Monday, December 13, 2010

More Candor from a Central Banker - Canada's Mark Carney speaks

In the past few days Canadians, in particular, have been getting warnings from our central banker Mark Carney, Governor of the Bank of Canada, about our bad habit of overspending and taking on too much debt.  Canadians are bad, bad people!

On December 13th, 2010, Mr. Carney gave a speech to the Economic Club of Canada in Toronto, Ontario.  In that speech entitled "Living Low for Long" he discusses current economic and financial trends around the world, most particularly how they relate to a prolonged period of very low interest rates.  Before we start looking at his speech, let's take a quick look at a chart showing Canada's Bank Rate for the past 15 years:

Canada's Bank Rate dropped to 0.25 percent in May 2009 where it remained until May 2010 when it started to climb to its current level of 1 percent.  Unlike Japan, Canada has had a fairly short term experience with near zero interest rates.

Now, back to Mr. Carney's speech.

"Current turbulence in Europe is a reminder that the crisis is not over, but has merely entered a new phase. In a world awash with debt, repairing the balance sheets of banks, households and countries will take years. As a consequence, the pace, pattern and variability of global economic growth is changing, and Canada must adapt."

At least Canada's central banker admits that the world is awash in debt and that the crisis is NOT over.  While it is obvious to most of us, apparently sovereign debt and deficit issues take a back seat to political wrangling in most countries where politicians seem to prefer to spend far more than their revenue. 

"...History suggests that recessions involving financial crises tend to be deeper and have recoveries that take twice as long. In the decade following severe financial crises, growth rates tend to be one percentage point lower and unemployment rates five percentage points higher.  The current U.S. recovery is proving no exception.  In such an environment, very low policy rates in the major advanced economies could be in place for a prolonged period–a possibility underscored by the recent extensions of unconventional monetary policies in the United States, Japan and Europe."

I would say that 15 million statistically unemployed Americans could be considered unacceptably high unemployment at this phase of the so-called recovery.  If the Federal Reserve is waiting to raise interest rates until employment returns to pre-Great Recession levels, we could experience near zero interest rates for years to come (or until millions more American workers simply give up looking for work and fall off the Department of Labor's statistical sample).

"With currency tensions rising, some fear a repeat of the competitive devaluations of the Great Depression. However, the current situation is actually more perverse. In the 1930s, countries left the gold standard in order to ease monetary policy, and the system became more flexible.  Today, the process is working in reverse. The international monetary system is sliding towards a massive dollar block. Over a dozen countries are now accumulating reserves at double digit annual rates, and countries representing over 40 per cent of the U.S.-dollar trade weight are now managing their currencies."

OMG, a central banker actually used the "gold standard" phrase and advises against accumulating excessive reserves of the United States dollar.  That is unheard of in this fiat currency world that we live in.

"A prolonged period of low interest rates also has important implications for insurance companies and pension funds with their longer-term guaranteed returns or benefits. By reducing yields on assets and raising the net present value of liabilities, a sustained period of low interest rates makes these guarantees harder to fulfill. To address potential shortfalls, funds could move into riskier assets in a search for yield and/or shorten their duration to limit asset-liability mismatches."

This should not be surprising to any of us.  Pension funds and insurance companies invest our contributions in the hope that the return on those contributions (when added to the principal) will be sufficient to meet the future demands of retirees and those who either die or suffer from an illness.  The system worked well as long as interest rates were high and claims were relatively low in number.  That has changed in this period of prolonged low interest rates and, as I have suspected all along, as baby boomers push into their retirement years, the pension and insurance industry will prove to be a massive Ponzi scheme where the first ones out get what they are owed but the last ones in will be left holding a rather empty bag.

Mr Carney then goes on to discuss the implications that a prolonged period of low interest rates have had on households in Canada (and elsewhere around the world by association):

"Encouraged in part by low interest rates, Canadian household credit has expanded rapidly during the recession and throughout the recovery. As a consequence, the proportion of households with stretched financial positions has grown significantly.
In a series of analyses over the past year the Bank has found that Canadian households are increasingly vulnerable to an adverse shock and that this vulnerability is rising more quickly than had been previously anticipated.

While there are welcome signs of moderation in the pace of debt accumulation by households, credit continues to grow faster than income. In some regions, lower house prices have begun to weigh on personal net worth. Without a significant change in behaviour, the proportion of households that would be susceptible to serious financial stress from an adverse shock will continue to grow.

The Bank has conducted a partial stress-testing simulation to estimate the impact on household balance sheets of a hypothetical labour market shock. The results suggest that the rise in financial stress from a 3-percentage-point increase in the unemployment rate would double the proportion of loans that are in arrears three months or more. Owing to the declining affordability of housing and the increasingly stretched financial positions of households, the probability of a negative shock to property prices has risen as well.

Even if the growth in debt continues to slow, the vulnerability of Canadian households is unlikely to decline quickly given the outlook for subdued growth in income. In addition, private consumption is unlikely to be bolstered by gains in house prices going forward."

