Proceedings of the Standing Senate Committee on
Banking, Trade and
Commerce
Issue 16 - Evidence
OTTAWA, Thursday, April 23, 1998
The Standing Senate Committee on Banking, Trade and Commerce met this day at 11:00 a.m. to examine the state of the financial system in Canada.
Senator Michael Kirby (Chairman) in the Chair.
[English]
The Chairman: This is our annual appearance with the Governor of the Bank of Canada. The governor will make an opening statement, a copy of which has just been distributed. The governor's opening remarks will be followed by our usually lively discussion session.
Mr. Gordon G. Thiessen, Governor, Bank of Canada: Honourable senators, it is a pleasure for us to be here. I should like to introduce my colleague, Tim Noel, who is the deputy governor responsible for our operations in financial markets and for the role that we play in the management of the public debt.
My colleagues and I look forward to our yearly appearance before your committee because it gives us an opportunity to present an account of how the bank has worked to fulfil its objectives over the past year, and it is also an opportunity for us to have a discussion with you on a range of economic and monetary issues.
[Translation]
I can report that the Bank has taken further steps to improve its communication with Canadians and to be accountable for its actions. We have increased our contacts with individuals, a range of business and other groups and provincial governments.
The most important initiative we have taken is to establish new regional offices in Calgary and Halifax and to expand our operations in Montreal, Toronto and Vancouver. These regional offices will multiply our contacts with Canadians across the country and help us gather information from a wide range of sources.
[English]
Recently, we have taken yet another step to ensure that we benefit from expertise outside the bank on monetary policy. We have created the position of special advisor to bring outside experts into the bank for one-year terms. Over time, this will also provide a number of university and private sector economists with first-hand knowledge of the bank and its role. Professor David Laidler, of the University of Western Ontario, has been chosen to fill the visiting economist's position for a one-year term starting in August of this year.
Honourable senators, when I spoke to you a year ago, the prospects for global economic growth were very promising. World economic activity was strong, with low inflation and stable or declining interest rates. In Canada, too, output and employment growth had picked up, helped by our low interest rates and a dramatically improved fiscal situation across the country.
As it turned out, the Canadian economy has performed well in 1997, with a growth rate of over 4 per cent, through the year, and a strong increase in employment. Today, the outlook for both the world and the Canadian economy is still positive, though the problems in Asia have led to a scaling back of earlier projections for world economic growth.
[Translation]
The effects on the Canadian economy of the problems in Asia are likely to come mainly via our other major trading partners and through the prices of some of our exports, especially primary commodities. These effects will no doubt have a dampening influence on economic activity in Canada this year. That is particularly true of British Columbia, which has a heavy reliance on the primary commodity sector and on exports to Asia.
[English]
There are other factors working in the opposite direction in our economy. With the exception of Japan, the economic performance of our major trading partners, particularly the United States, has been somewhat stronger than anticipated. In Canada, as well, we have a much sounder economic foundation than in the past, thanks to our low inflation, improved fiscal health and the progress that has been made in private sector restructuring. I believe that this puts us in a better position to withstand shocks such as those emanating from Asia.
Except for some temporary influences, the core rate of inflation in Canada has remained within our 1 to 3 per cent target range over the past year. By pursuing a monetary policy designed to keep inflation low, the Bank of Canada is contributing to making the economic expansions in Canada as long-lasting as possible, while also providing a buffer against external shocks. The longer economic growth is sustained in this country, the more benefits we will see in terms of improved incomes and employment.
[Translation]
In line with our commitment to keep inflation low, together with the federal government, we announced in February that we would extend our current target range to the end of 2001. This extension will allow our economy more time to demonstrate its ability to perform well under conditions of low inflation before we define longer-term targets for price stability.
[English]
On balance, the economic outlook in Canada remains positive. The IMF recently projected economic growth of 3.2 per cent in Canada this year, which will put us at the top of the list of G-7 industrialized nations in this respect. This is generally in line with our own projections, although we are probably more optimistic than that. We expect continued gains in incomes and employment through this year and next. Just how large those gains will be an ongoing basis over the medium term, however, will depend on how successful the private sector restructuring that I referred to a moment ago will be in putting the Canadian economy on a track of rising productivity. It is rising productivity that will provide the basis for an economy to generate improved living standards.
Senator Tkachuk: Welcome, Mr. Thiessen and Mr. Noël, to the committee. I am never one to miss an opportunity to promote our province. It is nice to welcome a fellow alumnus of the U of S. I am sure the people of Moosomin are very proud that a graduate of their high school is a governor of the bank. It goes a long way to showing the quality of people that we produce in the Prairies.
As you know, Governor Crow was the object of some controversy during the 1993 general election. Comments were made by the leader of the Liberal Party at that time, now Prime Minister Jean Chrétien, that a Liberal government would tell Bank of Canada Governor John Crow to pay greater attention to job creation and not be fixed on inflation. You were the senior governor during Mr. Crow's tenure.
Did you support the policies of then Governor Crow, and how have your policies differed since your appointment?
Mr. Thiessen: As the senior deputy governor at the time, of course I was strongly supportive of the policies we followed. I was part of the process of making those decisions. However, it is too easy to put monetary policy into segments like that. Monetary policy has a long-term effect, and you must look at what policy does over long periods of time.
The period of high inflation beginning in the 1970s had ongoing effects, and it took us some time to realize how difficult those were. We are now going through the virtuous side of that difficult period. We are benefiting from the efforts that were made to bring the inflation rate down so we could benefit from a situation of low inflation.
The fiscal situation also has a great effect. No doubt many of the difficulties we had through the period of high inflation were exacerbated by the problems which governments -- provincial, federal, and in other parts of the world -- had in getting their fiscal situation under control.
It is also interesting that, even after we got our inflation rate down, we did not get the full benefits of low inflation until the provinces and the federal government started to make moves to bring their deficits down. That is when we started getting the really low interest rates we now have.
Senator Tkachuk: Have the government's actions to reduce the deficit and bring it under control resulted in a change of monetary policy by the bank?
Mr. Thiessen: No, the policy is still the same; however, the implications of policy change as the circumstances change. Therefore, as the fiscal deficit comes down, there is more room for lower interest rates. As inflation comes down, there is more room for lower interest rates. However, throughout, and going back a very long way, the objective of monetary policy was to bring that inflation rate down gradually over time. We were not always as successful as we wanted to be, but going all the way back to the early 1980s, policy was essentially the same: to get that inflation rate down. We now have that inflation rate down. The monetary policy is still aimed at keeping the inflation rate low, but we are now seeing the benefits of that policy. However, the policy is not fundamentally different.
Senator Tkachuk: During the 1993 election campaign, Mr. Chrétien was asked what he would do if Mr. Crow disagreed, and Mr. Chrétien replied, "I am telling you that he is an official of the government."
Governor Thiessen, has the government, through the Prime Minister or the Minister of Finance, at any time during the last four years, by letter or in a meeting, asked you to change your policy to that of job creation rather than the policy that you have outlined to us today?
Mr. Thiessen: Senator, I really do not want to comment on conversations that I have, particularly with the Minister of Finance. We have those conversations regularly, as required by the Bank of Canada Act, and I do not think it is not proper for me to comment on what we say or do not say. I would say that most of the comments that I have heard from the government have been supportive of monetary policy.
Senator Austin: Governor, I extend my welcome to you as well. It is always a bit intimidating to have you here. Your expertise and your very significant role in our economy are well recognized, and I feel my Economics 100 course at UBC does not really match the situation.
I wish to address an issue which is of growing concern to me. We seem to be in an era of considerable confidence about our economy here in Canada today, as well as in the U.S. and in Europe. My questions come from a desire to be a bit of a contrarian and to test some thinking. They really relate to monetary policy, particularly the very large size of the M-3 in the U.S. I understand it is also growing in Canada. There is a concern that the major western share equity prices, especially in the U.S, are becoming dangerously overvalued.
