Tuesday, January 27, 2009

Carney Declares War on Loonie

In a speech today at the Halifax Chamber of Commerce, Canadian Central Bank Governor Mark Carney made some simply outrageous assertions that cannot go unchallenged. The entire speech can be viewed here, but I will cherry pick a few excerpts for the amusement of my readers.

Carney, 43, started the speech as all central bankers do: With some light humour poking fun of his age. Familiar readers of mine might find it quite ironic that I, being a full generation younger than Carney, am poking fun of Carney poking fun of his age. And they might be correct. However, it is important from a generational perspective to know that Carney has never lived through an economic crisis in his adult life. Additionally, it has been precisely his generation (Gen-Xers) that have perpetuated the worst crimes of this crisis. Complex quantitative models devised by Harvard grads like himself, assuming based on 10 years of data that asset prices never fall, are precisely what have failed. And we can see the same traces of this complete ignorance of history in today's speech. To the speech:

These are challenging times, indeed. We are facing a financial crisis without comparison for generations. Most financial markets have experienced historic declines in prices and unprecedented spikes in volatility. Storied financial institutions have fallen. The global capital market is under great strain. Issues of financial stability that were once the obsession of a pessimistic few are now the daily concern of many.

Were we obsessive pessimists or constructive realists? At least he's not trying to say nobody saw it coming, as many have claimed.

In challenging times such as these, people, rightly, look to a few constants: to institutions they can rely upon and to certain expectations that will be met. My message today is that Canadians can rely on the Bank of Canada to fulfill its mandate; they can expect inflation to be low, stable and predictable. The relentless focus of monetary policy on inflation control is essential in this time of financial crisis and global recession and remains the best contribution that monetary policy can make to the economic and financial welfare of Canada.

Translation: Don't worry. We'll find a way to steal your purchasing power. One way or another.

Inflation is, of course, defined as a persistent increase in the average price of goods and services; in other words, a rising trend in the cost of living. In the broadest terms, this is measured by the total, or headline, consumer price index (CPI), which tracks the retail prices of a representative "shopping basket" of goods and services over time. It is also the rate that the Bank of Canada targets for its monetary policy.
Disinflation occurs when there is a decline in the rate of increase in prices, while deflation refers to a sustained fall in prices; where the annual change in the CPI actually turns negative year after year.

This is a faulty definition of inflation. Inflation, by the Austrian definition, is an increase in the supply of money and credit. Rising prices are a symptom of that phenomenon. The reason is simple. A static or slowly expanding quantity of goods and services will prove a better store of value than money, which is growing even faster in supply. So people have an incentive to borrow money and buy assets, thereby driving up their price. Cause & effect.

Therefore, by measuring a "shopping basket" as inflation, the BoC is always misinterpreting the rate of inflation one way or another. By extension, their decisions on interest rates are always compromised by faulty data. It is akin to a doctor measuring the loss of hair on a leukemia patient as a benchmark for the growth of white blood cells. It is completely backward. Back to the speech:

While such transitory movements in prices are generally harmless over the long term, greater risks arise from a sustained fall in prices. Such deflation, if left unchecked, can weigh on economic activity in two main ways. First, it increases the real burden of debt, making it more difficult for indebted households to consume and leveraged firms to invest. Second, if deflationary expectations take hold, purchases and investments may be postponed in the expectation that they can be executed at a lower price at a later date. After all, if prices are falling, why buy that new car or refrigerator – or invest in technology or equipment – when they could be cheaper in six or nine month's time?

Carney is talking about the "psychology of deflation," which I have been writing about for months. Anyone with a clue has noticed that the prices of big ticket items are falling dramatically. How many young Canadians still believe that they have to buy a home now, or they'll be homeless for life? How many Canadians think that auto dealerships are not going to have to cut prices further to clear their inventories? Its as if Carney is drawing up plans to prevent a hypothetical Japanese attack on Pearl Harbour, yet it is already midway through 1943 and nobody has told him it already occurred.

