Bank of Canada on wrong track

June 12, 2008

The recent decision of the Bank of Canada not cut the trend setting interest rate by 25 or 50 basis points because of their fear of inflation may well have bitter consequences in the months ahead.The Canadian economy is slowing down, unemployment is not falling but will be rising in the months ahead and there are signs that the recession in the US is spilling across the border into Canada. Outside of the cartel driven energy market and the speculatively driven futures markets in energy and agricultural commodities there is no sign of price rise in the Canadian economy.
The enormous downword pressure of China and India upon both prices and wages continues to be the most defining element of the current economic environment in the services and manufacturing sectors.

Ontario and Québec still suffer from a major slump in manufacturing and low unemployment is still confined to Western Canada. Because of our export dependence upon the American market the combination of a high exchange rate on the Canadian dollar and an American slowdown is bad news for our manufacturing sector. Keeping the interest rate higher than it should be guarantees a higher exchange rate than is desirable. It forces manufacturers to either close their Canadian operations and relocate them in cheaper wage areas or decrease local wages in Canada or in the best case scenario increase productivity by substituting capital and machine tools for labour to lower costs per unit of outut.But even in this last case there will be structural implications for the labour force in manufacturing. If the machine tools, capital equipment and technology are not produced domestically but abroad Canada remains a net loser even if the factories stay open because the labour forces will other things being equal be smaller.

In addition , of course, in a low inflation environment tighter credit restricts consumption and business investment financed on credit thereby slowing growth and reinforcing a rise in the rate of unemployment. All in all its a bad policy for the current environment.

As long ago as September 1959 the American economist Charles L.Schultze demonstrated in a study on employment, prices and growth for the Joint Economic Committee of Congress," Recent Inflation in the United States" that the inflationary process can only be understood in a disaggregated way and that attempts to cure inflation which originates in a sector of the economy due to monopoly or structural reasons   by a general tightening of interest rates will result in doing more damage than good and in fact in the presence of declining growth overall is likely to produce stagflation.

So the Bank of Canada will make matters worse by general tightening in order to vainly fight a battle against a booming energy sector that world wide is directed by a cartel and heavily influenced by forward trading in the futures speculative market.

The solution to this problem can only lie in vigorous anti-trust, significant efforts at alternative sources of energy, reduced fuel consumption through the substitution of hybrid vehicles and enhanced public transportation and additions to supply from known and discoverable sources brought on stream as quickly as possible.

In addition the foolish and ill advised decision to privatize Petro-Canada thereby removing from public ownership an important window on the petroleum world and source of significant profits that could have been shared with Canadians across the whole country has made matters worse.The lack of a publicly held company has made us dependent on the privately owned oil companies to tell us what the known reserves are and we have to take them at their word when it is not in their commercial interest to be as forthcoming as they might be otherwise.

The Bank's approach and that of other central bankers worldwide to the energy crisis shows a rigidity of thinking and lack of imagination in bringing monetary theory up to date with twenty-first century global reality.