Next steps for monetary and fiscal policy

Just before Christmas, and lost between a trip to the mall and turkey with stuffing, David Laidler wrote a phenomenal piece on how we should be thinking strategically about a coordinated monetary and fiscal policy. I have reposted the key excerpt below because it should really be part of the mainstream discussion about how we address the growing crisis in the most efficient and effective way. Basically, the Bank of Canada should buy up federal government debt, as a means of financing our deficits over the next two or more years. And we could sleep a bit better knowing that our grandkids are not going to have to pay for saving our butts back in ’09. In normal times, we would be concerned about inflationary impacts, but these are not normal times and inflation is not the issue – arguably, deflation is.

Laidler is not the first to put forward such ideas but his pedigree as a monetarist academic, commandante in the Inflation Wars , and stalwart member of CD Howe’s Monetary Policy Council gives some weight to this basic idea for a harmonious blend of monetary and fiscal policy.

On the monetary front, the Bank of Canada is expected to drop the overnight rate from 1% to 0.5% on Tuesday (yay, variable rate mortgage). So we are basically done with traditional monetary policy, and in fact have already started down the road of unorthodox alternatives. Among unortodox monetary policy ideas, Laidler’s approach would be a much better one than having the Bank buy equities or commercial paper, or worse “toxic assets”. And the proceeds of a coherent public approach would go into things that have been underprovided by the private sector in spite of (or perhaps because of) a credit boom. A little thing we call planning, which as James Galbraith points out brilliantly in the Predator State needs to be brought back front and centre in a progressive policy framework. In Vancouver we have had over-production of luxury condos in recent years but no new social or rental housing; lots of new gas guzzlers on the road but little new public transit capacity. Why not set off a much bigger public-sector led investment program that builds out the infrastructure we need for the next generation (heaps of public transit, affordable housing and child care centres would be a good start).

We now have a federal budget tabled and while inadequate it is still much better than complete steady-hands-off approach we saw in the November Economic and Fiscal Statement. Provincial budgets are arriving as well, and at least in BC’s case, have been similarly disappointing. If we add the two together we have a good start for some major investment projects, but given the circumstances I think this stimulus package will need to grow, perhaps even by fall of this year, and a more accommodating monetary policy would make doing the right thing a whole lot easier. Because of the prominent role of the provinces, we would need the feds to act on their behalf or just let the Bank buy their debt as well (but because the Bank’s profits go to the feds, some future transfer arrangement would need to be worked out, so it probably ends up being financially equivalent. The feds could use this leverage to press for projects in specific areas.

I’m actually inclined to go further and demand a more central role of public sector money creation on a permanent basis – that might crowd out some (but not all) of the private money creation through the banks, and that would provide both more stability to aggregate demand and channel more of society’s resources where democratic forces want them to go.

Here is the original quote from Laidler in the Globe:

At this juncture, there is little point in Finance Minister Jim Flaherty and Bank of Canada Governor Mark Carney exhorting the banks to do better. Rather, the Bank of Canada needs to take the initiative in providing the financial system not with all the liquidity it wants, but with more than that. Only this will push financial institutions into becoming more aggressive lenders, as they dispose of excess cash holdings. The central bank could also enter the open market to buy assets directly from the non-bank public, furthering the goal of getting so much liquidity into the hands of households and firms that they too will increase their spending.

This is where fiscal stimulus fits in. Well designed, it can have immediate and beneficial effects on the sectors toward which it is directed; but more important for monetary policy, it must be financed by the sale of government bonds. If those bonds’ initial purchasers are in the financial system, or among the public at large, the Bank of Canada can then actively buy them up, as part of its efforts to force liquidity into the economy; a few intermediate transactions could be eliminated, while achieving the same ultimate result, were the central bank itself to be the bonds’ initial purchaser.

These recommendations will horrify anyone who believes that fiscal deficits financed by money creation are an inflationary route to ruin. So they are when the real economy is running near its capacity and financial markets are functioning normally. But when the real economy is depressed, and when deadlocked financial markets seem to be functioning normally, but in fact are providing insufficient stimulus to support a real recovery, those same policies will encourage the spending needed to restore normality.

In the early 1930s, U.S. policy makers were misled by the false signals of returning financial market normality to which a developing credit deadlock gave rise, and they let it grow into the Great Depression. In the early 1990s, the Bank of Japan made a similar mistake and failed to take advantage of the opportunities for aggressive monetary expansion provided by a fiscal stimulus program, thus helping ensure that the 1990s became a lost decade.