With this backdrop, the question is being asked whether sustained deflation could happen here in Canada. The possibility is actually remote for three reasons.

First is the resilience of our economy. The Canadian economy has a number of advantages: labour, product, and capital markets that are flexible and open; one of the soundest banking systems in the world; and households, corporations, and a public sector that have considerable financial flexibility. So while our economy will be tested by the current global crisis, it is well positioned to respond.

I believe quite strongly that the common proud assertion of Canadian banks being "the soundest in the world" is something that will come under fire in 2009. The reason they have been relatively insulated from the credit crisis thus far, is because our real estate markets have been some of the last to collapse. The falling collateral values on balance sheets of Canadian banks and households alike will prove that there is nothing magical about our banking system. We engaged in the same reckless fractional reserve lending tactics as the rest of the world. Was it just as reckless as Countrywide or IndyMac? No. But that's irrelevant.

Think of it this way: If a Russian mobster caught me looking at him the wrong way, and came up to me and said, "100 meeelion dollars, one week, or I cut you!" I'd likely think, "oh man, I'm screwed." I'd skip town and change my name. Consider the same scenario but it was only 10 "meeelion." The result is the same. That's essentially the argument made for Canadian banks being "sound."
Second, a floating currency means that we have an independent monetary policy. Quite simply, we are in control of our own monetary destiny.

Third, we have used that monetary independence to great advantage. As one of the pioneers of inflation targeting, Canada has deep experience with the clearest, most powerful monetary policy framework. The advantages of that framework have been demonstrated, with inflation brought down and kept low and stable since the early 1990s, and they are equally relevant in times of disinflationary pressures. To underscore this point, and before turning to the outlook for growth and inflation, let me review the Bank's monetary policy framework.

Aha! Now we're getting somewhere. One of the major problems for European Monetary Union (EMU) member states is that they cannot set their own interest rates. Even preliminary member states like the Baltics have given up control of their own monetary policy. So when the economies in Spain, Ireland and Estonia started tanking, there's nothing they could do to stimulate them, other than cut wages. Now that may be what needs to happen, nobody knows, but if they were allowed to set rates on their own, or better, if the individual market could set them, the original bubble wouldn't have occurred in the first place - or it wouldn't have been so big.

In Canada, Carney is quite proud of his ability to destroy the Canadian Dollar and thus attract productive capacity otherwise destined for the US. And indeed, he has been trying to do his part by buying up worthless mortgage securities in exchange for the government securities that normally occupy their balance sheet - the same balance sheet that our dollar derives its value from.

How far will he go in trying this? What happens if those mortgage securities can't be resold because home prices are falling rapidly? What happens if that extra production doesn't set up shop in Canada because many other central banks are trying the same thing? Or worse, what happens if the global slowdown simply dwarfs any competitive "advantage" a weaker Loonie would normally bring? Carney's Harvard model says that won't happen. Thank goodness!

Carney went on to profess the genius of the BoC's inflation targeting policy. He used the word "inflation" 21 times in 7 paragraphs. Somebody call Guinness. Unfortunately, every single use of the word was incorrect, as mentioned above. So the entire section was nonsensical. Carney alleged the BoC had been keeping the "core inflation" rate within their target range. What that means for the average person is precisely nothing. Not when home prices were rising at rates of 15%/year. Not when food and energy prices were skyrocketing for years on end. Not when the cost of getting your car fixed or furnace replaced was, well, whatever they wanted to charge. No, I've yet to meet one Canadian who actually believed those figures. Sure, Statscan (the ones who collect inflation info) can pick and tinker with the data to make sure it stays relatively stable. But that stability means nothing to people watching their savings dwindle in relative value.

