How to stop the next financial meltdown

Andrew Coyne talks with Mark Carney

Too big to fail? Not anymore.

Blair Gable/Reuters

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.”


How to stop the next financial meltdown

  1. "Born of the Great Depression, the Bank of Canada has found new relevance, 75 years later….."

    The Bank of Canada of today is in no way similar to the BofC as it existed from 1938 to 1974, when it was a Crown corporation that issued interest-free money for use. That is how we paid for WWII, the St. Lawrence Seaway, the Trans-Canada, and many other major infrastructure projects without becoming the debtor slave to private banks. Canada certainly does have one of the best-run central banks in the world, but it is still privately-owned and makes its money of the backs of all Canadians. Once its been in private hands for 97 years like the US Federal Reserve, we'll see how sound it is.

    • Umm… Didn't the B of C start out as a private institution and become nationalized in 1938, as it remains today?

      • It did start out as a private central bank in '33. King won the '35 election on the promise of nationalizing it, which he did in 1938. It was privatized in 1974, which is the main reason our national debt has skyrocketed since then. The actual coins and paper money in circulation are created interest-free by the Canadian Mint, but only represent 5% of the monetary base.

        • I don't get it. How did a change in the ownership structure of the Bank of Canada cause the Government of Canada to consistently spend more than it takes in?

          Secondly, if the Bank of Canada is a private entity, who is the shareholder(s)?

          • When the bank is fully owned by the government, the government uses it to spend money into existence, rather than lend. As such, money is created without the burden of interest. When you go to the bank to take out a loan, the money is created out of thin air when it is transferred into your account. It does not come from the bank's own cash reserves or from money held in other customer's savings accounts.

            It is prefectly fine for a government to spend more than it takes in when that spending is adding material value (e.g. infrastructure) to the economy. When spemnding for these projects has to be borrowed, and thus accrues interest, more loans are needed down the line just to repay that interest, deepening the debt cycle.

            I was wrong – the bank wasn't actually privatized in 1974, that's just when our government decided to start borrowing money rather than creating it themselves.

            See here for a good tutorial:


          • Indeed. The BoC is still owned by the federal government, and all of its 'profits' are transferred to the federal government.

            It's simplistic to say that creating money only through spending into circulation is an obviously better choice. It has costs elsewhere, by making banking less efficient and inflation harder to target.

  2. "The fail in too-big-to-fail"

    That's the interesting question – how do you allow big financial institutions to fail without jeopardising the financial system? The fallout from Lehman Brothers' bankruptcy was not pleasant.

    The discussion in the US, and between the US and Europe, over this is getting interesting and will be the backdrop to the G20 this summer. Hopefully, when you've had time to think over your discussion with Carney, you'll be able to say something substantive about this.

    • You can't really – so there are only two options: 1) provide a bailout (one way or another) or 2) don't let any institution get too big to fail.

      • There's also a 3) if institutions get too big to fail, make it really hard for them to fail by prohibiting riskier behaviour and requiring higher capital ratios. I expect the big Canadian banks are too big to fail (but not too big to not wipe out equity holders and force bondholders to take a 10-20% haircut), so we require relatively conservative capital ratios and more prudent lending.

        Investment banks should be allowed to do riskier things, but they should be small enough that the equity holders can get wiped out and bondholders severely decimated without destabilizing other institutions.

  3. A very informative interview. It's reassuring to know that the Bank of Canada is in good hands.

    Interestingly, Mr. Coyne's father was governor of the Bank of Canada when it celebrated its 25th anniversary, so it seems like a karmic coincidence that on the 75th anniversary of the BoC, James Coyne's son is interviewing the man whose signature currently appears on our banknotes.

    • I'm trying to imagine little Andrew listening to bed-time stories from Dad; I wonder if it was the standard fare that we share with our children?