I apologize for including such a large section of Mr. Carney's speech but he makes several rather profound points. Canadian household credit has grown by 7 percent since the trough in the GDP compared to the United States where it has fallen by 3.5 percent.  More and more Canadians are accumulating debt at a faster rate than their incomes are growing.  What is most interesting about his analysis is that if unemployment rates were to go up by 3 percentage points, the number of household loans that are in arrears would double.  As well, he makes the rather profound statement that he does not anticipate the price of housing to rise in the future, reducing the wealth effect that comes from consumers anticipating endless increases in their net worth based solely on the value of their real estate holdings.  It seems to me that it was that exact issue that created so much of the misery in the United States leading up to and during the Great Recession.

Mr. Carney closes with the following:

“Cheap money is not a long-term growth strategy. Monetary policy will continue to be set to achieve the inflation target. Our institutions should not be lulled into a false sense of security by current low rates.

Households need to be prudent in their borrowing, recognising that over the life of a mortgage, interest rates will often be much higher.”

I find Mr. Carney’s approach to Canada's economy rather practical but I do have one problem with his analysis.  His policy of low interest rates has led to a growth in consumer spending and greater consumer indebtedness and now he's unhappy with the size of consumer debt.  Isn't one of the main reasons why interest rates are forced to a low level by central banks around the world because they are a means to encourage consumer spending?  When consumer spending grows, the threat of the dreaded deflationary boogeyman decreases and central bankers can sleep soundly at night. Most of the world's economies rely on consumer spending as engines of growth; for example, some studies of the United States economy show that consumer expenditures total 70 percent of GDP.  When consumers get nothing for their savings, they might as well spend.  When interest rates are low, they might as well borrow and spend even more.  After all, we have the spectacle of endless spending and debt accumulation by governments setting a fine example for consumers around the world.  In fact, one of Mr. Carney's fellow bankers at the Bank of England, Mr. Charles Bean, commented that central banks impose a policy of low interest rates to force consumers to spend their savings as noted in this posting.  I'm not advocating for greater debt accumulation, I simply am trying to point out the fact that central bankers can't have it both ways; they cannot have a policy of ultra-low interest rates without creating a situation where consumer debt grows.

Mr. Carney's speech should impress upon all of us that low interest rates are not here to stay and that we had better brace ourselves for higher rates in the future.  Unfortunately, that seems to be a lesson lost on governments around the world.


  1. You've left me a little bit confused. You say you have a problem with Carney's analysis because he is not advocating greater spending through accumulating debt as all other central bankers are doing.

    But don't you disagree with the concept of greater spending through accumulating debt? I admit this is all stretching the limits of my brain, but I did think I had that right.

  2. Jenn

    I have a problem with central bankers using low interest rates to stimulate spending (and, by association, debt accumulation) and then chastising consumers when they accumulate too much of a good thing. As in the case of all other central bankers, my suspicion is that Mr. Carney also believes that greater spending by consumers is necessary to drive the economy forward and eliminate deflation.

    I added a sentence to the posting with the hopes of clearing things up.


  3. So ,our government spends 50 billion to avoid the recession(which they said we were safe from) and yet have shown no yield from that expense..It was the everyday citizen that kept the recovery from stalling by either spending their savings for a tax-break or borrowed for the same cause(Home Renovation Program)..yet when the interest rates started coming down,all the big banks stopped passing along all the rate drops to their customers ,theoritically padding their own Balance Sheets..So this past January.the Markets and the Big Banks demanded hiking the overnight rate and Mr. Carney caved and gave it to them..A 6% growth in 1 quarter and you don't think the Olympics had something to do with that??Gee wake up Mr. Educated Man..It was a one off, but you caved and now you have margin players all over the place as exibitted by the high dollar..Mr. Carney ,before you raise rates anymore,you had better have a chat with all the banks because if they are not going to go back to the old way of 1.75%over the overnight rate for Prime,all your doing is giving them(Banks) free money at the expense of regular people..And really,don't you think that all us regular folk don't have long memories and remember the days of sky-high rates and what some of our parents did(Besides freaking out),they just gave you the keys to the house and told you to shove-it..And when oil companies gouge,you should be having a chat as well..Anything over $85 a barrel should have everyone very worried(where's the inventory reports and really anything above that should be a signal of a double-dip),considering when oil dropped to $40 a barrel from the $140 ,oil companies just gouged the customer so not to lose money..Did anyone see the price at the pump go down to 50cents a liter ...NO..So Mr.Carney ,you have some work to do first before putting the screws to the common citizen..We'll all be waiting to see if you go after the Banks, Oil companies and the yield or margin players in the stock markets ..Or are you just going to screw the little guy as it always turns out.. Thanks Chris

  4. To the anonymous poster above (I hope you subscribed to follow-ups):

    So ,our government spends 50 billion to avoid the recession(which they said we were safe from) and yet have shown no yield from that expense..

    Relatively speaking, Canada has done quite well. Unemployment in Canada is lower than the US. Long-term unemployment is better. Everyone gets healthcare. Home foreclosures rates are much better.

    all your doing is giving them(Banks) free money at the expense of regular people..