Equally, the numbers mean nothing now when home prices are falling at 20% annualized in some areas, fuel prices have fallen dramatically, the value of Canadians' investment portfolios are off by more than 40%, etc. Savers are becoming richer by the day - compared to those stuck holding depreciating assets. Try and tell an average Canadian that there is more money in the economy than there was last year. You're liable for any hockey sticks that come flying your way. Carney can get away with this because he makes his speeches at places like the Halifax Chamber of Commerce. I wonder what would happen if he were to make the same speech to a strata council in False Creek.

Stabilization of the global financial system is a precondition for economic recovery. To that end, governments and central banks are taking bold and concerted actions. There are signs that these extraordinary measures are starting to gain traction, although more will be required and it will take some time for financial conditions to return to normal. In addition, considerable monetary and fiscal policy stimulus is being provided worldwide.

Carney is still operating in the old paradigm, otherwise known as "La-La Land." This was when people would scramble to take risk so they could impress their friends. It was also when the Boomer generation was still working and accumulating assets. This is all Carney has ever known in his adult life. Therefore, he considers it "normal." What he doesn't understand is that the entire paradigm of debt accumulation (starting in the early 80's) was itself anomalous. Lower burdens of debt and living within our means is "normal." That is what people are trying to achieve now. Any world economic recovery is going to be based on something else completely, which I explained in "Solutions for a Paradigm Shift." Carney still thinks the old paradigm will come back. Does he know that the younger, less-numerous generation wants nothing to do with debt accumulation? I doubt it.

I want to emphasize that this projected brief period of falling prices does not signal the onset of deflation for four reasons. First, most prices will not, in fact, be falling. At present, the prices of more than half the goods in the CPI basket are actually rising at more than the 2 per cent target.

Second, while core CPI inflation in Canada should ease through 2009, its anticipated low should be 1.1 per cent in the fourth quarter of this year – still within the target range for total CPI.

Third, consistent with the past experience that I referred to earlier, and reflecting the accommodative stance of monetary policy, we expect total CPI inflation to begin to converge towards core, starting at the end of this year, reaching 2 per cent by mid 2011.

Fourth, we should again see the benefit of well-anchored inflation expectations in helping to return actual inflation to the target...

The amount of arrogance in this last bit is extraordinary. Carney believes that simply because the BoC says inflation will stay within the targeted range, people will automatically believe it and therefore make it so. This is a load of crap. As I mentioned earlier, nobody believes Statscan's numbers, and nobody uses them to make economic decisions (except for the government). People use inputs from the real world. When they see condo prices in Vancouver being offered for 40% off, they take that as a signal that prices are falling. They don't ignore it and say, "well, Statscan said prices are still rising..."

The Bank's projection of an economic recovery reflects, in part, the monetary easing that we have already put in place – cutting the policy rate by 350 basis points since December 2007. Guided by its forward-looking framework, the Bank began cutting interest rates sooner – and has cut deeper – than most other central banks. With the usual lag, these moves will have a powerful impact on economic activity and inflation.

Again, this is old paradigm thinking. Carney assumes that because lowering interest rates "worked" in the mid 80's, early 90's and early 00's, it will work now. But he is not taking into account any of the socionomic or demographic changes that make today's environment different.

Finally, the role of the exchange rate in monetary policy should not be overlooked. The substantial past depreciation of the Canadian dollar provides an important offset to weaker global demand and lower commodity prices.

It is this ideology that I find the most dangerous for the Canadian economy. Carney thinks Canada can competitively devalue the Loonie to prosperity. He makes no mention of any negative consequences this could bring. How low is too low? 60 cents? 50 cents? Heck, if its so beneficial to have a weak currency, why not devalue it all the way to 10 cents per US Dollar? The reason is that because at a certain point, with the currency so weak, foreign capital flees for fear of a complete collapse. There's very little to stop Canadians from panicking and converting all their cash to US Dollars. Carney appears to think it's worth the risk so we can boost the manufacturing sector - for which there is no global demand anyway. He has apparently not received the memo that global trade has come to a standstill. There is no guarantee that a weaker dollar will attract capacity. Foreigners are retrenching.