I think you are aware, for example, of The Economist issue of April 18, which said that asset price inflation, especially in the United States, now poses a bigger and more imminent threat to the global economy. They also indicated that the slump in Japan and the financial crisis in much of Asia, which preoccupied the spring meeting of the IMF and the World Bank, just ended. They point out that U.S. stock markets have risen over the last two years by 65 per cent, a boom which they attribute to excessive monetary growth in the U.S. economy. They mention that U.S. M-3 has grown by almost 10 per cent in the past year, the fastest year since 1985, when the U.S. was recovering from a relatively deep recession. That is quite dissimilar to the circumstances today.
They believe that while there may be a risk on the recession side, the larger risk is that this asset price inflation will spread, causing over-investment and a consumer binge. They come to the conclusion that the Federal Reserve last year missed an important opportunity to raise interest rates and, to use their expression, to let some air out of the bubble.
As you remember, Alan Greenspan, the chair of the Federal Reserve, in December, 1996, spoke of "irrational exuberance," a term to which he has not returned recently.
I would ask you whether the Bank of Canada at this moment is watching the potential asset price inflation circumstance; whether the pricing of equities and the high P/E ratios that are being experienced are of any concern; and whether the excess liquidity in the equity market, particularly in the mutual funds, is driving an irrational economic picture. How does all of that affect Canada?
Mr. Thiessen: I think your introduction was designed to lull me into a false state of confidence. Senator Austin has raised one of the most difficult issues facing monetary policy analysis these days.
The role of monetary policy is traditionally to focus on what we call the real economy -- the production of goods and services and the prices at which those goods and services are sold. Virtually every central bank in the world sees that the best contribution it can make to maximize the production of those goods and services over time is to keep the inflation rate very low and that that should be the focus of monetary policy. You will note I have not said a word about the price of assets; it is the price of goods and services. Most of us have regarded that as an appropriate way to define very quickly what central banking is all about.
That having been said, we are all well aware of what happened in Japan, where the prices of assets, particularly real estate and equity prices, went up very high. There was a speculative bubble, and when that bubble broke, it had all sorts of consequences for the real economy. If one looks back, one could say that if people had just done so and so, perhaps they could have avoided that bubble and all the consequent implications for the real economy.
However, deciding when you have a serious speculative bubble, which is somehow separate from what is going on in the real economy, is a difficult judgment. I must admit that there is no consensus in the central banking community on exactly what you should do.
I have doubts about the issue of whether monetary growth is driving that. The degree of change that has gone on in the financial sector in virtually every country in recent years has been so enormous that judging exactly what you can make out of those aggregates, especially those that are broadly defined, is extremely difficult.
In Canada, we are in the process of redefining our aggregates. We had something called M-2, then something called M-2 plus, and now to something called M-2 plus plus because the world keeps changing. Therefore, I would be very hesitant to attribute too much significance to what is happening to M-3.
I would be far more inclined to suggest that major changes going on in the world are being reflected in the stock market. One might say it is very likely that there is an exaggeration of those changes. Interest rates are much lower than they were. Productivity growth, because of technological change, particularly in the United States, is rising. We see a flow of profits into the future that looks longer than before, and we discount that to a present value with a lower interest rate before. That gives us a higher present value and a higher market price that people are prepared to pay. There is no question, particularly in the U.S., that those prices are pushing the limits of what you can say about the expectation of interest rates staying low and profits going up.
I am much more inclined to that explanation for profits than I am one that relates to monetary aggregates. However, there is no question that everyone worries that if those markets become too speculative and then crash, they will have some implications for the rest of the economy.
We are monitoring them very closely, but I find it difficult to say more than that. There could be a moment when, quite evidently, things have gotten out of hand and you must respond to them.
Mr. Tim E. Noël, Deputy Governor, Bank of Canada: The wealth effect of stock market prices is far from sure. If you go back to 1987, the last time we had a stock market crash, the break in stock prices had very little impact on the economies of the Western World.
Senator Austin: I appreciate your answer. My concern, then, runs to how you measure when it is time to intervene, which is the question, governor, you have been addressing.
With respect to inflation, you have talked about long-tail management. With respect to asset price inflation, surely there is a long-tail question as well. The longer you wait, arguably, the more difficult the consequences of intervention will become. I appreciate your answer, which says that that is your concern. I understand that.
When Mr. Noël made his comment, what flashed through my mind was the psychological impact on tremendous wealth diminution -- the expectation that wealth will diminish dramatically -- and the impact that will have on consumer confidence, investment, and so on. I am hearing you say that you are watching it carefully. You are not sure when a time for intervention, if any, will occur, and the Federal Reserve is probably in exactly the same posture with respect to the U.S. economy.
Mr. Thiessen: I think the situation in the U.S. is rather further advanced than that in Canada, if I may put it that way. That economy has been operating at full capacity. The degree of confidence in that economy, which is reflected in the stock market, is much stronger than here, where we are still making our way to full capacity. The degree of optimism in the stock market would certainly be stronger there than it is here.
Senator Austin: Is it true to say that stock markets are now playing a much larger role than historically in determining monetary policy?
Mr. Thiessen: Not yet, but they are certainly much more on the minds of central bankers than historically.
Senator Austin: They are certainly on the minds of some.
I should like to discuss the relationship between interest rates, inflation, and the Canadian dollar exchange rate with the U.S. dollar. We read a great deal about this issue in the press, and very little is understood about the relationship. My next comment will prove how little I understand about it as well.
My understanding has been that one of the underlying weaknesses in the Canadian-U.S. dollar exchange rate relates to the pricing of Canadian commodities being exported. As commodities are weaker and we are in the lower part of the cycle today, the Canadian dollar will inevitably be weaker.
In those same equity markets we were discussing a few seconds ago, we are now seeing renewed support in the cycle for commodities, which would argue for a rising Canadian dollar vis-à-vis the U.S. dollar. That is the only relationship I am pursuing at the moment; otherwise the conversation gets very complex.
If that is true, what does that mean for your interest rate management strategy within the band that you continue to support? What consequence will that have with respect to the Canadian economy?
Mr. Thiessen: Commodity prices have indeed been a very important part of the explanation as to why the Canadian dollar has been on the weak side, certainly over the last six months or so.
Commodity prices have come down a long way. There has been quite a reaction in primary commodity markets to events in Asia and, more recently, particularly the ongoing stagnation in Japan.
That is, indeed, reflected in the Canadian dollar. While the production of primary commodities are less important in the Canadian economy than they used to be, they still remain an important part of our exports and, therefore, not surprisingly, have an important influence on the Canadian dollar.
There are a few signs, these days, of a turnaround in commodity prices. In a few commodities there has been a bit of an upturn. There is no doubt that that is being reflected in some resource stocks on stock markets, where they look forward, as markets do, and they see that things are turning around and they feel better about it.
That turnaround in commodity prices is by no means a certainty yet. We had a similar situation at one moment in January and then they slid away again. Much will depend upon the situation in Asia. Were there to be some sign of a stronger policy response in Japan than we have seen to date, you might see something more substantial coming out of the commodity markets, and that would indeed affect the Canadian dollar.
To get to the issue of interest rates we look at the combined effect of interest rates and the exchange rate on the economy. This is a very important, open economy and you must look at the two of them all the time. When the Canadian dollar rises or falls, we look at the likely future impacts of that on our economy. We then ask ourselves what kind of interest rates are consistent with non-inflationary and sustainable economic expansion. If the Canadian dollar has fallen further than we feel is consistent with that path of stable growth, we will raise interest rates to balance it and, conversely, if the Canadian dollar is very strong, we may lower interest rates.
Senator Austin: The raising of interest rates is a natural drag on the growth of the economy.
Mr. Thiessen: It is, but a decline in the exchange rate is a natural stimulus to the growth of the economy. However, when that decline in the currency relates to weak commodity prices, and therefore a weaker sector of the Canadian economy, you must take that into account. This is not a simple mechanism. I have probably already made it sound too complicated, but those are the judgments we must make.
If the Canadian dollar is falling, we must ask why it is falling, whether that means that the Canadian economy is weaker than before, what we should do about it, and whether the Canadian dollar has fallen further than would be justified by the impact of commodity prices on the economy.
