Proceedings of the Standing Senate Committee on
Banking, Trade and
Commerce
Issue 40 - Evidence
OTTAWA, Thursday, November 19, 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: Senators, our witnesses today are Gordon Thiessen, the governor of the Bank of Canada, and Cheryl Kennedy, deputy governor.
As all of you know, the governor typically makes an annual appearance before this committee to talk about monetary policy a week or so after a budget. However, in light of the turmoil in both markets and in the Canadian dollar over the last few months, I had a conversation with the governor in late September and suggested to him that he should appear before us this fall. This is not in lieu of his appearance following the budget -- that continues to be an annual appearance -- but he is here to talk about the turmoil in international markets, the state of the dollar and so on.
The governor said that he would be delighted to appear and that he felt it would be most useful to be here following the publication of the bank's semi-annual report which was released on Monday. That event gives the timing of the governor's appearance here this morning.
Given the broad subjects that we want to discuss with the governor today, he has indicated to me that he has a slightly longer opening statement than usual. We will turn from the governor's statement to questions.
Mr. Gordon G. Thiessen, Governor, Bank of Canada: Mr. Chairman, my colleagues and I always appreciate the chance to appear before your committee. As you noted, we did release our semi-annual monetary policy report on Monday. That report covers a broad range of economic and monetary issues and it provides an account of our actions and their results.
The ultimate objective of monetary policy is to help create and maintain conditions that are conducive to improved overall economic performance in Canada over time. The best way for the bank to make that contribution is through low and stable inflation.
As jointly agreed between the Government of Canada and the bank, we aim to keep the rate of inflation within a target range of 1 per cent to 3 per cent.
In our previous report, last May, we highlighted the uncertainties that clouded the global economic outlook. During the past six months, those uncertainties have intensified. While some stability returned to Asia around the spring, other parts of the world came under pressure through the late summer and the early fall and that followed particularly Russia's unilateral declaration of a debt moratorium and Japan's apparent inability to deal with its problems. Many emerging market economies in developing countries suffered large capital outflows and widening interest rate spreads as international investors looked for safe havens and greater risk protection. The spreads on interest rates between the private sector bonds and government bonds also increased and market liquidity tightened in many of those areas.
Those international developments have had a significant influence on the conduct of monetary policy in Canada over the past six months. Problems in Asia and Russia have led to a decline in the prices of the key primary commodities that we export. The difficulties that this caused in our resource industries continued to put downward pressure on the Canadian dollar through the summer. With global markets becoming extremely nervous after the Russian crisis in August and tending, I must say, to exaggerate the importance of commodities for Canada, pressure on our currency intensified.
Our medium- and long-term interest rates began to rise very sharply at a time when comparable U.S. rates were falling. To forestall a loss in our currency, the Bank of Canada raised the bank rate by one percentage point in late August. This helped the Canadian dollar to stabilize and medium- and long-term interest rates came back down.
When the U.S. Federal Reserve reduced its target federal funds rate three times between September and November -- the last time being this week -- by a total of 75 basis points in response to their concerns about a possible credit crunch in the U.S. and a slowing in the U.S. economy, the Bank of Canada followed suit. We felt that similar reductions in our bank rate were appropriate, given the importance of the U.S. economy to Canada and given our continued low inflation rate and the improving climate in international financial markets as a result of those U.S. actions.
[Translation]
Let me now turn to the prospects for the Canadian economy.
The international economic and financial turmoil has resulted in downward revisions to the estimates for global economic growth this year and next. Still, with the exception of Japan, economic activity in the major industrial countries is expected to remain reasonably well sustained through the end of 1999, especially in North America and Europe.
With the sustained U.S. demand, and with employment gains and accommodative monetary conditions at home, we expect that the Canadian economy will continue to expand over the next year. I must stress, however, that the outlook is more conditional than usual because of lingering international uncertainty.
I should also note that the extent to which growth in the economy will take up the slack over the next year will depend on how quickly international and domestic financial markets stabilize. Because financial stability is particularly important to household and business confidence, helping to preserve confidence among investors in Canadian financial markets will be an important consideration for the bank in the near term.
But, over the medium term, the fundamental focus of monetary policy remains on keeping the trend of inflation inside the target range of 1 to 3 per cent. We expect inflation to stay in the lower half of that range over the next year.
The main point I would like to underscore is that, even though Canada has been affected by the global situation, we are weathering the storm better than in the past. I believe that this is because of the remarkable progress we have made in getting our fiscal house in order, achieving a low and more stable rate of inflation, and restructuring our private sector to become more productive and internationally competitive.
[English]
I should also like to provide information regarding the implications for the Canadian dollar of this past year's global upheavals and the bank's response to that.
The cause and effect in the decline of the Canadian dollar must be identified in order to understand the situation. Exchange rates reflect developments both at home and abroad. Thus, the downward movement in our currency has been the consequence of developments since the summer of 1997. This downward movement is not, as some commentators suggest, the cause of the economic difficulties we are currently facing.
The worldwide flight of capital to the safe haven of U.S. assets and the 15 per cent decline over the past year in the prices of the primary commodities that we export have been the main factors behind the marked depreciation of our currency against the U.S. dollar. In particular, the drop in commodity prices has meant lower incomes and lower national wealth for Canadians. That decline is a harsh reality to which we must adjust.
Because we are on a floating exchange rate, this adjustment has taken place through a decline in the external value of the Canadian dollar. Had we been on a fixed exchange rate, the adjustment would probably have been slower and more costly. On a fixed rate, the adjustment would have had to come entirely through lower output, lower employment, and lower wages.
What can and should the bank do about the exchange rate in times of international financial turbulence and major external shocks?
The objective of monetary policy is domestic price stability -- that is, keeping inflation low and stable. In this policy approach, the exchange rate and interest rates are the channel through which our monetary policy operates, and they must be allowed to adjust to help us achieve those inflation targets. But when the momentum of currency movements push the exchange rate too far, beyond what is justified on economic grounds, the bank needs to remind participants of the positive trends in our economy. The intervention in the foreign exchange market to buy Canadian dollars through the first half of August was an example of a positive action. What we say publicly and bank rate changes also demonstrate positive responses.
Changes in bank rate are appropriate in two cases. The first case is when the magnitude of the decline in currency leads to excessive monetary easing. A falling currency is a source of stimulus to our economy because it encourages exports and domestic production of substitutes for imports.
A second good time to change bank rates is when there are signs that confidence in our currency is eroding. A loss of confidence can prove very costly for the economy if it leads to persistently higher medium- and long-term interest rates. I am speaking of those interest rates that affect loans for house purchases, construction, and business investment. It was because of concerns such as loss of confidence and increases in interest rates that the bank responded strongly to the decline in our currency during the Mexican crisis of early 1995. It was due to that loss of confidence that we raised our bank rate last August.
Senator Tkachuk: You mentioned in your opening statement the declining dollar, and said that it was as a result of the commodity prices and the flight of capital to the United States. The dollar has been declining over 25 years. During that time, we have had inflation and growth of deficits and stabilization of deficits. It is a long-term trend. As well, we have had high commodity prices during that time.
Your comments do not seem to answer that question. Could you expand on your comments?
Mr. Thiessen: If you look over the last 25 years, you will see a long downward trend in commodity prices. And if you look back, you can explain a very large portion of not only the trend but also the cycles in the Canadian dollar through commodity prices.
While it is true that commodity exports are less important to us than they were 10 or 15 years ago, they still do constitute 30 per cent to 35 per cent of our exports. If you include some more highly fabricated commodities, that amount would rise to 40 per cent to 45 per cent.
Another factor when looking at the Canadian-U.S. comparison is that our inflation rate from the early 1970s to about 1991 or 1992 was higher than that in the U.S. That differential inflation rate also tends to undermine the currency over a long period of time.
Another cause of the inflationary trends is that our productivity growth in export industries appears to have been somewhat lower than that of our American counterparts. The extent of the impact of this influence is a tougher one to demonstrate.