      • Heh. Probably not the standard fare. The whole Coyne family is remarkably talented, and they're as close as Canada gets to a dynasty. Coyne's sister Susan is a prominent two-time Gemini-award winning Canadian actress, and his cousin Deborah Coyne, a notable constitutional lawyer, is the mother of Sarah, Pierre Trudeau's daughter.

        • Riiiiight. I had a vaguish memory of the name Deborah Coyne, so I checked wiki; similar to AC, she seems to have opinions on topics of public interest. That must make family gatherings very entertaining, in a good way, of course.

    • Wow! That is amazing. I can only imagine the dynamics here. Carney and Coyne are close in age too, I am betting. They is more history here, than what one might expect.

  4. I'm not an economics guy, so it's quite possible I'm missing a lot of the subtleties and nuances of economic policy here, but I can't get away from the impression that this discussion boils down to the following argument.

    (1) The financial structure relies on responsible lending.
    (2) The responsibility of lenders relies on there being bad consequences for them associated with irresponsible lending, rather than encouragements.
    (3) Consequently bad lending has to be met with bankruptcy rather than bailouts.

    Shouldn't there be a number (4): so we are now taking out all regulation that either (a) encourages lenders to lend irresponsibly based on demographics or quotas, or (b) props up lending institutions that have screwed the pooch.

  5. I'm not smart enough to understand the economic jargon in this article.

    • Its not a matter of intelligence to understand. Just training.

  6. I do not see enough regulation to prevent another trough/recession/ possible collapse. When banks got into derivatives and when no one (or practically no one) knew what the hell they were really investing in bad things happened. Nothing that has been done so far assures me that this cannot happen again. Deregulation was and remains a very bad idea. And, by the way, what ever became of the regulations that were promised by the president of the U.S.?

    Also Canadian banks with investment arms continue to push very hard for Canadians with a reasonable amount of savings to invest said savings in the stock market. As someone who acts as financial power of attorney for a friend, I would never do so. The risk is too high. and such investments are not guaranteed. This fact was ignored by many Canadians. Notice how many have lost retirement savings when the market sank? Nothing is in place that will prevent that from nappening again. Does Mark Carney have any answers for that one?

    • To your point about the market: In general, history suggests (but doesn't prove) that long-term investments in the equity markets are good and that a diverse portfolio will yield higher returns in the long run. There are a few problems with this: One is that people, as you say, forget that equity markets are risky. Retired (or close to retired) people kept too much of their portfolio in equities. A good rule of thumb is that the maximum amount of your portfolio invested in risk instruments should be 100-your age%, keep the rest in Cash or "risk-free" products. People need to take some personal responsibility for how they invest their money, the same way they would do research before buying a car or a house. Unfortunately, people get overwhelmed by financial stuff and don't always make good decisions.

    • I'm sure he does, but I have a few for you. First, the Canadian regulatory system basically worked. OSFI is a solvency regulator and has a very broad mandate to determine what is required to ensure Canadian banks stay solvend.

      In the US, they have definitely struggled – I'm pro healthcare reform over there but it derailed the bank regulation conversation. Fundamentally, the financial crisis was caused lack of risk transparency and an ability to make money in certain parts of the value chain without taking any real risk (subpriime lenders who securitized everything) or perceived (investment banks who did not consider the systemic risk of a widespread housing price collapse). Some of the regulatory changes have helped this; but I agree with you they aren't sufficient.

    • Does Mark Carney have any answers for that one? Are you kidding? He was an employee of Goldman Sachs. Nobody has ever taken the investment industry to task for making absurd claims about the risks of owning stocks or mutual funds. Their mantra is invest for the longterm. They ask will you be able to sleep at nght. In other words are you man enough? Because if you are then stocks will make you oodles of money in some undefined "long run". As if. They don't tell you that between 1965 and 1982 stock investors lost their shirts, that in the last ten years stock indices have gone nowhere, that the Nasdaq is down 50% from 2000, that we had two massive busts (tech and telecom) that it took decades for stock prices to recover from the Great Depression. I cannot renew a GIC without getting a sell job about mutual funds. No thanks, not me. I tell them my name is Tucker, not sucker.

