The Governor's Gamble


TOM FENNELL May 7 1990

The Governor's Gamble


TOM FENNELL May 7 1990

The Governor's Gamble



John Crow, the patrician, 53-year-old London-born governor of the Bank of Canada, is on a determined mission. His stated objective: zero inflation, the Holy Grail of monetarist economic policy. And the weapon he has chosen to achieve that is the trendsetting Bank of Canada interest rate. So far this year, the governor has raised rates 11 times, to an almost eight-year high of 13.80 per cent last Thursday, from a low of 12.14 per cent last Jan.

18. As a result, a middleincome Canadian pays a much steeper 16 per cent when he takes out a bank loan to buy a new car or other consumer goods. Still, inflation remains just above five per cent, and critics say that Crow’s dogged pursuit of his economic ideal is unnecessary, outdated and has pushed the nation to the very brink of recession.

Declared Douglas Peters, chief economist at the Toronto-Dominion Bank: “Crow is running a stupid monetary policy.”

Dissatisfaction with Crow and his harsh high-interestrate policy escalated last week. Even traditionally conservative businessmen and politicians, some of whom

Crow: despite criticism, pressure to raise rates even higher

say that the governor and Finance Minister Michael Wilson may be deliberately trying to push the country into recession, joined the controversy. On Tuesday, Stelco Inc. chairman John Allan told the firm’s annual meeting in Hamilton that high interest rates had cut into the company’s profits, forcing it to eliminate at least 800 jobs. And in Ottawa, Donald Blenkam, the Conser vative chairman of the Commons finance committee, said that he will summon

Crow to explain his policies in hearings next week.

Crow’s policies are now exacting a high price. Statistics Canada reported last week that housing starts across Canada declined by 25 per cent in March, compared with March, 1989. As well, the department of consumer and corporate affairs reported a 30-per-cent increase in bankruptcies in January and February of this year, compared with the same period a year ago. Said Ernest Stokes, director of Canadian Services for the WEFA Group of economic forecasters: “Does the Bank of Canada want to create a recession? It seems that it does.”

Despite spreading layoffs and economic uncertainty, Thursday’s 0.03-of-a-percentage-point bank rate increase to 13.80 per cent, the sixth weekly increase in a row, reflected Crow’s resolute determination to reach a

zero inflation rate. But inflation is just one of many powerful factors—some of which are clearly beyond Crow’s control—that are pushing up Canadian rates. The need to attract foreign investors to finance Canada’s burgeoning $351-billion national debt is also a major factor. As well, the constitutional crisis created by the Meech Lake accord has caused confusion and deep concern internationally over Canada’s future, and the bank has to steadily increase rates to attract critical foreign investment, including buyers for federal treasury bills and bonds.

At the same time, inflation rates are rising in the United States, Japan and Europe, forcing central bankers in those countries to also raise their interest rates. As a result, Canada has to keep its bank rate competitive against other world rates to get its share of foreign investment. And last week, there were signs that a worldwide surge in demand for money will put

even greater pressure on Crow to raise Canadian rates higher. In Bonn, the West and East German governments announced that their currencies would be merged essentially on a one-to-one basis in July. But West Germany may have to borrow heavily to finance the unprecedented conversion and, when the proposed union takes effect in July, it will likely be inflationary, as pent-up East German consumer demand is suddenly unleashed.

Forces: In mid-May, Canadians will get a clear sign of just how much Crow’s monetary policy is hemmed in by international monetary forces, when the U.S. treasury department holds its quarterly auction of treasury bonds. About $18.6 billion in bonds will be offered for sale. While Japanese investors are usually major purchasers of 25 per cent to 35 per cent of the bonds, two weeks ago they unloaded $7 billion worth of U.S. bonds. If they fail to buy at their historical rate at the upcoming auction— the date of which will be announced on May 2—the United States will be forced to raise its rates to entice investors, leading to what some

economists fear will turn into an international interest-rate war. And Canada, with its huge national debt, could be one of its biggest victims.

Despite the gathering storm on international money markets, Crow says that the unyielding focus of his monetary policy is to wring inflation out of the economy. Indeed, Crow, who was appointed governor of the Bank of Canada in February, 1987, meets weekly with Finance Minister Michael Wilson and—being in one of the most powerful positions in federal government—has the authority to direct monetary policy in Canada.

And despite Crow’s best efforts to communicate more effectively to the public, he still declines most interview requests, including several from Maclean ’s. In that, he is following the practice of most central bankers. All of them say that an injudicious comment could cause a run on their currency or unleash other financial upheavals. “As a matter of principle, you are never going to get colorful, oversimplified and underqualified commentary from the bank,” Crow once said in a speech. “Such commentary may make for better copy and bigger headlines, but it risks causing exaggerated responses in financial markets.”

Passion: Still, he recently said in the Bank of Canada’s 1989 annual report—released earlier this year—that even helping set the value of the Canadian dollar in currency markets is secondary to his inflation-fighting goal.