Senator Tkachuk: You mentioned that our fiscal house is in order. We have a lower and more stable rate of inflation. As well we have become more productive and internationally competitive. Does the decline of the dollar not hide our ability to be competitive? If we are an exporting nation and the dollar was trading at 85 cents, would we be as successful in our exports?
Applying that view would mean that if the dollar were worth only 50 cents, we would be able to sell even more. That would not mean we are more productive; it might mean we are less productive.
Mr. Thiessen: It might. There is no doubt that our primary commodity industries have taken a 15 per cent hit in terms of the prices at which they can sell their products. That is a big hit. It lowers the valuation of all of the assets in those industries and puts downward pressure on wages. This occurrence is a major factor in the reduction of our exchange rate.
It does mean that in the manufacturing industry, the weak currency should make it much easier to get into some markets. People are taking advantage of this low currency but should not assume that it will last forever.
Some of those fundamental factors that I mentioned are going to lead to an upward trend in our currency over time. Once the Japanese deal with their problems and the American economy continues to expand, primary commodity prices will start to recover. As this occurs, there will be more upward pressure in our currency.
The second thing is that as our economy gets closer to full capacity, I believe we will start to see some of those productivity improvements that have been put in place which we have not benefited from to date. If that is true, and if those productivity improvements are large -- indeed, they would need to be larger than our American neighbour's -- if that were to happen, we would also have some upward pressure on our currency.
We should not think that we must learn to live with this low dollar. In fact, we should not even think about learning to live with the low dollar.
Senator Kolber: Since the introduction of inflation targeting, the bank has persistently fuelled positive expectations for Canadians should the low inflation rates we now are expecting be achieved. To some, the outcome has been somewhat of a disappointment. As facts seem to be, the Canadian economy still has a significant output gap, the unemployment rate is still high by most standards, income disparities have widened, real incomes have not risen for some time, and productivity has not responded in an enduring way to the substantial structural adjustments that have occurred. International confidence in Canada, as exemplified by the low dollar, seems somewhat problematic despite the fact that we have balanced the federal budget, the federal debt is being paid down and the fiscal positions of the provinces have improved.
Is this a correct interpretation? If so, has something gone wrong? If it is not a correct interpretation, what do we say to Canadians who are somewhat bewildered?
Mr. Thiessen: I return to this again and again. Having the prices in our primary commodity industries decline by 15 per cent on average, weighted by our production of them over the past 12 months, is a big negative shock to our economy. If you look at some of those products, the decline has been far larger than that. That is a big hit for an economy to take. We are, I believe, dealing with it remarkably well. You cannot make it go away. It is still there and because of it we are poorer.
That has made a difference to our ability to return to full capacity and to get our unemployment rate down as early as we might have done; indeed, it is difficult on the confidence side to live through a 10 per cent depreciation of your currency, as we have. This is not an easy adjustment for most people to make.
Given the kind of hit which we have taken because of the international crisis, the problems in Asia, I believe we have done remarkably well. As we get through this period, we will see some better results. We will see the Canadian economy move to full capacity. We will see declines in unemployment and a resurgence of confidence. Right now, however, we have just gone through a very difficult patch.
Senator Kolber: Would you have done anything differently in hindsight?
Mr. Thiessen: Yes. We believed a year ago that by this time the Japanese would have resolved their problems long since. I must admit that that has been a great surprise. Japan is the second largest economy in the world. They are the largest net lender to the rest of the world. They have a net foreign asset position that is enormous.
Theirs is an economy that is in an extremely good position to deal with its economic problems and its banking problems. I must admit that I and my colleagues thought they would have done so long since.
Senator Kolber: Would you advise all of us underpaid senators to go out and buy Canadian dollars?
Mr. Thiessen: Only if you are prepared to take the long-term view.
The Chairman: I must say that one of the advantages of the Senate over the House of Commons is that you can take the long-term view.
Senator Angus: As you know, over the past three or four years when you have been before this committee, you have stated, always in the same terms, that the fundamentals of the Canadian economy are good. From hearing your opening statement, I gather -- and I wish to be sure I understand -- that you still believe the fundamentals are good and solid?
Mr. Thiessen: Yes. For the record, yes. I believe that the fundamentals are good. I would suggest to you that, if they were not, this past year would have been substantially more difficult than it was. If we had gone into this situation with our fiscal position not under tight control, if we had had the sense that either inflation was high or would go up, and if we had had a private sector that really had not become as oriented to international competition as it has, this would have been one very difficult year. It already was difficult. I submit to you it would have been hugely more difficult.
Senator Angus: It is interesting to hear that.
You have placed much emphasis, as have most commentators, analysts and economists who have been trying to figure out the behaviour of our Canadian currency, on the fact that in the primary commodity industries the prices are down 15 per cent and it has had a terrible toll. Could you itemize what those primary commodity industries are when you make that statement?
Mr. Thiessen: We are talking about the agricultural sector, particularly wheat, cattle, hogs, oil-seeds. In the forest products industry, we are talking about lumber, pulp and paper, newsprint. In the mining sector, we are talking about precious metals, gold and silver, and also base metals; it is in the base metals area that it has been particularly difficult. The prices of nickel, aluminum, zinc and copper have all been weak. There are also a number of minerals -- for example, sulphur, potash and magnesium.In the energy sector we are talking about oil, gas and coal.
Senator Angus: You are attributing this largely to the unusual international instability, particularly in Russia and Asia. Is that correct?
Mr. Thiessen: Yes.
Senator Angus: Last week, because the Senate was not in session, I took the opportunity to make a family visit to Hong Kong. I was very fortunate just by chance to meet with some businessmen and bankers, who got onto the subject of the dynamic situation of globalization, capital markets and the nervousness of the markets and so on. Almost to a person, it was like a chorus, they said that the smartest thing the British ever did here was to peg the Hong Kong dollar to the U.S. dollar. When I came home on Sunday, I started looking into it and I find that a number of Canadian economists, like Tom Courchesne and Rick Harris, as examples, are advocating that we should be pegging the Canadian dollar to the U.S. dollar.
As I reflected upon that, I remembered your comment that we Canadians try to conduct our monetary policy independently of the U.S. In fact, I even went back to transcripts of a few years ago and read that again. However, everything you have done, and what you have said this morning, indicates to me that we are in lockstep with the U.S. When people talk about the flight to safety, although in absolute terms we have gone down only another nickel or 10 cents relative to the U.S. dollar, the decline in absolute terms is scary to many Canadians. However, we are told that relative to other currencies we have done well against the American dollar.
I would like to know what the Bank of Canada and your regime think about this pegging. My own sense is that the conditions for pegging our dollar to the U.S. currency have never been more favourable. I put it to you that it would be a wonderful thing for Canada if you were to do that at this time.
Mr. Thiessen: I am afraid I am inclined to disagree with you, senator.
Senator Angus: Well, of course I have seen page 4 of your opening statement, but it is an interesting subject.
Mr. Thiessen: It is interesting. It is something one should always be prepared to discuss and debate. The Hong Kong Currency Board arrangement where they are pegged in a precise way to the U.S. dollar has indeed served them well. However, they have had a tough year.
Being tied to the U.S. dollar may be the right solution for an economy as small as, and as oriented to financial services as, Hong Kong's. I would also remind you that the crises in Thailand, Indonesia, Malaysia, the Philippines and South Korea all revolved around fixed exchange rates that did not hold.
The problem with a fixed exchange rate is that when it gets out of line, the economy must adjust because the exchange rate will not. Economies adjust slowly and sometimes with difficulty. Therefore, you can end up with a substantial amount of pressure on a fixed exchange rate. That is what happened in those East Asian countries. In that situation, of course you try to keep that peg; you have made a commitment, and then, finally, you cannot; but by this time the head of steam that has built up is enormous, and when it goes, it blows, and you end up with a crisis.
Senator Angus: Governor, are we not living in substantially changed conditions, though? Looking out at the world scene, we see one currency coming in on January 1, the euro in all of Europe. We see the trading blocs here, the NAFTA, the North American bloc, and we talk of a flight to safety, the U.S. dollar as a currency, the euro as a currency and the yen, which you mentioned as coming from the world's second largest economy with this great possession of assets. Would it not be more realistic to get into line with the U.S. dollar that way? The Canadian dollar is like a yo-yo.
