regressive effects (the GST rebate), it generates lots of tax revenues, and it doesn’t penalise savings and investment. None of that is true of a high-inflation policy.

  • Yup, them rich bastards sitting around waiting for their GST cheques so they can run out and buy more memory for their lap-tops.

    Meanwhile, high-interest rates keep their serious green rolling in. All to save and invest, of course . . . .

  • There used to be higher statuatory reserves required of lenders as well, a role the BofC had before ’91.

    And, in line with some of Eric’s comments on this blog, targetted rates are possible for different sectors at different times.

    There are probably a number of other tools in the kit which could be used to prevent ‘high’ inflation, whatever that is in any given context, without rates that are usurious to poor and lower or middle income folks, in any given context.

    It is also an odd statement of Nick’s above, of Jan22, “I think the poor hold a larger percentage of their savings in the form of currency.” The poor do not have savings. Period. Neither do many lower and even middle income people these days. But the vast majority have debt.

    On the currency issue, that is where some of the recommendations in the AFB come in handy, particularly on the international front. There are lots of good options being floated at present.

  • . . . it’s easy to compensate for those regressive effects (the GST rebate), it generates lots of tax revenues, and it doesn’t penalise savings and investment. None of that is true of a high-inflation policy.

    But inflation does meet those three criteria.

    It’s easy to compensate for the potentially regressive effects of inflation by indexing social benefits to the inflation rate.

    Inflation reduces debt-servicing costs relative to government revenues, which has the same effect as generating more revenues.

    If tolerance of inflation permits lower interest rates, then it promotes capital investment.

  • Erin: why do you think that a higher average (anticipated) level of inflation would cause reduced real interest rates (so it would reduce debt service costs and increase the capital stock)?

    (I could cook up a model which gets these results, but I wouldn’t believe that model, and the effect would be very small.)

  • I am not arguing that higher inflation causes lower interest rates. (Although, for any given nominal interest rate, more inflation obviously does mean a lower real interest rate.)

    My point is that, if the central bank is more tolerant of inflation, it can keep interest rates lower than if it feels compelled to hike interest rates to squash inflation.

  • Erin,

    Why do you and your “progressive” comrades keep arguing that lower interest rates means a lower inflation rate? :).

    I have changed my mind. I don’t think some vintage of the law of conservation of energy stalks most economists heads. Rather it is the 2nd law of the conservation of misery:

    Misery cannot be created or destroyed it can merely be displaced across space and or through time.

  • Inflation reduces debt-servicing costs relative to government revenues, which has the same effect as generating more revenues.

    If tolerance of inflation permits lower interest rates, then it promotes capital investment.

    To repeat Nick’s question – because it’s one that a lot of people have spent a lot of time on – why do you think that high inflation reduces real interest rates? And why do you think that’s always and everywhere a good idea?

    Yes, you can always engineer a one-off surprise: increasing inflation to 5% will extract buying power from people who had bought government debt with the expectation of 2% inflation. Of course, you’d have to ask yourself:

    1) Are people who buy government debt automatically The Enemy? Before you answer, ask yourself if extracting wealth from pension funds is something progressives should be cheering.

    2) This is hardly a winning long-term strategy. Because then you’d have to spring surprises on people who bought debt on the basis of 5% inflation. And then people who bought debt based on whatever the latest surprise generated the last time around. And eventually, you’d be selling debt to people who knew that you had no intention of ever paying your debt in full.

    The error being made in the conventional, would-be progressive analysis is that relationships that are valid in the short run – conditional on expectations – are also valid in the long run, when expectations are endogenous. This is simply wrong. No good, and much harm, is generated by insisting otherwise.

  • I am not sure that I can answer this question any better than I did in this morning’s comment (above).

    You seem to be assuming that interest rates are set in financial markets based on more or less accurate expectations about future inflation.

    However, to a significant extent, interest rates are not determined in markets, but dictated by central banks. If central bankers are prepared to risk more inflation, they can simply choose to set interest rates lower.