It is a belief and passion that he inherited while being groomed by his predecessor, Gerald Bouey, who headed the powerful institution from 1973 to 1987. Throughout his two seven-year terms, Bouey also

said that interest rates should

not be reduced unless inflation is falling.

Bouey’s monetarist strategy helped to curb inflation in the past, but some economists claim that it also contributed to the onset of a painful recession. In 1980-1981, when inflation rose to over 12 per cent, the Bank of Canada rate reached 21.24 per cent, including a single 3.31-percentage-point increase in December, 1980. By 1983, high interest rates, a devastating global recession and federal controls that limited wage and price increases to five and six per cent respectively, had cut inflation to 5.8 per cent.

While Crow is now fighting a much lower inflation rate with the same high-interest-rate

strategy, many economists have begun to argue that there are less painful alternatives and they add that the campaign for zero inflation is, in itself, inflationary. They say that Crow is actually adding to current and long-term inflationary pressures by raising borrowing costs and choking off business’s ability to invest in new plants and equipment, which would increase the supply of available goods and lower inflation. Declared economist Eric Kierans, a former federal and Quebec cabinet minister: “Everybody is for ‘zero inflation,’ but the way to get it is to increase the supply [of goods] and certainly not to hammer the economy with high interest rates, which is selfdefeating.”

For his part,

Crow says that lower rates are inflationary because they encourage consumers to borrow and spend more for scarce goods and services.

But Peters, for one, claims that the increased tendency to borrow with lower rates will be offset by lower earnings from the interest on government bonds and treasury bills. He added that private bank and trust company deposits also would decline as rates fall and consumers would

spend more of their own money

without resorting to borrowing. With less money being paid out in interest, Peters says, consumer demand would moderate without the need for painful interest rates.

As well, Peters added that a unilateral reduction would ease inflationary pressure caused by the need to finance the national debt, because each percentage-point increase in rates adds about $1.7 billion to Ottawa’s borrowing costs and to the national debt. Completely eliminating the difference between Canadian and U.S. rates, maintains Peters, would cut the government’s $30.5-billion budget deficit by almost $8 billion. “He has room to manoeuvre,” said the economist. Added Duncan Cameron, a University of Ottawa political science professor: “We do not have to have a five-percentagepoint difference. If Crow brought interest rates down, then that would take care of a big part of the deficit problem.”

Meanwhile, Canada’s hard-pressed exporters say that high interest rates have pushed the

valué of the Canadian dollar too high against its U.S. counterpart and that is pricing them out of world markets. Many of them claim that it should be allowed to fall to 76 cents from Friday’s level of just under 86 cents (U.S.). But neither Crow nor Finance Minister Michael Wilson has indicated the government’s view of an ideal exchange rate of the dollar. Said Wilson: “We are not following a policy which is deliberately designed to increase the level of the Canadian dollar. We are following a policy which is deliberately designed to get inflation under control.”

Crow’s critics also argue that it is impossible to tell if the governor’s inflation-fighting strategy will eventually decrease inflation. In the bank’s 1989 annual report, even Crow acknowledged that the strategy had not yet achieved its objective. Said Crow in the report: “The Bank of Canada actions did not result in any improvement in our inflation performance.”

Impact: In fact, despite the almost constant rate increases, last month’s consumer price index (CPI) showed that inflation has moderated only slightly—to 5.3-per-cent in March from a 5.4-per-cent annual rate in February. And economists say that it may be too early to tell if consumers are changing their spending habits as a result of Crow’s policies because the dampening impact of higher rates could take several years to show up.

And one traditional measure of the magnitude of interest-rate gains is a comparison with consumer price index increases. While the CPI has risen by 14 per cent in the past three years, real interest rates, the average prime rate offered by Canada’s leading banks after subtracting inflation, have risen more rapidly than the growth in gross domestic product, the total value of goods and services produced within the economy. The resulting shortfall forces


Ottawa to borrow to cover interest on its national debt, increasing the indebtedness that it has pledged to cut.

The same principle applies to a family with, perhaps, car payments, a mortgage and other household debts, whose income is rising roughly in step with inflation. When the real cost of meeting interest rates exceeds the rate of income growth, the family is forced to borrow more in order to maintain the same living standards.

Vulnerable: High interest rates have indeed restricted Ottawa’s capacity to limit the growth in the national debt.

In the past three years, the cost of interest payments on the debt rose by 46 per cent, double the rate of increase in federal spending. By comparison, in the United States, where the national debt is $3.51 trillion, payments on the debt are proportionately about half as great—U.S. interest payments cost about 5.9 per cent of its year-end debt, compared with Canada’s 11.2 per cent. Says Carl Beigie, chief economist at Mclean McCarthy Ltd., a brokerage firm in Toronto:

“The combination of a major current account deficit, very, very high interest rates and a very vulnerable budget déficit suggests that maybe we

should go back and take a hard look at the overall policy package we are pushing.”