You have been over to the House of Commons committee and heard what they have to say, and Senator Kirby has mentioned the questions that we are getting on a daily basis from witnesses before this committee. It is very unsettling to see our currency erode in the way it has and in the way Senator Tkachuk has outlined.
Mr. Thiessen: I accept that. However, I also suggest to you that we would have to adjust to the substantial negative shock that has hit us. You must still adjust to it. A fixed exchange rate does not go away, it just means that you must adjust to it in a different way. That can be very difficult.
There are not only negative shocks to contend with; positive shocks can be difficult to cope with as well. It is not by accident that when we floated our exchange rate in 1950 and again in 1970, it was in the context of substantial increases in commodity prices and huge inflows of capital into Canada. Our ability to cope with both those price increases and the capital inflows was strained; it was very difficult.
The Government of Canada decided on both those occasions that the best thing to do was to float the currency, that having flexibility in response to these kinds of shocks that hit you from time to time was the best way to go.
Senator Angus: Are you now considering or would you consider pegging? Is it something the bank has under review as an option?
Mr. Thiessen: The answer is no.
The Chairman: I have a question that is supplementary to the intervention of Senator Angus. You spoke about a decline in commodity prices having been caused by the problems in Asia and Russia. What responsibilities do authorities in industrialized countries, including the bank as a lender of last resort, have for the scale of crises in those countries? For instance, there are those who suggest that one ought to have intervened, using moral suasion if nothing else, in order to stem the tide of uneconomic lending that was occurring in those countries prior to the formal public recognition of the crises.
Mr. Thiessen: Yes, one can say that in hindsight. I must tell you that the information was not as readily available as it should have been. One of the lessons that we have learned from the situation is that we do need more information. However, in many cases, people did not know the extent to which both the government and the banking sector in those countries had short-term, net, foreign currency liabilities; that information just was not there.
The fact that the banking system, for example, in Thailand, was borrowing in U.S. dollars on a short-term basis and lending in Thai currency to property developers is an example of all the things that should not be done in banking rolled up into one.
I must admit that we, the international authorities, did not know about that to the extent we should have. We did not know the extent to which some of those central banks were protecting, or trying to protect, their fixed exchange rates through the forward markets, because those forward market transactions did not show up on their balance sheets. We are trying to rectify those elements.
The Chairman: Recognizing that there were things that you did not know at the time, and therefore could not do anything about, are processes being put in place internationally to ensure that in the future you would be better informed?
Mr. Thiessen: Senator, that is one thing that has improved in the last little while. I do not know whether senators have had a chance to look at the last communiqué put out by the G-7 finance ministers and governors that came out a few weeks ago. It has had the effect of drawing together many initiatives that have taken place since the Asian crisis came on the scene. Increased transparency and disclosure have been recommended not just in those countries where the crises occurred, but generally, based on the argument that markets work better if they have more information. The time that you have these market crises is when there is a lack of information. You then find out that things are different from what you expected. As well, it is recommended to improve the quality of regulation and supervision of financial sectors around the world. Finally, we must see if we cannot deal better with crises once they start, by ensuring that private sector investors and lenders are part of the solution from day one.
These three initiatives are important. I cannot tell you that everything is resolved and nailed down, but we have made significant progress.
The Chairman: Having been around government for a long time, I know how long it takes government initiatives to move from the initiative stage to something that actually works in practice. Do you have any sense of a time frame for implementation of these initiatives?
Mr. Thiessen: There is a significant amount of pressure to have something more concrete to deliver by the next summit of heads of state and government, in the spring.
[Translation]
Senator Hervieux-Payette: I want to focus on the month of August and the newspaper headlines rather than on your specific comments, even though it was reported that your interventions in August were tied to some extent to the behaviour of certain speculators who bought up Canadian dollars short to make a quick profit.
As we saw in the metals sector, a single investor can cause turmoil throughout a particular sector through speculative actions. What measures can an institution like the Bank of Canada put in place? While it does have some reserves, it cannot intervene every day. Do you rely on an international network? Given that considerable wealth is concentrated in the hands of certain groups of major speculators, do you get help from someone or somewhere to prevent intervention based solely on the lure of a quick profit?
Mr. Thiessen: The Government of Canada has substantial foreign currency reserves, somewhere in the neighbourhood of $20 billion.
Intervention is really a signal. No amount of money can prevent all speculation. Capital flow is too great for that. It is really a signal that people are dissatisfied, in this case, dissatisfied with our falling currency. The more important thing is to send out a signal that things have gone too far. When that does not work, we must follow up our intervention with more substantial measures, for instance, interest rate hikes. That is the only way to react to this type of situation.
It is not really a matter of asking others to help us. This gives the impression that panic has set in, which is really not the case. The most important thing to do is to emphasize the basic health of our economy. If our economy is essentially sound, exchange rates will improve. When the situation is as volatile as it was in August, that is the only thing we can do.
Senator Hervieux-Payette: Given the current climate of global uncertainty, bank governors or finance ministers keep a very close eye on things to ensure that speculators do not profit from this situation at the expense of fairly stable economies. There has even been talk of "monitoring" the situation.
You said that we intervene on our own, that we do not act as part of a network and that we are left to our own devices. Canada has a population of 30 million and it cannot compete with its neighbour to the south with its population of 250 million or with Japan and its population of 90 or 100 million. Because our economy is too small, all we can do is intervene on a small scale to express our dissatisfaction. We have no other choice in a global economy. We cannot control how the rest of the world works.
Mr. Thiessen: If a crisis of major proportions were to erupt, we could always ask the United States for assistance. However, this option should be considered only as a last resort.
We went through a difficult time in August and September, but the situation has improved and the crisis proved not to be as bad as all that. It is difficult to do more than that.
[English]
It is important to be very careful about how you react in these circumstances. You want to ensure that you improve confidence, not undermine it. You must not give the impression that you have used all your ammunition and there is nothing left. You never want to be in that kind of circumstance.
When you are subjected to these kinds of shocks, and you have flows of capital, it can be difficult for a while; however, if it turns around in a reasonably short period, it is difficult to say that this has been a terribly costly experience, although I will admit that while it is going on it can be quite unpleasant.
[Translation]
Ms Kennedy: To answer your questions concerning networks, central banks always exchange information at all levels, that is not only between governors but also between currency market traders, between offices in London, New York and so forth. During difficult times, such as we witnessed in July, August and September, these types of exchanges intensify. When considerable uncertainty prevails, people want information and analyses. Generally speaking, it takes time for information to circulate. During difficult times when confidence may be low and risks more uncertain, not only speculators but investors as well react by a changing their portfolios and seeking out more stable and secure investments. During these times, we step up our exchanges of information because we need to analyse the situation as it is unfolding and we cannot afford to wait until all of the official statistics are in. We do what we can.
[English]
Senator Meighen: I should like to pursue the matter of productivity, which has already been dealt with to some extent. You say in your statement that, given the global crisis, Canada has done better because of the remarkable progress we have made in getting our fiscal house in order, achieving a low and more stable rate of inflation, and restructuring our private sector to become more productive and internationally competitive.
In response to Senator Angus's question, you reiterated that, in your view, and I do not quarrel with it, the fundamentals in Canada are good.
You will, no doubt, have noted the quote attributed to John Kenneth Galbraith that appeared in our erstwhile national newspaper the other day. It said, "The thing of which you should be most suspicious is when any government official says `The fundamentals are sound.'"
I know you are not a government official, Governor, but I am wondering whether Galbraith does not have a point. In your speech in 1996 to the Fraser Institute you suggested that monetary policy in the 1980s might have blunted our effort to become more efficient in our productivity; that is, that Canadians were getting a free ride and did not have to work as hard at increasing productivity as they should have.
If I am not mistaken, our improvement in productivity is the worst over the past two decades of all the G-7 countries. It is not that great. What are we doing wrong? Perhaps we are going wrong in areas that are not of your jurisdiction. I realize that, much as you might like to, you cannot criticize the management of the present government in the affairs of the nation.