  • “If central bankers are prepared to risk more inflation, they can simply choose to set interest rates lower.”

    The operative word being “risk”. Crucially capacity matters the most. What else could be the “sense” data for expectations?

    In a capacity constrained economy I can imagine low interest rates causing accelerating inflation. Producers know they are, for the short-run at least, at their maximum potential output and they know lower interest rates will make the financing of expanding production in the medium term easier but in the short-run they also know it is going to jack-up demand and thus price rationing will kick-in. Thus they will raise their inflation expectations and their prices.

    In a situation in which they are not feeling output constrained and in fact are searching for vents for what they already producing they know that higher interest rates will in fact dampen demand for their products thus lowering their expectations of inflation and perhaps prices and impede any plans to expand capacity and employment.

    Between those two structural extremes there is a dogs breakfast of combinations of interest and inflation rates.

    As long as one’s theory of expectations is tied to an overly socio-psychological explanation it is to my mind suspect. To improvise on Gary Becker (1986):

    “I do not mean to suggest that socio-psychological concepts like expectation are without any scientific content. Only that they are tempting materials for ad hoc and useless explanations of behaviour.”

  • Stephen said:

    “Are people who buy government debt automatically The Enemy?”

    Depends: what’s their relationship to capital? As you’ve suggested, money from pension funds doesn’t necessarily go into the same type of pocket for the same purposes as an owner would have.

  • Also, I think Stephen is concerned about the larger debt picture, as he’s mentioned this same element earlier on this blog; “you’d be selling debt to people who knew that you had no intention of ever paying your debt in full.” So I’m hearing that he’s concerned about trust issues. Others have addressed some aspects, I’ll just flag and highlight a few others.

    There are assumptions around deficits as necessarily creating debt.

    Also, there are assumptions around possibilities for structuring solutions to public needs, including job, wage, social, and environmental demands.

    Major public social and green infrastructure (and ensuing employment created) can be paid for with extremely low government-to-government rates. Municipalities can borrow directly from the federal government/BofC) and pay back the loans over the lifetime of a project.

    This approach has been described so many times in the past, by the Canadian Federation of Municipalities, by the AFB, by the Committee on Monetary and Economic Reform, by academics, by workers’ and social justice advocates, it is incredible to me why there are still blinders on in some circles.

    Why really are there blinders? Perhaps because of the stranglehold on academic and policy dialogue in recent years? Some financiers, on top of the billions already drained from the public purse in bailouts, want to continue to act as private bankers for governments. They want to be the middlemen in any government-to-government projects, and scoop their percentages. And they want P3s, to extend those percentages even further. Financiers for some reason can’t be satisfied with decent consumer banking, no they must leverage at 9-1 or 30-1 ratios their reserves, reserves which now are made up substantially of our handouts to them, in one form or other.

    Does this leveraging by private sector financiers not contribute to inflation? ‘No’ some may say, because the monies are invested back in the economy. But we know this largely isn’t true; investment in the real, useful, economy has been decreasing, the proceeds going to island retreats, paper games and buyouts. What is happening is a constant drain of public value through private leveraging, and ‘invisible’ inflation, invisible because it is cancelled out when the resultant multi-billions are disappeared into a few private pockets.

    This cannot go on. Commercial lenders need to lower their sights, and be content with acceptable and transparent forms of banking. They have to come back down to earth.

    The Bank of Canada needs to fulfill its broad mandate. This can include direct support to lower tier governments.

    If people are really worried about debt, some have argued that the BofC could also take back significant chunks of government debt. This would be far cheaper than continuing to subsidize the private finance sector with additional interest on top of that already paid, and owed in ongoing servicing. The BofC could buy back and hold that debt, and the public would service the debt over the long-term, again at lower rates than continuing to service the debt at high rates to private bankers.

    There are lots of good options. What we need are more people who are willing to think outside the box. We also need political will, and reduction in greed on the part of finance. I think that politicians and financiers are beginning to realize that the loaf of workers and the environment has imploded and cannot be re-inflated with more paper chase.