Those are the calculations we have made over recent months. We have concluded that the decline in the Canadian dollar was greater than was justified by the circumstances in the economy, even given the weakness in commodity prices and the impact of Asia.
We came to that judgment because our major trading partner, the U.S. is, as I said in my opening remarks, even stronger than expected. For us, that was a counterbalance.
Senator Oliver: My questions all relate to inflation. On March 25, you gave a major speech in Winnipeg on the Canadian economy, inflation and monetary policy. You made two statements that I think reflect your view. You said:
...high inflation increases uncertainty about the future.
Inflation is low, and we are committed to keeping it low.
With that in mind, on February 24 of this year, the Bank of Canada and the Minister of Finance made a joint announcement that the target band for the inflation rate would be 1 per cent to 3 per cent, and that you were extending this to the year 2001.
When this was originally introduced in 1993, it was supposed to be re-evaluated at the end of 1998. You will not be doing that. Why will it not be re-evaluated? Why are you extending it for three years?
Mr. Thiessen: We did re-evaluate it, senator. We had a very intensive program of research and analysis at the bank which included outside economists. That culminated in a major conference held by the bank last fall where all the analyses were put together. We then had discussions with our colleagues at the Department of Finance and we concluded that we needed more time. We needed to see the economy operating with low inflation for a longer period before we decided what was a long-term, sensible inflation control target for Canada.
Senator Oliver: What information were you lacking? What else did you need to study?
Mr. Thiessen: We felt that the economy had not been operating at low inflation for long enough. We have had relatively low inflation rates since the beginning of 1993, which is not very long after 20 years of high inflation. It seemed to us that it would be far better to make those judgments when we have lived through quite a long period of low inflation, particularly a period in which the Canadian economy is operating at full capacity, and we are not there yet. We would very much like to see this economy operating at full capacity with low inflation, and then decide what a sensible, long-term target is to set for inflation control.
Senator Oliver: Do you think you will know that by 2001?
Mr. Thiessen: I would think so, yes. That is our judgment. We must not let this slide. We must review it, as we did this year, to determine how things have gone. Has the economy performed as well as we expected it to? Are there rigidities that we did not see before? Is the economy as flexible as it appears to be? There are a series of questions of that sort that must be asked.
Senator Oliver: Did any outside agencies, such as the IMF, suggest that you should take more time and do more study before fixing it?
Mr. Thiessen: The IMF did suggest we extend the targets and take more time, yes.
Senator Oliver: Did they actually suggest 2001?
Mr. Thiessen: I do not remember that they suggested a particular time. They simply said that we should put it off for a while.
Senator Oliver: My next question relates to the core rate of inflation and how you arrive at it. An article which I read said that the bank prefers to calculate inflation based on a core rate, one from which food and energy costs are excluded. That struck me as a bit strange, because consumers face increases in real costs of food prices on a daily basis. In January, for instance, food prices increased by 26.5 per cent. With that kind of variation, how can you have a system which does not include the cost of food?
Mr. Thiessen: The target is defined in terms of the total Consumer Price Index. We concentrate on what we call the core rate in order to try to see through fluctuations. There are many fluctuations in food and energy prices. With only a little shift in the weather, not only do actual food prices change, but expected food prices change as well on commodity markets. That leaves a great deal of volatility in the measure of the Consumer Price Index.
We want to focus on the trend. We cannot fine tune the Consumer Price Index; we must not even try. Our job is to keep the trend of the Consumer Price Index within the 1 per cent to 3 per cent range over time. We use this so-called core measure only to help us see through those fluctuations.
If there were ever a persistent divergence over time between this core measure and the total CPI, we would look at the total CPI every time.
Senator Oliver: Do you actually run a series of tests? Would you run the real costs and plot the effect of the rise in energy costs and food costs at the same time as doing your core tests?
Mr. Thiessen: Yes. We have various ways of looking at this. We tried other variations which do not take out the volatile elements but simply reduce the weight attached to them on the grounds that if they have gone up sharply they will go down again. We do that to see whether we can get a smoother series that gives a better fix on the trend. We are always looking at a range of indicators. We do not look at only one, because it is not reliable enough.
Senator Kolber: In March, the unemployment rate in the United States was 4.7 per cent while the rate in Canada was much higher at 8.5 per cent.
The chairman of the American Federal Reserve, Alan Greenspan, has shown that the unemployment rate can fall considerably below conventional targets without triggering higher inflation. Many experts believe that there is much more slack in the employment market and that a substantial number of new jobs could be created by lowering rates without impacting inflation. The United States seems to have done a magnificent job in this area. Their inflation rate is running at 1.4 per cent annualized, based on February's numbers, compared to 1 per cent in Canada.
My two-part question relates to the lessons we might learn from the American experience. First, is the Bank of Canada willing to test how low the unemployment rate can fall in Canada in the same way that the chairman of the Federal Reserve has in the United States? Second, do you foresee Canada's unemployment rate closing the gap with that in the United States?
Mr. Thiessen: Those are indeed important questions. The U.S. experience is an interesting one. The U.S. Federal Reserve has managed U.S. monetary policy incredibly well.
I absolutely agree with you that the current level of unemployment in the U.S. is well below what most people thought was attainable on a sustained basis. There is some question as to whether they can sustain it at these levels, but there is no doubt that the sustainable level of unemployment in the United States is much lower than appeared possible. That is exactly the kind of process that we hope to go through with monetary policy in Canada.
It is interesting to note that the United States raised interest rates rather sharply in 1994, at a time when the U.S. economy looked like it was gathering too much momentum. Many people said at the time that the job market would be killed and the chances of getting the unemployment rate down would be severely lessened. That turned out not to be the case. Those increases in interest rates in the U.S. put their economy on a sustainable track. They continued to achieve improvements in productivity and unemployment.
It is crucial to remember that you must put your economy on a sustainable, non-inflationary track. If you do that, you will extend the length of your economic expansion and the prospects for achieving low unemployment will increase enormously.
Over the course of the last 25 years we have learned that every time an economy is allowed to burst through the ceiling of full capacity and go into inflation, a boom and a bust results. One does not get the kind of unemployment rates that they have achieved, without a greater degree of stability.
I am hoping that is what we will do. For the first time in 25 years, we have low inflation. Low inflation gives central banks room to manoeuvre that is not achievable with higher inflation. With high inflation, every time you have a burst of demand or increased activity, people start to worry. They start to push up prices and wages. They start to demand higher interest rates. The economy grinds to a halt.
When you have low inflation, people are more inclined to wait and see how things go before they start pushing up prices, wages and interest rates. Low inflation provides the opportunity to test the limits of capacity in an economy. We have been given the possibility to do that in Canada.
I do not know how low an unemployment rate that implies for Canada. One must be agnostic about it. You do not want to say that you know; you want to test rather than presume that you know how well you will do.
Senator Kolber: Since the Bank of Canada introduced the Monetary Conditions Index, or MCI, an artificial index that blends together movements in the exchange rate and the short-term interest rate, the financial markets have been following it very closely. However, there are other forces at work which affect Canadian policy in the shorter term, aside from interest rates and the value of the Canadian dollar.
Have you ever worried that the financial markets may be paying too much attention to the MCI, in the sense that the markets expect the Bank of Canada to automatically raise interest rates every time the Canadian dollar weakens? Is it possible that the bank has oversold the importance of the MCI to financial markets?
Mr. Thiessen: Yes, it is possible. I hope that is not the case, but I would accept that there are times when there is too much fixation on small movements in the Monetary Conditions Index. We use the Monetary Conditions Index as a general guide to policy. We do not try to fine tune it over a narrow range.
In response to an earlier question, I indicated that when the exchange rate goes up or down, we must judge why that is happening. Is this happening because something is affecting the Canadian economy, or is it something which is unique to the exchange market which has no counterpart in the Canadian economy and, therefore, we should offset? Those are judgments that we must always make. We do not have a narrow range for the Monetary Conditions Index. You are right; there are times that market participants exaggerate the importance and the narrowness with which we try to control that index.
Senator Kolber: I do not wish to belabour the question of the continuing soaring stock market, but no doubt we will experience a major correction at some point.