  7. Very interesting interview, Mr.Coyne. Carney touches upon some amazing insights. He uses the word "procyclicalities", as if trying to find a word which could encompass something very large. And indeed, the question arises if we are capable of holding together something so large and overpowering as the modern financial market. I think we are capable of holding separated fragments and an understanding thereof, and therein might be found the root of our problems ongoing.

    Carney talks about "The corollary lesson: markets are not always self-correcting." and "the tendency for markets to chase themselves off their long-run equilibrium values for a time". Excellent evalutions, but

    "self-reinforcing spirals and the herd instinct" must, however, be considered differently.


  8. (continued)

    Let me put it this way: although is appears to us as if a static "ideal' could be attained and maintained, and we most certainly are moved by believing in such directions, it is when consistency turns into inconsistency inevitably, whereby life is ongoing. I am not mistaken when I state that "the world of finances" is a life form.

    Once we come to understand the full meaning of life forms, will we be able to understand why markets are not always self-correcting, why markets chase themselves off their long-run equilibrium values for a time, and why there are self-reinforcing spirals and herd instincts besides…………………

    Fundamental stuff indeed.

    • I don't think you can answer the question of how markets work simply through psychology (though neuro-economics is giving it a shot). We are more than the sum of our parts – that is the real challenge for the social sciences. That said, there has been considerable progress since the 19th century, which suggests that we can figure out a great deal more than we used to be able to. Of course a big challenge is that the economy is embedded in the political system. We may know exactly how to produce the perfect world, and still fail to do so.

    • I don't think you can answer the question of how markets work simply through psychology (though neuro-economics is giving it a shot). We are more than the sum of our parts – that is the real challenge for the social sciences. That said, there has been considerable progress since the 19th century, which suggests that we can figure out a great deal more than we used to be able to. Of course a big challenge is that the economy is embedded in the political system. We may know exactly how to produce the perfect world, and still fail to do so.

      • My post is not about a fragmented state such as psychology. My post (3 in order) is all about the tension existing between consistency and ideal (or the inpossibility of attaining completeness)

        We may think we can bring the markets within such understanding of completeness, but such is never to be. And so we remain consistent and adjust the idea or we try to keep the idea in tact regardless through inconsistency and thereby sprialling out of control . I believe only the idea, or ideal, can adjust, as we see within the remarks of Carney.

        For instance, we's be consistent by letting the idea of a "free" market decide ultimately, by which we let the casualties fall (no bailouts for the banks and others) or we adjust the idea (that a 'free market' is indeed not "free') and thereby try and be consistent once again.

        Of course, everything is connected, just like you refer to within your reply (political systems, social systems, psycology and much more, etc). But the constant adjustments of ideas is good because without it life would come to a halt.

      • "We may know exactly how to produce the perfect world, ….."

        Theoretically we may know, or may think to know, ……….

        "and still fail to do so."

        because the differenct between theory and practice is significant. But we know at least THAT much, no?

  9. I don't like to work with too many examples because examples really tend to cloud the overal workings of a debate, but if I had go give one example by which to illustrate the workings of consistency giving way to inconsistency inevitably, I would take this example:

    Consider this: when the ideal of tolerance meets up with being tolerant of the intolerant (and this would most certainly apply to the world of finances as well) the ideal of tolerance would be defeated by its own ideal.

    And so, we choose to remain consistent and defeat thereby the idea (in this case the idea of "being tolerant"), or the idea is adjusted so that consistency will remain. But it can only be one of the two, not both.

    Now apply this generally and generously to the idea of "modern finances". I think Carney is pointing in such directions.

  10. The governor chooses his words carefully. “I think it's been cast as a binary issue and it's not a binary issue.”

    That, my learned friend, is a bullshit answer to a yes or no question. 40 year mortgages and 100% financing at rates close to nothing is madness, it discounts risk altogether. I have read less that 150 pages in "The Wealth of Nations" and Adam Smith has me convinced that a proper accounting of risk is necessary for the calamities and disasters that happen.

