The financial crisis of 2008-09 and the recession it caused didn’t do much for the reputations of many policy makers around the world, but they’ve been quite good for the careers of Stephen Harper and Mark Carney:
- Harper finally won a majority in 2011, and continues to enjoy high ratings in the polls for perceived competence. There are many dimensions where he scores much less well, but my understanding of the Conventional Wisdom is that if Harper can retain that reputation for competence when it comes to managing the economy, he will be tough to beat in 2015.
- Carney earned the reputation of being the best central banker in the world, at least in the estimation of the U.K. chancellor of the exchequer, who finally managed to persuade Carney to accept the appointment as governor of the Bank of England this week.
It is now commonplace to note that Canada’s recession was shorter and milder than those in the U.S. and Europe (Australia’s connections to the U.S. and Europe are weaker than Canada’s and it did even better) and these two men have either taken or been given credit for Canada’s performance. But are these reputations the product of making good choices or just sheer luck? As always, a bit of both.
I’m going to start with a short summary of what happened in Canada during the crisis, if for no other reason that I’ve never tried writing one before.
Canada entered the recession on much more solid footing than most other countries. The Liberal government had put the country’s financial house in order in the mid-1990s, and the Bank of Canada’s inflation targeting policy had delivered low and stable inflation for a generation. When the crisis hit, the government didn’t have to worry about its debt (at least in the short run), and the Bank of Canada didn’t have to worry about its credibility.
And as we all know by now, while the heavily-regulated Canadian banking system can fairly be described as a cozy oligopoly, it turns out that it is also almost indestructible. As Washington University economics professor (and native Canadian) Stephen Williamson once put it,
“[T]he Canadians have somehow solved the too-big-to-fail problem. The banks are too-big-to-fail, but they never fail, so problem solved.”
No Canadian banks failed in the Great Depression, nor would any seriously risk failure in 2008-09.
These elements were in place before Harper and Carney arrived on the scene—and in the case of the banking system, before they were born. Other countries were less fortunate.
And it was lucky for us that the financial crisis occurred when it did. Canadian financial institutions’ holdings of what turned out to be very dodgy asset-based commercial paper were not devastatingly large in September 2008, but they were growing. Similarly, although Canadian mortgage underwriting standards never degenerated to U.S.-style practices, there was a steady trend to making it easier to obtain mortgages: by the time the crisis hit, 40-year mortgages were on offer. If the world’s banking system had managed to stagger on for a few more years, Canada might have found itself in much deeper trouble when the crisis finally came.
When the crisis did hit, the Bank of Canada and the government dealt with it as well as could be expected. Holdings of problematic asset-backed commercial paper were restructured, and investors we obliged to accept their losses: no public funds were involved. The Bank of Canada applied all its available levers to supply short-term liquidity to financial markets: interest rates were reduced to zero, and the Bank expanded its balance sheet by means of purchase and resale agreements. For its part, the government provided liquidity via the CMHC and the Insured Mortgage Purchase Program (IMPP), which allowed chartered banks to trade mortgage assets for more liquid CMHC paper. Of all the measures implemented during the crisis, the IMPP is almost certainly the most clever. It was a classic application of Bagehot’s Rule for dealing with financial crises: “lend freely on good collateral at penalty rates.” Since the mortgages were already insured, the government took on no extra risk. And since CMHC paper trades at a discount from T-Bills, banks lost money in the transaction. The banks stopped using the IMPP as soon as markets started functioning normally.
In the area of monetary policy, the Bank of Canada reduced its policy rate as far as it could go on April 21, 2009, thus hitting the “Zero Lower Bound” (ZLB) for conventional monetary policy. Other central banks also hit the ZLB, but the Bank of Canada was the first to implement unconventional instruments, in the form of a “conditional commitment” to hold interest rates at the ZLB for another year. The Bank had also prepared for quantitative easing—this required the passage of special legislation enabling it to purchase a broader range of assets—but it wasn’t required. The conditional commitment was abandoned in April 2010 and the Bank raised interest rates above the ZLB in the following June.
As for fiscal policy, perhaps the biggest “what if?” of the crisis was: “what if the Conservatives had not cut the per-vote political party subsidy in the November 28 2008 fiscal update?” This cut was not part of the Conservative platform, and it led to the prorogation crisis. But what if the CPC had left the vote subsidy alone? The Conservatives’ initial reaction to the crisis was to impose austerity in order to avoid running a deficit—see Table 2.2 here. Not running a deficit under any circumstances was the position that the Conservatives had run on in the 2008 election, and the other parties had made similar promises. If it weren’t for the vote-subsidy measure, it seems to me that the opposition would have most likely let these measures pass.
If the government had imposed austerity, it may still be the case that the Bank of Canada could have and would have implemented measures that offset a contractionary fiscal policy during a recession and when interest rates are at zero — the debate over whether that would have worked is ongoing and lively. And it would have been risky to entrust policy to what is still an untested conjecture.
Happily, that conjecture was never put to the test. The March 2009 budget went the other way, applying the textbook treatment: an explicitly temporary increase in spending, one that was phased out when output and employment had recovered their pre-recession levels. The jury is still out as to the effectiveness of the stimulus program (the recession ended before the spending actually got underway), but it was definitely a good idea at the time. It’s extremely unlikely that the stimulus program actually made the recession worse.
There was more to the government’s handling of the recession than the stimulus package, of course. As noted earlier, the Department of Finance played a key role in providing liquidity to financial markets and worked closely with the Bank of Canada during the crisis. The bailout of the auto sector was also a good decision. A long-term decline of a large sector is one thing; a catastrophic collapse in the middle of a recession is quite another.
The Canadian recovery was due to three main factors:
- A sharp depreciation of the Canadian dollar, which helped boost exports.
- A quick recovery in commodity prices, driven by continuing demand from Asia.
- A housing sector that still had room to grow and consumers whose personal finances allowed them to take on debt.
These were things that countries like the U.S. and the U.K. didn’t have.
Looking back on all this, you see a lot of things that had nothing to do with who was actually in charge. Neither Harper nor Carney can take credit for Canada’s strengths going into the crisis, and they can’t be blamed for the financial meltdown that caused the crisis. So upon what basis can we allot credit for their performances?
Mark Carney first. It’s very hard—impossible for anyone who is not a Bank insider—to work through the relevant counterfactual exercise of re-running the crisis with someone else as Governor. But I think we can safely assume that the Bank would almost certainly have done much the same thing: central banking is not a one-man show, and Mark Carney can’t do everything for himself. That said, my impression is that Carney was generally an advocate of acting quickly and forcefully. (Much of this impression comes from his very first interest rate decision as Governor in March 2008: a surprise cut of 50 basis points in the overnight rate on the basis of the U.S. outlook.) And it is perhaps this reputation—plus his willingness to lock horns with financiers who opposed his calls for stronger banking regulations—that made his candidacy so attractive to the Bank of England. But it is too much to go on to conclude that we owe our recovery to Mark Carney.
It’s important to remember that Stephen Harper’s first instinct—austerity—was likely to have accentuated the severity of the recession. But it’s also important to remember that he ended up doing what the textbooks recommend. Doing the right thing only reluctantly and as part of a strategy to win a confidence vote may not sound like much of an achievement except for the fact that he did it. I suppose I might give extra credit to Stephen Harper if he had wanted to do the right thing from the start, but what really matters is the final decisions he made and implemented. (I’m certainly not inclined to give the U.K. Conservatives extra credit because they followed their instincts and imposed austerity in the middle of a recession.)
What I take away from this is that we could have done much worse, but I don’t think we could have done much better. Stephen Harper and Mark Carney were dealt good hands and they played them well.