What areas need to be improved, if we are to achieve the better-than-average levels that we should have, given the strength of the fundamental, to use your word? Where are we missing out?
Mr. Thiessen: Those are very difficult questions, indeed. I must also say they are not helped by the fact that the process of measuring productivity is so very difficult. Indeed, one of those national newspapers carried a comparison of manufacturing productivity in Canada and the U.S.; but those numbers are not comparable and, therefore, one should not make that comparison. The Americans will no doubt be changing their numbers to make them comparable, but as of now simple comparisons of manufacturing productivity in Canada and the U.S. are not legitimate.
However, there is no doubt that productivity growth in Canada has not been wonderful, especially through the 1970s, the 1980s and into the early 1990s. Part of that had to do with inflation. As I suggested to you before, because inflation was high, there was an inclination for entrepreneurs and enterprises to seek to benefit from inflation, or to protect themselves from it, as opposed to engaging in all their activities and becoming more productive and competitive. That was part of the problem.
You can also argue that the process whereby government sectors expanded and rates of tax went up high also had an effect. You can also say that the rise in the price of energy had an effect. All our plants were oriented to the rather low price of energy at the beginning of the 1970s. It has taken a long time for us in this cold climate to adapt to that.
I believe we will see some progress here. When you talk to individual firms in Canada, they will say, "There is something wrong here. When we look at our own firm, we can see productivity improvements which are very large, particularly over the last five or six years, yet we do not see any of that in the aggregate numbers." Many of these firms are large, and perhaps there is a difference in productivity between large and small, but we need to pursue that.
There is also the issue of how good we are at measuring productivity in the service sector. Indeed, according to the way we currently measure it, there is not a possibility of measuring productivity, because we measure the inputs rather than the outputs, but you can see some service sectors where it looks like there have been some quite substantial productivity gains.
Just getting your arms around the problem is not easy. However, I must say that I find that the attitudes and orientation of the private business sector in Canada lead me to believe that they have made major progress and will continue to do so, because their whole orientation is so different from what it was through the 1970s and the 1980s.
Another point worth making is that some of the best productivity gains in the United States occurred very late in the economic cycle, which is strange. Normally, we expect to get them just as you get close to full capacity, namely, when your factories are starting to go flat out. You frequently expect to see some deterioration of productivity growth the longer you are running at full capacity.
In the case of the U.S., some of their best productivity gains have occurred over the last year or two -- very late in the cycle. Why? It seems as if some of that investment, particularly in computers and information technology generally, started to pay off as that economy was pressing the limits of capacity. People started to take advantage of those investments more fully than they had before.
That is all, perhaps, a slightly long-winded way of saying that I think there is more to come for us in the future. However, I would certainly accept the proposition that we as a country need to have productivity very much on our minds because that is how you get increases in incomes and standards of living in an economy over time. If you lose sight of it, you will not get those increases.
Senator Meighen: Indeed, it is on all our minds. You have given us food for thought to try to figure out why we have not improved in a productivity sense. I think you would admit that you do not have all the answers. No one seems to have all the answers -- even some of the answers -- to make a start on this.
Let me suggest one thesis to which I do not necessarily subscribe but which might account for it. Somebody argued that because, allegedly, in the United States, there are more large businesses relative to Canada, where there is a larger percentage of smaller businesses, and while we often pay great homage to small businesses being the engine of employment, and perhaps they are, perhaps they are not the engine of productivity. Perhaps inefficiencies are greater in smaller businesses than they are in large businesses. Do you have any light to shed on that?
Mr. Thiessen: I have heard that argument, too. The other thing you need to remember is that there are more small businesses in the service sector where measurement of productivity is notoriously difficult.
Senator Meighen: Everyone can be a Monday morning quarterback, which I am not really trying to do. The bottom line of my question is this: Are you satisfied with the clarity of the bank's communications? I do not mean you should fire all your PR people or those who write your press releases. It seems that, for whatever reason, on many occasions recently the markets would appear to have misunderstood what the bank was saying.
You are well aware of the criticism that you waited too long back in August. Perhaps you would like to touch on that.
Finally, will the large-value transfer system that I believe is coming in have any impact on assisting the bank in putting itself in a position whereby its messages are clear and foretellable, in the sense that you could set the rate every day? As I understand it, you would be able to do that with one of the large-value transfer systems. I may be mistaken. That is to say, you would set the rate daily. Obviously, by your look, I am mistaken.
Perhaps you would care to touch on the question of communication. Would you think back to October and the reduction in the overnight intervention rate and tell me why you made the announcement in the afternoon rather than in the morning.
Mr. Thiessen: The LVTS will make our payment system more efficient, more effective and more risk proof. However, it will not change fundamentally the way we carry out monetary policy. It will make it somewhat easier for us.
We now set an operating band for the overnight rate. We typically aim to be in the centre of that band. Every time we get to the top or the bottom of that band, we intervene. Everyone knows that. There is no problem of communication there with what we are doing day by day.
I do not think there will be any major change from that point of view when we get into the LVTS system.
With regard to communication, most of that issue has to do with a more forward-looking sense of where the bank might be going. We have taken a number of initiatives over the course of the last five years to be rather more transparent and forthcoming about how we see the economy, how we propose to run monetary policy and what some of those implications are.
There are always difficulties when you move in that direction. It is easy to be misinterpreted from time to time. I believe that has happened to us from time to time.
It is also true that this has been an incredibly uncertain period. The inability of the Japanese to deal with their problems came as a surprise that made the international crisis much worse than we anticipated. Things that we expected to happen did not. Of course, there will always be surprises; it is the nature of economies and international systems, but this last year has been particularly uncertain, volatile and difficult to predict.
Perhaps we could have emphasized to a greater degree the uncertainty that is out there, because, although we can tell you these things now, they could well be pushed offside by international events and by uncertainties of one kind or another. That is the nature of making monetary policy.
Senator Meighen: I thought of asking you how far you think the Japanese have gotten in settling their crisis, but I will leave it at that. I have no further questions.
The Chairman: I am happy to use that as a supplementary from the chairman.
Mr. Thiessen: Just to reiterate, Mr. Chairman, while we can give you information and suggestions now, their relevance could well be altered by international events or by uncertainties of one kind or another. However, there is some ground for optimism.
I must tell you that I have been wrong in several instances with the Japanese situation. I had thought that the initiatives the authorities were undertaking would have put them on the recovery road before now, but two things have happened recently. The Japanese have passed legislation to restructure their banking system. As well, they have dedicated a sufficiently large amount of public money into that restructuring. The amount is approximately $500 billion U.S.
The Japanese banking system is in a lot of difficulty. When banking systems get into difficulty they do not make new loans. They are so preoccupied with the old loans that have gone bad that a kind of credit crunch results. The Japanese are in that situation right now. In Japan, a series of fiscal measures to stimulate the economy were undertaken at the same time as the banking system was contracting. The two things offset one another, and there is no net movement forward.
The basic parameters of the proposed restructuring look good and the fiscal stimulus expected from tax cuts also looks positive, but I cannot say more than that.
The Chairman: How soon would there be an indication that these measures will improve the situation? Is it a matter of weeks, months or years?
Mr. Thiessen: I do not know. If some of the major banks were being restructured, sort of setting up a model of how you do this, then I think you would see a number of others in the Japanese system following suit. What we need here is a model. It is proposed that the Industrial Bank of Japan go through this restructuring. The Industrial Bank of Japan is a solid bank. If they were to clean out their balance sheet and start again, that could be a very useful model for the rest of the Japanese banking system. However, I have not heard anything more about that recently.
Senator Kroft: Could you give us some sort of report card on the availability of credit. We have seen Brazil come through a crisis, and Japan is dealing with theirs. But could you make some comments focusing mostly on North America.