    Yes, this is par for the course. Canadians signed up for giving free money to the banks a very long time. See CDIC and "fractional reserve banking", both simple cases where banks are provided certain guarantees / benefits / "free money" by the government.

    considering when oil dropped to $40 a barrel from the $140 ,oil companies just gouged the customer so not to lose money..Did anyone see the price at the pump go down to 50cents a liter

    Clearly this is an issue of supply & demand. As the price of oil rose above $100, multiple large companies started massively capital intense projects to start bringing up more oil (see Alberta Oil Sands). These companies honestly can't just drop the cost b/c oil is down, they still have to pay for those big loans.

    If you feel that the oil giants are not competitive in their pricing and that they're just cartels, then you have to bark up a different tree. It's probably a fair question, there probably is quite of bit of price-fixing in the oil business, but you're not pointing to any evidence to support this.

    Or are you just going to screw the little guy as it always turns out

    If you feel that all of this setup is "screwing the little guy", then it's time to vote that way. I mean, the rules regarding the CIDC were put into place by the people you voted for (or your parents or their parents...)

    If you feel that banks are getting a much better deal than they should be, then it's time to explain this clearly and lucidly (preferable with paragraphs) to as many people as you can. It's time to propose a better solution that having the government insure the banks. It's time to ask your friends and family and everyone you know to ask for this better solution.

    Hey it doesn't even need a lot of money. If you have something better than CIDC and fractional reserve banking, I'm all ears. We'll hook you up with a web cam and youtube and you can broadcast to millions for basically nothing.

    But if you want to sit around and rant about "the little guy getting screwed", then you're just going to keep being the little guy.

  5. the pension and insurance industry will prove to be a massive Ponzi scheme

    For the pension funds, this is probably trivially true. Low interest rates basically kills their growth. But we've seen that coming for a long time. Some lucky government workers will definitely do a little better than their fare share. But even government workers retiring now (I know some teachers) are recognizing that the pension fund they've earned is completely inadequate for two or three decades of retirement.

    The truth is, lots of people will be required to work a lot longer. And frankly, that probably fair. Retiring at 55 with plans to live to 85 is simply not sustainable on a long-term basis.

    As to the insurance companies, this is a whole different ball of wax. I have a difficult time relating such a heavily regulated industry to a Ponzi scheme, unless it's a Ponzi scheme of our own making.

    I'm not really seeing the connection between my tenant's insurance and a Ponzi scheme.

    ...It seems to me that it was that exact issue that created so much of the misery in the United States leading up to and during the Great Recession.

    That's only a portion of the problem in the US. I mean, you have to factor in large-scale speculation, liar loans, jumbo loans, tax incentives and host of other very US-specific issues.

    The US has a huge backlog of existing homes on top of home that the banks are all holding to avoid flooding the market. Canada isn't currently having this problem.

    Are Canadian home prices too high? In many places I would say yes. But this probably just means that they will stop going up, not that they're going to crash.

    His policy of low interest rates has led to a growth in consumer spending and greater consumer indebtedness and now he's unhappy with the size of consumer debt.

    Yep, this is indeed a known problem with the Fed / Bank of Canada / etc. The Fed has one tool (interest rates) to guide several conflicting goals (inflation, employment, economic growth). It's really not possible to use one switch to correctly manage all of these things.

    It's easy to think that Carney is just a stupid government hack who doesn't know this. But it's clearly not the case. That's why he's even talking about these conflicting problems.

    The reason for low interest rates is to get businesses investing in growth opportunities. You want a business to look at low interest rates (3%) and think "hey, I can do better than that". You want businesses to take loans, because they do so with the expectation of creating more economic value (more jobs, more stuff, etc.)

    Carney here is annoyed, because instead of trying to "create more stuff", consumers are using cheap debt to bid up house prices and increase their amount of rotating credit. Carney clearly knows this is a risk.

    But remember, the Fed has one tool and that's it. They know that low interest rates carry consumer debt risks, but they really hope to minimize that damage with some timing.

    If the whole thing sounds somewhat comical and contradictory, that's because it is. But at this point, everyone has their hands tied. The Bank of Canada has only a limited capacity to provide economic growth. The Canadian government has limited funds with which to fuel further growth because Canadians are already heavily taxed.

    On the bright side, Canada is doing relatively well in all of this. The population is relatively well educated. Healthcare and social programs have given Canada a relatively stable middle class. We have reasonable control over public debt.

    This whole mess could be much worse.

  6. Thanks for all of your input! I only really disagree on one point - central banks also have QE which they now have to use because they are out of ammunition since interest rates are already essentially zero. I actually respect Mark Carney - he does seem to have his approach to the economy in order and, unlike Mr. Bernanke and Mr. Greenspan, he is at least warning consumers that too much of a good thing (cheap money) can be a VERY bad thing.

  7. Canada has done quite well. Unemployment in Canada is lower than the US. Long-term unemployment is better. Everyone gets healthcare.