The day after the last drop, which was in October 1987, real estate went way up in value. Gold started to soar. My original question was, if the market bubble bursts, how do you see the Canadian dollar and Canadian interest rates affected. I do not think you can really answer that. However, is there not, in your opinion, a transfer of assets?
Mr. Thiessen: Not completely. In many cases, it can be just the prices that move. You can have no transactions whatsoever, and then all the equities that everyone thought were worth a lot are worth much less. You do not have to have a single transaction for that to take place.
It is not as though all that money has gone from one place to another, although that can be the case. You will certainly find that when stock markets go down, many people wish to go into the bond market where they feel safer. However, if they wait until after the crash, they have less money to move into the bond market.
Senator Kolber: We sold our real estate company two weeks after the stock market crashed in 1987. The week after the crash, we were terribly over-subscribed by people who thought real estate was the place to be and not stocks.
Mr. Thiessen: Many people, including central banks, misjudged the impact of the stock market. They believed it would be more devastating to people's perception of their wealth and their confidence in the future than it turned out to be.
As Mr. Noël was saying, the wealth effect that people were looking for -- "If people are suddenly poorer what will happen?" -- did not exist to a large extent. We withdrew all the liquidity that we pumped into the market right after that crash more quickly than most central banks. However, I must say that some of the inflationary pressures in the late 1980s were as a result of an overreaction to that stock market crash.
Senator Kolber: My last question relates to the year 2000 computer issue which has captured considerable attention in the press. As you know, the year 2000 problem emerges because computers have been programmed to recognize only the last two digits of any year. For example, computers have difficulty distinguishing the year 2000 from the year 1900. Some analysts believe that the year 2000 problem is significant enough to trigger a recession. Is this something that concerns you? Could you comment on it?
Mr. Thiessen: I really think that is oversold. My perception is that the appreciation of the year 2000 problem is getting stronger and stronger, and therefore more companies, more institutions, and more governments are doing what they must to ensure that those things that are critical to their operations will be year 2000 compliant. Therefore, the notion of a serious recession after the year 2000 is pretty far-fetched.
I would not rule out that there will be companies that will not make it, that will either choose to go bankrupt or will be forced into bankruptcy.
Senator Angus: I should like to pursue a line of questioning that I have been following with you on your visits here for the last several years. It arises out of what you generally refer to as the fundamentals. I am happy to hear again this morning that you think the fundamentals are still good in the Canadian economy, but I would like to ask you to elaborate on that at the outset. I think I heard you say that, on the one hand, there is still some room for expansion in our economy, while, on the other hand, there have been some problems with which you have had to deal in the last three or four months.
First, could you elaborate on how you see the fundamentals? Second, are there any danger signals of which we or the Canadian people should be aware?
Mr. Thiessen: Yes, indeed, senator, the fundamentals do continue to look very good. In fact, I think one almost cannot overstate how much they have improved. This is as a result of the combination of an improved fiscal situation at all levels of government in Canada, plus low inflation, plus -- and this is very important -- the efforts that the private sector is making to become more productive, more competitive, and to take better advantage of all the technological changes going on in the world.
Those are huge improvements in the fundamentals. I believe those fundamentals are better in Canada now than they have been at any time since the 1960s. That provides us with a base for the future which is much better than it has been for a very long time. It also enables us to cope with shocks from abroad, crises that hit Canada, better than before.
You cannot avoid an impact in Canada of a major event abroad. This is a very open economy. We are dependent on trade and transactions with the rest of the world. We will always be affected. The real question is whether there will be ongoing confidence in the way we manage our affairs in Canada so that that impact will be minimized. I believe that the recent impact of the Asian crisis demonstrates that. When you compare it to what we went through after the Mexican currency crisis, the differences are quite dramatic.
Indeed, I do believe the fundamentals are very good.
Senator Angus: In regard to my question about any danger signals or other problems, you may recall that last year when you visited with us I developed a line of questioning with regard to whether these fundamentals were consistently good across the nation. I think that, at the end of the day, you agreed with me that the fundamentals were not quite as good in some areas. I focused on Quebec, which is my home province.
Have you seen similar improvement in the Province of Quebec in that respect?
Mr. Thiessen: There is no doubt, senator, that in some provinces the process of getting fiscal deficits under control started a little later and has taken a little longer. That is true of both Ontario and Quebec. However, as far as I can tell, in both provinces a great deal of progress is being made and a major commitment has been made by the governments in those provinces to get there. That strikes me as very good news indeed.
An area in which I think the fundamentals are not quite as sound as I would like them to be is the level of public debt, both federal and provincial, relative to the size of our economy. That ratio is only just starting to decline and debt levels remain very high, so I think we are still vulnerable. It will be very important to see that ratio decline over a number of years to reduce that vulnerability. If we do not reduce that, the next time a crisis comes along we may be hit harder than would be appropriate.
Senator Angus: Governor, on the Quebec issue, some analysts said that Jean Charest's announcement to seek the leadership in Quebec led to a substantial number of basis points gain in the Canadian dollar around the time of that announcement. Of course, this may have been a short-term effect. I am sure you would agree that one individual cannot have a really substantial effect. You were mentioning earlier, in response to Senator Austin, various issues and factors that affect the dollar.
Can you comment on the Charest factor as it relates to the fundamentals in Quebec today?
Mr. Thiessen: It is very difficult to interpret markets. However, you are quite right; on the day of that announcement there was an impact on the Canadian dollar. How long-lasting that will be is very difficult to tell. Those are judgments which are extremely difficult to make.
I would say, however, that there is no doubt that political uncertainty, of whatever kind or from wherever it comes, is difficult for economies and financial markets to cope with. As I was saying earlier, one of the great attractions of low inflation is that it minimizes economic uncertainty and allows economies to perform better. There is no question that anyone who minimizes political uncertainty also helps economies to perform better, and allows people in financial markets to do their jobs better than they otherwise could.
Senator Angus: Thank you for that.
On the issue of the dollar, some of the answers you have given this morning, not only in response to Senator Austin but also to Senator Kolber on the MCI index, reminded me a lot of debating in university: Resolved that monetary policy is an art and not a science. I have always been one who takes the affirmative of that resolution, and I am getting the sense that you do as well.
I just want to be sure that I understand your position on this, having stated, as you have, how different factors, even Jean Charest, can affect the dollar on any given day.
Is it correct to understand that one who is in charge of monetary policy is in a constant conflict; on the one hand, trying to maintain a dollar that is appropriate and relatively strong in the context and, on the other hand, not taking measures that would adversely affect economic growth, as, for example, increasing the bank rate? Is that a correct analysis? Is it a constant conflict between these two factors?
Mr. Thiessen: No, I would not say that, senator. In fact, one of the great attractions of the recent period is that those issues come up less frequently.
When there is a lack of confidence in economic policies, whether monetary policy or fiscal policy, you are far more likely to see a potential loss of confidence in the currency to which you must respond. We do know that if there is a loss of confidence in your currency, you pay for it very dearly. That is perhaps an exaggerated example to cite, but when you consider an Asian country such as Indonesia where the currency has lost 60 per cent or 70 per cent of its value, the costs are enormous. You do not ever want that loss of confidence to occur.
In the recent period, those things arise substantially less often. The main reason we raised the bank rate over the course of the last few months is that the decline in the dollar was applying a degree of stimulus to this economy that we did not think was needed to keep our economy on that nice, sustainable, non-inflationary path that will keep this expansion going for a long time.
Senator Angus: We read regularly in our financial press comparisons between the Canadian scene and the U.S. scene. In that regard, this committee will embark on a visit to Washington next week to investigate some of the differences between Canada and our good neighbour to the south. I have noticed and observed, not only in the press but also in your own reports and speeches, that you have referred time and again to these differences.
For example, there is higher inflation in the U.S. and higher long-term interest rates. We have constantly talked about the gap between the U.S. and Canadian rates. We talked this morning about lower unemployment in the U.S. and lower natural full employment.
When you take these things together, they seem like quite significant differences, yet the differences change as to their degree, I gather as a result of circumstances and the current environment. I believe that short-term interest rates in Canada are different vis-à-vis the U.S. Could you comment on these differences and what Canadians should understand from them?