Mr. Thiessen: In August, following the moratorium on debt servicing by the Russians, the interest rate spreads increased between those securities of the highest quality, say U.S. treasuries, and the emerging market bonds, the slightly more risky corporate sector issuers. There was a big opening up of spreads. Those markets became liquid. Even if one were willing to pay the higher interest rates, one could not get money anyway. There was a sense that markets were seizing up. Therefore, the federal reserve acted to reduce interest rates; it has done so three times over the course of the last three months. Since those actions were taken, the spreads have reversed somewhat.
The spreads have probably returned about one-third of the way to where they were before, but we would not expect them to go all the way to where they were before, because one of the problems is that prior to August, through the course of the winter and summer, those spreads got very narrow. There was a lot of money out there seeking investments, and those spreads became too narrow to justify the differences in risk between borrowers. Now people are running away from having taken too much risk without getting paid adequately for it to wanting to minimize the risks.
We will not get back to those narrow spreads. Nor will we get back to the degree of availability of credit that was there during the best times over the course of last year. However, there is some reversal and we are now also starting to see an increased number of slightly higher risk borrowers coming to markets, and doing so successfully; they may have wider spreads above U.S. treasuries, but they are coming nonetheless. A number of borrowers have fallen back into their commercial bank lines of credit. The amount of bank credit has increased. Again, it is the kind of thing that you would expect.
Most of the concern was more anticipatory than real, and the actual flows of credit have not cut back all that much. In many cases it was a fear of the future that was causing this highly negative psychology. We see that reversing gradually now.
Canada never got that same sense of extreme concern. That is partly due to the fact that a smaller proportion of financing gets done through the capital market here; more gets done through the banking system as a proportion and the banking system never seized up the way those capital markets seized up.
In Canada, as well, you see a reversal of those spreads and an increasing number of borrowers having new issues, and the spreads at which those new issues are taking place look a little better than they were before.
I cannot say that we are out of the woods completely on this, but it certainly feels much more comfortable than it did two months ago.
Senator Kroft: It is interesting that the high yield end of the financing market would have its birth in perhaps more pejorative terminology with other connotations, but it seems to have gained a legitimacy in the capital marketplace. It is interesting to me that it has become more of a legitimate indicator of economic activity rather than a fringe activity.
It is instructive for us, because this committee, in another context, has been preoccupied with attitudes on risk-related borrowing, obviously in an smaller, more focused area, on the basis of customers rather than capital markets. There seems to have been, as I understand it, a growing acceptance of more risk-related-higher-yield financing as part of the legitimate capital structure.
I would like to turn to another subject that bothers me a great deal. We talked about our commodity-related economy and the pricing of that and the implications. Another aspect of this world economy is reduced industrial activity in our traditional markets for those commodity prices at any price. The next shoe drops on low coal prices when low coal goes in to produce cheaper steel for the people that are using those markets and we end up with that steel back here. That is the second hit on the same cause.
Anyone with a view to economic history looks at the rising calls of steel producers for more protection in the markets, and there will be echoes of that very quickly throughout the economy. That puts some fear in my heart, as I see that development. Do you have a comment on those cries for protection within those industries?
Mr. Thiessen: You will always see them when the outlook starts to be a little softer. As long as the economic outlook looks strong, those things tend to disappear.
It is interesting how little we have heard of a protectionist nature coming out of the United States on this occasion. If you compare it to the situation in the late 1980s, for example, it is remarkably different this time. Part of it is the fact that the U.S. economy has been going so very well. When you are at a 4.5 per cent unemployment rate, operating at full capacity and have been doing so for four or five years, the pressures for protectionism are not as great. I am sure we will still hear some. I would not be surprised if President Clinton's visit to Japan does not yield some of that, because the Japanese trade surplus came out this morning and it is big.
However, I do not see the same kind of concerns that we saw in the 1980s. Part of it is that everyone is becoming more global in their outlook and less local. That helps. Partly it is that, while the outlook is softened, it is still not all that bad. Some of that great inflow of goods that people were talking about from Asia has not materialized. All of that has eased those concerns.
I should like to think they will not be as intense as they were before, but I cannot promise that. I cannot be sure, but so far so good.
Senator Oliver: All of my questions will deal with unemployment and the rate of unemployment in Canada. I have two specific questions that I will put to you. I wish to know what it will take for you to change some of your monetary policies to let us get down below 8 per cent, 7 per cent, 6 per cent, 5 per cent unemployment in Canada.
One of my questions deals with the NAIRU and the other one deals with what they call the natural rate of unemployment. I know this is something you have given some thought to, because last month, when you gave the Gibson Lecture at Queen's University, one of the things you said is the following:
A common criticism of inflation targets in Canada is that the United States has managed to achieve better output and employment performance since 1991, with an inflation rate that is currently only one percentage point higher than in Canada.
The Canadian Labour Congress, as you are aware, has criticized you and calls your NAIRU policy perverse and says that the bank and the Department of Finance see unemployment rates of the 8 and 9 per cent range as potentially inflationary.
What role does it play in the conduct of monetary policy and what would happen if the Bank of Canada took the advice of some of its critics and actually let loose monetary policy until inflation could increase a bit?
Mr. Thiessen: We do not run monetary policy on any estimation of the NAIRU. It is just too difficult. The estimates are very wide because it is a non-observable thing. You can have an estimate that is either too high or too low. If you have an estimate that is too high, then you will have a softer economy than you need to have. If you have an estimate that is too low, you will have a more inflationary economy than you need.
While we try to estimate what is the margin of excess capacity in the economy, and part of that will be affected by the labour market, we do not look at the labour market by itself and we most certainly do not have a target for the unemployment rate that we say is as low as you can get.
As I was suggesting in that lecture, perhaps in a comment that I made after the lecture, the American experience is a very interesting one. What they have done is essentially probed their way along. As long as that inflation rate was low and coming down -- they do not have formal targets but they do have some informal ones -- they were quite prepared to probe in order to see what the limits of capacity were. As long as you have a credible monetary policy, you can do that. The moment people think that you are following an inflationary course, you will make no progress, because everyone will run for cover.
What I hope for in the future is that, once we get through this commodity price difficulty that we are going through, we will be able to do the same thing, that we will be able to probe the limits of capacity; and if our inflation targets remain credible, then I believe we have the capacity to see how low the unemployment rate here can get in a way that we have not had for the last 20 years.
Senator Oliver: How would you do that?
Mr. Thiessen: You just keep probing the limits of capacity. You just make sure that demand in the economy is constantly pressing, and then you see whether that is leading to shortages, pressures on prices, pressures on labour markets, and when you have a credible inflation target you have the ability to do that. Whereas if you do not have one, the moment those pressures arise you start to see prices, wages and interest rates go up.
Senator Oliver: You have had an inflationary target for a long time, of between 1 and 3 per cent. Our unemployment rates have been 10, 11, 12, 9, and 8 per cent, and they have not gone down to anything close to that of the United States. What has been wrong?
Mr. Thiessen: We have not got to full capacity yet. A year ago we thought we were getting close, until we got hit by this shock coming out of Asia. That has set us back; so, until we get through that, it will be a while before we get back to full capacity, but I believe that once we get through this we will be on track again.
Senator Oliver: In Canada there are different regions, or provinces or areas where unemployment is different. A recent Nesbitt Burns report estimated that the natural rate in Canada averages about 7.5 per cent; there is a low of 5.5 per cent in Ontario and a high in Newfoundland of 16.5 per cent, and they average it out. The United States' employment rate is below what some believe to be the natural rate of unemployment. What is your view of full unemployment in Canada?
Mr. Thiessen: I do not know, senator; the world has changed so much. If you were to go back three years, most people in the United States would have said to you that the NAIRU in the U.S. is 6 per cent and if you go below 6 per cent you are in deep trouble, but they have gone below. That is the whole point of being able to probe. Having a credible anti-inflationary policy gives you the capacity to probe in a way that you simply do not have, if you do not have that credible policy.
Given the restructuring of the economy and given the changes in the world economy where markets are far more competitive than they were before, I do not think one knows. I do not think one ought to pretend to know either. One ought to take all those estimates with a very large grain of salt.
The Chairman: In responding to Senator Meighen earlier, you commented that the measures of productivity in Canada and the United States are different and therefore not comparable.