Still, while economists like Beigie ask for at least a discussion of alternatives to Crow’s policies, many others believe that, painful or not, Crow is following the correct path. John Parish, assistant chief economist at the Bank of Montreal, said flatly: “The Bank of Canada is on the right track. It is an unpopular policy: nobody likes it. But it is like taking cod-liver oil. If you don’t take high interest rates now, then inflation will be higher, which will cause higher interest rates.”

Part of the difficulty facing Crow is simply the size of that debt. Said economist Michael Walker, executive director of the conservative Vancouver-based Fraser Institute: “There is $56 billion worth of Canadian government debt held by foreigners. This changes the whole ball game.” The Japanese alone finance an estimated $40 billion of Canada’s $351-billion national debt—and the

rates Canada must offer to foreigners on government securities such as treasury bills and bonds are being pushed higher by international events beyond Crow’s control.

Many of the economic upheavals are unprecedented. For one, the rapid and breathtaking political changes in Eastern Europe, including the full integration of the East and West German economies, requires staggering amounts of new investment capital. As the demand for capital grows, interest rates throughout the West have climbed.

Indeed, the demand for money has been so great that officials from 42 countries and organizations are involved in negotiations to create a new European Bank for Reconstruction and Development, which will have an initial investment of $14 billion. The United States, contributing 10 per cent of the capital, will be the bank’s largest individual member, while Canada will take a 3.5-per-cent share.

Pressure: At the same time, West Germany and Japan, two of the world’s leading creditor nations, have themselves come under inflationary pressure, an economic problem largely foreign to them since the end of the Second

World War. Since January, central bankers in the two economic powerhouses have raised rates sharply to 8.25 per cent in Germany and 5.25 in Japan, compared with average rates last year of 6.8 per cent and 2.5 per cent.

World interest rates threatened to spiral even higher last week after West Germany confirmed that it would proceed with its costly conversion plan for the East German currency as a step towards unification later this year. If interest rates continue to rise in West Germa-

ny, Henry Schindele, the Tokyo-based general manager and regional director of the TorontoDominion Bank’s Asian region, predicts that Japan will likely have to raise its rates further, as well.

And Helmut Henschel, chief of capital services for the Westdeutsche Landesbank in Dusseldorf, says that only a co-ordinated international effort is now capable of stopping a worldwide interest-rate war. Added Henschel: “While reasons for the rise are peculiar to each country, rates have reached the level where only co-ordinated, worldwide action by the monetary authorities is likely to pull them down. The starting gun for action will sound when the authorities feel the rates look like starting a recession.”

Most economists say that Crow will have little choice but to respond to rising Japanese and European interest rates in order to assure nervous foreign investors. Said Mark Chandler, a senior economist in money markets for

the Royal Bank of Canada:

“The money could leave quickly, and that really ties Crow’s hands.”

Slumps: Indeed, some foreign investors are apparently increasingly concerned that the Canadian economy is already in a recession. According to William Robson, a senior policy analyst with the C.

D. Howe Institute in Toronto, the debate over Meech Lake may be causing investors to reassess Canada’s economic future. Yields on 25-year government bonds, which typically rise when investors fear inflation in the future, have climbed to 11.45 per cent from 9.42 per cent in Canada since January. Yields on long-term bonds are now 2.5 percentage points higher than those in the United States, compared with a January spread between the two countries of about 1.25 percentage points. Added Robson: “We are not very big.

We don’t affect the rates of other countries, but our rates are influenced by them. And there is a lack of long-term confidence in Canada, by both foreign and domestic investors.”

As well, a spokesman for Germany’s Deutschebank recently advised its investors to reduce holdings in Canada until political differences—along with high interest rates—receded. Said one bank spokesman, who requested anonymity: “The debate about the Meech Lake accord and Quebec sovereignty can only in-

crease uncertainties and political risks of the Canadian currency.”

Still, John Yochelson, vice-president for International Business and Economics at the Washington-based Center for Strategic and International Studies, said that American financial observers have recently been pessimistic about the Canadian economy. But he explained

that “there is a lag between Canadian reality and U.S. awareness,” and suggested that he felt that Canada’s economy was stronger than American analysts realize.

Meanwhile, WEFA’s Ernest Stokes said that Canada’s industrial production and mining output declined in both the third and fourth quarters of 1989, and he added that, if a recession is negative growth in two consecutive quarters, the manufacturing sector is now in one. Stokes said that the automobile industry, and the central Canadian housing and retail sectors, are also in deep slumps. Declared Stokes: “When people lose their jobs there, it affects the service sector next, and that is what is holding up the economy now.” Before Canada’s last recession took hold in 1982, Stokes said, there was also a lag between the time that the Bank of Canada raised rates and when they finally slowed consumer demand. Said Stokes: “Back in 1980-1981, when the bank raised the rates, it took quite a while, but when they hit, boy did they hit.” In

the end, perhaps only a similar deep and crushing recession will bring down inflation to the zero level that Crow is pursuing.