Mr. Thiessen: The best way to understand these differences is to go back and look at the situation in the 1980s. I always like to take a long-term view with respect to the implications of monetary policy.
In the 1980s, we went through a period where the U.S. dollar was very strong. There was a good deal of concern in the U.S. about their ability to compete, particularly vis-à-vis Japan. Many companies in the U.S. then restructured themselves in a major way to be become more internationally competitive and to take advantage of technology to a degree they had not done before. While many people were worrying about the hollowing out of the U.S. manufacturing industry and the so-called rust belt, in fact a number of companies in the U.S. were gearing up to be internationally competitive in the future. They started that earlier than anyone else, and they are benefiting from that now. They got into that earlier, restructured earlier, and have gained the benefits earlier. We are all running a little bit behind. Therefore, our economy has not reached full capacity, whereas their economy has. As a consequence, we have lower interest rates than do they. We have also managed a lower inflation rate, but it is less of a big deal.
The main point is that we are following a path not unlike the path the Americans travelled, but we are few years behind. That is the best way to explain those differences.
Senator Angus: That interest rate, especially in the short term, the 90-day rate and so on, was not always lower. It has been higher in recent years.
Mr. Thiessen: Of course. Mainly, we had a higher inflation rate than they did through the period.
Senator Angus: Is it inflation related, then?
Mr. Thiessen: It is inflation related, and it has to do with where the economy is relative to full capacity. A combination of low inflation and an economy that needs some stimulus to get to full capacity leads to lower interest rates. Through much of the previous period, our inflation rate was so high relative to the Americans that even if our economy rate was weaker than theirs, we never got interest rates below their rates.
Senator Angus: Another difference with the U.S. on the issue of inflation is that Mr. Greenspan has been talking lately about deflation and the risks therein. The February numbers for inflation were 0.9 per cent, below your agreed-upon band with the Department of Finance and the minister. Perhaps you could enlighten the committee in that regard. Did you sleep well last night, governor?
Mr. Thiessen: There are some temporary influences at work there, just as they were in November and December when we moved below the band as well.
We believe that inflation will move up in the band. We will probably move a little closer to 2 per cent as the year goes by. That will particularly relate to the impact of the low value of the Canadian dollar on import prices feeding through the economy. There will be no major pick-up in inflation, no major trend, but we will probably be closer to the middle of the range than to the bottom as the year goes by.
Senator Angus: Is it fair to say that you are not worried about deflation?
Mr. Thiessen: No, I am not, and I do not think Mr. Greenspan is either. He said that when people talk about deflation, they do not always talk about the same thing. In particular, they are sometimes talking about asset prices, as we discussed earlier. As I was explaining to Senator Austin, central banks focus on the prices of goods and services, not assets.
With respect to the prices of goods and services, while the inflation rates in those areas are low, I do not think there is a serious risk of deflation. The American economy is just pressing the limits of that capacity. That is not a scenario for deflation. Japan is another story.
Senator Angus: The flavour of the year, more than the flavour of the month, as we are all hearing, is electronic commerce and electronic money. I know it is a subject dear to your heart and dear to your colleagues. Can you comment on the effect of this new development? It seems to be growing by leaps and bounds. How will this affect economic growth?
Mr. Thiessen: We had a study done by the Bank for International Settlements about the implications of electronic money on a range of things. One of those studies focused on what implications it has for monetary policy. The conclusion was that this did not really have any implications for monetary policy except that it made monetary aggregates more difficult to read, yet again.
I think most of the issues with respect to electronic money are prudential issues. How can you be certain that those smart cards are not counterfeited? How can you be sure that the institution issuing those cards is indeed a solvent institution? Those are the big issues, in my opinion, and it is how you deal with those questions that is being discussed.
In Europe, there is a tendency to feel that all the issuers should be closely regulated banks. In the U.S., there is far more inclination to say we will only get the benefits out of this if we allow a little competition, so we would not mind if other people wanted to get into this business. Those are the issues we face.
Right now, the process is not sufficiently advanced that we need to make a hard decision. We are monitoring it closely. I can assure you of that.
Senator Angus: Are you comfortable with the advent of electronic commerce and the smart card?
Mr. Thiessen: I do not think we have a choice. I do not think you can say that we will not allow any of that. This is another evolution. It is like asking how we felt when credit cards and debit cards were developed, all of which changed the nature of transactions. The crucial thing is to ensure that you end up with a payment system which is secure and reliable, just as we worry now about bills being secure and reliable.
Senator Stewart: In your opening statement, governor, you made reference to the financial situation in Asia. You said that the effects on the Canadian economy of the problems in Asia are likely to come mainly via our other major trading partners and through the prices of some of our exports, especially primary commodities. You went on to say that to some extent this will be counterbalanced by the economic performance of our major trading partners.
Let us focus on the first aspect. I have here a copy of the statement that Mr. Martin made in Washington on April 16 of this year. He said:
However, recent events in Asia suggest that more needs to be done. Notwithstanding the efforts to broaden surveillance to include the financial sector, an inadequate focus on financial sector issues was a key factor that inhibited an early detection of the Asian crisis.
Earlier in that same statement he said:
It is also important that the IMF enhance the transparency of its own operations and communicate its advice to its members and the public clearly and with more candour.
Given the importance that you have established between the Asian situation and the Canadian economy, do you think that the implied criticism of the IMF in Mr. Martin's statement is justified? Second, is the remedial intervention of the IMF contributing to a moral hazard in global capital markets?
Mr. Thiessen: Senator, I do not think there was a very strong implied criticism in what the minister said. The IMF has been working toward improving the transparency of its activities. Part of the problem is that it is not always an easy sell with countries. The IMF cannot unilaterally say, "Right, we will tell the public everything we think about an individual country", because the IMF is, of course, a cooperative of countries. This is really the minister saying that we all must agree that we need to be more transparent, that the IMF's judgments need to be publicized so that financial institutions, markets which are looking at a country, have an objective source of assessment for what is happening in those countries. I do not think anyone believes that this will go very quickly. It is important to keep the pressure on to do so, and that is what the minister was trying to do.
On the issue of moral hazard, yes, there is no question that whenever an agency lends money, as the IMF does, it provides a degree of comfort and security for international lenders, which means, therefore, that they are more willing to lend into risky situations than they were before. Yes, indeed, there is an element of moral hazard there.
Among the things that we are trying to do is, first, as the minister says, upgrade the standards of supervision of financial institutions in countries around the world and, second, see if there are not ways of ensuring that when a problem does arise, private sector lenders and investors are part of the solution immediately.
Senator Stewart: I was caught a bit by the Asian crisis. The Foreign Affairs Committee brought out an interim report on Canada in Asia-Pacific last June and we did not detect the coming financial crisis. Subsequently, I asked for a collection of the items that had appeared in The Economist relative to financial institutions in the Far East. I was astounded by the amount of material. As someone told me when we were in London, there was no reason why literate people would not have known that financial institutions in many Far Eastern countries were quite unreliable. We did not need to wait for information from the IMF. I was also told by the same person that we must remember, of course, that the market is not really interested in facts.
I wonder how relevant authoritative information is to what goes on in global capital markets. Will we be in a situation where investors participate in global market transactions and then have the IMF, presumably at some taxpayers' expense, come along with a remedial intervention? I gather you do not regard that as a satisfactory situation?
Mr. Thiessen: No, I do not think that the current situation is satisfactory. It is true that, if you look hard at all the data that was available, you can make a case that we should have seen it coming. However, these crises are not as predictable as all that. People who take a very pessimistic and cynical view of things manage to forecast five of every two crises. That is where the problem lies. Investors can say that a certain person predicted a crisis last year and nothing happened, so they should not be concerned.
There is no question that there is room for more and better information. It is not clear that everyone understood the extent of the foreign currency exposure of some of these countries, and particularly some of their banks, and the fact that that foreign currency exposure was short term.
Senator Stewart: I wish to move away from the remedial intervention of the IMF to what I call the preventive side.
