When Mark Carney took over as governor of the Bank of Canada in early 2008, he had relatively little central banking experience under his belt. As fate would have it, the former Goldman Sachs managing director got plenty of opportunity to test his mettle later that year when the U.S. financial crisis erupted. He responded, perhaps predictably, by slashing already low interest rates until, by April 2009, they stood near zero. But he also took the unusual step of telling Canadians that rates would likely stay there until mid-2010.
It was a departure from the style of central banking popularized by former U.S. Federal Reserve chairman Alan Greenspan, who was once dubbed “maestro” for his seeming ability to orchestrate economic growth (critics would say “bubbles”) through the 1990s and early 2000s. Greenspan’s speeches and statements were often masterworks of ambiguity, forcing investors to parse their true meaning and lending the man behind them an Oz-like aura.
Carney’s straight-talking gambit worked. Canadians, reassured, took advantage of the rock-bottom borrowing costs and bought everything from big-screen TVs to new homes, with the housing market in particular helping prop up the economy. But a new problem has emerged: household balance sheets are now stretched to the limit, with Canadians’ debt to disposable income ratio sitting at 148 per cent, exceeding the U.S. level for the first time in 12 years and raising concerns about the country’s ability to withstand another economic shock.
And so Carney now finds himself wedged between a rock and a hard place: if he raises rates, he risks killing the recovery, but if he leaves them low, Canadians may be enticed to heap on even more debt—a risk that is already putting pressure on Finance Minister Jim Flaherty and Prime Minister Stephen Harper to demonstrate that Canada’s monetary policy isn’t about leading Canadian families to financial ruin. And, once again, Carney appears to be hoping he can use some blunt words to help head off another crisis.
In mid-December, he stood in front of a crowded room in a downtown Toronto hotel and gave a speech that began by outlining the fragility of the global economic recovery and ended by effectively lecturing Canadians about the perils of overextending themselves. “Cheap money is not a long-term growth strategy,” he said. “Households need to be prudent in their borrowing, recognizing that over the life of a mortgage, interest rates will often be much higher.”
That some Canadians are at risk of drowning in debt is likely obvious to anyone who has tried to buy a house in recent years. Prices have soared across the country, fuelled by bidding wars and a rush of first-time buyers armed with small down payments and big mortgages. It raises the question why Carney doesn’t simply throw a wet towel on the party, by resuming a program of gradual rate hikes that he initiated last year. “It’s like he’s brought out a fully spiked punch bowl and gave everyone in the room a cup, but told them not to have any,” says Douglas Porter, deputy chief economist at BMO Capital Markets.
While Porter doesn’t agree Canadians are in grave danger just yet—he argued in a recent report that household finances aren’t nearly as weak as they might first appear because the value of Canadians’ other assets, including stocks, life insurance and pensions, has also increased—he says Carney has little room to manoeuvre because low rates are still needed to maintain the bank’s two per cent inflation target and encourage growth in the corporate sector. “This is really the push and the pull the bank has been dealing with for the better part of the year, and will probably continue to be dealing with for 2011,” Porter says. He expects the bank will begin raising rates later this year. In the meantime, “the only tool they have is to jawbone us, to hector and cajole us.”
It’s not unlike the conundrum faced by Greenspan after the dot-com crash, when U.S. rates were dramatically cut and kept there for an extended period in a bid to ward off deflation fears. That decision, some now argue, set the stage for the disastrous 2008 crash by fuelling a housing bubble. But at least Greenspan and U.S. lawmakers had a measure of control over their own destiny. By contrast, Carney’s hand is increasingly being dealt by Washington, where the U.S. Federal Reserve is unlikely to raise rates for the foreseeable future as efforts continue to prime a sputtering U.S. economy. That means that raising rates in Canada would add more to the soaring loonie, which is already back at parity with the U.S. greenback. “The Canadian dilemma is made in Washington with the Fed’s policy of zero short-term interest rates plus QE2,” says Ronald McKinnon, professor emeritus of economics at Stanford University, referring to the Fed’s second attempt to juice the economy with a policy of quantitive easing—basically printing money.
A soaring Canadian dollar, in turn, would put further pressure on the battered manufacturing sector in Ontario and Quebec, as well as other export-dependent industries, leading to more job losses—precisely the sort of shock that Carney warns could tip some debt-heavy Canadian households over the edge. “Another 100 basis points [hike in rates] isn’t going to deter consumers, but it will put the Canadian dollar well over par,” says Peter Dungan, an economics professor at the University of Toronto’s Rotman School of Management. While Carney has reason to be confident that he can avoid fuelling a U.S.-style housing bubble because of Canada’s more conservative standards around mortgage lending, that will undoubtedly be of little comfort to those Canadians who find themselves in over their heads.
Carney’s not the only one trying to figure out how to save debt-ridden Canadians from themselves. He works closely with Flaherty, who has the power to rein in riskier mortgage lending activities through the country’s main insurer, the Canadian Mortgage and Housing Corporation. He’s done it once already. Last February, Flaherty introduced changes that included forcing buyers with government-backed mortgages to meet standards for five-year, fixed-rate mortgages even if they opt for variable rates. He also put stricter limits on refinancing and tightened rules around down payments. Flaherty has said that he is keeping a close eye on the current situation—“If necessary, we will tighten the mortgage rules again,” he said in December—but has so far suggested that further measures aren’t yet warranted. In fact, he has pointed the finger at the country’s big banks, saying they are the ones ultimately responsible for ensuring prudent lending practices.
But at least one top banker, TD Bank chief executive Ed Clark, has suggested banks are unlikely to voluntarily clamp down on their huge mortgage lending businesses for fear of losing customers to rivals.
It’s a lot of finger pointing. And at least one industry-watcher argues that’s likely by design since Ottawa is backed into a corner with few other options. Chris Ragan, an economics professor at McGill University and a former special adviser to the Bank of Canada, says even though Carney appears to be kicking the ball to Flaherty, who, in turn, is admonishing the banks, the reality is that both men are hoping their words will convince Canadians to get their financial houses in order before it’s too late. “These guys talk to each other a lot,” says Ragan, who also served as a visiting economist in the federal Finance Department. “I think we should view this as a co-operative effort.”
Will it work? “It is certainly a bit unusual, but it’s no bad thing,” says U of T’s Dungan of the warnings. “Of course, it’s not clear how much the relatively few people who need to pay attention to this actually will.” Indeed, unlike Greenspan, few people are hanging on Carney’s every word these days, or Flaherty’s for that matter. It just seems like a lot of empty talk—at least until it’s backed up by tangible consequences. But the strategy—to the extent that it can be called one—does accomplish one key objective in the meantime: it gives Ottawa political cover if some overzealous Canadian households are eventually pulled under by broken balance sheets. “The one thing you don’t want to happen,” Ragan says, “is to look back two years from now and say, ‘Gee, we should have warned people about this.’ ”