Mr. Thiessen: That is in the manufacturing sector.
The Chairman: Are the measures of unemployment in both countries comparable? Are we using the same statistical basis so that we are measuring the same thing?
Mr. Thiessen: They are slightly different. What constitutes looking for work is slightly different between the two countries. The estimate is approximately one percentage point.
The Chairman: That answers my question; they are relatively close.
Mr. Thiessen: By Canadian standards, they might be 5.5 per cent.
Senator Stewart: I am surprised at how different our meeting this year is from our meeting of last year. All of us have realized how important the things that are happening outside North America are for Canadians.
I have three questions. Two of them I like; however, I feel obliged to ask the third.
Mr. Thiessen: I am very nervous, senator.
Senator Stewart: In a sense, it will be a test of your rhetorical capacity to avoid giving a precise answer.
You said earlier that one of the causes in economic turmoil in the Asia-Pacific region related to the lack of regulation of financial institutions. You said that you were surprised by the failure of the Japanese to take action earlier to deal with their problem. You did not know about the extent of the difficulties there.
It is fair to say we have hovering over that part of the world the problem of a possible Chinese devaluation. Recognising that you have already established that there are major uncertainties, would you care to guess as to the probability that the Chinese government will be able to sustain a non-devaluation policy?
Mr. Thiessen: The Chinese have gained an enormous amount of prestige in that region by maintaining stability in their currency, while the Japanese have lost a significant amount of respect in the region by the weakness of their currency, at least until recently. Many of the Asian countries felt that they were put at a huge disadvantage because of the weakness and volatility of the Japanese yen, whereas they saw China as a bastion of stability.
To return to a theme I alluded to previously, China's is not a very transparent economy. It is not easy to make judgments about China. We do not know that much about them. What I can tell you is that the Chinese officials, including the central bank governor and deputy governor, whom I met recently, are adamant that they will maintain the value of the Chinese currency.
It is certainly true that as the Japanese currency recovers somewhat, and the upward pressure on the U.S. dollar is diminished, much of the heat is off. I suspect the Chinese are feeling rather more comfortable about maintaining the value of their currency.
Senator Stewart: If I had anticipated the very useful discussion we have had here this morning, I would have brought more ammunition. You spoke earlier about the recent action of the G-7, and yet, in an article in The Economist magazine, I read a piece scoffing at what the G-7 had done. Do you wish to persist in your original view?
Mr. Thiessen: Absolutely, senator. I have a significant amount of time for The Economist magazine, but on that occasion I believe they got it wrong.
I will admit to you that the G-7 communiqué was too long and, therefore, somewhat rambling. When seven countries try to agree on a text, you must add extra lines to satisfy the various individual concerns. Therefore, the text can be somewhat long.
However, if you persist through the communiqué, there is a significant amount of information there. There is a commitment there from the G-7 countries to proceed with this process.
The Economist has it wrong.
Senator Stewart: We know that the Canadian purchasing power parity is somewhere in the low 80s, compared with the U.S. dollar. Yet we have an exchange rate that is around 65 cents. We understand that these are two quite different measures.
I am interested in the exchange rate. In your initial remarks, at page 3, you referred to the capital flight of the U.S. dollar. I would suspect that much of that had little to do with fundamentals. The flight was to buy U.S. dollars and get out of these minor currencies.
You mentioned the help that the low dollar may have given to natural resource experts, albeit that there are problems there, pushing the price down. What about non-resource exports from Canada to the United States? How have they been affected? Is it correct to say that they, too, have been affected by the comparatively low value of the Canadian dollar, and, if so, roughly to what extent?
Mr. Thiessen: Senator, it is very interesting to see how rapid the growth of our non-auto manufactured exports has been over the course of the last year. It has been the most rapidly growing component of our exports, which is exactly what you would expect to see in a flexible and responsive economy. You have a low currency because of the difficulty in the commodities sector. I said, "non-auto," because the Auto Pact affects auto imports and exports and one can be misled by that. Those have been strong as well.
If you take the non-auto manufacturers, they have been doing well. I cannot remember the precise rate of increase; however, it has been the highest component. We should take a significant amount of comfort from that. I like to mention that to remind people that we are more than just a commodity exporting country.
Senator Stewart: That is good. Let us go to the other side of the coin. Let me simplify this. I live in Nova Scotia and I see a great deal of German money coming in to buy prime real estate, ocean frontage, and so on. When I hear about the prices being asked and received, I assume that the low value of the Canadian dollar is an important cause. Do you have any estimate of the effect of the low dollar on the purchase of Canadian assets -- not just good beach front, but Canadian companies and financial institutions?
Mr. Thiessen: No. That is a difficult statistic to obtain. We can get measures of capital inflow but isolating how, exactly, those capital inflows are used is difficult. In the end, you get a series of anecdotes of the sort that you just mentioned. There are lots of those anecdotes around, but not more than that.
Senator Stewart: I am concerned that while we have what we hope is a temporary low value of the Canadian dollar, in the meantime, all sorts of things may be bought up by people from other countries. I do not want to be mean or selfish about this, but they will be the ones who will enjoy the advantage of the improvement in the Canadian dollar, when it comes. That is my concern.
Mr. Thiessen: I agree with that, although it is not impossible for Canadians, if they wish to take the same point of view, to borrow in U.S. dollars and invest in Canada.
Senator Grafstein: That is a great response: Buy Canadian!
Senator Stewart: At page 2 of your paper you say, "With sustained U.S. demand...". That is a cautious qualification. You do not say, "In view of the prospect of U.S. sustained demand," but "With sustained U.S. demand...".
That reminded me of a piece that I read in another issue of The Economist, which I do happen to have with me. I think you will all find this quite interesting. At page 80 it reports the sharp fall of savings in the United States since 1993, "with households squirreling away 5 per cent of their income." It goes on to explain that "people have been making such great gains in the stock market that they felt wealthy and were prepared to spend more money." It states:
Corporate America has also been on a borrowing binge. JP Morgan calculates that the total private sector saving rate has fallen to its lowest level ever. In the second quarter of this year, investment and consumption by the private sector exceeded income by more than 4 per cent of GDP. In previous economic cycles during the past 40 years, the gap has never been greater than 1.4 per cent of the GDP.
Then it concludes with this terse paragraph:
This clearly cannot go on -- another reason for worrying that, sooner or later, the boom is likely to end in a bust.
In other words, they adduce this fall in the savings rate as an argument for an eventual bust. Of course, you are not taking that into consideration when you write "With sustained U.S. demand...".
Is this disgrace in savings in the United States something that we should worry about? How far should we take that into consideration when evaluating your optimistic paragraph, which begins with the words "With sustained U.S. demand"?
Mr. Thiessen: It is interesting that, if you look at most forecasts of the United States, none of them is predicting a bust. Morgan Stanley is the only one of the big financial-institution forecasters that is forecasting a recession. That is because no one else sees this in quite such apocalyptic terms as The Economist has recently.
There is no doubt that the savings rate in the U.S. is very low. Why is that? There are two reasons. First, there is the stock market boom. The stock market was reflecting a number of things: improved earnings, better productivity in the U.S. economy, lower interest rates than we had seen before, and a sense of somewhat less risk. All of those things lead to increased stock prices. That leads to increased wealth on the part of the holders of stocks, and that encourages them to spend more for a brief period of time and save less.
You can argue that that process went too far, but even if you believe it went too far and you think that the U.S. stock market may be a bit overvalued, the building-in to that stock market of these basic improvements in the U.S. will not go away. You then have a kind of once-and-for-all windfall to the wealth of Americans, which they have spent. They will not be able to spend at the same rapid pace in the future. That is certainly true, and so the U.S. economy will slow down. Indeed, it must slow down, because it cannot continue at the pace it has been growing. Its capacity to produce does not grow that fast. Most of us see a kind of slowing down and do not see why this must be in the form of a bust.