Mr. Martin, in the same statement, said:
The time has come to establish a new multilateral entity with a clear focus on the financial sector.
He goes on to describe how this new secretariat would operate.
How realistic is this? In a sense, what is being proposed -- and I know it has been proposed with all the modifications that one would expect in an international document -- is governance by an international agency of highly diverse systems of government. Financial institutions may not be run by the ministers of finance in Japan and South Korea and so on, but they are pretty close to the governments of those countries, and the style of the government, in Indonesia, for example.
Do we really think that a secretariat in Washington, or some other suitable place, can undertake to provide actions which would prevent the kind of incidents from which Canada will suffer in the current year?
Mr. Thiessen: It will not absolutely prevent, but it should reduce the risks of that happening. I agree with the point you are making, senator. It is not easy, where you have a fundamentally different government, a different style of doing things, to simply impose the way of doing things that we have in industrial countries.
The point is that if these countries and institutions in these emerging markets wish to benefit from international capital flows and lending from the industrial countries, there must be a standard of business behaviour that is seen by lenders as offering them a reasonable chance of getting their money back with interest.
The proposal made by the minister is for voluntary participation. It is a peer review process, where supervisors from industrial countries and emerging markets are part of a peer review that looks at the supervisory arrangements in individual countries. If a country wants to participate in that process, and if that peer review gives it a reasonable mark, then it will be able to attract more capital. If that country does not want to participate, it is not required to do so.
Senator Stewart: Assuming that country X, a very important country, decides that it does not wish to participate, would it be proper, in your view, for Canada, in its position at the IMF or whatever the agency is called, to say, "In case there is financial difficulty in that country which affects investors from abroad, we will not support remedial intervention because of the moral hazard factor"?
Mr. Thiessen: That is a good question, and it is difficult. If there were no circumstances that led you to take a more generous view, you might wish to vote that way, yes.
Senator Meighen: All my questions will be very easy, governor.
My memory is that you spent large sums -- and I am not being critical -- to defend the Canadian dollar earlier this year. The headlines mentioned figures such as $1.6 billion, $2 billion. That is a great deal of money. Some critics said you should not have spent so much and that you were having a tightening effect on the Canadian economy and on interest rates and that this is not good.
Can one conclude from the massive spending that was undertaken earlier this year that, in your judgment, the dollar had reached as low a level as was appropriate for the Canadian economy?
Mr. Thiessen: Our judgment was, in fact, that it had gone too low, and, given everything we knew that stage, that seemed to apply a degree of stimulus to the economy that just was not called for. However, I do need to remind you, if you do not mind, senator, that we did not spend the money. We exchanged U.S. dollars for Canadian dollars. Subsequently, the value of those Canadian dollars has gone up relative to the U.S. dollar, so that is not really spending money. It is changing one kind of asset for another. If we are essentially successful in this, it will be a profitable operation, or at least not a costly one.
Senator Meighen: Fair enough, governor. That is true if you are successful. If you are not successful, it seems to me it is very costly.
You mentioned that you thought the dollar had gone too low. You are aware that there are critics of yours who said that if that is the case, why did you not get into it earlier? Can you remind me as to why you decided to wait until it hit a level that was too low?
Mr. Thiessen: Markets jump around all the time. You do not want to be following every little blip in the market. We wait to see if any particular movement in the dollar looks as though it will be sustained for a while before we respond. Otherwise, you are in the market all the time, fighting against some movement which may be reversed tomorrow or next week.
Senator Meighen: It is easy to be a Monday-morning quarterback, and I do not want to sound like one.
Senator Kelleher: But you are.
Senator Meighen: Let us leave that for a moment. I may come back to it later.
I wish to ask you about the inflationary target which you and the minister set. Could you briefly outline the process that you go through with the minister to arrive at that band, and could you tell us why it is that inflation is the only target that is picked? Why would you and the minister not set up a target for unemployment or interest rates and see how well you and the rest of us can do in meeting those targets?
Mr. Thiessen: The impact of monetary policy over time is on the inflation rate and price levels. If you follow through any particular monetary action over a long enough period of time, the sole impact will be on the price level and on the inflation rate. Given that, the most sensible thing to say for monetary policy is that, therefore, you ought to set a target which will be good for the economy. The proposition that we support is that low inflation is good for the economy.
Over the short period, monetary policy will indeed have an effect on the economy, on unemployment, and so on, but not over long periods of time. Over long periods of time, the economy's performance has to do with productivity, international competitiveness, the growth of the labour force, the skills of the labour force, and so on. That is why you cannot, through monetary policy, get the economy somehow to super-perform. It just does not work. These other things are what really matter.
The proposition is that you should set targets for what you can achieve. In those other areas, you cannot achieve them. If you set a target for interest rates, for example, you might be able to achieve it for a short while, but if you set a very low target for interest rates, one inconsistent with keeping the inflation rate low, you could not hold it. Eventually, prices would rise so rapidly that no one would be prepared to save money, so you would be driven off that target. Therefore, it is not a sensible target.
The same is true with unemployment. There are so many factors in an economy that affect unemployment that you cannot say that one instrument, monetary policy, will achieve your goal. As I said in response to a question earlier, we do not even know for sure what the achievable level of unemployment is, so you do not want to set a target because it might be either too high or too low. You simply want to move the economy persistently on a non-inflationary path, a path which is as close to full capacity as you can get, and then you will get the lowest unemployment rate that the economy can produce in current circumstances.
Senator Meighen: I take your points, governor. Would I then be right in saying that, in terms of the Canadian dollar, you have pegged it at least above 69.5 cents? You told us a few moments ago that that was too low, in your view. Do you have a band of objectives as to where it should be, given the present state of our economy in North America and the world?
Mr. Thiessen: No. As I was saying earlier, we are constantly looking at the impact of the level of the currency on the economy. I look at the impact of the currency on the economy, I look at the impact of interest rates on the economy, I look at all the other things that are impinging on this economy, and I then ask: Does that combined effect of interest rates and the exchange rate look about right or not? If not, then we had better move interest rates to try to change that combined effect. That is what we do all the time. However, we do not say that it just happens that this is the right number for the Canadian dollar, because it may change. It may well be, for example, that commodity prices will go up. If commodity prices go up, they will probably pull the dollar up with them. Then we will have to say that with stronger commodity prices, the Canadian economy looks stronger and that maybe a higher dollar is appropriate; or if the dollar goes up too far, we may say it looks too tight and we need lower interest rates.
Those are the kinds of calculations we make, and that does not imply pegging the economy.
Mr. Noël: The last time we took action on the Canadian dollar via interest rates was at the end of January, and the dollar was a lot lower than 69.5 cents. It was at 68.10 cents.
Senator Meighen: You touched on the issue of pegging. Can you see any circumstances under which it would be appropriate to the dollar?
Mr. Thiessen: No. I do not think it is a good idea.
This last experience has been very interesting. We have been hit by an Asian crisis, as well as a crisis in commodity prices, and the currency has adjusted downward to some extent. It overshot somewhat, but some decline in the currency in those circumstances was appropriate. If that all turns around, as we fully expect it will, some rise in the currency will also be appropriate. This is a kind of shock absorber that the currency provides, and I cannot imagine why we would wish to give that up.
Senator Meighen: Regarding currency and rates, this committee twice unanimously recommended that we raise, as we did between 1990 and 1995, the percentage of foreign content that pension plans and the like could hold. If we raised the ceiling to 30 per cent in increments of 2 per cent per year over the next five years, would that run counter to your strategy? Would that put unwanted pressure on the Canadian dollar?
Mr. Thiessen: I do not think so. Exactly how fast or how far you do those things are fine judgments, and I think those are judgments governments must make. The general direction is not one with which I would have problems. However, it would be dumb to do it when there is a huge amount of downward pressure on the currency.
Senator Meighen: That is not the case now, is it? Are you saying that you know something that I do not know?
Mr. Thiessen: Absolutely not.
Senator Austin: If he does not, I am worried.
Mr. Thiessen: Do not worry.
