Born of the Great Depression, the Bank of Canada has found new relevance, 75 years later, in averting another. As Canada emerges, surprisingly strong, from what many had feared would be at least a Great Recession, the governor of the bank, Mark Carney, credits its interventions in large part for sparing us the worst of the financial crisis.
In an interview to celebrate the bank’s 75th birthday, Carney said one of the lessons of the near-collapse of global finance was the crucial part that central banks play in the smooth running of financial markets, especially in a panic. “The need for a lender of last resort, and not just a lender but a liquidity supplier of last resort, was made absolutely clear by the crisis.”
The corollary lesson: markets are not always self-correcting. Having worked in capital markets for many years at Goldman Sachs, Carney says he acquired “both a respect for [markets] and a skepticism of them. You know, I’m not a market fundamentalist. There are periods of excess in both directions in financial markets and it’s important to recognize that.”
Not that that’s exactly news: bubbles, panics and crashes are as old as capitalism. Rather than the revolutionary new world of finance that many commentators predicted would emerge from the crisis, Carney sees a reaffirmation of some age-old truths. “I think we’ve relearned some pretty basic lessons about financial regulation and the importance of having enough capital to support credit activity, the importance of liquidity, the need for good market infrastructure, relative transparency, clarity, etc. And so in many respects things haven’t changed.
“What has been brought a little more to the fore has been a question that has not yet been resolved at all, which is: what, if anything, can be done about some of the—given human nature, given the nature of financial markets—inherent procyclicalities in financial markets and in the economy?” By “procyclicalities,” he means the tendency for markets to chase themselves off their long-run equilibrium values for a time, in self-reinforcing spirals. The herd instinct, in short.
Some of that, he concedes, was driven by regulation—the very regulation that was supposed to stabilize markets. For example, the “Basel II” standards, agreed upon by the world’s central banks as a baseline for national regulations, set out how much a bank can lend in proportion to how much capital it has on its books. Problem: the higher the value of the capital, the more the bank is permitted to lend. So the higher asset prices rise, in response to the easier availability of credit, the more banks are encouraged to lend. Conversely, in a crash, when credit dries up, the same standard encourages banks to lend even less.
That’s one of the questions Carney and his fellow central bankers will be taking up at the June meeting of the G20 in Toronto. Another is the role played by monetary policy in financial crises, both as cause and cure. Carney believes Canada’s long experience with inflation targets, to which the bank and the Finance Department are jointly and publicly committed, was one of the reasons we escaped from the crisis comparatively unharmed. People knew that the bank had a good record of keeping inflation from straying too far below or above its two per cent target. So fears of deflation were never really a factor here.
Still, long experience of relatively stable inflation may also, oddly, have contributed to the crisis, by making investors less conscious of risk, less fearful of the proverbial Black Swan—what’s known in the literature as “disaster myopia.” Carney says he thinks “there is still a case to be answered about the implications of a period of low, highly predictable [interest] rates feeding procyclical behaviour in asset markets.”
Does that mean that central banks should, as some have suggested, keep one eye on asset markets when setting monetary policy? A lot of people blame the U.S. Federal Reserve for letting the housing bubble in the U.S. get out of hand, by leaving interest rates too low for too long. Some take that a step further, arguing central banks should deliberately “lean into the wind” of asset prices, raising interest rates if need be to prevent such bubbles from forming, rather than simply targeting inflation. Indeed, Carney himself seemed to suggest as much in a speech last August. Is that what he meant?
The governor chooses his words carefully. “I think it’s been cast as a binary issue and it’s not a binary issue.” On the one hand, “the idea that monetary policy can surgically target asset prices is naive and dangerous and diversionary from what we have learned, which is it should have a core focus, which is the Consumer Price Index.”
On the other hand, should asset markets really get overheated—well, maybe. “What I’m trying to do is restrict it down to a very small, relatively rare set of circumstances, where one might consider leaning.” He can see a situation where an inflation-targeting bank might depart from its targets long enough to pop an asset bubble, drawing on the credibility it had built up with capital markets—in effect asking them to trust that the departure was only temporary.
(Talking of bubbles, are we in a housing bubble? No. The housing market “is looking increasingly firmly valued,” he acknowledges, “but there is a supply response. We’re seeing starts up above replacement levels. So we expect to see some moderation for the balance of this year.”)
What about that other idea making the rounds in advance of the G20: a tax on financial transactions, sometimes called a Tobin tax (after its inventor, the economist James Tobin). Some justify it as a way of discouraging excessive speculation and “churn.” Lately, it has picked up adherents as a kind of insurance premium for banks, with which to finance any future bailouts. Carney rolls his eyes. “We don’t, at the bank, look favourably on the Tobin tax.”
He says he can understand the argument for taxing banks after the fact, to make up the cost of past rescues. “But the idea of setting up some form of fund or creating ‘fiscal space’—you can imagine how well that would be preserved. A fiscal space to deal with a future crisis? It doesn’t make sense to us.” The message it sends to bankers, he says, is that if they screw up again, they will be bailed out again. “It would be entrenching moral hazard.”
Moral hazard—the tendency for insurance to encourage the very thing it is insuring against—is very much on the governor’s mind these days. It’s a familiar enough concept: if banks (or more precisely, bank creditors) are bailed out rather than having to face the ultimate penalty for overly risky behaviour, they will have every incentive to take on too much risk, and thus to make bailouts more likely. Heads, they win; tails, the taxpayer loses. Moral hazard was a major contributing factor to the crisis, from the rescue of Bear Stearns in the spring of 2008 through the bailout of Fannie Mae and Freddie Mac to the collapse of Lehman Brothers in the fall. Indeed, it had been hanging over the system for decades, a hazy, ambiguous, unstated policy that certain banks were “too big to fail.” If there’s any good to emerge from the crisis, he argues, it is the opportunity to dispense with that doctrine, once and for all.
“We have to have as an organizing principle that we’re going to move to a system that is robust to failure, so that no institution is too big to fail. Now that is a tall order. It takes multiple initiatives. It will take time. But that should be the objective.
“And to go the other way—which is to say, ‘okay, we’re going to create a big pool which is going to help deal with failure’—means that you’re not going to get bond holders and other capital providers at least looking over the shoulders of institutions and hopefully stopping them from doing some of the more crazy things that have gotten them into trouble.”
Still, won’t it be tough to make that credible? After all, governments have said many times they would not rescue this or that financial institution, only to bail them out in the end.
“Well, ultimately you have to resolve somebody,” he says. By resolve he means force into bankruptcy. Put them under. Take them to Jesus. The fail in too-big-to-fail. “I mean, I think you have to work toward it and you have to have the resolution mechanisms. But I think if the question is full credibility, yeah, somebody has to be resolved.”