To conclude, let me say that the inflation target that has served Canada so well when inflation was above the 1 to 3 per cent control range, will also serve it well when inflation falls temporarily below that range. So let me leave no doubt, no uncertainty about the Bank's commitment. Our focus is clear, our actions consistent, and our objective explicit: 2 per cent CPI inflation

In conclusion, Carney has now officially joined the ranks of Ben Bernanke and Paul Krugman in proving without a doubt that he is intellectually bankrupt. Due to his ignorance of what inflation really is, he is walking a tightrope between the most catastrophic potential outcome: A rapidly depreciating Loonie and a flight of foreign capital exacerbating falling asset prices. It is a cocktail meant for one purpose only - the rapid decline in standards of living for ordinary Canadians.


EconStudent said...

I agree with your analysis that Canadian banking system isn't as sound as people want to believe.

In Canada, the international Basel II requirements do not need to be met by government law, which means banks can choose not write down bad or depreciated asset. As a result, Canadian banks look much stronger and healthier than they really are. Tier 1 Capitol of 10% is overstated and exaggerated, since bad or depreciated assets do not need to be written down.

The Neo-Keynesian models suggest to depreciate the Canadian dollar to improve exports for a small open economy. You are correct that this is Carney's state of mind. However, Carney's approach may work since Canada is an export oriented economy. Congratulations in keep all your asset in US dollars for now.

Matt Stiles said...

You raise a really good point about the optionality of Basel II. That's something I've heard before, but completely forgot about. My suspicion though is that the market will snuff that out and pound their share prices, thereby shutting off their access to private capital. I highly doubt any of the Canadian banks will be allowed to go under. But if property prices really take their toll like I think they will (50% in some areas), I wouldn't be surprised to see British-like treatment.

The "export based economy" is something I think gets a little too much play also. In times of peak social mood, free trade flourishes (as it did in the 20's for example). But when things go sour, protectionism spreads like wildfire. And it only takes one country to set the precedent of broken treaties. They could fall like dominoes if that gets started. To this end, having an export based economy could prove to be more of a burden than a benefit.

Additionally, the export related sector makes up only 34.5% of our economy. The service sector is twice that size or more. So any slowdown in service growth would have to be met with an export expansion of double that - just to break even. Something to think about...

Thanks again for the comments. Keep em coming.

Medieval said...


Great blog! I've been reading it quite a bit. My desire to understand why this global economic crisis is occurring has led me to try to understand economics better.

Anyway, I currently commute to work everyday from Windsor to Detroit. When I finished my master's and started working 16 months ago, I was "loosing" 10% on every cheque due to the strong CND dollar (I had to exchange most of my cheque to pay bills.. bloody student debt!:))

This "economic shift" has favoured my situation (higher USD->CND exchange rate). With many people I know continuing to lose their jobs (Windsor is the automotive capital of Canada..), I'm thakful to keep my position. However, back when the exchange rate was around 0.90 USD=1 CND, I was thinking of finding something else (which would likely involve moving).

How would you explain this shift in currency? Where do you think it's going? (obviously with the economic uncertainty today it's tough to say!)


-Matt Lawson

Matt Stiles said...


For many, your situation is enviable. Having that kind of diversity could be a life saver. I don't often tell people exactly what to buy or when to buy it. However, what I can say is that spreading out your assets and risk among different countries is never a bad idea. Work one place, live another, invest in another entirely.

I liquidated any of my remaining Canadian dollars at around .95, and don't plan on going back until I see low 60's. I'm hoping that coincides with meaningful bottom in the TSX, allowing me to buy even cheaper shares. But that would be too perfect, wouldn't it? :)

EconStudent said...


This is the irony of investing. Lower systematic risk (lower stock prices and higher dividend yields) actually means higher future returns. I used to think in opposite manner and I have corrected myself.

I think you are right that a low Canadian dollar will coincide with a low TSX period.

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