  • Depends: what’s their relationship to capital? As you’ve suggested, money from pension funds doesn’t necessarily go into the same type of pocket for the same purposes as an owner would have.

    Well, this is the thing. If a policy instrument penalises both Paris Hilton and Ontario Teachers’ indiscriminately, then it’s far from clear that it’s a useful instrument for advancing progressive goals.

  • However, to a significant extent, interest rates are not determined in markets, but dictated by central banks. If central bankers are prepared to risk more inflation, they can simply choose to set interest rates lower.

    Nominal rates, yes. Real rates, no. This distinction is absolutely crucial, and disappointingly absent from the conventional progressive narrative.

  • “Nominal rates, yes. Real rates, no.”

    I donno, I am looking at BOC data which shows them picking a nominal rate trend and that trend being reflected in real rates of all kinds from corporate paper to mortgage rates. That would suggest that they are picking real interest rates when they pick nominal rates.

    At first I was shocked but then I realized that was the whole PREMISE behind monetary policy.

  • Travis: yes, it is the whole premise behind how monetary policy works. Since inflation, and expected inflation, are slow to adjust to monetary policy, if the BoC cuts the nominal rate, this will cause the real rate to come down as well. Eventually, however, the lower real rate will cause demand to increase, and inflation to increase, and expected inflation to increase, which lowers the real rate still further, causing a further increase in demand and inflation and expected inflation..(compared to what would otherwise happen). So the BoC will be forced to raise nominal rates, above where they were originally, to raise real rates again to where they were originally, to get demand back to where it was originally, to stop inflation accelerating further into hyperinflation.

    To a first approximation, for every equilibrium at one rate of inflation, there is a second equilibrium at a higher rate of (actual and expected) inflation, where everything real (real interest rates, real income, real investment, etc.) exactly the same.

    That first approximation is not exactly right however. Since currency does not pay interest, the real rate of interest on currency is now lower (more negative) in the second equilibrium. So the real money (currency) stock must be lower. That in turn may have other real effects. Those other real effects will probably be bad. Also, if firms change prices at fixed intervals (not continuously), that will cause other real effects (also probably bad). Maybe these other effects will indirectly lower real interest rates a bit, or maybe raise them a bit. It depends.

  • Nick, looking at mechanics of your model I have three queries.

    1.) In this model expectations of inflation are soley linked to previous interest rates and previous inflation rates. That is it makes no mention of how lower interests rates at time one will impact investment and output at time two. I can only gather that in this model firms do not ramp up their investment plans in time one because they think interest rates will increase at time two thus dampening demand so any demand that is generated in time one will be limited to time one. In time two all that extra demand is eroded by higher inflation and higher interest rates.

    All of this seems like a model in which there is a natural rate of interest, employment of resources and inflation. That is, what would appear to be an unemployment (resources incl labour) equilibrium at time one is in fact, given the structure of the economy, for all intents and purposes a full-employment equilibrium.

    2) Can you fit the Japanese experience with inflation and interest rates into this scenario?

    3) What empirical evidence (scenario) would force you to reject your model?

  • Travis: Starting with the easier, continuing to the hard, then very hard queries:

    2. My first approximation definitely won’t work when inflation gets so low we hit a liquidity trap. (It won’t even work approximately). Here, the zero nominal interest rate on currency puts a floor under all other nominal interest rates, and that floor is binding in a liquidity trap. From past experience, my guess is that a 2% inflation target is probably OK, but I would not want to go lower than 2% for just the fear that we might hit that lower bound (since the BoC can’t target inflation perfectly). There may be ways to increase safety by switching to a target for the time-path of the price level, growing at 2%, but that’s another question.

    3. Dunno. Cross-country comparisons over long periods with different average inflation rates and different real interest rates might make me wonder, but then I would always first suspect that something else might be different across countries as well, so that causation is reversed. I think I would need a theoretical explanation, and that theory to be both intuitively reasonable, and backed up with some empirical support. What I have at the moment is a strong theoretical result, which seems intuitively reasonable across a wide class of theories, and which seems at least roughly in line with the data.