Senator Meighen: I realize this is dangerous ground, but we have seen mega-mergers of banks in the United States. There is talk of similar mergers in our country. The Bank of Canada rate has been known as the trend-setting rate. Is it possible that if merger mania continues in the banking sector in the United States, critical as the U.S. situation is to our interest rate situation, we could soon be in a situation where the big bank rate in the United States is the precedent setter in Canada and not the Bank of Canada rate?
Mr. Thiessen: No, I do not think so. Financial markets are very broad and deep. They are international. They have a lot players in them most of the time, and even more players in them some of the time. Those markets really matter. Those are the markets that we seek to influence at the very short end by our interest rate moves and the Federal Reserve seeks to reserve by their interest rate moves. I do not see circumstances in mergers that would compromise that ability to influence the very short end of financial markets.
Senator Kenny: Our committee is being televised today, and there is a much broader audience listening to this conversation than is in this room. To some extent, our conversations tend to be fairly inward looking. It would be useful if you took a moment to explain to Canadians what your principal responsibilities are and what tools you use to reduce employment and cause the economy to expand.
Mr. Thiessen: The job of the bank is to ensure that monetary policy contributes to the best-performing Canadian economy we can manage. It does not mean that monetary policy is the only thing that matters, but monetary policy has an important contribution to make in ensuring that the economy performs as well as it can, which means producing as much income and as much employment as it can over time. By keeping the inflation rate low, we will contribute to that economy, thereby producing more jobs and more income in a more stable way. That is how we at the Bank of Canada see our objective.
There are other things we must do. We feel obliged to provide Canadians with as secure a system of currency as possible, and we are responsible for issuing the government's debt at the best interest rates we can manage.
Senator Kenny: Perhaps you could go a step further and describe to Canadians how your role relates to fiscal policy and how you and the Minister of Finance relate to each other.
Mr. Thiessen: The Bank of Canada Act requires the minister and the governor to meet regularly to discuss economic policy generally and monetary policy. That is something we do, not only with the minister, but also with officials of the Department of Finance. Those conversations and discussions go on all the time so that there are no surprises between institutions.
Fiscal policy and monetary policy are different things. Fiscal policy focuses on issues of the size of government and the level of taxation, as well as the size of deficits and surpluses and what they do to government debt. That has a large impact on interest rates.
There is an interaction between monetary and fiscal policy. Monetary policy relates to the expansion of money and credit over time. Depending on what is happening in Canada and in the rest of the world, that will generate levels of interest rates and a level of the Canadian dollar which, in turn, have their impact on the economy. Our job, as I said, is to do that in a way that will allow the Canadian economy to perform as best it can.
Fiscal policy that is not credible, and a lack of confidence in fiscal policy, will lead to different interest rates and exchange rates than will a fiscal policy in which there is a good deal of confidence. That is the type of thing you must take into account with respect to monetary policy.
Similarly, if you have an expansionary fiscal policy; that is, when governments are expanding their operations and their expenditures rapidly and that puts pressure on the economy's ability to produce, the job of monetary policy is to squeeze the private sector to make room for an enlarged government. That is how the process works. You do that with high interest rates and a high Canadian dollar.
Senator Kenny: What signs in the economy should cause concern for Canadians and what action should they expect from you when they see these signs?
Mr. Thiessen: There are not a huge number of reasons to be concerned right now. The fundamentals are good. Anything that turns around the declining ratio of public debt to GDP for all governments in Canada should be a matter of concern. If Canadians see that, they should be concerned. There is nothing that monetary policy can do about that, but it would imply higher interest rates than we now have.
Canadians must always be concerned about what is happening abroad. We have a very open economy. If events occur abroad, it is crucial that the Bank of Canada manage interest rates and exchange rates in a way that moderates the impact of the event on Canada. You cannot avoid the impact, but those things should be managed in a way that will moderate the impact. There are no other things that quickly come to mind.
Senator Kelleher: Certainly Senator Meighen spoke the truth when he said the bottom-feeders were at work. I started out with a number of what I thought were extremely relevant and probing questions. You will be happy to know they have all disappeared one by one. I will switch to another area, another part of the Grand Banks, if you will.
As you are well aware, OSFI asked the Senate Banking Committee to go to London, which we did in January and February, and look at the new Financial Services Authority they created there. As you know better than any of us, we have a somewhat fragmented system here in Canada. We have not only a fragmented federal system of regulation, but we also have the provinces involved at various levels as well.
In Britain, we found that, under the new Financial Services Authority, they have swept everything in under this new authority and left the Bank of England out there as a banker of last resort. They have swept in many areas that were handled by the private sector in many cases.
I realize you cannot tell the provinces what to do; federal governments have learned that over the years. However, in light of our fragmented system, and in this era of merging conglomerates with everyone getting into everyone else's business, might we be better served to move toward something similar to Britain's system, assuming this were achievable?
Mr. Thiessen: Senator, I do not believe institutional arrangements per se are important. The crucial thing is that there is a degree of cooperation. There is a question of how best to achieve that. In the big debate in the United Kingdom, the Bank of England would say that there is already cooperation.
The real question is whether cooperation within institutions works better than cooperation between institutions. They made the judgment that it would. In most cases, it probably does work better that way, but you cannot say that it does not work any other way.
The U.K. is the most inclusive of the regulatory agencies anywhere in the world. The Australians also moved in that direction but opted to keep securities markets regulation separate from the mega-regulator. I do not think it can be said that only one model will work. The fact that we had merged regulations of banking, trust companies, insurance companies and pension funds under OSFI did make it something of a model for the U.K. and for Australia.
Whether you need to go the other step, I cannot be sure, but you do need to ensure that there will be cooperation. As you rightly point out, the larger the conglomerates, the more you want to look at all aspects of their business. That is not just true domestically, it is true internationally. There are a number of initiatives internationally to ensure that banking supervisors and insurance supervisors and securities markets supervisors all get together. There is an initiative, and most of those meetings occur in Basel at the Bank for International Settlements, to ensure that these people are talking about how to review conglomerates.
Senator Kelleher: One of the interesting areas which we discussed with them, particularly since London has become such an international banking centre, is how they can possibly keep control. They said there were over 400 foreign banks operating in London.
This is something that we may be facing in the future as we look at opening up our banking system. Do you have any thoughts on how a country keeps control of things when so many foreign banks move into a country's bank system?
Mr. Thiessen: One thing you do is rely on the home country of the foreign bank to regulate on a worldwide consolidated basis. That is not the only thing you do, but it does provide a large level of comfort.
Senator Kelleher: You would not say that if you were looking at Indonesia, for example.
Mr. Thiessen: That is the point. This takes me back to the initiative which the minister announced in Washington. If you have an ongoing peer review process not just for emerging market countries but for all countries as part of a regular process of supervisory and regulatory arrangements in every country, when the banks which are regulated by that supervisory system come to Canada, you can then have a level of comfort which is higher than it otherwise might be. If you do not like what the peer review system says about the supervisory system, then you might be less comfortable about them. Indeed, you may not wish to let them in. If they are already in, you may wish to devote more of your energies to examining the operations of those branches rather than those which look to be well regulated on a worldwide consolidated basis.
That would be true for Canadian banks operating abroad as well. If there is a sense that OSFI does its job very well, you will find that foreign regulators will supervise very lightly the operations of Canadian banks in their countries.
Senator Kelleher: I thought Mr. Martin's suggestion was quite sensible, but the kindest thing I can say about the reaction is that it was lukewarm. Will it not create a problem in London and also here in Canada if we allow our banking system to open to further competition from foreign banks?
Mr. Thiessen: You do want to ensure that that increased competition occurs on a basis which is prudentially sound. Exactly how you do that will depend on how well the regulatory systems are working elsewhere. If you believe that no one has a good regulatory system, then OSFI must look at every single branch and the way it operates. It will need to know something about the parent company of that branch, and it will guide itself accordingly. That will be a great deal of work, but it is possible.
Senator Callbeck: My question relates to the second tier of financial service providers. Do you feel that we have a strong sector in Canada?
