Central Banks vs. Public Debt

Imagine that there is a car in front of you that is suffering from a range of mechanical ills: wheels out of alignment; needs an oil change; transmission won't reliably shift into reverse; and so on. Someone then places a tool in your hand and tells you to get to work. You look down and what you see is that you're holding an impact wrench. It's a very powerful tool but wholly inappropriate for most of the work ahead of you. However, it's all you have so, good luck, and give it your best shot.

Central banks are often in a similar dilemma: the economy can suffer from a variety of ills due to many and complex causes and inter-relationships, yet they must attempt to get the economy back on track with pretty much one tool, that of monetary policy. They are often smart enough to do the best they can with the tools they have but without access to a wrench and other useful tools there is a limit to what they can realistically accomplish. Often they must resort to leveraging the grand stature of their institution by giving speeches and influencing those holding the proper tools -- industry, consumers and government -- to effect desired outcomes.

Consider this quote from Peter Foster's opinion piece in the Financial Post:

“Cheap money is not a long-term growth strategy,” warned Mr. Carney during a speech in Toronto on Monday. But where did this cheap money originate? Also, from what I can remember of economics 101, cheapness is a signal to purchasers to buy, and that includes buying money. People are acting entirely rationally. The only problem is that they are likely not aware that they may have been lured into a cul-de-sac by delusions of macro management.

And this one by Maxime Bernier, also in the Financial Post:

Mr. Carney offers us three “lines of defence” that are clearly an admission of impotence.

Here we have Bernier, a government MP and former cabinet minister, complaining about the BOC's impotence when it is the government which sets the BOC's powers. It is amusing that he then goes on to complain as follows, in effect the pot calling the kettle black. For his part, Foster blames Mark Carney for only having, and then using, the limited toolkit he's been provided with by the government (elsewhere in the piece, he also seems to be confused about the respective roles and powers of the BOC and the federal government).

It is the government, not the central bank, that has the better toolkit for repairing the economy. This starts with building confidence among the true economic players: citizens, both as consumers and business owners. They could also use their powers over taxation which can be used to more accurately target problem areas than is possible with the central bank's interest rate policies. For example, the government could lower corporate tax rates, which would have the affect of encouraging private sector investment and hiring similar to lower interest rates, but without simultaneously encouraging borrowing. That is, leave more capital in the hands of those entities that can give the economy the push it needs.

There have been attempts by the BOC and the government to blame the banks since they are the ones we go to for our borrowing needs. This is unfair: the banks lend money as a business proposition and make loan decisions based on risks associated with both the broader economy and the individual borrower. Ed Clark, CEO of TD Bank has quite rightly deflected the criticism right back at the government. The points he raises in this article are spot on in my opinion. If the government, for example, wants to rein in low-quality mortgage risk -- most commonly associated with the longest-terms with their lower monthly payments but high interest costs -- they should prohibit them.

Speaking of blame, we should also beware playing the blame game when it comes to the US Federal Reserve or the Bank of Canada. It is easy to point fingers and they are tempting targets. Yet they would have an impossible task if they are the only institution expected to right what everyone else has set wrong. They can ease interest rates lower to make it less expensive for consumers and businesses to spend and invest, but that policy can spark investment bubbles and inflation. Go the other way and, as happened so famously following the 1929 crash, and we can be pushed into a deep depression. Finding an optimal middle ground, if it even exists, is more than a little challenging for a central bank.

Even so, Mark Carney is not being entirely forthright regarding debt and, as I will come to, neither is the government. The Governor's warning goes something like this:

When rates do begin to rise again, Carney said, the repercussions may be fierce and have the potential to catch many with debt loads they can no longer afford.

This is true and, although there are words of agreement from Flaherty, there is no mention of the government's own debt problem. They tell us, as individuals and as business owners, to be careful not to take on debt that we cannot easily repay when interest rates rise once more, while at the same time the federal government is taking on over $50B of debt in the current fiscal year. That is not really government debt; that is public debt. On our behalf the government is borrowing money against the wealth and wealth-production capacity of the Canadian public. That debt, too, could easily become difficult to repay when interest rates rise.

There is a measure of hypocrisy when they fail to discuss government-incurred debt, debt which is also our debt and subject to the same risks. I do not mean to criticize the government having used this debt to smooth over the worst impacts of the economic air pocket we've just been through, just that they should not avoid lecturing themselves at the same time they lecture us. The lecture is a good one for both the private and the public sectors.

The thing is that Flaherty does intend to rein in spending, eventually, and so he has missed an excellent opportunity to lead by example and explain how both types of debt are due to public borrowing. Perhaps he is being cynical in an attempt to retain some flexibility to keep spending, and taking on more public debt, for a while longer.

The question is even more pertinent in the United States where Federal Reserve Chairman Bernanke is thinking of the extreme government debt policies he has been pushing, including financial sector bail-outs, which very much depend on keeping interest rates low at least until some of that debt can be extinguished. We had all better hope that he does a good job of juggling interest rates and debt policies since if he or the US government stumbles the Canadian economy will also suffer.