    1. The tough one. My intuition on the super-neutrality of money works by comparing two economies, each with its own past, present and future, each being hit by shocks and moving around, and growing, and otherwise identical in all the exogenous stuff, but having different average inflation rates. Sort of comparative dynamics. They are on two parallel time-paths. You are asking the true dynamic question, of what happens when we try to traverse from one time-path to the other. Will we ever get there? If history matters permanently (if there is true hysterisis), we won’t. What matters during the transition (when real interest rates are temporarily lower, and then perhaps temporarily higher), may matter permanently. But, like other effects once we get past the first approximation, I think the effect on the real interest rate could go either way. It depends on the model, and on the actual numbers. Dunno.

  • Nick, we could perhaps agree that for at least he last 20 years CBs in the advanced capitalist zone (ACZ) have been using some vintage of the model you described above. And it is on the basis of the apparent success of this model, and its apparent empirical verification, that you and Mr. Gordon have argued that the left (or scare quotes “progressives”) have been proven wrong.

    Let us leave to one side that fact that any historical investigation of nominal interest rates, unemployment rates, real rates and inflation rates, scatter-plotted, leaves sufficient room for doubt.

    However, my last query on this subject is rather this. Would it be safe to say that it has bee you and your people that have been in control of monetary policy for the last twenty years, and most certainly not my people? In fact, earlier you argued that because inflation had tracked in the neighborhood of 2% that the BOC had generally got it right. Hence we-the left-were wrong. Right?

    Now, today, the whole ACZ is in a liquidity trap, in which you say your theory will not work. In other words, the BOC has gotten it exactly right (or as near as mortals can come to perfection) yet it and we sit in a liquidity trap. How did we get here? By following the left-progressive conjecture or by following the centrist-right conjecture? Obviously the latter.

    Warning my hammer has found a nail! How does the FACT of a global liquidity trap make you and your comrades right and my comrades and I wrong (not that it makes us right)? And how is it that in this conjuncture that Mr. Gordon can show up here acting as though he and his theory have somehow been vindicated?

    We are in a global liquidity trap precisely because you and your theory were followed to its real world logical conclusion. In short, we are HERE because the world believed you, not my comrades, nor I. It is you and some vintage of your theory which have enjoyed dominance. To be precise, this world economic crisis is your creation, which was not predicted by your model. No conclusion from any of the similar such models that you have proffered here have suggested that we would end up here.

    But alas you and Mr. Gordon (Mr. Gordon more so) come here again and again to lecture the rest of us on our naiveté and misplaced ideas on how to serve the subservient.

    Who will pay in the taxes or the programme cuts to cover the 64 billion deficit? Who will pay in terms of unemployment and income loss? The citizens sitting at the CD Howe round table and their ilk or the rest of us?

  • Travis: sure, but the only central bank I’m aware of over the last few years that doesn’t believe something close to what I have sketched above is the central bank of Zimbabwe.

    Even leaving Zimbabwe aside, the socialist model(s) haven’t fared so well either, historically. No economies, except maybe the most primitive, seem to be immune from crises. So we are all still looking for the cause(s) and cure(s).

    Maybe the cure would be to target a higher rate of inflation, so that when demand fell, we could push real interest rates lower without hitting a liquidity trap. But then I’m still resorting to the same theory I used above.

  • “No economies, except maybe the most primitive, seem to be immune from crises.”

    Nicholas, primitive economies have crises but they have them for different reasons. More importantly, I suspect that you have been in search of something more illuminating than a “hey, shit happens” theory.

    Maybe your little corner of the academy could devote more time to developing an endogenous theory of capitalist crises? No cheating though; it has to be a truly endogenous theory of capitalist crisis which has micro-foundations, rational expectations, the assumption of the neutrality of money and with no reference to the state or bad public policy.

    Good luck getting funding and resources for that.

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