Bank of Canada refuses to lower interest rates

September 6, 2007

The Bank of Canada yesterday decided to stand pat on its previous decision to raise interest rates arguing growth was still robust in Canada but admitting that it would slow in the future on account of the US burst bubble in the housing market and the spreading crisis in asset backed commercial paper.
The Bank is taking a definite risk that the US Fed will not cut its principal discount rate in its next decision on the Federal funds rate expected later this month. Because if it does in response to the spreading gloom and liquidity crisis flowing from the sub-prime mortgage disaster and the paralysis in the asset backed commercial   paper markets the   narrowing spread between Canadian rates and the US rate will promote a rise in the value of the Canadian dollar in US dollars and deepen the slowdown in manufacturing activity in Canada.

If one couples this with the turmoil in the money markets Canada could face a major slow-down in the next few months. The money market disruption has had far wider consequences than most officials as opposed to post-Keynesian economists and those in the know in the financial derivatives business believed would be the case.In the current global economy where the level of financial intermediation and derivative development has multiplied ernormously the original insights of Keynes and Hyman Minsky about risk, uncertainty and Ponzi finance are more relevant than ever.

In addition simply consulting one of the classic monetary experts of the past is revealing. R.S.Sayers wrote the definitive work on Money and Banking in Britain, Modern Banking which first appeared in 1938. Over the next three decades it reappeared in more than six editions. I had the pleasure of having studied from the sixth edition issued in 1960 in 1964 in a class taught by the then young Gordon King who later joined the Bank of Canada as an economist.

If one reads Sayers, particularly his chapters on the Supply of loanable funds and Commercial bank liquidity and lending policy the current predicament comes as no surprise. Sayers points out that commercial banks can face major losses if they fail to maintain an adequate degree liquidity   in their assets.But because cash is both highly liquid and pays no interest being an idle asset banks are forced to acquire less than perfectly liquid assets in order to earn a higher rate of return than zero.

As Keynes pointed out interest is paid in return for parting with liquidity.The key to the degree to which assets are relatively liquid is what Sayers calls their shiftability.As he puts it ``particular assets are readily shiftable`` when they can be shiftable on to other banks or institutions or persons willing to supply cash "in return for them.(p.159, 6th edition)

The amount of cash that people are willing to pay for assets is a function of the inherent risk involved and how far off into the future the maturity date is. The asset is attractive to the bank if it can wait until maturity "devoid of risk of loss" and is also shiftable. In other words there are buyers for the asset in the time interval before maturity.

If this shiftability disappears or if the risk element has been inaccurately assessed both of which are true of the sub-prime mortgages and the commercial paper based on them then serious trouble can arise. A major liquidity crisis is possible and the turmoil in the financial markets can cause a severe economic downturn.

What Minsky pointed out was the absurd and even borderline fraudulent assessments of risk that were possible under Ponzi finance or pyramid schemes which when a bubble burst could bring the whole house of cards tumbling down.

Many of the banks and   financial institutions that bought asset backed commercial paper had no idea that they were"backed" by sub-prime mortgages which made them much riskier than the risk assessment awarded them by the banks. Even less well informed were retail investors who were sold these money market funds as safe RRSPS or investment funds.

Now the truth is emerging and the results are less than pretty.