For a while in August and September, when it looked like financial markets might seize up, there was a risk. That is why, as I said earlier, the Fed reduced interest rates on three occasions. You get a sense now that most of that fear is ameliorating at least, and, therefore, while we cannot say that it has gone away, the risk of that credit crunch seems to have dissipated. So I certainly do not think you should move quickly to say, "Low savings rate; ergo, economic bust." It does not follow.
Senator Kenny: I have been sent here with instructions from my mother, again. She is at that stage in life where she finds winters cold. She lives on a fixed income and she is very concerned about the loonie. What advice do you have for that generation of Canadians? Should they take comfort in the lack of inflation they have been experiencing? How should they react to the value of the dollar?
Mr. Thiessen: I can certainly understand why a lot of people are distressed by the value of the dollar; I am not happy about it, either. I would much rather that we had a stronger economy than we do and a stronger currency. I would much rather that we had not been hit by a 15 per cent decline in commodity prices, which makes us a nation that is poorer than we otherwise would have been. I would rather none of that had happened and that we were not faced with these kinds of problems. But we are. I am afraid that we must accept them. By and large, we are getting through this not badly.
As I said earlier, there has been an exaggeration with respect to how important commodity prices and commodity exports are to Canada. To that extent, there has been more downward pressure on our currency than there should have been. I would hope that we would see some reversal of that. However, I cannot make a hard prediction about these things. In fact, I must not, because that can imply to people monetary policy moves that we might or might not make, and I must never do that.
There are enough reasons to believe that our currency will be stronger in the future than it is now. How encouraging that is for people who were worrying about this winter, I am not sure. However, it means that there is not much reason to expect that we will have such a profoundly undervalued currency, as we do now, for a long period of time.
Senator Kenny: In discussing the value of the dollar, you did not mention whether we are currently experiencing a political discount. Are we?
Mr. Thiessen: I cannot tell. There is no doubt that financial markets dislike political uncertainty, but I cannot tell how important a factor it is. There are discussions about the effect of the election in Quebec, but I cannot tell you what kind of an impact that has.
Senator Kenny: You have talked about having a fundamental policy focus of 1 per cent to 3 per cent inflation. One gets the feeling that the other shoe has to drop. If we are to have a robust economy, what sort of fiscal policy do we need to complement this? If a government had a surplus of $5 billion to $10 billion and options of a tax reduction, more spending, or paying down the deficit, what sort of fiscal policy would go well with the monetary policy that you have described to us?
Mr. Thiessen: Senator, you will not be surprised to hear that you are getting into territory that makes me feel very uncomfortable. I do talk to the Minister of Finance on a regular basis, and I do give him advice on a number of things. I believe that if I am to give him that advice, I must give it in private rather than in public.
A number of the choices you mention are of a political nature -- with a small "p" -- and are choices that governments and parliamentarians must make. As a central banker, I hesitate to give you advice on those things.
I believe strongly that we should continue to have a declining public-debt-to-gross-domestic-product ratio. Exactly how rapidly that declines is the choice of governments and Parliament, but I do believe that a continued decline would reduce our vulnerability to nasty surprises.
Senator Grafstein: My first question is about the historic spread between Canadian interest rates and American interest rates, having in mind the differing rates of inflation. In the past, you moved to reduce the spread between the rates, and we then had a differential for a very short period of time, which some say was quite beneficial.
That situation has been reversed again. Canadian short-term and long-term rates, which were lower than those in the U.S., are now higher. We all talk about preserving the dollar, but how much room do we have to lower interest rates, without impacting inflation, to get closer to U.S. rates? If we went against the general trend in that way, would it trigger greater productivity and growth?
It is the reverse of what has been asked here. Rather than preserving the dollar, how far can we go down to try to trigger higher employment and fuller capacity, getting the machinery running a little faster and a little hotter?
Mr. Thiessen: I will first remind you that the difference between the very short-term rate that we control and the very short-term rate that the Federal Reserve controls is one-quarter of 1 per cent. It is not very large.
Canadian medium-term and long-term rates have moved from below American rates to above, partly because of the flight to quality in the U.S. A lot of people around the world have decided that they would rather be in the reserve currency in the strongest economy and the deepest financial markets right now.
There is a sense that that is one of the reasons some of the longer-term U.S. rates are as low as they have been. We, on the other side, as a so-called commodity currency, perceived as such, have not been a recipient of those flows, and that immediately makes the difference there.
Another thing that has happened is that the American inflation rate has come down to a remarkably low level. Looking at the underlying trend, there is still about a 1 percentage point difference. However, many people do not look at that as carefully as they should. If you do not look at the underlying trends but rather just at the headline rate of the CPI, there is almost no difference right now.
The inflation differentials that we thought in the past were keeping our interest rates low and tending to give an upside trend to our dollar are no longer as well perceived in the market. The Americans have done very well on inflation, as have we, but they have been getting theirs down whereas our inflation rate is already down.
Monetary policy has its effect over a lag of a year or two. When we make monetary policy now, we must look toward the end of 1999 and into the year 2000 and ask what we should do now to ensure that things go reasonably well in that period of time. That is very difficult right now because there is such a huge amount of uncertainty out there.
We cannot counter completely the current effect of the commodity price shock on Canada, because whatever we do now has its effects too far in the future. Therefore, to some extent, we have to accept where we are right now.
In the report that we published, there is a chart on monetary conditions, which is the combined effect of short-term interest rates and the exchange rate on the economy. It is at record easy levels. It is more stimulative than it has ever been in the post-war period. We believe that that is likely to provide a substantial amount of support to this economy in the period ahead.
Senator Grafstein: Obviously, our inflation rate is lower than it is in the United States. That message has not got through to the international marketplaces. We have done something in the last decade or more to shift our value-added from commodities to manufacturing. It has moved from about 35 per cent to 47 per cent. Yet, those things that we were told a decade ago were good have not helped us in this international market turbulence. There may be other reasons for that.
Mr. Thiessen: They may not have helped us as much as we would have liked. I know these counter-factual judgments are difficult, but we have weathered this storm immensely better than we did the Mexican currency crisis of 1994-95.
Senator Grafstein: I will not quibble with that, Governor. The sense is that we are trying to do the right things and we are moving on all fronts; yet, if everything is so good, why are we feeling so bad?
I want to turn to the issue of foreign confidence in Canada in the short term. There has been a flight to U.S. dollars and, as a result, we are suffering. We can ask ourselves whether foreign investors have a failure of confidence in Canada and whether that failure of confidence is matched by Canadian investors in Canada. However, I will leave that topic until December 1, when we can perhaps come back to look at it again.
I would be interested in your comments on what the impact of the euro will be on the Canadian dollar. The euro will be instituted in a month and a half. Some of us who have been in Europe on Senate business have been told that the advent of the euro as another reserve currency has as its economic goal a devaluation against the American currency. We have been told that by some sources, including a former governor of one of the largest central banks in Europe.
In a way, that made us concerned because, if in fact there is that impact, what further impact would that have on the Canadian dollar and our situation vis-à-vis our exports? In other words, if there is a devaluation, in effect, in the European currency through the euro, what negative effect would that have on us?
I am not sure that that is right or wrong. However, we know that next month there will be a movement of dollars to the euro as a reserve currency. The question is: What will be the impact on the Canadian dollar and our fiscal well-being as it applies essentially to our export situation?
Mr. Thiessen: Initially, senator, you will not see very much. Not very many people will use the euro as a reserve currency right off the bat.
A reserve currency has to provide you with a number of things. One of them is very deep and liquid markets of the kind we have in New York; if we wish to intervene in the exchange market, we go into New York and we sell U.S. treasury bills that the government holds in its reserves, and we do not move that rate by a basis point, those markets are so big. If you wished to do that in Europe right now, you would be hard pressed.
Most reserve holders hold their reserves in the most secure form, namely, government debt. First, you have to get a whole stock of government debt from France, Germany, the Netherlands, et cetera, all denominated in euros. You have to get a full and deep market going there. Capital markets in Europe are much smaller and less important than they are in the U.S. I think they have a long way to go before those markets will be really deep. You do not just want a deep market for government securities; you want corporate securities as well.