U.S. credit markets are now emitting similar misleading signals, but, to judge from recent announcements, the Fed has seen through them this time. So are Canadian markets, and the Bank of Canada should follow the Fed’s example. It is, after all, assigned to keep inflation at 2 per cent, and the way things are now developing, that is going to require quite an expansionary effort over the next year or so.

UPDATE (March 1): This article by Julian Beltram for CP is started to make some of the right noises about what the Bank of Canada’s next steps might be:

“There is clear evidence that very low interest rates are not working to expand economic activity,” former Conservative cabinet minister Doug Peters, once also a TD Bank chief economist, wrote in a paper for the Canadian Centre for Policy Alternatives.

“In the current recessionary environment, banks are obviously worried about lending to each other, and of course, are worried about lending to consumers and firms. Interest rates that count, such as inter-bank lending rates, mortgage lending rates, bank commercial lending rates, are all unusually high, especially considering that inflation is also very close to zero.”

Even before Mr. Carney’s Tuesday move, a new report Monday from Statistics Canada is expected to reveal that the Canadian economy, in Finance Minister Jim Flaherty’s blunt words, “fell off the table” in the fourth quarter of 2008.

Private sector economists are predicting a sharp three-to-four per cent contraction in economic activity — severe recessionary territory — but remarkably it could be worse. In fact, Mr. Carney is predicting worse for the first three months of this year with a 4.8-per-cent economic contraction.

In his last public speech in January, Mr. Carney insisted that monetary action taken so far “will work,” noting the lengthy lag time between action and impact, often cited as 12 to 18 months. Since the bank started cutting 15 months ago, Canada should be just beginning to feel the effects.

Hmmm, is this a commitment to keep interest rates super-low for the next 12 to 18 months?

… In his January speech, Mr. Carney talked about other measures at his disposal besides rate cuts, no doubt foreshadowing last week’s action on corporate bonds. The bank could also follow the Fed example by implementing so-called “quantitative easing” facilities to pump funds into the private sector, or follow Japan’s lead by directly buying corporate bonds, or still more exotic intrusions in the money markets.

… The next big round of central bank action should be left to the Fed and perhaps the Bank of England, he said. This could involve printing mounds of money to buy up government treasury bills in order to free up more cash for the private sector economy.


  • Comment from Thomas Bergbusch
    Time: February 27, 2009, 2:56 pm

    It is interesting that British historian Niall Ferguson’s gloom and financial-crisis version of the policy irrelevance argument (!) gets all sorts of play in the media — he spoke in Ottawa this weak against counter-cyclical public investment — but Ha-Joon Chang’s demolishment of the financial liberalizers’ one-size-fits-all model of growth gets no play at all. Ferguson gets fawned over by Steve Paikin, but the far more incisive Chang apparently doesn’t even rate an invite.

  • Marc,

    I am all for public banking whereby the government gets into consumer branch banking say through the postal system. They could be restricted to mortgages, consumer credit, vanilla savings and chequing accounts and retirement. The government could then sell bonds directly to the public system and the public system could then use those assets to make loans. The BOC would stay in place and operate as normal with commercial banks as its clients and private banks would be free to offer the same services and compete with the public system.

  • Where will the pressure be on fixed rate mortgages? Is there potential (liklihood?) that this “quantitative easing” will impact the bond markets which, as I vaguely understand it, impacts the fixed term mortgage rates? And if so, in what direction? I have a variable rate mortgage which is the bank prime, less 3/4’s. The effective rate will soon be at 1 and 3/4 percent!!! Sadly, the five year term ends in November, and the bank is not offering that product anymore. So, all things considered, I suspect that I will be in the market for a fixed term mortgage and will need to start shopping around in August. A better understanding of the possible impact on the fixed mortgage side is something I, and I expect others, would greatly appreciate.

  • John,

    I’m impressed. My variable rate will fall to 1.9% as of April, and you are 15 bp below mine. My mortgage is on for another 18 months, though, so I will have to make the same call at some point.

    My sense is that the Bank of Canada is going to keep short-term rates low for some time, like 12-24 months, which should bring down fixed rate mortgages, though slowly. If you can lock in at a decent rate for 3-5 years this fall, but you may be better off with another variable rate (albeit at a higher starting interest rate) depending on the spreads between the two.

    But six months is a long time from now given current circumstances …

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