    The first rumblings of the impending financial meltdown happened in August 2007 when the market for Canadian made Asset Backed Commercial Paper (ABCP) seized up. The Big Banks in this case proved to be too big to accept responsibility. That it took 18 months, a very complicated bankruptcy, and an 11th hour gov't loan guarantee to finally resolve the matter, has left me thinking that "being tolerent" has been a misplaced priority.

    Of course, if one of the Big Five were to fail, that would leave us the Big Four. And how would that serve the greater good, Mr. Governor General?

  11. Mark Carney is a breath of fresh air! Tells it like it is, blunt in his assessments, and gets it done.

    Hopefully, Canadian business paid attention to him telling them that they have to get off the sidelines and buy the machinery, etc., needed to boost their productivity now while the gettin's good.

    We're at 70-80% productivity of any similar sized American business, yet our currency is trading at par with theirs. Doesn't take a genius to realize that we have to close that gap, and close it quick.

    • Remember that the exchange rate is not an indicator of relative productivity. We are not 100 times more productive that the Japanese because the Yen is worth less than a penny Canadian.

  12. "bubbles, panics and crashes are as old as capitalism."

    Thats funny, when did we try capitalism?

  13. While the Canadian economy is not in as dire straits as the U.S. economy, we cannot ignore the huge influence of the U.S. and we can't ignore how much Canadian money is invested in U.S. ventures of questionable worth. We should also remember that not long ago, Mr. Harper wanted to change Canadian Banking regulaions.

    Are we out of the woods? Well perhaps we are on the edge of the forest, but an elephant could cause us to plunge back in.

    • You are correct, when the elephant decides he has had enough, he will tell Carney(mouse) how to act. Canada is doing great, but raising interest rates only hurts the working person, and that is what keeps any country going, not banks. The rich do not spend money!!!!!Without a tax break!!!!

  14. "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." — Absolute rubbish.

    Central banks create economic crises by creating easy credit, leading to malinvestment. Free markets are self-correcting. We've never had a free market in Canada.

  15. ..compared to the u.s. of a. market meltdown which was a result of improper practices, mass corruption, bogus regulations and invented mortgages from disreputable bankers…whose mainstay was fee and recap practices and most disgusting… the abuse of common hard working people who never read the small print and trusting in a system that thought them as fool hardy spenders…yeah they had a gripe and an envy with canuckian bankers and regulators….our bankers stuck to their guns and maintained solvency primarily because of strict enforced regulations

  16. interesting…andrew coyne is grand son of the bank of canada big kahuna! that is so cool…andrew is a great person…watch him on cbc and is one s a v v y commentator on the game of politics! smart dude…. makes a boring topic rather interesting

  17. how did this happen?

  18. I'm not surprised that Carney is not supportive of the Tobin tax – which bankers are? Interesting that he focuses on it "entrenching moral hazard,” rather than the short-term negative financial impacts on the banks' bottom line. That aside, given the IMF's latest proposal at the G20 meeting, there is at least growing recognition that a tax on the banks is theoretically and logistically possible? The Robin Hood tax being talked about a lot in the UK, isn't just about a fund to create a pot of cash to bail out the banks. It's also about poverty alleviation, so goes many steps further than the Tobin tax/ taxes proposed by the IMF.
    See my blog post on this here:http://bit.ly/ckbId7

  19. Carney has all these ideas, but I promise every working Canadian, that it's you who will pay in the end. Interest rises and making banks accountable only means you and I will have to pay for it. Carney is just another pawn for big business, who in turn, owns the banks. Isn't this capitalism great. FOR THE RICH

  20. I think Banknotes lose economic value by wear, since, even if they are in poor
    condition, they are still a legally valid claim on the issuing bank.

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