Mr. Thiessen: Senator, I am in favour of competition. I would love to see a stronger second tier than what we have had. We have gone through some difficult times for financial institutions over the last 20 years, and many of them have faced difficulty. Some of them have merged or been taken over or wound up. The second tier does not look as strong as it did some time ago. I am hopeful that we have much of that behind us, that we will now see more second-tier financial institutions. It is a matter of time.
Part of the problem that second-tier financial institutions face right now is their reputation for not being secure due to the problems we went through at the end of the 1980s. However, those concerns will gradually disappear and we will have the prospect of more second-tier institutions. There is no doubt that, as some institutions get larger, there will always be room for smaller competitors. That is the way the world works.
Senator Callbeck: There has been much discussion this morning about the range of inflation being from 1 per cent to 3 per cent. I understand that many countries, such as the United States, do not have such targets. I am wondering about the advantages and disadvantages. Do countries that have targets have a better performance record?
Mr. Thiessen: No. The countries that have targets have them because their past performance record was worse. Those countries that have a very good performance record tend not to have targets. Those of us who have not had such a good performance record tend to have targets.
Germany, Japan and the United States, all of whom did reasonably well at controlling inflation, do not have targets, at least not inflation targets. The U.K., Australia, New Zealand, Sweden and Canada have targets. There is a range of large European countries that have chosen to have exchange rate targets in order to link themselves to Germany.
Targets are a way of generating credibility and confidence in inflation control in countries that did not always do as well as they should have.
Senator Callbeck: In your opening remarks, you said that the effects of the Asian crisis will no doubt have a dampening influence on economic activity in Canada. Could you comment further on that, please?
Mr. Thiessen: Yes, I can. It is still difficult to get a good fix on how large that influence will be. This is partly because the uncertainty surrounding Asia has not disappeared. It is a good deal more certain than it was a couple of months ago, but the situation in Japan remains uncertain. They have recently taken measures. We do not know at this time how effective those will be. Japan is significant for the rest of Asia.
It is not a coincidence that one of the reasons Mexico recovered so quickly from its crisis is that it is situated right next to the United States, which has a very large economy. If the Japanese economy were strong, the situation in Asia would be fundamentally better. There is still much uncertainty there.
With regard to the potential impact, there must be a margin of uncertainty. It looks to us as though the growth of economic activity in Canada will be in the order of 0.3 per cent to 0.5 per cent weaker than we before. That is essentially what the IMF announced at their meetings in Washington the week before last. There is a certain amount of consensus on that.
Senator Callbeck: Is the exposure of our financial institutions in Asia large?
Mr. Thiessen: No, it is not. Including Japan, all of Southeast Asia and Korea, it would be in the order of $17 billion, which is about 1 per cent of the total assets of the Canadian banking system. One should not leap to the conclusion that all of those loans are bad, because they are not. That is their total exposure to that region, which is really not very large.
Senator Callbeck: This morning you spoke about the natural rate of unemployment. Do you believe that with the correct monetary policy we can get below that rate, as they have in the United States?
Mr. Thiessen: I must admit to you, senator, that I absolutely hate the term "natural rate" because I do not think there is anything natural about these things. There are rates of unemployment at which labour markets get really tight and it is difficult to hire people. The pressures on wages go up. That will vary over time in ways that are not readily predictable. However, I believe that with all the changes which have taken place in the Canadian economy recently there is a very good chance that we will get our unemployment rate down lower than it has been in a long time. I do not know that for sure, but the prospects are very good that we will. I do not know exactly how low, as I said earlier, just as the Americans did not know they were going to go to 4.6 per cent.
The Chairman: I should like to wind up with a couple of questions dealing with the bank's role in managing systemic risk and operating as the lender of last resort.
Seven or eight years ago, your predecessor, in his appearance before this committee, was asked whether it mattered to the Governor of the Bank of Canada whether major deposit-taking institutions in this country are domestically owned or foreign owned. Mr. Crow said that it was important to him as governor that major deposit-taking institutions be Canadian owned.
Given the way capital markets have globalized in the eight or nine years since Mr. Crow made that comment, I shall ask you exactly the same question. Is your role, particularly in relation to being the lender of last resort and responsible for systemic risk as opposed to monetary policy, easier or harder if major deposit taking institutions are foreign owned?
Mr. Thiessen: It does not make any great difference with respect to monetary policy because, as you say, markets are wide and deep and that is really what matters.
With regard to systemic risk, there must be a reassurance of the supervision of institutions, whether they are domestic or foreign. That goes back to the question which Senator Kelleher asked a moment ago. It is a question of the institutions which operate in your country. You want to have a sense that they are being managed in a careful and cautious way. Beyond that, I do not think one can really say anything. It is very difficult to come to a hard judgment on that.
The Chairman: If you had adequate confidence in a home institutions regulator and in other places in the world where the institution operated, the need for the institution to actually be owned in Canada by Canadians is not that critical?
Mr. Thiessen: That is correct from that narrow point of view. There may be many other reasons why you wish them to be Canadian owned, but on the narrow issue of systemic stability it is a question of how well regulated those institutions are.
The Chairman: Is it correct that from the point of view of the Bank of Canada the issue is not really who owns the institution but how well they are regulated in their home markets?
Mr. Thiessen: Again, from our narrow point of view, that is right.
The Chairman: On the question of second-tier financial institutions, prior to the failures of the 1980s second-tier financial institutions in this country were regionally based. Historically, these institutions frequently failed because they were regionally based. They made loans extensively to local industries which, in many cases, were natural resource industries and, given the cyclical nature of the natural resource sector, when the sector went down, the institution failed. Indeed, the origin of most of the national banks in Canada were amalgamations, over a long period of time, of regional institutions.
On the other hand, when you read the commentary in the U.S. press about the recent rash of mergers there, and when you listen to some of the comments this committee received when we were speaking to people in Europe, there appears to be now emerging the other side of the coin, which I would almost call the too-big-to-fail issue. Do we run the risk of moving from the historical, systemic problem of small regional institutions, which we seem to have corrected, to a different systemic problem, the too-big-to-fail problem?
Mr. Thiessen: Any time you are in a too-big-to-fail situation, it is a difficult situation because it raises all those issues of moral hazard. The moment an institution feels that it will be preserved no matter what, there is an incentive to take risks that would not otherwise be there, and there is not the same need for customers of that institution to make hard judgments about its strength and solvency. That is a situation you most certainly do not wish to have. There must not be a sense that institutions are too big to fail, which is one of the reasons why systemic stability matters so much. You want to ensure that the spillover effects of a problem in any single institution are minimized to the extent possible.
The Chairman: How do you prevent the perception or belief arising, either within the institution or, much more importantly, with the public at large, that an institution is too big to fail? What can government do to prevent that misconception arising, assuming for the moment that it is a misconception?
Mr. Thiessen: I must say I do not have an easy answer for that, Mr. Chairman. It is difficult for the government to go around saying there is no bank that is too big to fail here; they may well fail. That is not a sentiment anyone wishes to express. You must simply carry on regulating these institutions in a way that will minimize the risks attached to them.
I must say, off the top of my head, I do not have an easy way of dealing with that.
The Chairman: I have a question which follows from much of the evidence this committee heard when we were in Europe and what I suspect we will hear when we are in the United States. The statement is frequently made, by commentators as well as institutions, that in order for a world-class deposit-taking system, a banking system, to exist in country X, and in order to achieve world-class service for customers, it is critical that the players be sufficiently large that they are world-class players. Is there is any evidence to support that statement?
I ask the question because we heard that as an obvious, ex cathedra statement. It was made by witnesses in London. It was made by people talking about the Swiss mergers. It has been made in the United States by people talking about the U.S. mergers.
Are you aware of any evidence linking the quality of a deposit-taking system, in terms of services to business and retail customers, with size?
Mr. Thiessen: I do not know of any evidence one way or another, Mr. Chairman.
The Chairman: Therefore, the statement is not a researchable, analytically provable statement.
Mr. Thiessen: I do not know if I would say it is not researchable. I just have not seen good research evidence one way or another.
The Chairman: Governor, we said we would finish at one o'clock. We have gone a little bit over time as usual. On behalf of the committee, I thank you for your time with us.
The committee adjourned.