If we go in and sell government obligations in Europe that some of those current holders are happy to move out into corporate holdings, and you do not have these sharp movements in interest rates, then I think they have a long way to go. I do not doubt that they will get there, but it will not be tomorrow.
On the issue of a euro devaluation, I must say that I have never heard that. That comes as a huge surprise to me. I would suggest to you that most Germans will be very distressed if there is a weak euro, because, having lived with a strong and solid Deutschmark, if they are replacing Deutschmarks with weak euros, there will be a lot of difficulty. I would be surprised if that were to happen.
Senator Grafstein: I will give the governor the response that we heard from some of our colleagues in Europe to precisely that question, because it was of great surprise to us. We were told that this was at least a methodology that allowed the Germans, essentially, to devalue their currency, without having the direct impact of having to devalue the Deutschmark. Maybe that is too sophisticated by far, but that is certainly part of the conventional thinking that we came across as a Senate committee to stimulate, in effect, their exports.
I leave that on the table as an interesting question. We will see who is right or wrong when we address this question again when next we meet with you, sir.
Mr. Thiessen: Over the short run, senator, you can have ups and downs. However, if there is some kind of significant depreciation of the euro, I will be very surprised.
In fact, Europe tends to run balance-of-payments surpluses these days. The Americans are running a very large deficit. If you want to go out five years, or a significant amount of time, I think you can readily predict that the U.S. dollar on balance will be weaker, because they have a balance-of-payments deficit that they will have to deal with. Of course, if they are weaker, against whom will they be weaker? Presumably, they will be weaker against the yen and the euro.
The Chairman: I have a question about long-term capital management and the process used to solve that problem in the United States. When the problem arose, the impression one got from reading the newspapers was that the U.S. Federal Reserve called in the key cast of players. I guess in true godfather style they were made an offer they could not refuse. In turn, that led to the problem being solved effectively by increased private sector investment.
Assuming a similar type of problem arose in Canada, could we respond as quickly? Would our process be the same or would your approach to that kind of problem be different from the approach used by the U.S. Federal Reserve at the time? In particular, if it is a different process, does it provoke any possible involvement of public funds?
Mr. Thiessen: All of these things you have to do on a case-by-case basis. You never want to have a sense that there is some process out there that will protect investors. We use the term "moral hazard" in economics; it is a terrible term; however, it really is important. If you encourage people to take risks on the ground that you will be there to help them out, that is the worst thing you can do, because you encourage them to take more risks rather than to be cautious.
The U.S. Federal Reserve did nothing more than to provide a meeting room and sandwiches and organize the meeting. They did not twist any arms. A lot of the participants in that bail-out realized that, if long-term capital management was to be unwound over a short period of time, those markets in which they held securities would deteriorate much further and would become even more "illiquid" than they already were. The financial institutions that came to their aid had investments in long-term capital management and also had investments in the same markets.
If they had had to mark all those investments to market, in the context of a rapid wind-down of long-term capital management, that would have been very painful. The judgment was that it did not have to be that way. If they could unwind long-term capital management in an orderly fashion, then all of them could avoid some losses that just did not have to take place.
The Federal Reserve is absolutely adamant that it does not wish to be seen as bailing that out in any way, shape or form, because of the moral hazard issue.
In Canada, if we were confronted with something for which a solution of this sort seemed to minimize what would otherwise be enormous costs, then of course we would look at it. I will never say in advance that that is exactly what we will do, because I should not and I will not. However, are we prevented? Absolutely not.
The Chairman: To that extent, it is an option that will be on the table.
Mr. Thiessen: I almost do not even like to tell you that, senator.
Senator Angus: Governor, it has been fascinating listening to your very thoughtful answers to these questions regarding currency.
I should like to take advantage of this opportunity to remind you that we have just spent five weeks holding hearings all across the country on the MacKay task force report and its 154 recommendations about changing the financial services sector. We are now in the process of preparing our report.
You stated in the other place the other night that there would be inherent risks to the safety and soundness of the sector if some of the MacKay recommendations were implemented by government. I am thinking of things like opening up the payments system and so on.
Do you have any specific warning or advice to us from a public policy point of view that we might take into consideration as we get into the final drafting stages of our report?
Mr. Thiessen: Senator, I would only repeat what I said before the House committee.
Many of the proposals in the MacKay report would help increase competition, and hopefully efficiency, in the financial services sector. However, you must realize that, in many of these cases, some risks are raised. You want to take that into account. One of the things I suggested is that it should encourage the government authorities to think about early exits for weak institutions before they get insolvent and actually result in losses to the deposit insurance corporation and to other liability holders.
If you want to take a few more risks to get a more efficient financial market, realize that and adjust the way you regulate institutions to take that into account. Accept the fact that, in those circumstances, you will have more failures. Just say, "We can deal with that. If we can minimize the cost, it is worth doing." That is a judgment that you face.
Senator Angus: Is this particularly relevant to opening the payments system? Are there any specific recommendations you might want to pinpoint for us?
Mr. Thiessen: No, it does not apply to just that, although it does certainly also apply to the payments system.
If you want more participants and more competition, then you must worry about how you deal with some added risk. There are ways of dealing with it, but you must realize that that is part of the process and look at it, not ignore it.
Senator Angus: I have heard you state in one or other of the speeches that have been referenced this morning that one must be careful not to create financial institutions that are too big to fail. We heard evidence that our banks, as an example, are already too big to fail. Have you any comment on that?
Mr. Thiessen: I do not think that is exactly what I said. I said one must never accept the proposition that an institution is too big to fail.
Senator Kolber: Alan Greenspan, in testimony before Congress a week or two ago, mentioned to one of the interlocutors that they were preparing to print a lot of currency in the last quarter of next year because potential "screw-ups" in the bank system will mean that more people want to have cash at home or access to cash. They think that the potential for problems in the year 2000 will be very severe.
Do you have any comment on that? Do we have the same sort of problem here?
The Chairman: That is the Y2K problem.
Ms Sheryl Kennedy, Deputy Governor, Bank of Canada: First, and most important on the preventive side, at the Bank of Canada and in the financial institutions across this country, much work and investment is being done to test the systems and change the systems so that there will not be a problem. That is the most important answer to your question, and that is the first line of defence.
Of course, we also work closely with the financial institutions to ensure that currency is always readily available to Canadians across the country. As part of our forecast of demand through the course of next year and into the year 2000, we are examining with them what we think the demand might be.
I wish to underline that the first and most important thing is to ensure that, to the best of our ability, we have a financial and payments system that will function well. That is our major effort. Also, the banks will be taking precautionary measures as well to ensure that we have the currency available that might be needed in different sorts of scenarios.
Senator Kroft: My question is on the same topic. I have read articles going beyond the immediate problem of individuals wondering if everything will still be in their bank accounts the next day.
Through our hearings over the last several weeks, one thing that has been most forcefully drawn to our attention is the elaboration and clarification of the incredible interconnectedness, on global terms, of electronic systems, whether trading or regulatory, or whatever aspects of what makes the financial system work.
I have read articles that suggest that the uncertainty has the capacity to have an impact on an economic level or in some way on an economic cycle. I am sure this is a subject about which central bankers chat over lunch. Have you any thoughts on that, or do we just not worry about it?
Mr. Thiessen: I think the likelihood of major economic impact is not very high. There is a risk of lots of little "screw-ups" of one kind or another for systems that are not absolutely crucial. Most of us look at the things that really matter, as Ms Kennedy just said, and make absolutely sure that those things will work. We have those well and truly tested. In many cases, however, there will be less important things that may not work.
You will probably find ongoing expenditures on information technology systems that go well into the year 2000. All these guys who are doing rather well currently will not suddenly lose their jobs on January 1. You will have an ongoing demand for that.
I just do not see any scenario where there is anything of a major consequence economically. There can be a bunch of little things, but I do not see how that translates into a worldwide recession or anything like that. That is not a scenario that looks at all credible to me.
The Chairman: Governor, on behalf of the committee, I thank you and your deputy governor for being with us this morning. It has been a stimulating meeting, as usual. We look forward to seeing you again shortly after the budget.
The committee adjourned.