Bill Totten's Weblog

Thursday, May 21, 2009

The Life and Death of a Fiscal Theory

by Thomas Walkom (April 25 2009)

Monetarism is finally dead. It's been ailing for a while, but this week Bank of Canada governor Mark Carney drove a stake through the heart of the economic theory that has dominated Canadian government thinking since 1980.

Put simply, monetarism was a reaction to government activism. Purists, such as the late US economist Milton Friedman, argued that governments should focus on balancing their budgets and cutting taxes. Indeed, state efforts to regulate or stimulate the economy (which the Friedmanites usually called government interference) could only make matters worse.

In the monetarist world, the only legitimate government actors were central banks. Their role was to be strictly limited to issuing just enough money to keep the economy rolling without causing inflation.

By the late 1970s, as inflation wracked the Western world, monetarism held great appeal. Business liked its low-tax message as well as its resistance to anything, such as welfare or unemployment insurance, that might keep wages up.

Governments, disillusioned by their often clumsy attempts to foster growth and worried about their own finances, were happy to leave the economy in the hands of inflation-fighting central bankers.

Which is what they did. Before 1980, the Bank of Canada - while always conservative - had been more accommodating to activist government. Indeed, by literally printing money and giving it to the federal government in exchange for government bonds, it helped to finance these actions.

In those days, this was called monetizing the debt and was considered quite respectable. In 1980, on the eve of the monetarist revolution, the Bank of Canada held about 25 per cent of the federal debt.

But to the monetarists, this was anathema. The printing of money, they argued, should be strictly targeted to the needs of the private sector, and in particular, the need to fight inflation. If governments wanted to finance deficits they should borrow on the private market and bear the full cost.

Through most of the 1980s and 1990s, the Bank of Canada was the real power in Ottawa. By drastically limiting the growth of the money supply, thereby forcing interest rates up to twenty per cent, it induced one punishing recession in the 1980s. Then, using the same techniques, it did the same thing a decade later.

For those thrown out of work, both recessions were disasters. But to the monetarists, they did the job. Double-digit interest rates forced companies out of business, pushed down wages and, eventually, tamed inflation.

At the same time, high interest rates on government debt sent deficits soaring, creating a political climate of fear in which all governments - to the applause of the country's editorial boards - could begin dismantling Canada's social safety net.

Technically, the period of pure monetarism ended in the early 1990s when the Bank of Canada began to focus on its so-called target inflation rate rather than the money supply. But in large part, this was a distinction without a difference. Inflation was still the number one enemy.

More important, the central bank continued its policy of refusing to finance government spending through its printing presses. In 1995, a commons committee noted that the Bank of Canada held only six per cent of the national debt.

But now, under pressure of events, that's changing. The first ideological shoe to drop was Prime Minister Stephen Harper's decision this year to run a $35-billion deficit in order to stimulate growth.

The second came this week with Carney's tacit admission that the Bank of Canada's old ways no longer work. The central bank knows it can choke off economic growth through the usual methods of raising its benchmark interest rate and squeezing the money supply. However, as events of the past few months have shown, it can't do the reverse.

Even though the central bank has cut its benchmark interest rate to almost zero, commercial banks have not followed suit.

So it seems that it's back to the future for the Bank of Canada. Like its US counterpart, the Federal Reserve, it is re-inventing the idea of printing money to directly finance government - and sometimes even corporate - spending. What once was called monetizing the debt is now renamed quantitative easing. But both amount to the same thing: purchasing large quantities of government or corporate bonds with newly minted money.

More novel perhaps is the central bank's simultaneous decision to engage in what it calls credit easing, which, simply put, involves lending directly to corporations without increasing the overall money supply.

Meanwhile, the Bank of Canada has quietly shifted its target. It is no longer waging war against inflation. Instead, it is fighting deflation in an attempt, as it noted on Thursday, to raise prices.

RIP monetarism. As a theory, it was based on the assumption that markets worked, that commercial banks were socially rational and that - left alone - the economy would sort itself it out.

Carney's new strategy belatedly recognizes the fact that none of these assumptions holds. It is also an admission that the commercial financial system has become particularly dysfunctional, absorbing too much of the money the central bank is trying to pump into the economy instead of passing it on. In effect, by lending directly to government and business, he is eliminating the middleman.

Need money? Can't get it from the commercial banks? Don't worry. The Bank of Canada will print you some.


Thomas Walkom's column appears Wednesday and Saturday.

Bill Totten


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